Trading What I See

Last Thursday I pointed out a trade using the A-B-C Fibonacci pattern. Yesterday the market repeated that action. These patterns occur in all timeframes, and often you will see patterns inside of patterns inside of patterns. In today’s 15 minute chart you can see three levels of A-B-C.

The basic pattern consists of a move (A), a retracement (B), and a continuation (C) that usually stops at either 62%, 100%, or 162% of the original move. My interpretation of what is likely to happen after the A-B-C completes is based on which level turns the market.

If wave “C” is only 62% of “A” the market move was not very strong, and a good reversal is likely. If wave “C” turns at 100% of “A”, the market is in balance. But if wave “C” is 162% or larger, there is a good chance that the entire move is not over.

Today’s chart shows three A-B-C patterns, all starting at the top marked with the multiple “X” symbols. The pattern in blue was yesterday, as price broke downward from a long rectangle. The pullback into the close became the “B” wave of a larger pattern (yellow.)

If including a gap in the middle of a pattern makes it hard to follow, consider doing as I do — consult a chart that includes the trading outside of market hours. You’ll find that there really isn’t a gap — trading occurred during that empty area. It just happened between 4:15pm and 9:30am (Eastern time), so it doesn’t show on “regular” charts.

The yellow wave “C” didn’t stop at 100%, so there was a warning that more downside action was a strong possibility. And that brings us to the green wave “B”, which on a 3 minute chart contained a very small a-b-c, with “c” stopping at 62%. If you saw the larger pattern, that created a potential entry for the afternoon drop. If not, there was a downside triangle that could have been used for the short sale.

Where are we now? The large green A-B-C pattern has just reached the 100% mark. That does NOT necessarily mean we will bounce on tomorrow’s open. You can’t classify an A-B-C pattern until a pivot has occurred. But the market has been struggling for the last two weeks, and with the severity of today’s drop my assumption is we are finally seeing a long overdue correction.

Yesterday closed with a Test of Top in the Russell 2000, and today opened with a failure of that test. Nothing serious — just another inside day, but when a market makes new highs and can’t continue there is a serious threat we may head in the opposite direction.

The first chart today is the 15 minute timeframe, and it shows a large rectangle formation. This gives a good picture of how much congestion there has been in this shortened trading week. Criss-crossing moving averages are another good indication that trading opportunities will be hard to find.

With no reasonable trade setups today, lets review two types of retracement patterns that, under better conditions, I watch for potential entries. The first, marked in yellow, is a normal Fibonacci retracement. This is the one most people recognize, where the market pulls back to give traders a second chance at entering a change of trend. It is often 62% of the original move, but other Fib numbers will occur.

The retracement marked in magenta is less well known. It has several names, but I like to call it an external retracement. This is a retracement that goes farther than the original move, and will often reverse direction at 127% of the first move.

Neither of these are automatic trades, but since they can be drawn long before price reaches them, they give lots of time to look for confirming signals. The two levels also work well together, since a purchase at the 62% level can often use the 127% level as a first target.

You can see how that would have played out today — if we hadn’t been in congestion. If someone is new to Fibonacci measurement, these are the two levels I would have them watch first.

Fibonacci Extensions are one of my most useful tools. I use them to help me decide where prices may turn and, just as important, where I expect prices to continue. Today we had a series of Fib extensions inside a larger extension pattern.

First, a disclaimer. Although I traded some of the smaller patterns today, I didn’t recognize all of the internal relationships until tonight’s analysis. And although I’ve used standard Elliott Wave labels because they fit so well, I’m not really an Elliott trader. (Note that some letters are lower case and some in capitals.)

We gapped down this morning, opening below yesterday’s low. After a fast drop to the level of the December 1st pivot bottom, we reversed and climbed back to more than fill the gap. My first thought was “Oops!” If you are not familiar with this, it is a Larry Williams pattern that plays reversals of gaps. Point “a” would be a buy signal.

I don’t trade the Oops! pattern by itself, but that signal gave me an upside bias. But only until 8:00, when we reversed from point “c”. The reason was the extension level that we reached. Let’s go over extension measurements again, using this first rally as an example.

An extension measurement takes the distance of a move in one direction, and applies several percentages of that distance to the next move in the same direction. In other words, we would compare the distance from “X” to “a” with the distance from “b” to “c”. In a normal movement the second length will end up at either 62%, 100%, or 162% of the first length. This time it was 62%.

If the Oops! pattern were going to work I would have expected at least a 100% extension, also called a Measured Move. When that didn’t occur I became very cautious. That doesn’t mean I quit trading — just that I no longer had an upward bias.

The movement down from “A” to “B” subdivided into a smaller a-b-c , although the Fib relationships were not as exact as I would like to see. Then we had another movement upwards, shown as the white line from “B” to “C.” This is not a simple up-down-up movement, but what Elliott practitioners call an Impulse move. And it ends at a closely packed Fibonacci Cluster.

If you measure from “B” to “1″ and then add the Fibonacci ratios of that distance to point “2″, it gives you the top of points “3″ and “5.” If you measure from point “2″ to point “3″ and use the ratios from “4″ it also gives you point “5.”

Now let’s take a larger look. Measure from point “X” to “A”, apply the Fib measurements and add them to point “B.” Once again you come up with the level of point 5, the entire pattern making up a large A-B-C. Three Fibonacci Extensions all pointing directly to the same level. And that’s where we turned down.

Whether you use Elliott Wave counts or just Fibonacci measurements like I do, the 791.50 level from this afternoon looks like an important number. Remembering that I don’t trade Elliott by itself (BIG DISCLAIMER), that A-B-C pattern looks just like an Elliott correction in a down move. I wouldn’t be at all surprised to see a drop tomorrow back below point “X.” But all that means to me is that I start tomorrow with a bias of down.

Robert Prechter’s Elliott Wave Principle

Today had some indexes breaking out, the DOW to a record high and the S&P to a six year high. The Russell 2000 tried with a nice early rally, but then went flat in a narrow range for the rest of the day.

Unless you are trying to catch very small moves, today would have been full of whipsaws as you kept expecting the market to continue (or reverse) the early trend. And looking at the wrong indicator can give you signals that are not reflected in price.

You’ll usually see a Stochastic oscillator at the bottom of my charts, and I use it for both timing and directional information. The Stochastic is what is called a “normalized” oscillator, meaning that it will keep going back and forth between zero and 100, even if the price swings become very small.

That works well if the market is moving in tradable swings, but can give you a false impression of what is happening in a narrow sideways market. Look at the Stochastic (bottom) with the MACD (Moving Average Convergence Divergence) oscillator above it.

The MACD is constructed by taking the difference between two moving averages. Compare its rise and fall with the separation of the moving averages I keep on my price chart. (It won’t match exactly, because the moving average lengths are not the same.) After you’ve watched them long enough, you can actually get equivalent information from either, but some find the MACD easier to read.

The MACD is not “normalized,” meaning it has no arbitrary limits to its up and down moves. But this also means that, being smoother, it sometimes gives you less detailed information. That’s why many traders like to keep an eye on both types of oscillators.

Their differences are most apparent when the market is going sideways. When the market becomes less and less volatile, the MACD starts to stay very close to the zero line, while the Stochastic keeps giving overbought and oversold signals.

After todays early rally, the sooner you decided there was no tradable movement the better. And using the MACD (or carefully watching the moving averages) was the easiest way to stay out of trouble.

While many people trade multiple markets or multiple stocks, when I am working on a very short timeframe I feel more comfortable concentrating on one. But that doesn’t mean that I ignore all the rest. On intraday moves, my market (the Russell 2000) sometimes leads the others, and recently it has been lagging. But overall, your best trades will occur when the markets are moving together.

How can you keep an eye on other markets without becoming distracted from your own? My solution is to standardize my charts so the important things stand out. I use two monitors during the trading day, but that doesn’t mean I am limited to two screens full of data. With a mouse click I can bring up a general market layout to see what is happening elsewhere in the trading world.

First the standardization. On my markets page each of the six charts has a green line showing yesterday’s high, a red line for yesterday’s low, a thin blue line at yesterday’s close, and two moving averages. All six of the charts are linked, so by simply typing in a number (3, 15, etc.) they will all switch to a different timeframe. The bars are color-coded (see Dunnigan post) so I can instantly see the direction of the last bar. And in the bottom pane is a modified MACD to show the overall trend.

In addition to the major futures markets (NQ, ES, and YM), I have a chart for the semi-conductors (SOX) and the two parts of the S&P 500 (the large cap and mid cap sections.) Although this is a screenshot from the end of last week, look at the information available at a glance.

The DOW futures (lower right) are above yesterday’s high (green line), while the midcaps (upper center) are still trading below yesterday’s low. All the other charts are inside yesterday’s range. Quite often, just watching the OEX and the MID charts, you can get a feel for the strength of a rally or decline. If they are moving together, there is momentum. If they are fighting each other, there is more likely to be congestion.

Seeing how price and the two moving averages are acting gives you another clue to trending or non-trending motion. Notice how easy it is to see that the SOX are the most congested at the present moment.

On a shorter timeframe, look at the colors of the last few bars. The mid-caps are rallying — trying to catch up (many green bars), while the other markets are going sideways (magenta or alternating red and green bars.) And the MACD at the bottom is oscillating in smaller and smaller moves as option expiration day expires in a sideways motion.

I keep this chart hidden to avoid being distracted from my interest in the Russell, but when I’m trying to get a feel for the markets, or just before initiating a trade, I’ll take a quick look at these charts. Never for signals, but for the context to know what to anticipate from my own trades.

Watching the overall market, the number of advancing and declining stocks, the rise and fall of sectors, and what is happening to volume is all a part of understanding the context of your trades. Although most traders can see the importance of this information, setting up a structure that is easy to use can be intimidating. I’ll be out of town the day before and after Thanksgiving, so I’ll use this opportunity to show how I track the rest of the market. I’ll start by talking about TRIN.

I have the actual numbers for the NYSE advances and decline, as well as up and down volume figures, showing on one of my monitors all the time (image on left.) But one key element of my trading requires that all my basic information can be interpreted at a glance, and the raw numbers don’t do that job.

Richard Arms came up with one solution in 1967. It is the ARMS index, but more people probably know it by the name TRIN, or the Short Term Trading Index. It is an attempt to measure the amount of volume going into advancing and declining stocks by combining their ratios into a single index. The number of advancing stocks is divided by the declining stocks to get their ratio. The same is done with advancing and declining volume. Then the first ratio is divided by the second to get TRIN.

According to Gerald Appel’s Winning Market Systems

This is a quite sensitive indicator and frequently changes direction moments in advance of market turnarounds on an intra-day basis. It is usuful in trading operations but its extreme sensitivity does result in false signals and fosters emotional activity.

He goes on to say that, in its raw form, the best use is to time the exact moment for pre-planned entries or exits in the market - not as a signal in itself.

There are many ways to use TRIN, and the most simplistic don’t work very well. You’ll find it written that a number less than 1.0 is bullish and over 1.0 is bearish. As a very general observation, this is true, but it is actually the direction (or change of direction) of TRIN that is most important to traders. And that leads to a visual problem, that in turn can lead to mistakes in a fast market.

When the market is rising, the TRIN tends to be falling. When you chart the TRIN under the market, a falling TRIN is bullish, and a rising TRIN is bearish. In one of his columns Dick Arms said that if he had it to do over, he would have turned the Arms Index upside down to make it easier to read. Of course, after almost 40 years, no one is going to change the actual numbers.

But with a computer you can reverse the direction of the numbers yourself. Because the indicator is so sensitive, many traders slow down the action of the TRIN, usually with some type of moving average. I use a modified MACD on the raw TRIN, and in the process, I flip it upside down.

The MACD (created by Gerald Appel - that’s his quote above) uses three moving averages to create a momentum oscillator. But by putting the numbers in backwards, you can reverse the direction of the oscillator. This way I accomplish two things — I slow the TRIN down to a level that matches my trading, and when my indicator goes up, so does the market.

The normal numbers for an MACD are 12, 26, and 9 — all exponential moving averages. The second moving average is subtracted from the first to give the MACD. Then you create a moving average of that result (using the third number) to create a trigger line. And if you want to reverse the direction of the oscillator, just reverse the order of the first two numbers.

Experiment with the input numbers to come up with a TRIN oscillator that matches your trading style. At the present time I’m use the Fibonacci numbers 34, 21, and 8 on various timeframes, but the goal is not to match my indicator — it’s to find something useful for you.

A magic indicator? Not at all. This is not even necessarily what your market is doing — it’s just another way of tracking whether your potential trade is riding the general market trend or fighting it. Have a nice Thanksgiving tomorrow, and Friday I’ll show you how I track multiple sectors of the market in real time.

Gerald Appel’s Winning Market Systems: Eighty Three Ways to Beat the Market