From the April 01, 2008 issue of Futures Magazine • Subscribe!

Safe profits with bull and bear stairs

Most of us learned to climb stairs not long after we learned how to walk. Before long, and with practice, it became second nature. Observing and properly reacting to the charting formations known as bull and bear stairs can become just as simple.

Once you understand the basics, using stairs is a way to make consistent, relatively low-risk profits. Soon you can be executing trades based on this pattern as intuitively as you physically climb and descend stair steps — with hardly any deliberate thought at all.

Before we get to the execution, however, we need to look at exactly what goes into this simple bar chart formation on a daily chart.

CHILD’S PLAY

Currency futures markets make excellent candidates for this strategy. We will look at the euro, Australian dollar, Canadian dollar and British pound. Currency trading is often presented as a specialized practice, requiring specialized knowledge of global finance and macroeconomics to trade successfully. While a fundamental background doesn’t hurt when you’re trading any market, price movement is price movement. In that sense, bull and bear stairs, which are predominant in the Nasdaq 100, the Dow Jones Industrial Average, the Russell indexes and the S&P 500, are just as useful in forex.

Indeed, stair patterns are common on daily charts, and if you’ve been trading for any time at all, you are probably quite familiar with them. A bull stair is marked by successive trading days in which each day’s low is higher than the preceding day’s low and each day’s high is higher, though not always, than the preceding day’s high. The price seems to climb a set of stairs along steadily rising lows.

Stairs can be elusive. If you do not know what you’re looking for, a profitable stair can be buried in plain sight among all the other days on a daily chart. However, once you know what to look for, stairs will stick out with neon signs signaling potential profit. When you know how stairs work, you will have one more moneymaking play in your trader’s playbook.

“How hard is this?” shows a four-day schematic of a bull stair and a bear stair. Look familiar? Taking the bull stair as an example, the lows rise steadily. The highs rise steadily. Each day’s low is roughly the same increment above the preceding day’s low. Each day’s high is roughly the same increment above the preceding day’s high.

EUREKA!

If you know that the price in a bull stair will move below each preceding day’s high before resuming the uptrend, you could buy below that level and hold on until you reach the appropriate profit target. You repeat this, day in and day out, as long as the stairs continue.

Trading is a competition. Markets are constantly exploring potential breaking points in the competition. So, when price is rising, there is only a degree of probability that it will continue to rise. The rally must be tested each day. Knowing this, each morning, dominant buyers hesitate. These buyers want to test and, at the same time, exhaust selling pressure before bidding aggressively. The price pulls back from the previous day’s high. Frightened longs see the weakness and sell. They want out. Bold sellers smell a bearish day and short the market. The price continues to break.

The move often stops just above, or sometimes alongside, the previous day’s low. The bulls are ready now. The price has been tested. Bidding becomes aggressive. The price rallies to a new high. Some of the bulls may have sold or shorted on the way down to set up a better entry price on the day. These bullish traders set up the frightened longs and bold shorts. Traders are competitors.

If you do not understand how, or why, stairs work, you can easily become one of these frightened longs or shorts. Getting whipsawed on a bull stair can be unnerving and expensive. The experience can have a long-lasting negative impact on your trading.

BEARS WIN, TOO

The second chart in “How hard is this?” shows a schematic of a bear stair. The highs fall steadily. The lows fall steadily. Each day’s high is roughly the same increment below the preceding day’s high. Each day’s low is roughly the same increment below the preceding day’s low.

When a price steadily falls, there is only a degree of probability that it will continue to fall. The break still needs to be tested each day. Each morning, dominant sellers hesitate. The sellers want to test and exhaust buying pressure before offering aggressively. The price pulls back from the previous day’s low. Frightened shorts see the strength and cover. They want out. Bold buyers smell a bullish day and go long. The price continues to rally.

The bears are waiting just below or sometimes alongside the previous day’s high. Their mouse cursor hovers over the sell button. Every uptick means more profit when prices fall again. The price rallies far enough, then they strike. Dominant sellers overwhelm the buyers and price breaks. Some bears who went long on the way up to play both sides smoothly flip positions, joining the other bears in adding to the selling pressure.

WHAT CAN GO WRONG

True stairs happen only rarely. As such, they are a limited tactic. What looks like the start of a stair can be a false start. The would-be stair can fail on the second day. Of course, all stairs will fail at some point. A bull stair failure occurs when the price cuts below the previous day’s low. A bear stair failure occurs when the price cuts above the previous day’s high. Most runs tend to exhaust themselves on or about the fifth day.

Sometimes, during a bull stair, the price will rally off the previous day’s close without breaking farther (or, in a bear stair, break off the previous day’s close without rallying farther). Sometimes, the price will gap higher in a bull stair (or gap lower in a bear stair). When a stair fails, it can be a false failure. For example, in a bull stair the price may cut below the preceding day’s low then continue to rally on the following day (the reverse is true during a bear stair).

Despite their faults, stairs can still be powerful predictive tools. The basic logic in a bull stair is to buy low/sell high each day (in a bear stair, sell high/buy low). One defensive play in a bull stair is to place a stop-loss below the preceding day’s low (in a bear stair, above the preceding day’s high). The stop could be a close-only stop or a series (layers) of stops so that you exit at multiple levels instead of a single level.

REALITY CHECK

The forex market on Feb. 1, 2008, presented a good illustration of what can go right and wrong with stairs. On Jan. 30, 2008, the U.S. Federal Reserve Bank cut U.S. interest rates sharply. You might have thought this would be bullish for non-U.S. currencies. Well, the run up to the announcement was bullish in general. The aftermath of the cut was mixed.

In “Bull stair: Day 8”, you see a daily euro chart covering 30 days. Counting the days from right to left, you see that the euro has been rallying in a well-defined bull stair for eight days. Each day’s low is generally higher than the preceding day’s low. Each day’s high is generally higher.

On the rightmost trading day, Feb. 1, the euro pushed higher then collapsed. On a closing basis, the euro is now pushing bull stair support at its Jan. 31, 2008, low. This is what’s known as an opposing low close, in which the price closed in the opposite direction of the bull stair. Longs were alerted on Feb. 1 to the possibility that the stair could fail. You also will see that a seven-day bull stair occurred in late December 2007 on the far left of the chart.

In “Made you blink,” you see a chart of the Australian dollar covering the same time period. Notice the resemblance to the price action in the euro. The Australian dollar is in a seven-day bull stair. On Jan. 31, 2008, the second day to the left, the Aussie dollar cut below the preceding day’s low on an intraday basis then closed higher. A tight stop-loss would have been triggered. A layered stop loss would have been partially triggered. A close-only stop loss would not have been triggered. If you trade without stops and track multiple currencies and related markets, you might have bought when the price cut below the preceding day’s low. Strictly speaking, however, you would have exited any long position on Jan. 31 then re-entered later that day or re-entered on Feb. 1.

In “Close call”, you see a chart of the Canadian dollar. On the second day to the left, the price cut below the preceding day’s low. On Feb. 1, the price struggled to regain momentum. You would have exited any long position and you would have hesitated to re-enter on Feb. 1. The lines on the charts are linear regression channels. Although they are not the focus here, they add an interesting dimension to the study of bull and bear stairs. The upper (sell-line) of the channel is resisting the price. The proximity of this resistance would have added to your hesitation to re-enter on Feb. 1. You would have looked elsewhere for a profitable trade. Nevertheless, for five days you enjoyed a good run.

In “Oops!” on the rightmost day, Feb. 1, the price cut sharply below the preceding day’s low in the British pound. If you use stops, you would have been taken out. Once again, the proximity of the linear regression sell-line would have alerted you to the potential of a sell-off. Nevertheless, you would have enjoyed a bull stair on the way up to the sell-line.

Look at a daily chart of the currencies you follow. See how many bull and bear stairs have occurred over the last 30 days. Each of these occurrences was an opportunity to profit. Learn to recognize a stair. Study how stairs behave. Pretty soon, you may be climbing them to consistent, safe profits.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day-trade his own account. He publishes a day-trading diary on his Web site www.DayTradingWithLinesInTheSky.com .E-mail him at richardmue@yahoo.com .

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