Use the following “Truncated Price Swing” day trading strategy for stocks, forex or futures. This strategy is best combined with trend analysis and understanding how trends function. For an introduction to trends, see Trading Impulse and Corrective Waves. This strategy not only provides a way to trade trends, and possible reversals, but helps you analyze the trend because you are forced to watch for higher/lower lows and highs in real-time, and then act them on. This means you need to be thinking ahead and planning…concept I call trading beyond the hard right edge.
Truncated Price Swing Trading Strategy for Stocks or Forex
A trading strategy that can used on its own, or in conjunction with other strategies, this is one of my favorites. Why do I like it? It gets a trader into a move early and it aligns the trader with the trend, or with the potentially emerging trend.
While no system is perfect, this trading strategy often provides very high rewards for the risk, and we often know quite quickly if we are on the right or wrong side of a move. We are using a trade setup which should show us a profit quite quickly; if the price doesn’t move as expected, something is likely wrong and we can exit with a very small profit.
A truncated price swing is a move that falls short of the high/low of the previous move (or other major highs or lows seen throughout the day). Truncated means shorter, reduced, or cut off. Therefore, a truncated move is one that is shorter than the prior moves.
If the trend is currently up and a correction doesn’t pull all the way back to the prior correction low, that is a truncated move. If a move higher (trend direction) doesn’t make it as high as the prior high high, that is a truncated move.
If the trend is currently down and a correction (higher) doesn’t pull all the way back to the prior correction high, that is a truncated move. If a move lower (trend direction) doesn’t make it to the prior low, that is a truncated move.
Truncated moves tell us whether a trend is healthy or in trouble.
When to Trade It, and How
I especially like this strategy near a market open, such as the open of the London market when forex trading, or the US open when trading futures or stocks. In the stock market the first few minutes are often volatile, setting an initial high and low level to watch. Trading a lower high and/or lower low relative to those initial highs and lows can be very lucrative. That said, this strategy can be used at any time of day, and on any time frame actually (doesn’t have to be day trading).
Why is the open so good for the this strategy? Because the first 30 minutes of trading is prone to quick reversals; traders are unsure which direction the price will go, which means when the price turns it often moves quickly, which favors this strategy. We get the most “bang for our buck” just after the open.
Let’s say a $50 stock drops $0.50 off the open. The price then corrects higher, but isn’t able to make it back to the prior high (the open price in this case). As the price stalls out (discussed below) at a lower high, say $49.80, we have a truncated price move, and a possible trade. This setup provides an opportunity to sell the stock short.
A “stall out” is consolidation of three bars or more (as you practice and get better at reading price action you only need to wait for two price bars to consolidate) that move sideways. The high and low of the that consolidation are then used as a guide for the entry and setting a worst case stop loss order.
If the trend is up, and price stalls out at a higher low, we will want to go long, but only if the price breaks above the high of the consolidation. Set a buy order $0.01 above the high of the consolidation. Set a stop loss $0.01 below the low of the consolidation. The difference between the entry and stop loss give you the number of cents at risk on the trade. Multiply this by two, and that is your minimum target. Often on these types of trades you can attain profits which are many times your risk, although 2:1 is the minimum reward:risk you should strive for.
The chart below shows a 1-minute chart of BAS. A volatile stock that has been on the Day Trading Stock Picks for multiple weeks (see the Stock Trading category for current Day Trading Stock Picks, posted every Tuesday). The price flies higher off the open, pulls back and consolidates at a higher low. Once there are two (preferably three) bars that move sideways, draw a rectangle around the consolidation. If the price breaks higher out of consolidation, buy, as we have a truncated price swing strategy trade. The risk on this trade was $0.09 initially, although it can actually be smaller this. As the chart shows, placing a stop loss below the consolidation is a “worst case” stop loss. If the price breaks higher, and we are expecting it to move higher based on the trend, it should do exactly that. Therefore our stop loss could actually be within the consolidation; we really only need to risk $0.05 or $0.06 on this trade.
Our target is set at a price which offers a reward of at least two times the worst case loss. In this case, the worst case SL was set at $0.09, so our initial target is set $0.18 (or higher) above the entry price. If actually using a $0.05 or $0.06 SL (even though the worst case SL is $0.09) then your potential reward is 3x greater than your risk.
Below is another example, this time for a short trade. The price initially moves higher, but then drops and makes a lower low, shifting the bias to the downside. We are now watching for a lower high. The price moves higher, but consolidates at a lower high. Take a short on a breakout of the consolidation, one cent below the low. Place a worst case SL one cent above the high of the consolidation, but as indicated earlier the actual SL could be a bit lower. Place a target at a price which gives you a potential profit of at least 2x the worst case risk. If using the “trading beyond the hard right edge” concepts, then the target can be altered based on market conditions. The price enters a range in this case (big circle), so we have options:
- If the price breaks above the range, exit the short trade, or let your trailing stop get you out for a reduced profit.
- Exit near the bottom of the range. In some cases this may produce a bigger profit than the initial target, and sometimes it will be smaller.
- If the price breaks lower, hold the trade for a bigger gain. This would have produced the biggest profit in this case, but we also face the risk of the price reversing on us and giving us a smaller profit (scenarios above).
Considerations and Final Word
To summarize, for an entry we are watching for any move that is heading to test a high or low, but doesn’t make it there. Once the price stalls we are trading a breakout of the consolidation away from the recent high or low.
A worst case stop loss order is placed just above the truncated high (consolidation) if going short, or just below the truncated low (consolidation) if going short. Typically this should never be hit, unless the price just snaps against you (no time to react). Typically your actual risk is smaller, because if the price doesn’t move in the anticipated direction after a breakout, just get out.
Profit targets for this trade vary based on the daily market dynamics and can be adjusted after they have been set. Initially set a target at a price which will produce a profit of at least 2x the worst case risk. This is just a guide though. Depending on how the market is moving, you may aim for a bigger target, or you may have to take a profit early if momentum dies. This strategy can even be combined with the Daily Range Day Trading Strategy to create the highest possible reward for the trade. With this approach though you only get one or two trades a day, where as using the reward:risk model you get multiple trades each day.
The down side of this strategy is that we don’t know if the stock is actually going to move in our direction, although based on the evidence we are making an educated assessment that it will, and have some minor evidence (the consolidation breakout) that it already is. An uptrend is simply defined as higher highs and higher lows as it relates to the swings in price. We are simply exploiting this concept and trying to make more on winning trades than we lose on losing trades.
As the day progresses we have more price waves to consider, therefore the strategy becomes a more complex. Don’t trade every truncated price swing that comes along; you must look at the overall trend and determine which ones have a high probability of success and which ones don’t. This takes practice; use a demo account until you are consistently profitable. I use no other indicators for this strategy. There aren’t many rules, which can make this strategy dangerous if you haven’t practiced it for yourself. Truncated price swings occur all the time, but it takes practice to determine which ones are worth trading. If you are looking for concrete rules where you don’t have to think much, this strategy isn’t for you. You need to always be thinking ahead and studying each price wave relative to prior waves. Typically this strategy is used at the most volatile time of day, and therefore flexibility and adaptability is a must.
Each trader should test the strategy, adding their own elements so it suits their trading plan.
This strategy forms the initial steps of the Day Trading Trending Strategy, although they each have slightly different purposes. The main difference is I like this strategy near the open, and I like the Day Trading Trending Strategy during the day (after the first 30 mins or so). The Truncated Price Swing also makes more assumptions than the Day Trading Trending Strategy, but the truncated price swing strategy keeps you very focused on the market, watching for higher/lower highs and lows, which will help you implement other strategies as well.
Here are a few things I recommend. Not rules, but some personal touches that work for me and may help you too.
This strategy requires aggression. If trading a volatile stock (and this strategy should be used on volatile stocks, not stocks that don’t move) there isn’t going to be a massive chunk of shares sitting there for you, and if there is they won’t be there long. You need to take them where you can get them. Remove liquidity: don’t bid if you want to buy or offer if you want to short…hit the bid to sell and hit the offer to buy. Things move fast, watch your Level II and pick up shares a touch earlier or later than the $0.01 outside the consolidation discussed above…especially if it is a volatile stock that moves a lot (get shares a few cents outside the consolidation, as long as the profit potential outweighs your risk). If you aren’t aggressive the only trades you will get filled on are the crappy ones. Remember, we want the price to be moving in our favor very quickly, which means we will need to be very quick to capture the trades where that happens. Also, by removing liquidity you help give the trade a nudge in your direction.
If you miss it, let it go. Don’t chase the price. Look for another trade.
For forex, set your order outside the consolidation and you will be fine. I put my orders about 0.3 to 0.5 pips (half a pip) outside the consolidation. That way when it breaks out in my direction, I get in. If the price breaks the consolidation in the other direction, drag your order well away from the current price or cancel it. When another trade develops, drag your order to the new entry price (or create a new order if you canceled the old one) and make any necessary adjustments to the stop loss and target attached to the entry order.
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