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A PullBack Technique for Swing TradingOne familiar recommendation for swing trade entries is to buy the pullback's. But, what is the best method for determining at what point a pullback makes a good entry? The Ideal Pullback CriteriaDesirable characteristics of a pull back entry technique include:
Popular PullBack MethodsSeveral methods have been used to identifying suitable pullbacks, but most have one or more disadvantages:
Table 1. Pullback methods and potential disadvantages of each Only the last item, deviation from linear regression center line expressed in standard error units, appears not to have any significant weaknesses. Let's take a closer look at this method and see why it is favored. Chart Setup for Swing Trade AnalysisThe chart below shows a linear regression line drawn thru the most recent 2 month period of a daily chart of GLBL (Global Industries). This company was identified in a scan for companies that had a high Sharpe ratio over the most recent 2 month period. Sharpe ratio is the annualized average growth rate divided by the standard deviation of the grow rate. The ideal Sharpe ratio stock (one that will have a high Sharpe ratio value), will be growing at a relatively high rate, and have a very little variation in this growth rate. High Sharpe ratio stocks will, using the chart below as an example, have a linear regression channel with a relatively steep slope (high percentage rate of change) and a relatively narrow width if the width is measured in standard error units. Standard error, by definition, is the average amount the price deviates from a linear regression center line drawn thru the price trend for the time frame under question. A low average deviation from the linear regression line means the channel will be relatively narrow. This Sharp Ratio screening of potential swing trade stocks favors the 4th criteria of a desirable swing trading techniques, by limiting the technique to symbols with high riskadjusted gain. Fig 1. Linear Regression Channel Standard Error Deviation Method of Swing Trading The above chart stock represents a typical stock selected for swing trading. In the sub graph, the running 40 bar Sharpe Ratio indicator reflects the risk adjusted (volatility adjusted) rate of gain of the stock. The FxDeviation indicator reveals where the current price is in terms of standard error units from the linear regression line. At the right most bar, the current closing price is 2.01 standard error units above the center line. Looking at the Linear Regression Channel in the main chart, the closing price of the last bar is 2 lines above the center line. Displaying the FxDeviation indicator in the sub graph provides a convenient way to crosscheck the Linear Regression Channel (LRChan) settings to ensure they have been specified correctly. The Avg$Traded indicator, expresses the liquidity of the stock in terms of dollars traded each day (price X total daily volume, expressed in millions of dollars). Expressing liquidity in dollars traded rather than shares makes it easier to determine if the desired trade size can be accommodated, since the trade size is usually expressed in dollars. Important Characteristics of Standard Error Linear Regression ChannelsWhen a stocks is in a wellbehaved trend, the price action typically moves between minus 23 and plus 23 standard error units from the linear regression center line. This is true regardless of the price and regardless of the volatility, since the standard error calculation automatically adjusts for volatility and price and sets the width of the linear regression channel accordingly. Thus, this pullback measure has a selfnormalizing property that makes it especially attractive to traders, allowing a single technique to work well for a diverse group of symbols with respect to price and volatility. Swing trading entry and exits goals are approximately 2 standard error units and +2 standard error units, regardless of the entity traded. Not only does this method provide you with a rational entry point, it also provides for a rational profit target. For this method to work reliably, the time period over which the stock trend is analyzed must be long enough to show at least 2 or more decent amplitude "wiggles" so that the standard error measurement has some validity. If the time frame is too short, you will not have a "history" of what is "typical" for this stocks volatility as it continues its trend. The symbol should also be in a well behaved trend, which is encouraged by using a symbol selection filter requiring a high Sharpe Ratio. There is a second important observation regarding price action within the linear regression channel. When the price deviates by more than 3 standard error units from the center line, the trend is usually breaking down. The parallel line between 2.5 and 3 standard errors below the center line can be considered a proxy for a classical trend line drawn just below the lows of a trending stock. The corresponding rule for trading is then: Do not take trades in the direction of the trend when the price has pulled back to almost 3 or more standard error units from the center line. This becomes similar to the corresponding trend line rule: "do not take a long trade in a symbol that has just broken its trend line support." The standard error deviation that is a proxy for a classical support trend line is easier to calculate than the algorithm required for calculating the exact position of a classical support or resistance trend line, and therefore lends itself evaluating a large number of symbols in an automated fashion, as will be seen later in this article. Recommended Swing Trading RulesIn stocks prescreened for adequate liquidity and riskadjusted growth rate (Sharpe ratio), recommended swing trading rules for long trades may be summarized as follows: Entry Rules
Exit Rules
Examples of Successful Swing TradesDVR: Entry at 2.00 standard error (SE) units. DVR: Price hesitated and then rose for profitable exit at +2 SE units, in 22 days. GLBL: Entry at 2 SE units , exit at 2.5 SE units in 12 days. IDCC: entry at 2.00 SE units, exit at +1.75 SE units in only 4 days. ETRM: Entry at 1 SE units, exit at +1.9 SE units. Avg$Traded indicates adequate liquidity. VG: Entry at 1.75 SE units. Added to position 3 days later. VG continues upwards but price never reaches +2 SE profit target, then falls and trailing stop is hit. Examples of Failed TradesCPST: Entry at 3.5 SE units, stopped out. Deviations >=3 SE units often signify a change in trend. ACHN: Entry at 4.2 SE units because price appeared to be holding, but violating rule #3. The 2.5 standard deviation trend line can be considered a proxy for a classical trend line drawn between the lows of the price action. Therefore, a price deviation greater than 3 SE units is essentially the same as breaking the classical trend line of support. Entering long after a classical support trend line is broken would be considered unwise, as this trade illustrates below: ACHN continues to decline and stopped out. Rule #3: Do not enter long below 3 deviation band. EMKR: Entry far below 3, a risky trade as price has already broken the upward trend. EMKR moves sideways and continues to hold. Added to position. Pullbacks greater than 3 standard error units are often tempting, especially when they appear to be holding at a new support level, as shown above. This resulted in adding to position which proved unwise, as shown below: EMKR inches up, but then falls back stopping out. Deviations < 3.0 SE usually signify the prior trend is over. HW: Entry at 3 SE units, therefore a risky trade. HW Stopped out at 4 standard error units deviation. Price continued to decline. Swing Trading Method Summary1. Screen for Adequate LiquidityMy minimum liquidity criteria is the intended position may not exceed 2% of daily dollars traded per day. This is a fairly aggressive position relative to liquidity. More conservative traders may prefer limiting position size to less than 0.5% to 1% of daily dollars traded. In general, position size greater than 0.1% of the daily dollars traded per day may require scaling in and out to enter and exit over a several minute period to avoid moving the price significantly. With low liquidity stocks, it may also useful to hide the size of your limit orders using the "Show Only" size option of the Order Bar, or make trades near the beginning or end of the trading day, when volumes are typically 35X higher than those of midday. Stocks may be prescreened for adequate liquidity using the scanner and a custom indicator, Liquidity. Liquidity is measured in millions of dollars traded per day rather than shares because it is easier to relate this unit of measure to the position size (in dollars) the trader is prepared to take in each stock in the portfolio. The scanner setup is shown below: Fig. 2. The entire universe of stocks and ETF's are selected (approximately 8000 symbols) Fig. 3. Custom indicator Liquidity implements the liquidity criteria Input parameters for custom indicator Liquidity are set to ensure the 10 day (Length1) average dollars traded and the 50 day (Length2) average dollars traded are both above 0.5 million dollars. Daily average dollars traded is simply the daily closing price multiplied by the daily volume of shares. A second criteria (Min$) is used to ensure the price of the stock is above $0.50. My preference is to look for low priced stocks in the $1 to $15 range. I will rarely consider a stock below $1, even if the liquidity is adequate. Low priced stocks tend to move up at a greater rate of growth and also show more resistance to downward movements when the market indexes are pulling back. Out of the entire universe of stocks and ETF's (8000) approximately half (4000) pass the liquidity screen. The results of the liquidity scan are saved as a custom symbol list named "Liquidity" using the following scan settings: Fig. 4. Scan result settings to create named list of resulting symbols, "Liquidity". 2. Determine Best Risk Adjusted Return Candidates.A 2 month (40 daily bars) or 4 month (80 daily bars) Sharpe Ratio value is calculated for all stocks determined to have adequate liquidity by the preliminary liquidity scan above. The best 500 Sharpe ratio stocks become the candidate group for long trades, using the scan setups shown below.
Results of the previous Liquidity scan are used as the symbol universe Scan formatting: Scan criteria tab settings RealTime Monitoring of Price PullBacks
