Pimp My Trade

Swing Trading Strategy: Touch and Go!

Posted on February 8, 2009 by Adam

I promised to share some trading strategies that I use to make money, for those of you who are learning to trade, or just want to add a few new tricks to your arsenal.

The strategy I want to cover tonight is one that I love to use, simply because it is low risk and high probability - exactly what I look for in a setup. I call it the touch and go, because I look for prices to “touch” a certain support/resistance level, and then load up a position in anticipation of a big move.

To demonstrate, I will walk you through a real scenario that I traded, and tell you what I was thinking along the way.

When I look for stocks, I often look for charts that are showing me signs of weakness. For example, a trend may be weakening when it fails to make a higher high. Perhaps it will make an equal high, perhaps a lower one. Here is a six month chart of Illumina, ILMN, from last summer.

Notice how the stock forms an equal high here, indicating weakness in the trend.

The stock has been steadily trending higher all summer - it would have been a good investment at the time. I believe I was actually looking to get long when I came across this chart, but I was alerted when ILMN had failed to make a new high in the trend. Failure to exceed the previous high is a red flag when it comes to the health of a trend. It could mean that there is a big seller, or maybe buyers have just run out of steam. Whatever causes it, I’m on alert. I want to see if investors will buy into the pullback as prices approach the bullish trendline.

Investors did not buy into weakness, allowing the prices to break beneath the trendline.

In the next two days, where trendline support should have held, Illumina staged a sharp breakdown. Not only did it break down beneath trendline support, but it appeard to confirm a nice little double top pattern (illustrated in the next graphic), signalling the reversal of the trend. It would have been nice to be short leading up to the move, but the conditions had not been right for an entry. I would have felt like an idiot had prices been bought up near the trendline. On most occasions I would have been stopped out for a loss.

Would it be wise to go short here, after the breakdown? Maybe, but there is a lot of risk in this entry point, given how far the stock has already moved. It might have worked out, but it’s quite hard to short into a stock that’s already moved 5% in one day. I would have to wait for the stock to crack back up above 44 before I could stop out - more risk than I want to take. No, the time is not yet right…

It's already moved to far to short here, confirming a double top with a violent 5% move. I'm waiting for a retest of old support as new resistance.

I’ll be in this situation all the time. Either I miss the breakdown, or I just don’t feel comfortable shorting the breakdown for whatever reason. Instead, what I do is wait for a retest of the old support level, which should act as new resistance. Technical analysis teaches that support, once violated, can become good resistance, as buyers looking to break even on their losing trade become sellers at the price they bought. If I can catch a move up to resistance at 44, ideally on weak volume, then I would looove to short!

If you think about it, it’s a perfect trade. There is very low risk - the closer I get it to 44, the less risk I have. It’s also a high probability trade, given that we have just confirmed a reversal pattern by violation support, indicating a change in trend. If it doesn’t get back up to resistance, and instead cascades lower, then I missed it. But who cares? If ILMN doesn’t want to behave, then I’ll take my money elsewhere, thank you very much. That’s why I look at so many charts.

I look at my trading like shopping. I only want to buy the best I can get, and I don’t want to spend too much. First, I figure out what the trends are, and I go to the stores that offer what I want. I might check out some stores I’ve been to before - stores that have worked for me in the past. I don’t let other people tell me what to buy, because I have my own taste. Finally, if I find something that I really like, I check the price tag. If it’s too expensive, then I pass, and go to another store, perhaps a competitor.

Anyway, let’s see if we will get a chance to take a stab at Illumina.

Two days later ILMN gave a low risk, high probability sell signal.

In just two days, ILMN rallied right back up to resistance. Had I shorted into the breakdown, I would have been $1.50 in the hole. When I see a setup like this, I think, “Money!”. I waited to see how the stock reacted to resistance. Intraday, prices rallied up above resistance, but I entered the trade as prices sold off into the close. I believe I bought puts here, to leverage a sharp move. If you are unfamiliar with how put options work, you may want to read this article that outlines some simple options theory.

Illumina generates some quick profit, with a 3% move the next day.

Illumina put some money into my account the next day - great - the trade is working. What do I do now? There a couple of acceptable approaches to managing a trade from this point on. Which you choose depends on your emotional temperament

1. You get a nice move, then get out. To be honest, that’s what I did here. In all probability the stock would head lower, but I was already looking at almost 20% gain in my puts, and I didn’t want to have to deal with the stress of waiting it out. I probably should have continued to hold here, but hey, I’m not perfect.
2. Tighten your stop. Probably would have been the best way to handle the trade. What you can often do is tighten your stop-loss to break-even on the trade. If it’s a big enough move, then you can use a stop-loss or a trailing stop to book some guaranteed profits.
3. Take off a portion of the position. Say you shorted 100 shares. Cover 50 and let the rest run. For another approach, use a hybrid of methods 2 and 3.

Here’s what would have happened had I not closed the trade:

Illumina made another nice move down. I would almost certainly take profits here - but that's just me!

Had I stayed in the trade, I would have booked another 3% move! Personally, I would have covered any shorts when I saw how the stock started to rally off of its lows intraday. I would be out and looking for another setup. That doens’t mean you shouldn’t continue to hold. Just as long as you are doing something to protect your profits, whether it be a stop or reduced position, you can hold as long as you feel comfortable, or until the technicals dictate otherwise. I am a short term swing trader by nature. I wasn’t made that way, I was born that way. My stomach would be turning if I had to hold through a rally up to 44. The trade still is not wrong, even if it rallies up to 44, but I would still feel queasy.

Let’s see what would happen if you continued to hold a short position in ILMN:

The trend reversal in Illumina proved to be an accurate signal.

After the trend reversal occurred, via a nice double top, Illumina continued way down. A great technical setup all around.

The touch and go strategy works for both bullish and bearish trades. My advice would be to be careful about using it - remember to only trade the absolute best setups!

Until next time…

Happy Trading!