Trading What I See

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.

First Pullback measurements are always external retracements (see yesterday), but they are Fibonacci ratios that few seem to follow. You can mark the Fib levels for the next potential turn as soon a reversal pivot forms following the first significant pullback.

Today each of the major reversals turned at one of these levels (all shown with white lines and arrows.) The 7:30 bottom turned at 127% just as it reached the continuation of a trendline from one of yesterday’s pivots. It also had a Stochastic divergence, and lead to the best move of the day.

That mid-day rally also ended in the same manner, but this time at the 262% external retracement of the first major pullback. This is what I consider a “normal” move. Once again the turn also had confirmation from a trendline at the top of a channel.

After making the high of the day we had another move down. For the third time, the actual reversal near the close was a 262% external retracement of the first good pullback.

This doesn’t work every time, but that’s the case with all support and resistance or Fibonacci levels. They give you an area where turns are more likely to take place. It’s up to your trading plan to give you entries to take advantage of them.

Sometimes markets make sharp bottoms — other times they are less abrupt. By drawing tentative trendlines using each pivot top and bottom you can often follow the change of direction as it happens.

Today started with a drop down through flat moving averages and then took about an hour to find the first real bottom at “A.” Drawing a lower trendline and its parallel caught the top at “B.”

Parallels aren’t quite as exact as trendlines confirmed by several pivots, and price overran this one by several ticks. That’s why you look for some type of trigger at potential turns. In this case an entry as the Dunnigan bar turned red would have worked quite well.

The bottom at “C” looked like a good setup. It was both a Measured Move and formed a divergence right at the continuation of the lower trendline. That could easily be taken as a reversal, and is a good illustration of why many traders don’t try to pick bottoms.

You’ll have to decide whether the losing trades in this situation outweigh the winners. My entry would have been the first green bar after the bottom with an exit as price came back down through the blue moving average. Probably a breakeven trade or perhaps a small loss, depending upon execution. Personally, I like reversal trades when there is a clear setup.

The “real” bottom created a Spring setup as the continuously modified channels (in first magenta and then green) defined the reversal. If you didn’t take the Spring (which is again picking bottoms), the safe entry was the pullback to the green parallel trendline. Notice that in this case it is at about the same price as the bad entry at “C.”

Trying to pick tops and bottoms, finding pullbacks, or following breakouts are three different methods of trading the markets. Each has its advantages and disadvantages. In specific situations I may trade any of them. Part of your trading plan should include when (or if) you want to use each technique.

For some reason my data provider (eSignal) posts two hours of trading on holidays. I ignore this extra data (which plays havoc with my trendlines), and will sometimes start my Fib measurements with the day’s open. That was the case today.

Over the weekend Steve asked some questions in comments about initial protective stops, so I’ll use today’s setups to illustrate my answers. First, I always set an immediate hard stop. Where I place the stop will be determined by previous market action.

I prefer using pivots, but will sometimes use the cross of a moving average. Once in a while I’ll use the reversal of the entry bar as an exit. If I can’t find a logical stop that I like, I’ll pass the trade. If the stop would be more than two points from my entry, I will probably pass the trade.

Because of the extra holiday data, I wouldn’t even be looking for a trade near the open. The first clear setup would have been the short entry at today’s high. Price completed an A-B-C with the “C” leg being 62% the length of “A.” A second indication was that a reversal there would form a divergence with the Stochastic oscillator. And you could see that if the trade triggered (first red bar) the setup would turn into a Spring.

I’ll be using the colored Dunnigan bars to explain the entry and stop level so you might want to follow that link first. As we hit the high of the day at a precise “C=62%” the top bar was colored green.

I like the Dunnigan colors, because in real time I can tell when a signal is given. As soon as price extends below the previous bar, the color will turn to red. That is my entry signal (usually executed by way of a stop.)

In this case that top green bar has a range of 0.70. If my entry is one tick below the top bar and my stop is one tick above it, the risk is 0.90 — well below my maximum of two points. The entry in this case would have been 839.60.

What followed was a nice drop with a sequence of red or magenta bars. That means that no bar made a higher high. Assuming you exited at the first change to green (835.60) that would be a four point profit. (I’m not recommending that as a specific exit technique, but there is certainly no reason to exit earlier.)

The 50% pullback to “B” turned exactly at the white parallel trendline (drawn as soon as the pivot at “A” was complete.) An entry at this point would be handled exactly the same as the first trade. The first down bar turned red at 836.70 after touching the 50% level and the trendline. The stop would go above the pivot at 837.50 for a risk of 0.80.

Because the market acted as though it was creating a double bottom, I probably would have exited this time on the first hint of green for a small gain (1.90.) The first trade had a Reward/Risk ratio of 4 to 1. The second about 2.4 to 1. A question I often receive is what is my minimum R/R ratio.

I hate to break the news, but I have no way of predicting how far a move will go. Sometimes trades fail (all too often.) Sometimes a Spring will move to twice risk. Sometimes it will be a larger reversal and produce ten times risk. Some of my patterns have clear minimum targets, but many do not. The actual reward depends more upon your exit technique, and that is possibly the most difficult part of trading.

When I take a position, I’ve looked carefully at the trading environment — how far away is support, what pattern am I trading, etc. I won’t take a trade unless I think there is reasonable room for profit that is larger than my risk. My risk is the only thing I can calculate in advance.

Much of the reward in a trade comes from your trade management. An excellent setup preceding a good move can either make or lose money depending upon your trading style, regardless of what you perceive as the potential reward. The last trade of the day provides a good example.

The correction from today’s high made a nice A-B-C pattern with “C” turning at 62% of “A.” This setup often occurs at a reversal. “C” was also an exact 127% external retracement of the “A” to “B” move, which also occurs at reversals. The bottom was a 50% retracement on a 15 minute chart. A perfect signal, complete with a Stochastic divergence.

Anyone using my entry techniques on that setup, provided they also leave their stop at the original pivot, would have made over four points on the last move of the day. I would have lost money on that trade. The first pullback was too large and my trailing stop would have created a loss.

But that’s just my trading style. Everyone has to develop their own style — one they are comfortable with. I feel that a key to successful trading is being able to take the trades you like without hesitation. And you can only do that if the “rules” you follow are your own.

I wasn’t thinking about Monday being a holiday until I looked at the first hour of trading. I hope most of you made this into a four day weekend. However it’s surprising how regular the movements often are on a narrow range day.

After a small gap, the first hour had a trading range of under five points, and because of the holiday weekend the day’s entire range was only a little over six. The market made an early pullback and then rallied with a small A-B-C Measured Move that completed a larger A-B-C pattern that began yesterday. That gave a double Fibonacci signal for the high of the day.

From the top, a Measured Move down (100%) created the first leg of a larger A-B-C. It ended with a Stochastic divergence at the same time the market tested a pivot from earlier in the morning.

A rally of 50% set up another reversal, and then it was down again in an A-B-C Measured Move to set up a bottom pivot. This was the third touch of a support level shown by the blue horizontal line, the third Measured Move of the day, and it completed a larger A-B-C that ended at a Fibonacci 62%. Lots of tradable setups but unfortunately no range to work with. Have a nice long weekend.