A while back, I wrote a short how to article describing how to use swing trading indicators. The one indicator I focused on was the RSI or the Relative Strength Indicator.
After I posted the article I received several questions and comments asking for further examples so that traders could get a better feel for using this method to swing trade stocks. In this tutorial I will outline the steps I go through to apply the divergence method to stocks in more detail.
Some Swing Trading Indicators Need Minor Adjustments
The first step that you want to do is adjust the RSI indicator from 14 days to 10 days. The RSI indicator was originally developed for trending commodities and applied to stocks later. The indicator was not developed originally for swing trading but for long term trend trends. By adjusting the period from 14 days to 10 days, the RSI becomes much more responsive and dynamic, these two qualities are very important when selecting swing trading indicators.
After adjusting the indicator from 14 periods to 10 periods, the next thing is to find stocks or other markets that are making a minimum 50 day low coupled with RSI reading 20 or lower. You can see what I mean by looking at this graph of Amazon stock.
The Longer the Trend Before Bottoming Out The Better
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The next step, after you find both a stock making a minimum 50 day low; and RSI reading 20 or lower, is to continue to monitor it. You can give the stock up to a month to make the second low. The second price low must be below the first low but the RSI indicator must provide a higher signal than the first one. In this particular case, the first RSI signal was 20.00 even while the second RSI low bottomed out at 29.43.
The Second Price Low Must Be Lower and The Second RSI Low Must Be Higher
The next step is to find the entry point. You must wait for the stock to rally above the high price that was made on the exact day the second low was reached. If the market trades lower than the second low the pattern is invalidated. Unlike the moving average, the RSI is a leading indicator. These are swing trading indicators that project the future instead of relying on past price history.
How To Enter the Trade
The most frequent question I get asked is when and how to enter the actual trade. Fortunately, this is the easy part, you simply wait for the stock to trade above the high that was made on the second down day. I typically give the stock about 5 trading days and place a buy stop about 25 cents above the second bottom day. Remember if during this 5 day period the market trades below the low that was made on the second bottom day the trade is invalidated.
If The Stock Trades Below the Second Low the Trade Is Invalid
You can see by looking at this particular example that the stock rallied almost immediately after making the second low. Make sure you place your buy stop one quarter or few ticks above the high that was made the day the second low was made.
Always Use Stop Loss Orders When Trading Short Term Reversals
The next step assuming your filled is to place a stop loss order 2 ticks or one quarter below the second swing low day. You can leave the stop loss order as a GTC (good till cancel) order so that you don’t have to re-enter it daily. Always keep a list of your GTC orders or have your broker send you a daily list of all your GTC orders. They are easy to forget and can cause serious financial risk that could easily be avoided in the first place.
The Distance Between Your Stop Loss Level and Entry Level Is About $7.50
Assuming you successfully entered the trade, you must measure the distance between your entry price and your risk level. Once you do so you simply multiply this by four and add it to your entry price. This is your profit target and I recommend you follow the 1 to 4 risk level formula to assure a positive risk to reward level across your trades.
If you are trading large positions or using this method to trade futures or currencies you can take partial profit at three times your risk level and the partial profit at the 4 times risk level. Most good swing trading indicators provide at least 1 to 3 profit vs. risk level.
Things To Keep in Mind
When using the RSI as a swing trading indicator you must change the settings from 14 periods to 10 periods, otherwise the indicator will be too slow to respond to short term swings. Also remember that this method works just as well to the short side as to the long side. The RSI is overbought at 80 and that’s the level you want to use for your fist swing low.