Swing Traders: Find More Reliable Tops And Bottoms Using Bow Ties

Picking tops and bottoms can be costly, as markets are prone to long-term continuation moves and false reversals. On the other hand, blindly jumping on an established trend can also be costly, as these markets are prone to correct. Below we will look at “Bow Ties,” a swing trade setup which attempts to solve for the above by utilizing multiple moving averages and a counter-trend correction.

Background

The pattern uses a 10-period simple moving average, which is simply the sum of the last 10 closing prices divided by 10.

The pattern also uses a 20-period and 30-period exponential moving average (EMA). An EMA weighs current periods higher than prior periods. The theory is that recent price action is more relevant than older price action. It’s beyond the scope of this article to cover the calculations of this average. For details, see Moving Averages: The Ins and Outs Of, or do as I do--forget about the formula and have the computer do the work for you.

A simple moving average (SMA) gives you a true picture of the average price. EMAs, being front weighted, tend to “catch up” to prices faster. One is not necessarily better than the other. Both have their purpose and that is why I use both in this pattern.

Why These Averages?

I use a 10-period SMA because it gives a true representation of the average price over the last two weeks (10 trading days). The 20- and 30-period EMAs give a rough representation of performance over the last month and six weeks, respectively. I like the exponential averages for these longer periods as they are front weighted and catch up to prices faster. These are my personal preferences, but feel free to use your own.

Proper Order

Moving averages tend to follow price. The faster-moving averages (shorter periods) tend to track closest to price, whereas the slower moving averages (longer periods) tend to lag further behind. During consolidations, prices tend to bounce above and below the moving averages. During up trends, the faster moving averages remain above the slower moving averages (and vise versa for downtrends).

Referring to the chart of Emulex (EMLX | Quote | Chart | News | PowerRating) below, notice that during the consolidation, price bounces around the moving averages--and the averages themselves are in no particular order. However, once price begins to trend, the 10-day SMA climbs (and stays) above the 20-day EMA and the 20-day EMA climbs (and stays) above the 30-day EMA. I refer to the 10-SMA > 20-EMA > 30-EMA as uptrend “proper order.” Conversely, for downtrends, I refer to the 10-SMA < 20-EMA < 30-EMA as downtrend “proper order.”

When a market makes a transition from an uptrend to a downtrend (or a downtrend to an uptrend), the moving averages converge and then spread out again--giving the appearance of a bow tie. For this setup, ideally the convergence (the middle of the bow tie) should be very tight (the moving averages are all close in value) and the moving averages should spread out quickly. In other words, it should look like a bow tie.

In a perfect setup, the transition from proper downtrend order to proper uptrend order (or vice versa for short sales) should take place in a maximum of three to four days.

The Setup

Here are the rules for the setup:

For buys (short sales are reversed).

Using a 10-period simple, 20-period exponential and a 30-period exponential moving average:

1. The moving averages should converge and spread out again—giving the appearance of a bow tie. At this juncture, the moving averages should be in proper uptrend order, that is, the 10-SMA > 20-EMA > 30-EMA.
   
2. The market must make a low less than the prior day’s low.

3. Place a buy order above the high of bar described in (2.).

4. If not filled, continue to work a buy order above the prior day’s high until either filled or the low trades below the 20-EMA.

5. Once filled, place an initial protective stop below low of (2).

6. Trail your stops until stopped out and/or exit in two to six days.

Examples

1. On 6/08/2000, the moving averages converge and spread out again, giving the appearance of a bow tie as NPS Pharmaceuticals makes a transition from a downtrend to an uptrend. Notice that the 10-SMA > 20-EMA > 30-EMA.
   

2. The stock makes a lower low.
   

3. The stock trades 1/8th above the high in (2) and a signal is triggered at 18.
   

4. The stock trades over 6 points higher over the next seven days.

1. The moving averages on EMC converge and begin to spread out on 6/12/2000.
   

2. The stock makes a lower low on the same day.
   

3. Go long at 70, 1/8th above the high of (2). Place an initial protective stop at 67 1/2, 1/8th below the low of (2).
   

4. The stock rallies nearly 13 points over the next four days.

1. On 12/29/1999, the moving averages on Allegiance Telecom have converged and begun to spread out.
   

2. The stock makes a lower low.
   

3. Go long at 63 1/2, 1/8th above the high of (2).
   

4. The stock climbs over 20 points in five days.

Here an example on the short side in the Nasdaq Composite. Signals in indices can help you time your stock market entries and exits or they can be traded in and of themselves by using index futures or holder shares.

1. On 4/07/2000, the moving averages converge and begin to spread out as the Nasdaq rolls over.
   

2. The index makes a higher high.
   

3. The index trades below the low of (2), 4323, triggering a signal.
   

4. The index loses over 1,000 points, nearly 25%, over the next four days.

The pattern also seems to work well in the futures markets.

1. On 7/12/2000, the moving averages on September Orange Juice converge and begin to spread out as the market rolls over from an uptrend to a downtrend.
   

2. The market trades above the prior day high.
   

3. A signal is triggered as the market trades below the low of (2).
   

4. OJ drops over 3 points in two days

Q&A

Q. Why use multiple moving averages?

A. When several moving averages converge, at the middle of the Bow Tie, it suggests that the longer term and shorter cycles are coming together. Once they spread out again, it suggests a new trend is being formed.

Q. So why not just buy the market as soon as it comes out of the convergence?

A. In spite what many books on technical analysis will tell you, moving-average crossovers do not work. I suppose in their defense, many of these books were written before everyone had a computer sitting on their desk. Before computers, crossovers worked much better.

Q. Do you think they used to work better because it wasn't so obvious?

A. Yes. Technology has helped to eradicate this edge.

Q. Back to Bow Ties, does the counter-trend movement (rule #2, a lower low for buys and a higher high for short sales) help to eliminate false starts?

A. Exactly. You often avoid false moves by waiting for a countertrend and only entering if the trend re-asserts itself. Conceptually, it's no different than pullbacks. Essentially, you are looking for thrust/trend, correction and then resumption of trend.

Q. Why cancel your entry order if the market trades back to the 20-day EMA?

A. If a market comes all the way back to the 20-day EMA, it's possible that what appeared to be a new trend is a false move. This doesn't mean that the market isn't worthy of trading. As you know, in trading there are no exacts. However, in any pattern, you should have a rule for when you should step back and re-evaluate your analysis. Maybe some other pattern is forming? Maybe not.

Q. But it's okay for the market to trade back to the 10-day simple moving average?

A. I think it's normal, and likely healthy, for a market to pull back to the 10-day SMA.

Q. You refer to the Bow Tie from downtrend to uptrend for longs and uptrend to downtrend for shorts. Does the pattern work on markets coming out of consolidations or bases?

A. Yes. I discovered the pattern while studying markets that had major changes in trend--from up to down or from down to up. The beauty is that you avoid top and bottom picking by waiting for a confirmation of this rollover. A "half bow tie," if you will, emerges when the price is coming out of bases/consolidations. These seem to work, but I prefer the "rollover" pattern, as the chance exists that there are players still trapped on the wrong side of the market.

Q. The "trapped" players will add fuel to the rally or sell off for short setups?

A. Yes.

Q. This seems like a great setup. Why publish it?

A. I love research. I have numerous setups just like this one. I can't trade all of them all of the time. Also, I have found that after I publish a pattern, I receive e-mails pointing out markets where these patterns are setting up. Like most traders, I can't watch everything all of the time. In addition, many take the research to the next level, adding their own twist to it. From this, I learn more tips and tricks.

Q. Ever think of writing a book, publishing some of that research?

A. I have one out now. Click here for details.

Do you have a follow-up question about something in this column or other questions about trading stocks, futures, options or funds? Let our expert contributors provide answers in the TradingMarkets Question & Answer section! E-mail your question to questions@tradingmarkets.com. For the latest answers to subscriber questions, check out the Q&A section, linked at the bottom-right section of the TradingMarkets.com home page.

Click Here For A Free 1-Week Trial To Dave Landry's Daily Swing Trading Alerts

Click Here To Learn How To Trade Dave Landry's Best Strategies