Trading What I See

I wish the Fed would make its announcements over the weekend instead of messing up a perfectly good trading week. But even on Fed day the Fibonacci levels keep working. I just question whether it is worth trying to trade them.

We started with a fast drop that reversed right at a 127% external retracement of yesterday’s last rally. It was no surprise that we then went into a sideways pattern as everyone waited for the Federal Reserve Policy statement.

I’ve marked two A-B-C patterns — one in yellow and one in blue. This type of overlapping pattern will often end in a Fibonacci cluster with several measurements pointing to the same level, in this case to point “C.” On another day this might be tradable, but I took a long walk about that time.

There is one interesting feature today that is sometimes quite useful. Although I first heard about it from Robert Prechter (Elliott Wave Principle), it is best explained in Connie Brown’s Technical Analysis for the Trading Professional, one of my favorite comprehensive trading books.

Notice where the two trendlines that create the triangle pattern cross. After a triangle breakout the market will often change direction right at the triangle apex. The top came very close to a Fibonacci 162% of a even larger A-B-C pattern, so you would have had both a price and time target. Always useful information.

Connie Brown: Technical Analysis for the Trading Professional

Sometimes Fibonacci measurements are obvious, and other times you have to make some tough decisions during the trading day. This morning was an example of how I attempt to make my choices.

The move up before lunch is marked with both magenta and blue A-B-C patterns. The magenta pattern started with yesterday’s 11:00 pivot low, and the blue pattern started at the magenta letter “B.” Looking back it’s easy to see that the blue A-B-C was the one to trade, but could you tell that in real time?

Remember that Fibonacci lines are just places where turns may occur — not where something has to happen. However if you have several Fib levels that match, a reaction becomes more likely. I had both patterns marked on my chart.

As soon as we exceeded yesterday’s high (green line), I drew the 127% external retracement of yesterday’s pullback (shown in white.) There is an almost perfect match between the blue A-B-C and that retracement, creating a Fibonacci cluster. As we reached that level, the Stochastic made a divergence with price, indicating a probable top and a good exit point.

The move down over the lunch hour also made an A-B-C pattern (not marked), but this one didn’t quite reach its target. The reason — it stopped precisely at the 38% retracement of the entire move. As is often the case, when you get close to a support or resistance level (or a Fib level), you must switch to price action for your final decisions.

The afternoon was another A-B-C pattern that once again ended at a 100% Measured Move. Notice that it was a flatter pattern than we had earlier. That often means that it’s time for either a pause or a correction. With tomorrow being Fed day, that’s not surprising.

Someone asked me last week for a good book on Fibonacci relationships. I probably have 10 or 15 that cover the subject in some manner, but the one that has influenced me most in the way I treat the A-B-C pattern was Forecasting Financial Markets by Tony Plummer. I just noticed that he has now expanded his book with new material in an updated version. If you are interested, see below.

Tony Plummer’s Forecasting Financial Markets

Once again it’s necessary to use part of the previous day’s price data to show all the Fibonacci relationships, so this is a five minute chart rather than my trading time frame. Today starts at the beginning of the blue dotted line (yesterday’s close) in the middle of the chart.

The narrow yellow channel was already in place, and yesterday we closed right at the lower trendline. This was also a 50% Fibonacci pullback of the previous rally. On my 3-minute trading chart the Stochastic was oversold, so an entry would only risk a break below the rising trendline.

The upper line of the narrow channel didn’t stop the early price surge. When this happens,I usually draw another parallel line from an earlier peak. These secondary channel lines are not quite as consistent, but you can see they certainly worked today. When we approach the top of a channel, I move my trailing stop quite close, so I didn’t catch the last part of the move.

Then came a series of divergences — first at point “3″, and then at what I have marked as “B.” Point “3″ is the type of divergence that I use for exits, but not to take a position in the opposite direction. Notice that each minor peak is higher than the last, and so are the pivot lows. Higher highs and higher lows still indicate an uptrend. I’ll only take a reversal here if the divergence looks very strong.

But by the time we get to point “B” things have changed. Point “A” was a lower low, so the trend is now sideways. Point “B” becomes a test of the top at point “3″, and since “B” is slightly higher than “3″ it could be considered a Spring top. This divergence creates a short sale setup, with the trigger being the break of the blue trendline and the moving averages.

If you look at the entire move that started Friday, you’ll see on a larger scale the patterns I’ve been pointing out lately. The first pullback (#2) is a 62% Fibonacci retracement, and the second pullback (#4) stops at 32%, in this case of the entire move from Friday’s bottom. A large first pullback followed by a smaller second pullback are the norm. After this happens, additional entries become much more risky.

Today I was tempted to take at least one trade, but decided against it. Let’s look at some longer term charts and I’ll show you why. First the Daily.

I last showed a Daily chart when we broke out of a four month up-channel. Since that time we have been traveling sideways in what looks like a rectangle. We’ve had some new highs in various indexes, but not in the Russell. If I were trading the daily chart I’d probably be on vacation. One tip worth remembering — according to Linda Raschke, the longer a consolidation takes, the more likely it is to be a reversal.

On a 45-minute chart you can see why I didn’t get excited when we broke down this morning. After a slight gap up to the longer moving average (white,) by 7:00 AM we had dropped and bounced off a rising trendline. Notice that the moving averages are crossing back and forth, showing that this time frame is also in congestion. Add that down trendline and it sure looks like a triangle to me.

Finally to the 3-minute trading chart. If you’ll remember yesterday I called the small gap up and the reversal as a tradable setup when it crossed the moving averages. I hope you don’t consider this a similar situation. Yesterday we poked through resistance — a requirement for a Spring. Not today. Yesterday we were hitting Fibonacci resistance. Not today. Yesterday there was a divergence. No trade for me here. It would have made money, but it doesn’t fit my trading plan.

As you saw on the 45-minute chart, we bounced where it was expected, and this placed us back in some tangled moving averages. Congestion is now showing on three time frames. And as I’ve mentioned several times in the past, when I can’t find a tradable move in the first hour I will tend to wait for a breakout from this range. In this case the range was set in the first 30 minutes of the day.

Over the next three hours we formed a rectangle, and my only temptation was to take this breakout trade at the end of the day. If you don’t normally trade chart patterns, here are my requirements for a rectangle trade. First the volume must decline, with the only exceptions being false pokes through the boundaries. Second, the actual breakout must have a nice increase in volume. And third (many don’t agree with me on this one,) I want a pullback to the top of the rectangle for my entry.

All of these happened today, and we quickly reached the first target in about 20 minutes. But it was Friday. And we are in congestion. And a lot of traders had already left for the weekend.

If you want to learn more about chart pattern trades, I still think the best book available is Edwards and Magee’s Technical Analysis of Stock Trends (see my review.) It’s also the most-used book in my trading library.

Edwards and Magee’s Technical Analysis of Stock Trends

Yesterday we ended the session trying unsuccessfully to get through the 799 level, and I mentioned that the pattern looked like an upside triangle but with the wrong volume. Unless a triangle’s volume consistently decreases, they will often fail. Add a few more factors, and today’s false breakout was tradable as a short sale.

In white I’ve marked off the last pullback and its retracement. As usual, if a reversal is going to occur, it will often happen at a 127% or 162% external retracement. I consider this zone a danger area, and try not to initiate trades there.

Not only did we reverse at 162%, it was also at what some traders call a “Round Number.” In this case the number was 800. These numbers often become important support or resistance levels since many traders will exit as we approach them.

Finally, there was a Wyckoff Spring pattern — a break to a new price high or low with an immediate reversal. If a breakout can’t hold or continue, we’re likely to have a tradable move in the opposite direction. I particularly like this trade when it is accompanied by a divergence as marked in the Stochastic. This is one of the few times I will enter on the break of flat moving averages.

The move down to “A” gave a nice Stochastic divergence signal for a profit-taking exit. Unfortunately, as I’ve explained over the last few days, unless there are other reasons for a trade, I want the first pullback to be at least 50%. The 38% retracement left me watching the continuation down.

But as I’ve also pointed out, if the first pullback is only 38%, the second is likely to be the same. Point “D” also came right back to the declining moving averages. I would have preferred more separation between the two MAs, but a stop above “D” was never challanged

The bottom didn’t meet any good Fib measurements, but there was a nice divergence for an exit. And catching two out of the three moves by following the rules isn’t bad.

“Patience has Big Rewards.” That’s another note I have posted on the bulletin board right next to my trading setup. Take another look at yesterday’s non-trades. Fortunately I had the patience to ignore questionable signals. Today you’ll find the reverse — all my signals were there. And I had the reward of only taking signals that followed my style of trading.

The early rally ran up to yesterday’s high and reversed. That allowed drawing the first trendline from the previous high pivot up to point “1.” Whenever I draw a trendline, I try to draw a matching parallel, because that is often where the next trade will occur. Point “2″ is where price hit that parallel line, and it occurred precisely at a 62% retracement of the original move for the first clear entry of the day.

The rally from “2″ to “3″ wasn’t nearly as strong as I would have liked. For a good continuation I want the second rally to be stronger and faster than the first, so I was not surprised that the move ended between the 127% and 162% external retracement of the move from “1″ to “2.”

Now I have a new top pivot, which allows me to draw another upper trendline. And of course I draw the parallel. As I said yesterday, when the first pullback is at least 50%, I expect the second to end near 38%. When the 38% level occurs just as price hits my parallel line, it calls for another entry, but in this case a very cautious one. Here’s a case where my rules are met, but I’m not thrilled by the action so far. I really wanted that second rally to be stronger.

But with patience (and a very close stop) everything worked out as it should. The final top is a Measured Move, the distance from “4″ to “5″ matching the distance from “2″ to “3″. The divergence with the Stochastic was an added reminder that the move was probably in its last stages.

Is that the top? I have no idea. The “safe” parts of this short move are over for now. The last pattern looks somewhat like an upside triangle, but one with faulty volume. That means I’ll do as I always do — wait for the opening bell and re-evaluate as I draw more trendlines and Fibonacci measurements. And wait patiently for setups I really like.

Understanding your own trading style is critical to trading success, and when the market doesn’t offer signals that match that style patience is the best practice. I’ve labeled the chart today showing where the signals I trade on just didn’t occur. Because today I didn’t trade at all.

Point “A” was a nice early drop that could have led to a reversal signal, but after yesterday’s flat close, only a strong divergence would have convinced me to enter there. The yellow trendlines show that there is no divergence at “A”, so the break up through the moving averages is not one of my signals.

At point “B” we start the first pullback in a potential move higher. But if you’ve followed my trading analysis very long, you know I expect the first pullback in a move to be at least a 50% retracement. I like signals when price is bouncing off moving averages as at point “C”, but this was only a 38% retracement with no encouragement from the Stochastic.

The nice rally to point “D” was followed by another pullback. If a first pullback is 50% or greater, the next pullback is usually 38%. If the first pullback is only 38%, sometimes the second pullback will equal the first. But today we only got a 25% retracement at point “E.” Again this doesn’t give me a signal without additional strong confirmation.

With very small pullbacks, even trendline channels (not shown) tend to fail. Only when we get to point “F” does one of my expected Fibonacci levels work as price reversed at a 127% external retracement of the drop from Friday’s high. But that is normally my exit point. It only becomes a signal to take a position if there is a strong divergence. Looking at the Stochastic you can see that isn’t the case.

I know traders that would have done well today, but my trading style requires that the market set up patterns I’ve seen work over and over in the past. And to have patience on days when this doesn’t happen. If you’ll review the last week, you’ll see that it has fit my style quite well. Today didn’t. Learning the difference is one key to trading consistency.