Trading What I See

After a narrow range yesterday, the market made two tests of the top before turning down over the lunch hour. There was declining volume on the second test, but at that time it looked like the entire day would just move sideways.

As usual, when there is no setup during the first hour I’ll mark off the top and bottom of the range and wait for a breakout (magenta lines.) Of course when we broke down there was the obvious support of yesterday’s close and yesterday’s low, so I didn’t see that as a setup.

During the day there were three pullbacks, and each showed declining volume (all marked with yellow.) The earliest was inside the first hour’s range and didn’t threaten to break out. However the second was outside that range, and the low volume pullback turned at the 50% retracement level. That’s a potential setup with a short sale just after the yellow trendline break at the blue “B.”

Again there was a low volume pullback after yesterday’s pivot bottom was broken for another potential entry (yellow “B”.) I like the second entry much better, since by this time the moving averages are pointing down.

The eventual bottom came on a spike through the yellow A-B-C and turned at both the blue parallel and at the larger A-B-C where the “C” move equaled 162% of the “A” move. Not a great trading day, but still a good example of how declining volume on pullbacks is usually followed by continued moves in the trend direction.

Returning on a Fed day doesn’t make for exciting trading. As you might expect, I marked off the first hour range and then joined a lot of other traders waiting for a good breakout that never happened. I think perhaps summer trading is finally here.

With the lack of action, I’m just posting a daily chart showing the limits of recent movements. April and May formed a rectangle, and now at the end of June we have another. However, as yesterday’s trend day demonstrates, you can still get a good move even when the larger pattern is basically sideways. It just takes a lot more patience during slow trading periods.

With the market closed next Wednesday for the Forth of July holiday there may be a lack of activity for the next several days. Because of this my posts, as today, may be a little short. If you are trading, be sure to wait for clear setups.

A weekend trip was unexpectedly extended. Since I have no access to my charting software there will be no commentary tonight. Should be back Wednesday or Thursday.

Lowell

Wedges usually appear during the final surge of a larger move, as a last gasp rally or decline before a reversal. Yesterday’s WEDGE was an exception, since it was pointing against the recent downtrend.

But all the identifying features were there. It made three touches of the bottom trendline and two of the top, creating converging lines. Each of the internal moves can be seen as a small A-B-C. The second major pullback doesn’t find support at the peak of the first wave (overlapping moves.) And volume declines throughout the pattern.

We broke out of the wedge at the open, had a pullback to the rising trendline for a potential entry, and made a relatively fast move to the wedge’s initial target — the very beginning of the pattern.

A wedge will usually reach target in half to three-quarters of the time it took to form. Normally that won’t be the end of the move, but there was a nice divergence (double bottom) warning that at least a strong bounce might occur over the lunch hour.

Like a triangle, a wedge will often reach its target (and sometimes reverse) at the same time the pattern lines cross. That’s certainly a place to take at least partial profits.

The afternoon trading was just a sideways move, perhaps caused by traders unsure of what would happen during the aftermarket rebalancing of the Russell 2000. That’s what caused the spike just after the market closed. It’s interesting that it went just high enough to complete an A-B-C=100% close to the week. Maybe there’s something to this Fibonacci stuff after all.

Setups are easier to trade when they occur at pre-determined locations. That’s why I mark off specific Fibonacci measurements as soon as a move extends beyond 162% of the first major pullback in a trend. Sometimes these levels will be ignored — but surprisingly often they correspond to pivots in the price action.

This morning provided a good example. In yesterday’s chart I had marked the next logical Fib level of 423%, and that’s where the market tried to stabilize. There was no assurance we would turn there, but look what happened between 6:45 and 7:00. The second bottom was a Fibonacci 127% external retracement of the bounce, and at the same time there was a divergence with the Stochastic oscillator.

That’s a nice buy setup, and since we had reached the 423% Fib level, my expectation was for a reasonable move. I first started watching for this level after reading Tony Plummer’s book Forecasting Financial Markets some years ago. He calls these levels Natural Reversal Points.

The concept involves market moves being influenced by the momentum of the next larger wave. Plummer considers a 262% external retracement of the first major pullback to be a “normal” move. As he says in his book:

…when a higher level trend counteracts the impulse wave, then the appropriate ratio for calculating the subsequent objective is 1.618; while if the higher level trend complements the impulse wave, then the appropriate ratio is 4.236…

And it worked again today. The Plummer book has the best explanations of Fibonacci relationships I have read. It is highly recommended, and is now out in an expanded version.

Where does that leave us now? The bounce continued for the rest of the day, but notice that the second major pulse reversed at 127% of the first pullback. And as price rose during the trading session, the volume contracted making the converging blue trendlines start looking very much like a WEDGE.

Nothing definite here, but it’s not really encouraging for any upside movement in the very short term.

Tony Plummer’s Forecasting Financial Markets

After a well structured five wave move like we had yesterday, a reversal of some sort is common. Not required, but certainly not a surprise. So when the market created a Spring setup at the open, the first red bar could be an entry for a short sale.

The Russell tried again to break above yesterday’s high, but didn’t exceed the first pivot — the most logical place for a stop. From there the market kept getting weaker all day long.

Since Spring setups can catch a lot of breakout players on the wrong side of the market, you will usually get at least an A-B-C move against the previous trend. After the 8:00 pullback price moved right to the parallel trendline just beyond where “C” would equal 100% of “A.” But then price couldn’t get back to the top of the channel.

Of course you couldn’t predict that in advance, but by the time we had reached the blue “X” on the chart, just by drawing trendlines and their parallels after each new pivot gave you a potential short entry at the top of the new channel. How much of the next move you could capture depends entirely upon your money management technique.

Over the past few weeks I’ve been pointing out Fibonacci external retracement measurements based on the first major pullback in a larger move (marked in white.) I look for reversal points at 127% and 162%. However if we get beyond the 162% level the most common turning point is 262%. As you can see, price didn’t even hesitate at that level.

What comes after 262%? In a runaway move there will often be at least a good bounce at 423%, and many times that will end the move. No — that is not a prediction. And no, I’m not carrying a position overnight. But I’ve already marked the 837.50 level on my trading chart for tomorrow — just in case.

The more you can structure your trading the easier it is to make decisions during the day. I use Fibonacci and trendlines as guides, but in yesterday’s comments John asked an Elliott Wave question. Elliott is another way of adding structure, and in many ways it is similar to what I do. Today the market was kind enough to give me a good example. (Elliott Wave traders — forgive me for some simplification.)

In Elliott Wave theory a strong move usually has three pulses in the direction of a trend (circled waves 1, 3, and 5.) An Elliott rule says that the middle wave (3) cannot be the shortest wave. Another says that wave 4 may not drop below the peak of wave 1 (although this rule is sometimes relaxed in commodities and futures.)

A general Elliott guideline also says that waves 2 and 4 will normally be different in some way — either in the depth of correction or in the number of bars in the wave, and often both are true. If you examine today’s chart you will see that all of these rules and guidelines are met.

Unfortunately, as nicely as this chart matches the rules, I have to agree with Robert Miner — in real time you can only find moves that follow clear Elliott Wave patterns about half the time. That’s why what I look for often resembles Elliott, but doesn’t depend upon complete patterns.

Let’s look at the same chart as I describe it in my commentaries. I expect the first pullback to be relatively large (50% or greater) and the second pullback to be smaller (usually 38%.) [Waves 2 and 4 are usually different.]

In a continuing move, the second rally will usually exceed 162% of the first rally. [Larger third wave.] That’s when I start looking for a third rally after the next pullback. A healthy move will also respect the support of previous pivots. [Wave 4 doesn’t enter territory of Wave 1.]

As you can see, there is a lot of similarity between what I do on this blog and Elliott Waves. But when I think in Elliott terms I tend to make predictions, and for me predicting the market often costs me money. So I use Elliott as just another tool — it gives me levels where setups may occur, just like trendlines and general Fibonacci measurements.

For example, at point 4 today we bounced off the pivot support from point 1. Because the second rally had exceeded 162% of the first rally, there was a stronger expectation of more strength ahead. Add in what looks like an Elliott sequence and it just gives more confirmation to the setup.

A basic understanding of Elliott Waves can give you one more profitable way of looking at the market. My favorite EW book is listed below.

Robert Prechter’s Elliott Wave Principle