Trading What I See

It’s nice to end a trading example and have everything work so precisely. Not only did we hit and reverse at that 262% Fibonacci target I mentioned yesterday, but we did so at a logical time interval. Before I explain, a quick message.

I’ll won’t have computer access for a few days. Hope to be back online by Monday. In the meantime — Good Trading.

Lowell

The first chart today is just the completion of the patterns shown yesterday. As expected, we reversed right at the 262% Fibonacci extension, completing a nice A-B-C move. What I’ve added is a timing signal that I mentioned once before. In a triangle pattern, there is often a reversal just at the time that price reaches the apex of the triangle.

Like many other things I follow, I never trade this by itself, but as you can see in the example, Time and Target matched up exactly. Sometimes it is just a big bounce, and sometimes an actual reversal. Because of declining volume on today’s rise, I think this time it is probably just a bounce.

Since I won’t be commenting for several days, I’m including a Daily chart that shows some potential problems. You’ve just seen an example of the power of a 2B reversal. If you need a refresher, check this earlier post, or buy Trader Vic’s book from the link at the end of this post.

On the Daily we broke a well-established uptrend on February 27th. I’m sure you remember that day. We’ve spent the last two months trying to regain the earlier peak, and as soon as we did, the breakout failed. I prefer a cleaner top, but that certainly looks like a large scale Trader Vic 2B setup to me.

And the entire rise from the bottom in early March looks like a rising Wedge that broke down yesterday. If it is a wedge (and remember I don’t try to make predictions) the initial target could be around 760.

But the nice thing about day trading is that you can use these longer term patterns as general guidelines without becoming commited to any one direction. Do as I do and just trade what you see — one trade at a time.

Victor Sperandeo: Trader Vic - Methods of a Wall Street Master

You’ve probably noticed that recently I seem to be showing a slightly larger picture of market action. Actually I try to look at this every day, but since right now I can’t follow the market in real time (and may not be able to for another month), the larger picture is what I see first. And it has been providing interesting information.

On Thursday I pointed out the Trader Vic 2B Top. They don’t always work out, but since they allow a close stop, I never ignore them. They are, of course, a specialized instance of the Spring patterns I like to trade. Since the pattern took over a day to form, it was a warning that the larger trend had probably changed to down.

Friday and today completed what is called a Downside Triangle with a downside break after about four hours of trading. Triangles of any type usually break with a strong price surge, and today was no exception. One thing I watch for in all patterns, but particularly in triangles, are internal Fibonacci measurements. The better the Fib setup, the more likely the triangle is to work as expected.

I have three peaks numbered in the chart representing the three rallys making up the triangle. The second rally is 62% of the first, and the third rally is 62% of the second. That type of symetrical pattern seems to make the breakout more likely to reach its minimum target. In this case the target is the parallel to the upper edge of the triangle which we hit near the close.

The triangle itself is made up of an A-B-C pattern which has passed the two first logical Fibonacci targets. Notice how it tried to bounce at 100% and 162%. If it continues, the next target will be 262% which usually creates a bottom. And if it develops into any kind of panic move it could drop to 426%. Check out a longer term chart and you’ll find old congestion near these levels.

Which doesn’t mean we won’t turn around tomorrow morning. Fibonacci targets are not predictions, but if you’ve read this commentary for very long you are aware of how often they work out.

I’ve gone to a 15 minute chart to show the context of today’s trading, and because the best trade of the day isn’t obvious on a shorter timeframe.

The eleven bars before point #1 represent the almost three hours of sideways movement from yesterday afternoon. The support is from yesterday’s low. The opening gap broke through the yellow trendline with two anchor points set up during that congestion. Within a few minutes we broke the blue 2-day trendline, and then bounced from the support of yesterday’s low.

And then came the only reasonable trade of the day. If you caught it. And I didn’t. And I have no excuse, because that is a beautiful example of Trader Vic’s 2B SETUP which I’ve posted about several times recently. A trendline break late yesterday, a reverse and penetration of the pivot low this morning, and then a reversal back up through that same pivot.

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. That’s why the rally went up so fast.

But (quickly changing the subject away from my missed trade) this chart brings up a touchy point about trendlines. Many traders that I highly respect say that a valid trendline cannot go through prices. I want to show you why I disagree.

The first bar today moved down fast, but there was no reason to consider the move unusual. However look at point #3 and beyond. The market, with four more touches so far, thinks that the broken trendline is still valid, and so do I.

There’s a lot to learn with a careful study of trendlines, so let’s continue at point #2. The rally ran into resistance at a logical point, and then started easing down. This is where I stopped looking for trades, for now we were within converging blue trendlines. At first I though it was a large triangle, but the volume pattern changed my mind. Still, converging trendlines should always be seen as a caution signal.

I think people were waiting for the Phily Fed release, since it moved the market so much last month. That occurred at the blue bar, with prices first dropping and then going the other way. When they came back up, they pierced the trendline. Although that volume bar looks a little tall, most of it came on the first downmove, not on the breakout. Upside breaks through trendlines are not to be believed without volume increases, either on the break or immediately afterwards.

Most people will shift the angle of their trendline here. But if you do, you may lose some very valuable information. See how price acts as though the blue line doesn’t exist. That shouldn’t happen. Trendlines tend to be stronger than that. Either price respects them, or it pushes through with a spurt of volume. But when price ignores a trendline, you can be pretty sure that a triangle is forming, and sometimes this gives you a very early warning of congestion ahead.

The breakout at point #4? That came after the stock market closed — futures trade for an additional 15 minutes. Upside breakout — not! No volume there.

I’m not saying don’t change trendlines. I’m saying that as a trader you must make a decision about where a trendline goes. If you can’t decide right now, draw two. Then erase one later. Broken trendlines don’t necessarily stop being valid, even when price goes far beyond them. Keep watching and I’ll give you some examples as I see them.

Oh, and don’t forget — remember 2B.

Many think that when a correctly drawn trendline breaks, prices have reversed. That’s not quite the way it works. A trendline is simply a “best representation” of the direction of a market, showing how quickly price is rising or falling. The only conclusion you can draw from the break of a trendline is that conditions are changing.

The market may actually reverse, but it may just pause and continue higher. Or it might decide to go sideways for a while. A 15 minute chart shows we are following the third course.

Point 1 shows the end of a two day rally, as price broke both a trendline and a short moving average. Sometimes this leads to a complete reversal, but more often there is a re-test of the rally high. This occurred at point 2. If point 2 had exceeded the rally peak we would have had a Trader Vic 2B SETUP, and a potential trade. But since it didn’t, what we get is a trading range.

After you’ve had a re-test of top following a trendline break, you can draw the two yellow lines shown in today’s chart. These lines will define short-term support and resistance, and trades between them should be taken with care. A break of the bottom line will confirm a change of trend, which looked like it was going to happen this morning at point 3. When that didn’t occur the equivalent of a rectangle formation developed.

A good upside breakout of a rectangle requires a volume increase, and we didn’t get that this afternoon. Today was Columbus Day, with it’s expected lighter volume. Tomorrow when some more traders return, maybe we’ll find out which side of this trading range will be broken.

Today was a good example of why watching a longer timeframe is a good idea. It’s not to make entries, but to observe the context for setups on your trading chart. Tuesday I showed the way a longer chart can influence your trade timing in a negative way. This example shows how they can save you money.

The first 3-minute bar broke through yesterday’s high, and although price turned down within the 127% - 161.8% danger zone, the move looked pretty strong. The pullback stopped right at the .618 retracement just as the Stochastic hit the oversold area, and price was still above my longer-term moving average. A good setup. So why did I pass the trade?

Because on the 15-minute chart, that break above and then below yesterday’s high produced a Trader Vic 2B SETUP (see example.) The 2B occurs at trend reversals — in this case from up to down. My good setup is now in the wrong direction, and as you can see, taking it would have been a mistake. Instead I started looking for an opportunity to join the new downtrend and found two before lunch.

Someone asked me today whether using longer timeframes meant trading in the direction of the longer term chart. Not always. The trend is going to change first on the shorter timeframe, so the goal is to understand how your chart fits into the larger picture. In today’s situation the 15-minute chart showed an uptrend, but the pattern told me that below the surface the direction had probably changed to down. Even if this trade had worked out well, for me passing was the right decision. Good trading is always a matter of assessing risk.

Yesterday I mentioned the possibility of a breakout today, and it looked like it was happening — for a few minutes. We started with an almost five point gap on fairly good volume. Price opened above the highs of the last two days on the Russell, which has actually been the weakest of the indexes I follow. Three minutes later we were on our way down. Predictable? Not by me. But the move gave two different short sale setups within a few minutes of the open.

The first setup is most easily seen on a longer term chart. While many watch an hourly chart, I don’t really like them. If you are trading stocks, there are 6 1/2 hours to the trading day. Index futures have 6 3/4 hours. In either case the last hour of the day is shorter than the rest. Am I being picky? Probably. For that general time frame I use a 45 minute chart for futures, and there are exactly nine of them in a trading day. (I used to use 65 minute charts for stocks. With computers, you can make the rules.)

The setup is from Victor Sperandeo. If you haven’t read Trader Vic — Methods of a Wall Street Master, you’ve missed a great trading book. The pattern is called the 2B SETUP. I won’t go into much detail, but the essence is that a trendline break followed by a new high and a failure is almost a definition of a trend reversal. It’s easiest explained with a picture, so here it is. This pattern alone is worth much more than the price of the book.

The second setup, occurring at exactly the same time, comes from Larry Williams. He calls it the Oops! pattern. It requires a gap above the previous day’s high that can’t hold. In other words, it fails soon after the gap is made. And all the traders that took the breakout say “Oops!” He trades it as a one-day trade, holding until the next day’s open. We won’t find out until Monday if his trade works. I take my profits a lot earlier.

The Oops! pattern doesn’t really require a chart to understand, but you’ll still want to look at this one. Once you had convinced yourself that the true direction was down there were multiple patterns, Fibonacci measurements, and pullbacks for trade entry and exit. Too much to explain in one post, but this is what the Trading What I See Blog is all about.