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Momentum Entries For Pullback Trading

04/20/11 09:04:43 AM
by Billy Williams

Markets are ever dynamic in their price action and with a little planning, you can customize your approach for fast-moving stocks and ride them to maximum profits.

Security:   GOOG
Position:   Sell

Markets go through different stages -- expansion, contraction, range bound, fast-moving trends -- which call for a customized approach based on the characteristics of the market at the time of entry. Because markets are dynamic and ever changing, your trading approach needs to take that fact into account while you have to develop the ability to be flexible in order to maximize your profits while controlling risk.

You can't expect to trade a bearish trending stock the same way you would a stock that is in a bull market but undergoing price contraction, leaving it in a tight trading range.

By the same token, a stock that is experiencing a strong trend -- whether bullish or bearish -- common sense dictates that you must tailor your approach, specifically, how you enter the move. A fast-moving stock that has momentum in a given direction cannot be arbitrarily entered at a certain price level.

Instead, using the momentum of a stock is the most logical entry approach simply because you let the price action dictate your entry. Just as a surfer latches onto a wave that is gathering force and forming up into a larger wave, the skilled surfer allows the natural movement of the wave to determine his entry into the wave's momentum and rides it to its tipping point just before it loses its strength, stepping off before it crashes and fades away back into the larger ocean.

This is why it's critical that you pick your points of entry where they hold the highest probability of success, so timing is paramount. Like a major league baseball player, you must develop strong patience and alert awareness to pull the trigger and commit to a trade by entering just when price sets up, offering you the most opportune time to enter as momentum is about to carry your position in the dominant direction of a fast-moving trend.

One of the greatest opportunities for a stock trader to maximize his profits is when a stock is in transition and forming a new trend. By using a few simple tools to act as a visual reference as well as a few simple rules to dictate the proper conditions to define the entry points in the price action as the setup, you can have a powerful tool in your trading arsenal to exploit profitable trades. See Figure 1.

FIGURE 1: GOOG. A bow tie formed in the SMAs, signaling a trend reversal under way in GOOG. Price then pulled back into the 21-day SMA and triggered a short, but later, was stopped out as it traded back up into the 34-day SMA. However, GOOG later set up again for a short again and plummeted over 50 points in just a few days!
Graphic provided by:
Using a combination of 13-day, 21-day, and 34-day simple moving averages (SMAs), you can have a trend filter to help define the direction of the trend at a glance. To properly define the trend, the SMAs must be stacked in proper order -- lowest to highest for a bear market, highest to lowest for a bull market -- to set the conditions for the setup.

The setup should be when price is trading at a eight-week high for bullish trades and an eight-week low for bearish trades, then price pulling back into the 13-day SMA and the 21-day SMA while setting a significant price high or low to act as the entry point.

If price pulls back into the 34-day SMA, then the trade setup is voided.

For trends in transition, watch for a SMA crossover where the order of the SMAs begins to reverse. This is called the "bow tie area" as coined by Dave Landry, a hedge fund manager specializing in swing trading stocks. It is in this area where the stock's trend is likely to reverse and you want to watch for a new eight-week high or low, then a pullback into the SMAs as the setup for a trade.

By using a combination of price action and SMAs, you can quickly define the trends as well as spot the price setups just as momentum pauses before taking off again, allowing you to ease into the trade and letting the stock's gathering strength to trigger your position and riding it to maximum profits.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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