Setups don't exist in a vacuum. You must consider the overall market and sector action. Further, you must consider the bigger-picture technical patterns within the individual stocks that are set up. Below we will show how to factor in these outside influences into your trading, using recent examples.

What's The Market Doing?

The first question you should ask yourself is, "What's the market doing?" Is it going up? Down? Sideways? It is trading above/below its moving averages? Is there momentum? Are there setups in the overall market? Bigger-picture patterns?

For instance, on 04/25/01, the Nasdaq formed its first pullback from highs after rallying over 35% (low to high). This action also sets up a low-level cup and handle formation. Further, notice that the 10-day simple moving average and the 20-day and 30-day exponential moving averages have crossed from downtrend proper order¹ (10-SMA<20-EMA<30-EMA) to uptrend proper order (10-SMA>20-EMA>30-EMA). On a even shorter time frame, notice that on 04/25/01 the index closed well (near the top of its range) after closing poorly (near the bottom of its range) on the prior day. This is known by Jeff Cooper as a 180.²

The S&P 500 sets up in a similar fashion. Notice that it is in it first pullback since rallying from lows, it formed a cup and handle, the moving averages have turned up and after a poor close (a), it reversed to close well (b).

Check Market Timing Systems

Now that I know that the market is poised to rally on a pattern basis, the next thing I do is to see if any of the short-term market timing systems that I follow are triggering a buy signal. In historical backtesting, these systems have shown a 60%-80% chance of correctly predicting the market over the next two to seven days. They include TRIN Reversals, ³  the Connors' Vix Reversal (CVR) Systems (including the CVR III, ⁴ which I co-created with Connors, and the CVR III-Modified, ³ the Oscillator Swing System, ³ and the CHADTP.⁵

In looking to these systems,  I see that on 04/25/01, a CVR I signal is triggered: The VIX hits a 5-day (plus) high (a) and reverses to close below its open (b).

Check The Sectors

Now that I know the overall market is poised to rally, I then look to the individual sectors to see which sectors are poised to rally. Sector action is vitally important as sectors can often outperform or even trade contra to the overall market. Here, I look for the same patterns and momentum described with the indices.

In looking to the sectors, I see the semis ($SOX.X | Quote | Chart | News | PowerRating)  are in first pullback mode after a sharp rally from lows. Notice the moving averages and the price action also sets up the sector as a Bow Tie. On a smaller scale and like the overall market itself, notice that the sector reversed to close well, after closing poorly on the prior day.

Another sector of interest on 04/25/01 was the biotechs ($BTK.X | Quote | Chart | News | PowerRating). Notice that it formed a pullback, a big-picture cup and handle and also was able to reverse a poor close (a) to close well (b). This action suggests that the sector was poised to rally out of the pullback/cup and handle formation. One thing to consider though, in looking to the left side of the cup, I notice that there is overhead resistance. This must be factored in when considering a trade in the sector.

Finding Setups

Now that I know that the overall market is poised to rally and that biotechs and semis are the sectors most likely to benefit from that rally, I then look to individual stocks within that sector. 

In my analysis of the semis, I see that Triquint Semiconductor (TQNT | Quote | Chart | News | PowerRating) (mentioned in my 04/25/01 Stock Outlook) has shown strong momentum from lows--nearly tripling in value. The stock also had Trend Qualifiers, ⁵ such as gaps, strong closes, and wide-range bars higher. Notice that the stock forms a pullback and a bullish outside day. Also notice that it, like the overall sector (see above), was able to reverse a poor close (a) to close well (b). This action triggers a Bow Tie entry and suggests that the stock will continue to resume its uptrend.

In looking for setups in the biotechs, I see that Protein Design Labs (PDLI | Quote | Chart | News | PowerRating) is in its first pullback since doubling from lows. During this uptrend, it had Trend Qualifiers such as strong closes, wide-range bars higher and a gap higher. I also notice that it closed well--reversing the prior day's sell off. This action suggests that it's poised to resume its uptrend.

Position Management

Unlike Ron Popeal's rotisserie roaster, in trading, you can't "set it and forget it!" You must take an active role in managing your positions. In addition to placing initial protective stops, this involves taking profits and trailing stops. If you're fairly new to my trading style, now might be a good time to review the general concepts I use here, in my articles on Money Management under Traders' Lessons. In addition to those rules, you have to consider the stock's technicals, the overall market and sector action.

Both stocks trigger an entry and are profitable over the next few days, but, notice that on 04/30/01, the biotech index clears its recent highs (a) but is beginning to show some signs of stalling as it approaches recent overhead resistance (b).

On the same date, the semis are acting OK but are still short of their recent highs and did begin to tail off a bit intraday (a).

On the same day, Triquint approaches its recent highs but is just short of breaking through. It did close slightly off it daily high (a) but so far, hasn't done anything wrong.

And so far, PDLI hasn't done anything "wrong" either. However, you can't ignore the fact that its approaching its old highs (a) and overhead resistance.

On the following day Triquint takes out its recent high (a) but is now in a zone of overhead resistance (b).

PDLI looks like it may be getting into trouble. Notice that it fails to clear its prior high (a) and is stalling in the area of overhead resistance.

On 05/02/01, the semis fail to take out their recent high (a) and tail off to close poorly (b).

The biotechs also fail to take out recent highs (a). This has them stalling below the area of overhead resistance.

Looking to the overall market, on 05/02/01, the Nasdaq forms a Hanging Man⁷ in the area of recent highs and longer-term highs and overhead resistance (a).

The S&P 500 also formed a hanging man (a) near its recent and longer-term highs.

Moving forward, we later see that this day becomes the exact swing top (a) of Triquint.

And, the highest closing price on PDLI before it begins to implode.

In Closing

As you can see, setups don't exist in a vacuum. You must take into account the overall market and sector action. You must be fully aware of the bigger picture technical patterns within the individual stocks. It doesn't end there, however, you must then monitor the stock, market and sector to manage the positions.

Q&A

Q. You emphasized studying the market and sectors. How do you find setups, once you know which sectors you want to focus on?

A. I keep a small database of stocks which I tool though each night. From this, I'll take notes if any stocks are setting up within that sector. I also run scans to look for setups. Further, if I think a sector is really poised to rally, I might just tool through the majority of the stocks in that sector that are suitable for swing trading.

Q. Suitable for swing trading?

A. It must be priced high enough, it must be volatile enough, it must be liquid but preferably not too liquid, it must show persistency and so forth.

Q. Can you elaborate?

A. I could, but then I'd have to kill you. Seriously, it's too much to cover in this forum. I spent a whole chapter in my book³ on these factors alone. I'll plan on doing an article in the near future which will cover this aspects in more detail.

Q. Above is the first time I've seen you use candle charts. Is this a new area of study for you?

A. No, I studied candle charts years ago. I was probably one of the first people to purchase Nisson's book⁶ ten years ago.

Q. Do you still use candle charts?

A. Yes and no. When I see certain patterns occur with bigger-picture technical patterns, I tend to take notice. For the most part, I use standard O/H/L/C "Western charts." I can usually pick out the most relevant candle patterns out of the Western charts. 

Q. Why not use candle charts then?

A. I began working closely with Jeff Cooper about four years ago. I viewed and still view him as one of the best chart readers in the world. Being "old school," he uses standard Western charts. In order to be on the same "page" as him, I switched back to Western charts from candle charts.

Q. Back to the subject of this article, are there any other things to consider when looking at setups, sectors and the overall market?

A. Yes. Good traders tend to anticipate market action.  For instance, on 04/24/2001, the Nasdaq pulled back to the gap/2000 psych support level. It closed poorly but so far, really hadn't done anything wrong. On that same day, the biotech index also closed poorly but was still acting constructive by not breaking down. Cephalon (CEPH | Quote | Chart | News | PowerRating), a biotech mentioned in my stock outlook on that day, managed to close well in spite of the sector being down. This action suggested that it was poised to rally out of a cup and handle. Those who traded this setup know that it was up 3 points on the following day and rallied nearly 10 points over the next four days.

Also, if you are nimble and willing to watch a screen. You can establish a day trade position with the intent of turning it into a swing trade. On 04/25/2001, the biotechs began to turn intraday. PDLI opened flat but held (a). Once it started moving, you could have got in as a day trade and placed a tight stop right below the morning range. This would have given you a 2-3 point "head start" before a potential swing trade would have triggered on that same day (b) or on the following day as shown in the above article.

Q. Where can I find more about swing trading?

A. I thought you'd never ask.

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Footnotes, References and Additional Reading
¹See article on Bow Ties.
² Hit and Run Trading, Jeff Cooper
³ Dave Landry On Swing Trading, Dave Landry
⁴ Connors On Advanced Trading, Larry Connors
⁵ Investment Secrets Of A Hedge Fund Manager, Connors/Hayward
⁶ According to Nisson in Japanese Candlestick Charting Techniques: "If the market opens lower the next day, those who bought on the open or close of the hanging-man day are now left 'hanging' with a losing position."

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