In the event you plan to succeed in day trading over the prolonged haul, you’ll will need a reliable way of distinguishing between high-probability and low-probability day trade setups. Blindly taking all trading signals produced by most buying systems is simply not a great idea and will likely be a road to ruin in many cases. I began day trading in the late 90s, and as a result, I have come across numerous methods for separating the great trades from the poor ones. A filter that I still use to this day is one that I call the Butterfly Pattern. This pattern uses moving averages on different time frame basis to reveal the true supply and demand forces which can be driving a stock.
I have found that when a Butterfly Pattern exists, it is important to aggressively purchase stocks on pullbacks for long trades and sell stocks on rallies for short trades. This design can be a good way to screen many of your signals for the greatest trading candidates mainly because you can instantly see which side – i.e., the buyers or the sellers – is in control of a stock.
Even though a Butterfly Pattern is a highly effective screening tool, the rules for identifying the structure are remarkably uncomplicated. 1st, you have to choose two unique chart intervals which are greater than the chart interval in which your entry signal occurs. 2nd, a Butterfly Pattern exists when the 20-period simple signal typical is above the 200-period simple moving average in each of the greater chart intervals. That’s truly all there is always to it.
A very good rule of thumb is usually to need the first larger time frame be more substantial than the entry signal time frame by an aspect of five and the second larger time frame be more substantial than the primary higher time frame by a factor of 12. For instance, if the entry signal occurs about the 1-minute chart then pick both the 5-minute and 60-minute charts for your increased time frame analysis. Therefore, in order for a valid bullish Butterfly Pattern to confirm a 1-minute entry signal, the following criteria must each exist (note: reverse the logic for a bearish Butterfly Structure):
The 20-period simple moving average should be over the 200-period simple moving average for the 5-minute chart (i.e., first larger time frame).
The 20-period simple moving average must be above the 200-period simple moving average for the 60-minute chart (i.e., 2nd higher time frame).
Why is this pattern so powerful in picking out excellent trades? From the case of long trades, significant new purchasing activity would have to occur on the higher chart intervals for the shorter term 20-period moving average to cross above the longer-term 200-period moving average. A moving average crossover on two different larger time frames is clear and compelling evidence that a bullish change in sentiment has occurred. Apply the reverse logic for short trades.
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