In my special five-part trading course -- "Swing Trading Done Right: The Secrets to Putting the Odds in Your Favor" -- I shared numerous technical analysis insights and techniques with you. I demonstrated how to accurately label the peaks and valleys of a trend, how to draw a trendline, and how to spot the thrust, consolidation and countertrend movement typical of any "cell" of a given trend.
You learned about support and resistance, and about "the alternation principle," which states that old support, when broken, becomes new resistance. I also demonstrated a number of specific, highly profitable trading strategies based on the use of support and resistance. In my lesson on candlesticks, I shared several original ideas on candles and pointed out five key reversal candlesticks that not only nailed all major turning points for the S&P in a six-month historical time period, but that are also likely to do so again in the future.
In today's Bonus Report, which I've reserved for paid subscribers only, I want to share with you one of the most valuable technical analysis tools I have learned in more than 30 years of studying the subject. I call it, "The Trading Technique That Will Always Keep You on the Right Side of the Market."
The concept is "four-stage analysis." As I mentioned Lesson #5 of my trading course, the basic method is not original to me. An important researcher named Stan Weinstein discussed the four stages in a book entitled Secrets for Profiting in Bull and Bear Markets. The book is not new -- it was written in 1988 -- and is not all that widely known. However, that does not necessarily make it unimportant. When I discussed four-stage analysis at the local chapter of our technical analysis society, almost no one had heard of the idea, and even fewer folks were actually putting it into practice. Believe me -- this omission has undoubtedly cost those traders loads of money.
Over the years, I have read many, many books on technical analysis. I hold a large number of these in my personal collection and have borrowed countless more from the library. Yet out of all of these many valuable works, there are only FOUR books that I would unhesitatingly recommend to serious students of technical analysis. For me, these are the "classics." I define a classic as a book that I cannot fully absorb in one reading. It is a work I will return to again and again, each time gaining something new that I missed the time before.
Weinstein's book is a member of this very select short list. Unless you have an unusual local bookstore, you will probably need to order it. I think it will more than repay your investment.
You can order this book today for under $14 by visiting the following link:
"Stan Weinstein's Secrets For Profiting In Bull and Bear Markets"
I came across four-stage analysis in the mid-1990s. I covered it dutifully in my TD Waterhouse courses when I discussed moving average systems, but did not fully appreciate its value. It wasn't until the bear market started in 2000 that I realized how important this concept is.
Four-stage analysis is now my starting point whenever I analyze a chart. It is a concept largely geared toward investors. Yet as I've worked with four-stage analysis over time, I've developed many of my own insights and have worked hard to customize the idea to the swing trading timeframe I operate in.
In today's special Bonus Report, I will begin by clearly explaining Weinstein's basic concept of the four stages. Next, I will show you how I use four-stage analysis as a basis for swing trading. Finally, I will explain how I have customized this concept and will show you how you can use it to make more profitable swing trading decisions.
(1.) FOUR-STAGE ANALYSIS EXPLAINED
Four-stage analysis is always done with a weekly chart, and it is based on the relation of a stock or index's price to its own simple 30-week moving average. (Weinstein never explains why he chooses the 30- and not the 40-week, but I have performed my own studies on this topic and will tell you about these later.)
Basically, the concept says that every stock or index sequentially moves through four stages: Basing (I), Advancing (II), Topping (III) and Declining (IV). Furthermore, this cycle is repeated over and over again throughout time. The four stages provide a roadmap that indicates not only where a particular stock is at, but also where it's headed in the future.
Before we get into too many details on this important topic, a quick review of some of the key points of moving averages may be of value. A moving average may be thought of as a "curved trendline." During a bullish period, the moving average provides support, and during a bearish period resistance. In a bullish period, the moving average is consistently below the stock price. Just as importantly, during a bullish period the moving average consistently slopes upward. Meanwhile, bearish periods are the exact opposite. In these cases, the moving average is consistently above the price and slopes downward.
(2.) CISCO AND FOUR-STAGE ANALYSIS
I've presented you with a historical chart of Cisco Systems (CSCO) below to help explain the four stages -- particularly stages IV and I. It contains weekly data for a three-year period from about March 2000 to March 2003.
The chart begins with CSCO at the very end of stage II -- "Advancing." You can see this at the very left-hand edge, as the stock is still rising and is above an upward sloping 30-week moving average. CSCO's hyperbull market began in late 1998 when the shares tested support at $10. By the time the stock finally topped out at an April 2000 peak of $80, those who had held for the two-year stratospheric ride were showing healthy gains of 800%.
The selloff that occurs after a major price peak is often met with disbelief. CSCO's was no exception. The stock, which at the time was perceived as one of the great "blue chips" of the Internet era, had been at $80 in April, yet by June was selling for "fire-sale" prices in the $50 range. Naturally, investors at that time reasoned that the shares were a downright bargain, and they jumped headfirst into the pool. As it turns out, they were right in doing so. After all, in the spring of 2000, CSCO's moving average was still rising.
From a low of $50, CSCO quickly rallied to $70. Here it met resistance, and then created a failed ascending triangle. It then formed stage III -- a period in which the price played "tag" with a moving average that had now flattened out dramatically.
With CSCO, as with many tech stocks of the time, stage III was extremely short, lasting only about three months (from July to October of 2000). The stock took the form of a rectangular consolidation between $60 and $70. Investors who were not aware of four-stage analysis likely saw this as normal sideways action and did not pick up any real danger signals. (FYI -- We will return to stage III in more detail later in this report when we discuss Lennar.)
In late 2000, however, note that there is a change in the stock's visual pattern. The moving average had been sloping upward until now, but for the first time in a very long while it was finally beginning to slope downward. Notice how all of the consolidation takes place below the 30-week moving average, which is now DOWNWARD SLOPING.
Once CSCO broke below the consolidation at around $40 the stock experienced a "waterfall" decline. An alert swing trader who recognized that a stage IV decline had started could have made a nearly 300% profit in just eight weeks by being short at this time, as the stock plummeted from $40 to $15. Recognizing the stage IV decline also saved the swing trader from taking heavy losses, as many other traders were still establishing long positions in this "bargain" stock at that time.
Stage I Begins
After an enormous stage IV decline, any feelings of affection for the stock felt during the stage II advance have probably changed into anger and hatred. Rallies are sold into and provide persistent selling pressure that checks meaningful advances.
In stage I, however, supply and demand come into a rough balance. The stock stops going dramatically lower and instead begins to move sideways. The steeply declining 30-week moving average now begins to move horizontally, reflecting consolidation in the stock. The stock is beginning to form what is known in technical analysis as a "base."
From an investor's point of view, Weinstein notes, stage I is generally to be avoided. I assert, however, that a swing trader can profit from this period by going long at support and going short at resistance. As the chart presented above ends, CSCO remained in a stage I consolidation or base-building process.
Stage II
To more closely examine stage II, we will look at a historical chart for Garmin (GRMN) -- a manufacturer of GPS satellite receivers. The shares opened on the NYSE at $16 in late 2000 and essentially went sideways for the next two years. Note the very strong resistance established at just under $25, which contained the stock on four separate occasions during this period.
During this two-year time period the 30-week moving average basically moved within a sideways trading range. However, with the breakout in late November 2002, the moving average began to slope upward. A brief correction in January 2003 took the stock from $32 back to $28, but held above an upward-sloping moving average -- a signature of a stage II stock. As the historical chart above ended, GRMN was in a strong stage II period.
If you remember back to the uncertain market environment of early 2003, you'll note that GRMN was a strong stage II stock in a bearish stage IV market. I compare this coupling to a dog walked on a long, retractable leash. The leash, which in this analogy is the bear market, allows the dog to go for short runs, but the dog soon runs out of leash and is pulled abruptly back. When the market has a countertrend rally, however, these stocks often advance smartly and are well worth swing trading from the long side.
Stage III
After a long stage II advance, most investors love the stock. However, valuation may become a concern, and advances in the share price are often limited. A warning of an imminent stage III may occur when prices for the first time in a long while decline below a rising or flat 30-week moving average.
Below you'll find a historical chart of major homebuilder Lennar (LEN). Investors who held the stock at the time the chart ended needed to be very aware of the support level at $50. If this support level were to break, then the stock would likely experience a swift, painful drop. On the positive side, of course a break below $50, reinforced by a declining 30-week moving average that remained above the share price, would provide alert swing traders with an excellent shorting opportunity. For LEN, the stock would probably reach minor support at $45 very quickly.
When I write my weekly newsletter, I always start each issue off by discussing "The Primary Trend." I typically include several moving averages in this analysis, but the one I pay the most attention to is the 30-week. For example, as the historical chart below shows, the S&P was in a clear stage IV decline at the time this chart was drawn.
Savvy swing traders should always analyze the stock they are trading in conjunction with the overall market. In a stage II market, there is a strong tailwind at the back of most stocks. Breakouts carry further, and swing trading from the long side is typically successful as long as one makes sure not to catch the market (or any particular stock, for that matter) at a very overbought point. As the saying goes, everyone is a genius in a bull market.
In a stage IV market, on the other hand, the primary trend is a downward one. Breakouts of stage II stocks usually get their wings clipped by the overall market. Except for very brief periods, it is very difficult to trade the market from the long side during a stage IV decline. Instead, the swing trader's job is to find shorting opportunities. For example, stocks just breaking down from stage III consolidation patterns often prove to be excellent short candidates. Similarly, those that are in advanced stage IV declines, but which have broken an important support level, are also usually worth shorting. I've summarized these and many other trading tactics below.
Based on the above discussion, it is clear swing traders should choose trading strategies in harmony with the market's prevailing stage. With this in mind, here are some general principles to follow:
1.) In a stage IV market most of your trades should be from the short side. You should identify and track stocks that are liable to break down from stage III or are already in an advanced stage IV selloffs. Short these stocks as they break down from support levels. You can see a good example of this strategy by examining the historical chart of Harrah's (HET) below. Aggressive traders who want a quicker entry point may also short these stocks when they rally, when they hit important levels of resistance and then begin to decline, or when they fail to break through resistance.
During periods of countertrend rallies, previously identified stage II stocks should be traded from the long side. The chart of GRMN we discussed above would be an example of this strategy.
2.) In a stage II market, most of one's trades should be from the long side. Stocks that are in stage II advances should be bought when they are oversold or when they break out of a resistance area. The chart of Glamis Gold (GLG) below provides a good example of a stage II stock in a stage II group -- precious metals. At the time the chart was drawn, the shares were in a multi-year uptrend. Note how the stock made an excellent swing trade whenever it broke through a resistance level.
3.) Stage I and Stage III markets are trickier to trade than stage II or stage IV. During a stage I market, you should identify those stocks that are showing high relative strength and that have already entered a stage II advance. Meanwhile, during stage III markets, seek to find stocks that have already broken down from their own stage III consolidations.
(5.) A SWING TRADING SYSTEM BASED ON THE FOUR STAGES
One question I am often asked when I teach four-stage analysis is, "Why was the 30-week moving average chosen?" Indeed, the moving average that analysts typically use to define the long-term trend is 40 weeks or 200 days.
Weinstein does not deal with that question, so I decided to find out for myself. What I discovered was that the 30-period moving average best defines a stock's trend. Moreover, the 30-period moving average works best over ALL trading time frames whether you are using weekly, daily, hourly or even five-minute periods!
Again, look at the chart of Lennar (LEN) above. Note how a trendline drawn off the low near $30 in September 2001 breaks at just about the same time that the 30-period moving average flattens out and begins to go sideways. Also observe how even in a "trendless" period of consolidation, the 30-period moving average describes the "trend" by going sideways.
This shows the power of the 30-period moving average. If you wish to experiment, try inserting other moving averages -- such as the 10, 20 40 or 50-week -- into the chart. You will find they are not nearly as good at defining the trend and picking up on trendline breaks.
After that insight, I began to experiment with daily and intraday charts. To my delight, I found that the 30-period moving average consistently best defined the trend. That key discovery, when used along with the existing framework I had developed over a lifetime of technical analysis study, led me to create my own proprietary swing trading system.
I share this system with you as part of the commitment I made in my very first trading lesson -- to teach you everything that I know about technical analysis. Up until this time I have told only a few close friends about this discovery. And though I sent my five-part trading course free of charge to all trial subscribers, I've reserved this bonus report EXCLUSIVELY for long-term StreetAuthority Swing Trader subscribers. Before I share my system, however, I'd like to request that you not share this report with your friends or "trading buddies." It is meant for paid long-term subscribers only, and I hope it remains our secret.
The trading system involves four indicators: price relative to the S&P 500, MACD, the Bollinger band and full stochastics. Volume bars are included, as well as a number of moving averages. You could add additional indicators to this core group if you'd like, but they really are not necessary. The moving averages are the daily 150, 30, 20, 6 and 4.
Let me explain why I chose these specific "pieces" of the system. The 150-day moving average (equivalent to the 30-week) allows me to pinpoint the long-term trend for any given stock. If it is sloping downward and price is below the moving average, then the stock is in a stage IV decline and I believe the stock should be traded from the short side only. Countertrend rallies should be ignored. (If we are in a stage IV market, during the countertrend rallies you should instead buy long on stage I or stage II stocks).
The 30-day moving average defines a short- to intermediate-term trend. It is 20%, or 1/5, of the 150-day moving average. If we were to go short, we would want to find stocks whose 30-week moving average is above the 30-day moving average, with both moving averages sloping down and both still above the share price.
I've included the 20-period moving average in this system because it is the centerpoint of the Bollinger band, which I use as an overbought/oversold indicator. The 20- and 30-period moving averages also give me a crossover signal. (A crossover signal is generated when a shorter moving average cross over a long-term one, and visa versa.)
The final moving averages are the 6- and the 4-day, which for me define short-term swing trading trends. In conjunction, these two moving averages create vital crossover signals. The 6-day moving average is 20%, or 1/5, of the 30-day moving average. Meanwhile, the four-day moving average is a subtle way of tracking the hourly trend. Since there are 6.5 hours in a trading day (9:30 A.M. to 4:00 P.M., Eastern Standard Time), a 4-day moving average is approximately the same as a 30-hour moving average. Again, the two moving averages give crossover signals.
Stochastics is an oversold indicator. It will confirm and reinforce an oversold signal on the Bollinger band. MACD will give a later signal, confirming the stochastics buy or sell.
In one of my very first issues of the Swing Trader, I recommended a short trade on Teradyne (TER). The trade subsequently racked up a 13% gain in roughly one week. Below I've presented a three-month chart of TER from that time period. FYI -- I chose a 3-month period to ensure a very clear chart.
Note how the daily chart reproduces in miniature the four stages, which would be observable on the weekly. I find that observation fascinating. If you look closely, you will see that in a three-month period, TER completes several "miniature" four-stage cycles. I've labeled each of these in the chart above. Since TER is in a stage IV decline according to the 30-week moving average, every time the stock forms a "miniature stage" III top and breaks down from it, this creates an opportunity to sell short.
I'd like you to focus your attention on the miniature stage III top that occurred in early January. Note the following setup. First there was a gravestone doji candle. It occurred outside the Bollinger band and with stochastics overbought. TER then went sideways for four days. At the end of that period, note the large dark cloud cover candle followed by a hangman. (Again, I've labeled each of these on the chart.)
Immediately after the hangman, the 6-day moving average (magenta) negatively crossed through the 4-day (green). They penetrated the downward sloping 150, 30 and 20 on the next trading day as the shares sold off on high volume. Stochastics and MACD signals gave sell signals almost simultaneously. Support was also broken at $13.
After the 4- and 6-day moving averages crossed, they stayed in bearish alignment until mid-February when TER created a miniature stage I base. Just previous to the mid-February positive 4- and 6-day crossover, there were two dojis in three days, suggesting supply and demand had come into balance. Positive stochastics and MACD signals were also evident. Clearly, it was time to cover the short.
TER would NOT, however, in my system be traded long at this time, as it was below the downward sloping 30-week moving average and was therefore a stage IV stock at the time this chart was drawn. Instead, the alert swing trader would then be waiting for another miniature stage III top and breakdown, confirmed by the indicator signals, signaling that it was again time to short TER.
In today's Bonus Report for paid subscribers only -- "The Trading Technique That Will Always Keep You on the Right Side of the Market" -- I have shared with you some precious technical analysis secrets that I have discovered through years and years of patient study. Rest assured that I will continue to use these very same concepts each week to select stocks for my Swing Trader newsletter that have the capacity to make you money from both the short and long side. In addition, I will continue to share with you other key technical analysis ideas in my regular "Inside the Black Box" articles.
Thank you for once again for subscribing to my weekly newsletter -- the Swing Trader -- and best of success in the markets!
Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader
StreetAuthority LLC
P.O. Box 83217
Gaithersburg, MD 20883-3217
USA
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