Finding a trading strategy that works well over time can be a challenge. Toni Hansen explains.

When it comes to favorite trading strategies, there are a number I am very fond of. However, finding a strategy that works well over time can be a challenge. As the market passes through different phases of trend development, different strategies fall in and out of favour. Sometimes I’ll focus primarily on reversal strategies, while at other times I’m interested only in continuation moves.

However, there is a strategy that can be easily adapted to fit both roles. I like to make the names I use for trading setups very easy to remember, and based upon what I’m visually presented with. As a result, I simply call the pattern a Two-Wave Continuation Buy/Sell. This Two-Wave setup can be found near the start of a new trend, or it can occur within a trend that is already under way.

The Two-Wave setup actually consists of four waves of price action, with the trigger occurring on a fifth. The Two-Waves refers to the counter-trend moves within the larger price pattern. There are two examples of this setup on the intraday charts of Capital One (COF) in figure 1. Both are setups that trigger trades on the short side. The initial downside moves in each setup is followed by two corrective moves off support. These are the counter-trend moves that give this setup its name. They are labeled from lows to highs, with 1 to 1 and 2 to 2 and are shown in blue.

The first setup, which follows A, is a Two-Wave setup that serves to confirm the start of a new downtrend in COF. The pattern is still considered a continuation pattern, however, since the setup triggers a continuation of the new downside bias (A). The second setup occurs within an already established downtrend and follows the downside move labeled B.

The criteria I focus on when looking for high-probability Two- Wave Continuation setups are as follows:
1. A strong price move. These are labeled A and B in figure 1.
2. Two counter-trend moves. These are shown in blue. Ideally, the second counter-trend move will be more gradual than the first. This was the case in the setups that followed both A and B.
3. Counter-trend moves that do not retrace the entire original moves (A or B).
4. Volume decline as the two waves develop, leading to a gradual or sideways trading channel.
5. Moving average resistance (typically the 20 period moving average) corresponding to the highs of the second wave for a sell setup, such as in A and B, and lows of the second wave when the setup is developing for a long position.

This strategy becomes more risky when a trend is well developed or the security is coming into strong support for a short trade, or resistance for a long. One thing that makes this strategy so appealing is that it has straightforward rules for trading it. Granted, there are innumerable variations of this setup, but the core guidelines for trading them remain the same (or extremely similar). Since my examples in COF involve short sales, I’ll focus upon that criterion, but you can flip them upside down to apply to the long side and positions you wish to buy instead of short.

Entry: To enter this setup on the short side, wait for a channel break out of the second counter-trend move. There are alternative strategies, such as connecting both lows with a trend line and then waiting for that trend line to break, but this tends to diminish the success and risk/reward ratio for the trade. The entry can be improved, however, if there is a Two-Wave Continuation setup forming within the second wave of the larger Two-Wave pattern. This was the case in the first setup in COF prior to 12:00 ET.

Stop: The stop on a Two-Wave Continuation short setup goes directly above the second high. Allow enough room for slippage. If a stop is above $100, for example, then my exit will likely be around $100.07. This will vary somewhat, based upon volatility, but the idea is to make it break resistance by enough that you will not get flushed out just before it makes the move you expected, while at the same time confirming that a break in the resistance means pattern failure. A trick is to drop down to a 1-minute chart and look at the average range of each 1-minute increment. I then cushion my stop by that amount when trading off a 5-minute chart. Similar adjustments can be made using larger or smaller time spans.

Target: The target on a Two-Wave Continuation pattern varies, depending upon trend development and momentum. Nevertheless, one of the most common targets I aim for is what I call an equal move. This can also be thought of as a measured move. This means that I am looking for follow through on the setup that is comparable to the move that comes directly before the two waves of correction. That move is labeled A in COF. The price range of this move can be measured. The next step is to take the highs of the second correction and subtract the difference that took place in the first move. This will give you a target zone. It’s not necessary
to measure this move exactly. Merely visualizing it and identifying additional levels of support that correspond to that same price zone will dramatically improve your accuracy for timing the target on the setup. B forms the equal move for the first setup. The move was almost identical to A in both price and momentum. C is the measured move for the setup that follows B. It took longer to hit, but it was also a nearly identical move in terms of price.

A great way to improve your accuracy on this strategy is to keep a record of the trades you take based on it. You will quickly start to notice additional pros and cons, and multiple ways to tweak the strategy to improve its odds even further. In and of itself, however, it remains one of my all-time favorites and I hope you will quickly profit from it as well.

Toni Hansen is a full-time trader, as well as a popular lecturer and market columnist, who has been sharing her knowledge with others over the past decade. To learn more about Toni‘s methods, go to www.tradingfrommainstreet.com.

This article was originally published in the Nov/Dec 2010 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd. 
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