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It feels tempting to buy a stock that’s hitting new highs, but many buyers get shaken out by pullbacks that tend to follow rallies. That’s how people end up buying high and selling low.
If you identify an uptrend and then wait for a pullback, you can get your stock at a discount (and if you don’t get it – forget it. There are many more fish in the sea). We can protect a pullback trade with a stop not too far away, and take profits when that stock rallies again.
If you compare a trend to a tide, a pullback is like a wave splashing against that tide.
The same approach works with selling short. Once we identify a downtrend, like a tide going out, wait for a counter-trend rally in order to sell short. Shorting is a very worthwhile activity, popular among professionals, but not suitable for beginners because stocks drop twice as fast as they rise. Shorting demands quick reactions and good risk management skills. Learn buying first and expand into shorting later.
To implement the pullback system, we’ll use two charts. We’ll make our strategic decision – to be a bull, a bear, or stand aside – on the weekly chart. If that chart is bullish, we’ll turn to the daily chart for tactical decisions on where to enter and place our stop and target. If the weekly chart is bearish or doubtful, let’s skip the daily and move on to the weekly chart of another stock.
There is a lot of chaos in the markets and when a stock looks doubtful, skip it and move on to the next candidate. Traders with a scientific background often have a fantasy that they can identify a trend by adding more tools, but no fancy indicators will clear up a chaotic market. A promising trade has to grab you by the face. When a stock’s trend is unclear, no amount of analysis will find a good trade. Don’t waste your time on doubtful stocks – trade only those whose signals leap at you from the screen.
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Here’s what we’ll be looking for:
* The weekly slow EMA is rising.
* The weekly Impulse system is green or blue (cannot be red).
* On the daily chart prices are in the value zone or below it (cannot buy above it).
* The daily Impulse system is blue (wait until it stops being red).
* The two-day Force Index is below zero.
Trade rules:
* Buy in the value zone on the daily chart.
* Place a stop near the low of the second lowest recent bar or 1.5 ATRs below your entry, whichever is lower. We’ll discuss ATRs in a chapter on stops.
* Set a target at least as high above value as the purchase is below. Attractive trades have reward-to-risk ratios better than 2:1.
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In 2014, Silica Holdings, Inc. (SLCA) was in the news for most of the year. The stock was in the news as a major supplier for the Canadian tar sands industry. Looking at the weekly chart, we see a steady rise, with the stock consistently above its fast and slow moving averages. The Impulse system stopped being red in February, permitting buying.
To create a weekly chart similar to Figure 24 from scratch, follow these steps:
1.) Type “SLCA” into the “Create a Chart” box at the top of any of our webpages and then click the “Go” button
2.) Find the “ChartStyles” dropdown box located just below the bottom of the chart
3.) Click on that dropdown to open it up, then select “Elder’s Weekly Stocks” from the dropdown list.
With the weekly chart clearly rising and permitting us to buy, let’s turn to the daily chart for tactical decisions where to enter, set targets and place stops. Here you can see that once every five or six weeks a brief panic hits the stock. It gets pushed down into its value zone, Force Index turns negative, and the Impulse system goes red, prohibiting buying.
To convert your weekly chart into a daily chart, simply select “Daily” from the “Period” dropdown above the chart and press the “Update” button.
As soon as the red disappears, the Impulse releases us to buy that pullback to value – those bars are marked with vertical green arrows. Stops should be placed in the vicinity of the pullback lows, and profit targets near the upper channel line. Once prices rally above the upper channel line and drop back below it, that’s the last call to take profits, in the areas marked with vertical red arrows.
Some may ask: once I buy using this system, why not keep the stock for as long as the weekly trend continues to rise? Why exit at a nearby profit target?
You certainly may attempt that, but it will no longer be a swing trade. Long-term trend-following lures us with its promise of great profits, but it has its disadvantages. It is a hugely stressful challenge to hold a trade through a deep drawdown, not knowing whether the trend will continue or reverse. Deep drawdowns are likely to occur during long-term trends. Swing trading is more reliable and less stressful. We’ll return to this question in a later chapter.
You learn to trade by making trades and managing them. The more often you trade and keep good records, the more you learn. Swing trading – holding trades from a few days to a few weeks – provides the sweet spot for learning to trade. Once you become a competent and confident trader, you may expand in both directions: long-term investing or day-trading.
Returning to the daily chart above, notice a very severe bearish divergence of MACD near the right edge. Additional warnings to the bulls come from a bearish divergence of Force Index as well as the fact that prices couldn’t rise above their channel during the latest rally. No tree grows to the sky, and an accumulation of bearish signals sends a message to look for another stock to apply the pullback system to. Sure enough, by the time of this writing the oil crisis has hit and SLCA is back in the low 20’s.