Decision Points - Go or NoGo
When you talk to a non-technician about the market they’ll often say something like “If you draw enough lines on your charts, of course price will bounce off one of them.” They say the same thing about Fibonacci retracements and extensions. Let’s look at today’s chart with decision-making in mind, and I’ll show you one way I use trend channels and moving averages to tell me which lines to ignore.
We started with a push up through yesterday’s high (green horizontal line.) If you’ll remember from yesterday, we turned twice at the 127% retracement of a move. And a few days earlier I pointed out a gap right into a 127% retracement that failed. And what do we have at the open? A push to exactly 127% of yesterday’s last pullback.
No to be too repetitive, 127% is an important Fibonacci retracement number. The push through resistance fails — we’re at a Fibonacci number — time for a short sale. And where does it try to stop falling? 127% of the previous move up. (OK - after a 15 minute stall it drops a little lower at point #2, but I think you get the idea.)
As we pull away from point #2 you can draw the lower blue trendline and then the blue parallel, and when price turns away from the parallel we have a down channel defined. I’m a little worried about a sideways day at this point, but my risk is only breaking the blue trendline, and my potential reward is much greater — the bottom of the channel.
Here is where I draw my “multiple” lines, and my thinking as we reach each of them. I measure the distance between points #1 and #2, and multiply by 0.618, 1.0, and 1.618. Measuring from point #3 gives the Halloween orange lines (sorry - couldn’t resist.) These are the Fibonacci extensions, and I’ll evaluate each if price goes that far.
If the overall short term trend is still up, we will probably stall or reverse at the 0.618 line. If we are going sideways, the move will probably carry to around the 1.0 line. And if we are moving downward, the 1.618 line is the probable target. Predictions? Not necessary. We’ll just watch what happens at each level.
Point #4 didn’t hold at the Fib number, but just in case, I’d use the blue 13 period moving average for protection. Really short term traders could even use the pullback to that moving average as an entry point. We also have a way to go before hitting the lower channel boundary, so I’d consider a hold here.
Point #5 is a bit different. We are almost at the channel bottom, so here is where I’d take partial profits. A reversal wouldn’t surprise me, because this is a Measured Move (equal to the first drop.) But I also don’t like to completely close a trade early, so again I’ll use the blue moving average as a stop level for the rest of my position. And down we go - through the lower trendline.
Next stop? I’m hoping for the 1.618 level, but any strong push through the moving average will get me out. And what happens at the Fib line? A nice Stochastic divergence allows an exit on the first green bar, just off the bottom.
What if the 1.618 Fibonacci level didn’t hold? On really strong moves it won’t. Then you can draw the 2.618 and 4.236 Fib levels. The last is where we often reverse after “panic” moves. I don’t try to tell the market what to do. I just try to make logical evaluations at points where experience has told me to expect possible trouble. For me, that’s what trading is all about.
Trading by the Numbers
Even I was surprised at how well the market followed the “rules” today. The combination of trendline channels and Fibonacci retracements and extensions produced plenty of action. Let’s start with the gap down opening.
Friday left us in a downtrend as show by the upper orange trendline. As soon as price moves well away from the second peak, you draw the parallel line. Within several minutes of the open, that’s where we bounced (point #1.) Any trade here would be fighting the trend, but look at point #2.
Other traders are watching as we close the morning gap, pull back to exactly yesterday’s close, and can’t get through a downtrend line. Several reasons to short. And the target? Several reasons for that, also.
At point #3 we hit a yellow trendline formed by drawing through two bottoms from Tuesday and Wednesday of last week. That’s also where we hit the orange parallel for the second time this morning. And just for good measure, it is the 127% retracement of that first pullback. An exit, but not a buy. For that I would need a divergence which didn’t happen.
This time the upmove broke though the trendline, which is often followed by a pullback as seen at point #4. The move was also supported by my two moving averages (not shown for clarity) and it is a 38% pullback. Three reasons to say we have reversed direction.
Can we find reasons for an exit around point #5. It’s a 127% retracement of the drop from points #2 to #3, and it’s also a Measured Move — the first rally from point #3 is duplicated by the move from #4 to #5. Two reasons to think there may be at least a temporary pause here and bank some profits.
As soon as we pull away from point #5 we can draw the upper blue trendline, followed by the lower parallel. As nicely as our measurements have worked out this morning, it’s not really a surprise that we hit that parallel just as we also hit a Fibonacci cluster. That’s a 62% retracement of #4 to #5 along with a 38% retracement of #3 to #5. Time to get on board for another rally to the top of the channel.
Technical Analysis of Stock Trends - REVIEW
Edwards and Magee’s Technical Analysis of Stock Trends
This is (and must be) the first book review posted on Trading What I See. It’s the first technical analysis book I ever bought, and from its condition it is obviously my most-used book. Besides continually pulling it out for reference, I read it from cover to cover every few years.I won’t tell you how long I’ve had it, but I started with hand-drawn charts using colored pencils for drawing trendlines. There weren’t any personal computer trading programs back then.This is the book that taught me how to draw and interpret trendlines, and although at the time it was written a daily or weekly chart was about all anyone used, almost everything in the book can apply all the way down to trade-by-trade tick charts.
The book is written in two sections: Part One – Technical Theory, written by Robert Edwards, and Part Two – Trading Tactics, written by John Magee.
In Part One, Edwards gives a detailed look at all the various patterns that appear in markets, from triangles to wedges to head and shoulders reversal patterns and everything in between. You’ll find out the volume requirements of the patterns, and information on support and resistance, trendlines and channels.
In Part Two, Magee shows you how to make use of the theory from Part One in actual trading. If you’ve wondered which bottoms or tops to use when drawing trendlines, he covers this in his “three-days-away” rule. (For Intraday charts just substitute bar for day.) Want to know how far a breakout from a pattern will probably carry? He has a chapter titled “Measuring Implications of Chart Patterns.”
But to me, the most valuable section is “Trendlines in Action.” Every pattern is made up of trendlines, and if you have a set of rules to follow, you don’t even need to know the pattern names. Here are the signals to follow when price breaks up through a rising trendline. Or when price breaks up through a flat or falling trendline.
What is your plan of action when you see converging trendlines forming a triangle? What do you do if you already have a position, and then trendlines start converging? This section covers the parts of trading where too many authors stop writing – Magee gives you the answers.
Then he gives you a tactical review of the different types of chart patterns, what to do if you see one, what to do if the pattern forms in a position you already hold. There is even a short chapter giving a quick summary of what to do in different situations.
There is a reason why this book is called “the bible” of Technical Analysis. Many authors assume you have read this one before you pick up their book. This is not a quick read, but with some study it will give you the best education in charting you can find. Highly recommended.
For More Information:
Edwards and Magee’s Technical Analysis of Stock TrendsA Tale of Two Triangles
After a gap down, the market decided to go sideways for a while. What developed was a TRIANGLE pattern. But there are two triangles showing on the chart, and understanding the difference between them can be the difference between making and losing money.
Unless the volume decreases markedly during triangle formation, you don’t really have a triangle — just two converging trendlines. This morning the volume bars went down nicely as the pattern formed. There were other ways to draw the original triangle. I could have used yesterday’s high and today’s early low. In fact I did that for a while. But understanding how triangles usually act led to the yellow trendlines you see now.
The blue trendline was an early possibility, so let’s talk about it first. If a triangle extends all the way to its apex, you will often have what is called an “end run.” Price will push out the tip, move a slight distance, and then end up going in the opposite direction. That’s what happened to the blue triangle.
Not only did price go to the end of the triangle, but the “breakout” had absolutely no increase in volume. From any type of congestion pattern you need volume for an upside breakout or the move is likely false. That’s when I started looking for a better set of trendlines.
The first volume spike occurred, depending upon how you want to view it, on the “end run” or on the actual breakdown from the final triangle. A large percentage of the time you will get a pullback for a better entry, and this one was perfect — right back to the lower trendline.
Where are we going? Let’s check with my favorite charting book, which is also the book that taught me how to draw trendlines. In Technical Analysis of Stock Trends, 8th Edition
A decisive breakout from a Symmetrical Triangle is likely to carry at least as far as the height of the Triangle measured along its first reaction. This is a conservative measurement. The move may go much farther.
How much farther? How about a long pause at the Fibonacci 127% retracement level of today’s first up move, followed by a drop to the 162% level before the market closed. Trendlines and Fibonacci, guidelines along the market’s path.
Reference: Technical Analysis of Stock Trends, 8th Edition
The Reason for Triggers
Although I try to avoid it, some days I get a directional mindset that would have me fighting the market throughout the session. Today was one of those days. Fortunately, I require more than a potential setup. Until I get an actual entry trigger, I patiently watch the market go against me without being in a trade. It’s a lot less stressful that way.
Some of my triggers require the moving averages to agree with the trade. Others require a Fibonacci pullback of at least a certain amount — or no more than a certain amount. A few require volume confirmations. After this morning’s drop, I got none of those.
We started with a gap-up opening, with little volume. I had no intention of entering here, because there was a 127% retracement level not too far away (red line.) I’ve had that marked on my 15 minute chart since shortly after the bottom was made yesterday. Remember that two of the common reversal points are 127% and 162% of previous moves. A gap into one of these measurements often means a false breakout.
And false it was. This is the Larry Williams Oops! pattern — a gap above the previous day’s high followed by a retracement into yesterday’s range. Larry says in Long-Term Secrets to Short-Term Trading that
It is the most reliable of all short-term patterns I have researched and traded.
You could have entered on the big blue bar as it crashed down through yesterday’s high (green line), or waited for the pullback a few bars later. Either way a nice short sale. That’s assuming you got out in time. Larry’s “official” trade is an overnight hold, so it would have turned into a loser today.
I always consider this just a day trade, and that 62% retracement is a logical place for a bounce. And that’s when I started thinking we would go down for the rest of the day. Look at that volume drop. We can’t have much of a rally on that kind of decreasing volume. We’re going to break through that yellow trendline and I’ll have another nice short.
Sure we will. As I’ve said before, when I’m fairly sure I know what is going to happen …. Which is why I have triggers. On this particular trade I need to see that trendline break. Or sit and watch the market. By the time I had decided the market had really turned, I wasn’t willing to go long. That’s one advantage of being a day trader. I get a new start tomorrow.
Resources: Long-Term Secrets to Short-Term Trading
Order out of Chaos
Once in a while I can find a trade I like on Fed days, but this was not one of them. There seems to be so much random activity by traders trying to anticipate other traders just before and after the Fed announcements. But just how random is it?
Yesterday’s post showed how the market can sometimes turn exactly at parallel lines, giving either entry zones or potential exits. However we all know that the fluctuations that accompany Fed announcements change things. Maybe we shouldn’t expect the market to act the same under these conditions.
But what if we follow the same rules — in fact let me repeat them from Tuesday’s post.
Find two pivots that seem important to you and draw your first line (points 1 to 2.) Copy that line to the pivot between those two points that is the farthest away (3) and extend it into the future. Pay careful attention if price approaches that line.
I moved out to a 30 minute timeframe to include the high point of the rally that started in August. (No, that is not a prediction that we won’t go higher — I try to avoid guessing as much as possible.) Green points 1 and 2 look important to me, and point 3 is the most distant pivot between them. When the market had a rally this morning it reversed just as it reached the green parallel line drawn from point 3.
That big solid blue bar is what happened during the 15 minutes before and after the Fed made its announcement. The overanxious traders tried to anticipate by pushing the market up. Then by 11:15 (Pacific) we were moving in the opposite direction. And where did we stop? At the parallel to the magenta line drawn between 1 and 2.
Predictable? No. Tradable? It depends on your style. But drawing trendlines and their parallels certainly ranks high on my list of trading tools.
Do You Believe in Targets?
Today was a great day to practice drawing trendlines instead of trading. The range from high to low was 6.1 points — not just an NR7 day, but the narrowest day in weeks. When I find a day where I’m not happy with the setups, I’ll sometimes practice finding relationships I might miss on a more hectic day.
Today I didn’t have to look far. This is a five minute chart to show most of the last two days. I’ve drawn the trendlines in different colors to make it easier to see the parallel lines. The sequence for drawing parallels is always the same.
Find two pivots that seem important to you and draw your first line (points 1 to 2.) Copy that line to the pivot between those two points that is the farthest away (3) and extend it into the future. Pay careful attention if price approaches that line.
It doesn’t always work this well, but today it picked out two of the main reversal points almost to the tick. Although I have them listed as “targets”, perhaps that isn’t the best term. If you trade in multiple contracts (or shares), this is a logical time to take some profits. Price sometimes will break right through parallel lines, and of course, sometimes it doesn’t get that far.
Although I stayed on the sidelines today, do I see any potential trades (if you ignore the small range)? Look at the opening pattern. We had a gap down that immediately broke through yesterday’s low. Some volume. Some excitement. Here’s what I said last Thursday.
Any time you have a breakout failure, you must at least consider a potential trade in the opposite direction. Because if the change in trend continues, everyone that shorted that break has to cover their position.
The second bar (or the third bar on my 3-minute trading chart) gave a potential entry signal when it reversed. There was another potential signal at the magenta number 2. On the 3-minute chart the Stochastic oscillator gave a clear divergence as price couldn’t clear yesterday’s close (blue dotted line.) Small gains today, but even on small-range days chart reading works.
Dunnigan Bars
When you are day trading, anything you can do to make decisions easier or faster is to your advantage. Even when swing trading, as you scan through chart after chart, being able to interpret the information quickly allows you to be more productive.
I received a question the other day about my colorful charts, since most candlesticks have one color for bars that close higher than the open and another color for the reverse. I’ll be away from my trading desk today, and since I’m able to schedule posts that appear at a later time, we’ll take a look at Dunnigan Bars.
William Dunnigan was a market newsletter writer in the 1950’s, and spent much time searching for a mechanical system for trading stocks and commodities. For mechanical trading you must carefully define everything, and for Dunnigan “everything” included different types of bars. In his book One-Way Formula for Trading in Stocks & Commodities he talked about Inside, Outside, Up, and Down bars (but only used the last two for his One-Way system.)
Although I’ve coded my own color bars in programs like Metastock, QuoteTracker, and Ensign, someone saved me the trouble in eSignal by writing an EFS (script) appropriately named Dunnigan_Bars. I just modified the colors to make it easier to read on my black backgrounds.
A green bar has both a higher high and a higher low. A red bar is the reverse, with a lower high and a lower low. These are what Dunnigan used in his system. But I’m at least as interested in the other types.
The magenta bar is an inside bar. Notice how it points out the small pullback in this nice downmove. Sometimes that’s the only opportunity for a pullback entry in a fast, sustained move. And the blue outside bars often appear at reversal points, where they turn blue just as the bar starts in the opposite direction.
If you use exceeding the previous bar’s extreme for an entry (as I sometimes do), you can tell the instant it happens without looking at the price scale. The bar will change color, often from magenta to red (or green) as in this downmove.
Like candlesticks, they don’t actually add information to the chart, but they make it tremendously easier to see what is there. You’ll see them on most of my posts.
Reference: New Blueprints for Gains in Stocks & Grains and One-Way Formula for Trading in Stocks & Commodities (Traders’ Masterclass)
