Using Swing Points To Identify Price Reversals

We know that there is no such thing as a 'holy grail' in Forex trading. However, when it comes to Forex charting, there is something that comes really close, and that is Swing Points. In fact, Swing Points really are the trader's best friend as they are so much simpler to spot than complicated candlestick patterns with exotic sounding names, and more consistent in meaning when found at significant confluences of support or resistance. If you train your eyes to see these simple yet powerful chart structures and make them the central point of your analysis, you will be amazed at how much more accurate your trading calls will become. Guaranteed.

So, what exactly are Swing Points? A Swing Point (SP) High is an upside price extreme (ideally, but not necessarily represented by a price rejection wick) both preceded and followed by two lower highs on each side. This means that there needs to be at least five candles in the pattern. On the other hand, a SP Low can be defined as a downside price extreme (again, detected most easily by a price rejection wick) both preceded and followed by two higher lows on each side. The diagram below illustrates this concept.

The relationship of the two candles on either side of the price extreme to one another is not important, except that they have to be above a Low, or below a High. If they equal or exceed the extreme of the middle candle, then the pattern is considered not valid. An acceptable variation of this pattern is when the price extreme is found on two middle candles instead of one, resulting in a pattem consisting of six candles in total.

Now that we know how to identtify them, what is it about Swing Points that makes them so great? I can think of three things.

Firstly, Swing Points are a 'natural' indicator, i.e. they are found within price action itself, and they show you in real time when a potential change is underway. By contrast, technical indicators (at least lagging ones like Moving Averages and MACD), usually need a little time to catch up to the turn.

Secondly, Swing Points relate to the wave structure of price action in a very direct way. In other words, constituent waves of a larger pattern - whether an impulse or a retracement - very often mark both their beginning and end points, on a SP High and Low. Obviously, this can be very helpful in detecting turns in the market.

Thirdly, on a lower level chart (e.g. 15 minutes), Swing Points can provide an effective signal for both entering and exiting a trade with relatively limited risk; and often, right when the market is about to start moving in the direction favorable to the trade. Can you think of any technical indicators that can do all that?

Now, here's the challenge. While SP Highs & Lows do serve extremely useful purposes, they share something in common with conventional indicators (although occurring less often): the potential to yield 'fake' readings. Generally, this is more of the case on lower than on higher timeframes. On a Monthly chart, for example, well-formed SP Highs & Lows are far more likely to channel a turn into a major, many months' (or possibly years') long trend than on the 5 minute chart, where they can be overly abundant, sometimes reflecting mere noise. In other words, a 'fake' SP High or Low (as opposed to an invalid SP High or Low) is one that possesses all the characteristics indicated in the diagram above, but without accurately signifying a major price reversal.

Therefore, an important principle to remember is that we need a confluence of events to justify every single trading decision we make. This is because no matter how good the pattern, or the signal, or the measurement, none of them is so consistently reliable that we can safely use it by itself. So, while 'fake' Swing Point readings do occur, so too do 'fake' signals on trendline breaks, Fibonacci levels, Head & Shoulder patterns, oscillator divergences, or anything you can think of. But we don't give up on them because of it. Trading is only a probability, never a certainty. We should only respond to those trading oppotunities where the weight of evidence puts the balance of probabilities in favor of the market moving decisively in one direction or the other. Thus, we'll always look to confirm a SP High or Low with other things.

1. Start and End of Wave Structure
The following chart shows a market top clearly marked to the left. As we can see, the trend turned down thereafter with lower lows and lower highs, and a clear contrast between those linear looking legs down in line with trend, interrupted briefly by overlapping or flat periods of consolidation or retracement. Within this procession, we can see both SP Highs (marked by red arrows, usually signaling an opportunity to sell the rallies in the downtrend) and SP Lows (marked by green arrows, usually signaling near-term excesses of selling pressure).

While there are other Swing Point formations on this chart which are not marked, we nonetheless see that every single significant wave within the larger formation did start and end with a valid Swing Point. For instance, the third small corrective wave up from the left hand side of the chart (labeled 6) marks the end of a pullback to very near the 38% Fibonacci retracement level of the preceding leg down. That SP High marked both the end of a corrective leg and the start of the continuation down in line with trend.

Selling that rally at 1.4414 and holding it through to the start of the next major corrective pullback at 1.4029 (labeled 11 on the chart) represented an opportunity of 385 pips. You may want to look closely at all the marked portions of this chart example to see how Swing Points confirmed similar reversals, whether with or against the trend.


2. Well-timed Entry Signals with Limited Risk
When we have carefully analyzed all our charts from the higher to lower time frames and concluded that a high-probability setup is unfolding, that's where we can drill down to successively lower timeframes to look for a SP High or Low to trigger into the trade. You may have indicator signals you already like to work with for that purpose - such as a fast Moving Average crossover or a Parabolic SAR reversal - and that's fine. But what a Swing Point entry can do for you is both confirm the indicator signal and get you in, right when the market is turning. Again, it often takes an indicator a few bars to catch up with the Swing Point, so with this method you might actually enjoy a faster entry which can both reduce the size of your stop and increase your profit levels.

As a simple entry trigger, it is on the open of the first candle after the five candles comprising the SP pattern when a market order can be executed. In other words, all five candles in the pattern must have closed before action can be taken. Don't be too excited to jump into the trade that you don't wait for that last candle to close. A SP pattern wouldn't be based on five candle closes if it wasn't for a good reason. Trust the setup and wait patiently for it - it works.

The two charts below show a H4 chart followed by a concurrent M15 chart. On the higher time frame chart, we see a very large-scale corrective pullback against the uptrend, down to the Monthly Central Pivot (the horizontal black dashed line) - a potentially powerful support area. Price eventually pulled up from that area (circled, with green arrow marker), forming a higher degree SP Low. At the exact same point that price was nearing that support, a SP Low was confirmed on the M15 chart (again, on the close of the two following candles with higher lows). As can be seen from this example, once price started to move in the opposite direction, there was virtually no drawdown whatsoever: a very clean entry point with limited risk. Though this is admittedly something of a 'cherry-picked' example, it is fairly representative of price action in conjunction with quality Swing Points that we're always on the lookout for.

The above example demonstrates a bit of a dilemma we face, though, looking for Swing Points on different timeframes concurrently. If we want to act on the signal on the M15 chart, how do we know it will be confirmed by a later Swing Point on the H4 chart? If we wait for it on the H4 chart, won't the market have moved off the Swing Point on the M15 chart? In the live edge of trading, we can't know the answers to those questions definitively. The point is, when we execute on a low level timeframe, we are forced to act on incomplete information (the as-yet unconfirmed Swing Point on the higher timeframe, for example). That's where a confluence of events becomes so important - we need lots of evidence of support on several timeframes when we go long, and similarly, we need lots of evidence of resistance on several timeframes when we go short. That's the insurance we need to act on the low-level Swing Point.


3. Well-timed Exit Signals for Maximum Profit
Finally, the chart below looks at the closing side of the trade from the two charts above. Entering long where we did, and with a well-informed outlook that had the market rising in a larger 5-wave impulse pattern, a logical place to take profit would have been on or near a retest of the Old High resistance area (from the H4 chart), here marked' A'. You could have simply set an Exit Limit for a few pips shy of that Old High and left well enough alone. But let's say, you initially decided against that strategy. Then later, watching the live edge of the market as price approached that resistance level, maybe you changed your mind; perhaps the momentum of the move was starting to look questionable, so you decided it was a good place to take profit after all.

In this case, the SP High ending a leg up on a lower timeframe in close proximity to a documented resistance area would provide an excellent place to cover the long, just before price started a pullback, or possibly an outright reversal. In this example (a M30 chart), from the entry point on the third candle after the SP Low, to the exit on the open of the third candle after the SP High near the old resistance level, the total size of the run (excluding spread) was: (1.6970-1.6745) = +225 pips. This example has shown how Swing Points are realistically used in actua1 trading situations, as the logic of the profit target selected was quite typical.

If you are not familiar with Swing Points, the best thing to do is to simply practice, practice, and practice! A useful assignment might be to print off a single hard copy of each of the charts you work with for any Forex pair you like to trade (Monthly on down to M15), and simply circle every single SP High and Low you see, as per the guidelines specified above. Then ask yourself: Where did price go after each Swing Point? What was it about the Swing Points where sharp reversals happened that made them different from less effective Swing Points?

Were there other things going on in the chart at the same time? As you research these issues yourself, in particular by applying some of the other tools of technical analysis, hopefully you'll start to develop a sense for which Swing Points are meaningful, and why are not.