“Sweet Spot” Trades – Trend Confirmation Zones

Aug 4, 2007: 8:06 PM CST

Would you like to pick tops and bottoms more accurately?

sweet-spot.jpgHonestly, this shouldn’t be your goal as a trader, but with the “Sweet Spot” concept, you will be able to put trends and markets in a better context to identify when conditions favor a final phase of a trend in motion and a potential birth of a new trend.

Let me warn before moving on that trying to pick tops and bottoms can be hazardous to your account for two reasons:

1)  Odds favor continuation of a trend when it is in force by traders
2)  The “Last Dying Breaths” of a trend may be  chaotic and highly volatile, taking you down with it

My goal in this lesson is to alert you to trend confirmation zones within the general market (price) structure so you don’t get caught off guard as much.

I call these trades or zones “Sweet Spots” because these patterns allow clean-cut entry points and clear stop-loss levels and allow you to play for a piece of a larger price target than a normal retracement or swing trade.  In fact, position traders would do well to study examples of these conditions.

Recall that a “Trend” is a wave-like series of  higher highs and higher lows (vice versa for a downtrend).  For a trend to change, the following MUST take place:

  • Price makes a lower low
  • Price then swings up in a failed retest to make a lower high
  • Price falls downward from the failed test to TAKE OUT the price of the established lower low

When price takes out this zone (zone of demarcation, if you will) following an extended and tired uptrend, this spot creates a trade entry parameter that allows you to enter at the place where there are highest odds for the genesis of a new trend, but allows a clear stop-loss point if the conditions do not play out as you expect.

Let’s look at a few recent examples:

First, Beazer Homes:

bzh1.jpg

Notice the previous uptrend which really wasn’t extended beyond reason, but the pattern still emerged.  Buying pressure eased (which is evident from indicators not shown above) and price swings consolidated until a lower low was made (condition 1), a peak retest swing occured resulting in a lower high (condition two), and once you identify these two conditions, it is merely a waiting game until price TAKES OUT the low of the most recent swing low.  When it does, that is your trigger for entry.  Your stop is placed just above the trend’s price high (which is logical because you are betting that the trend will not take out that price, and if it does, your trade idea was wrong and you need to exit your position – in this case, a short sell trade).

Let’s see what happened when you entered short close to $44.oo:

bzh2.jpg

In my experience, “Sweet Spot” trades often take heat near the beginning when price often makes another upswing test.  Conservative traders/investors may wish to enter the trade at this price swing instead of the initial “sweet spot” to play for better position.  Either way, price never threatened your stop, which should have been placed just above $47.50.  Essentially, you are risking approximately $3.00 to play for a longer term position that could yield you upwards of $10 to $20 if you stay patiently with the trade until the reverse pattern occurs.

Another recent example comes to us from Bear Stearns:

bsc1.jpg

This uptrend did become slightly extended and bulls gave it a last chance breath before rolling over to concede defeat.

The first ‘warning light’ condition occurred with the  lower low at $155; the second conditioned occurred with a failure retest higher that ended the swing just shy of $170.  With the first two conditions in place, we wait and see if price can take out the $155 lower low.

Price does so with a compelling gap through the zone, indicating blatant strength on the part of the sellers attempting to make their stand.  Entry wasn’t perfect, but it was signaled as close as possible to $155 (which would have been filled nearer $150 most likely).  This – again – is a short sell trade.  Because of the gap, your stop is – for some – an uncomfortable distance of $20 away.  Remind yourself that your target may be upwards of $40 to $50 or more.  Only take trades your account can handle and practice good position sizing – in other words, don’t bet the whole account on a trade that requires a stop of $20.

What happened to price?

bsc2.jpg

Price stands now at less than $110.  I probably would recommend exiting to take profits due to the possibility of a price exhaustion move – notice the volume spike.

Again, price never threatened your stop and ‘rolled over’ as anticipated after a consolidation period of indecision between the buyers and sellers.  Sellers had the edge and their dominance played out over the next few months.

As always, two charts do not create overwhelming proof of this strategy.  Run through your own chart examples in both directions (uptrend death/birth and downtrend death/birth) to fully understand the concept.

Also, you can use your newfound knowledge as ‘confirmation/non-confirmation’ for trading candidates you are considering.  For example, do not go long a stock which is showing a possible or confirmed “Sweet Spot” short-sell condition.

I consider myself a retracement trader, and I look for the patterns of highs and lows to determine entry.  I have greater confidence in the potential of a retest trade in an uptrend when it is not showing a ‘trend death’ pullback pattern.   I often play for ‘small targets’ which simply are retests of previous highs only.  However, I’ll almost always have at least one ‘sweet spot’ position trade on in my accounts at all times, albeit with very few shares usually.

The “Sweet Spot” pattern occurs across all timeframes; as such, the concept of “Large Target” is relative to your timeframe and normal ‘targets’.

I do want to emphasize the point:  Do not anticipate “sweet spot” position trades.  Let the market “tip its hand” and confirm direction before entry.  Doing so will never allow you to enter at the exact top or the exact bottom, but it will not only greatly increase your odds of success, but also give you a clear exit point if your idea did not play out in the market as expected.

5 Comments

5 Responses to ““Sweet Spot” Trades – Trend Confirmation Zones”

  1. Frank Says:

    So how are the main indices looking now – anywhere near a ‘sweet spot’?

    Any stocks you see in the sweet spot ready for shorting?

    Thanks

  2. Corey Says:

    I actually almost posted a reference to that in the article but chose to keep it educational in nature.

    We’re no where near a sweet spot on any of the weekly charts, but we are seeing condition #1 in the S&P and Nasdaq (not yet on the Dow). Both charts show a daily lower-low swing. Price would need to rally back up in a retest fashion – which I believe it probably will – and we will have to see if it makes a lower high. If so, that would be condition #2, but it would need to take out the lower level to generate an actual sweet spot.

    Know that stocks that follow or mirror the indexes will be setting up similar patterns should the conditions turn negative into a short-sell sweet spot trade environment, and there may be plenty to pick from. Citigroup also showed the pattern in June – many financial stocks have done so (I showed Bear Stearns above). I have not specifically been looking for the pattern recently but will do so with a more watchful eye now. Caterpillar (CAT) looks to be in condition #2.

    Remember, to be an official “Sweet Spot” trade, the stock must have been in a pronounced uptrend of a relatively long duration. Sweet Spot trades actually are rare. I suspect we could be seeing more pop up, but it takes time to find them. They’re just an additional tool in the trader’s arsenal.

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