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.

Evidently the 127% external retracement was the correct turning point from yesterday’s close. But remember, there were too many other potential reversal levels. If that had happened intraday it was only a trade to consider with extreme caution.

After a gap and a 50% retracement, the market completed a small A-B-C (red) for a Measured Move. The next three hours created a sideways pattern that eventually turned into a rectangle. Although it takes four touches (two on each side) to confirm a rectangle, each touch of the top was on less volume. That’s a strong hint that a consolidation pattern is forming, and a rectangle was a likely possibility starting just after 9:30 (Pacific time.)

Rectangles can go on for a long time, but remember the importance of forgotten trendlines or trendlines drawn from the first small pullback. At the second bottom marked “B” price bounces from that trendline and then makes a volume breakout from the rectangle. The market didn’t even slow down at the rectangle target (width of the pattern), but went to the 100% Measured Move of the larger formation to make the high of the day.

There were three close targets for the high — the yellow parallel (not quite hit), yesterday’s high (green line) and the C=100% blue target. Unlike yesterday’s close, two of the three were exact hits, and the third was close. Certainly a point for partial profits if not a complete exit.

Take a look at the earliest pivot marked “B.” That was certainly a potential entry, and although it’s hard to call it a successful trade, it shouldn’t have been a loser. I’m often an impatient trader, and my exit would have been during the sideways action in the center of the rectangle.

If you had more patience, the false break to a new high should have been an exit. Compare that action to the Spring pattern that often appears on my charts. A break to a new high for any move must have a volume increase to be trustworthy. Any reversal after a low volume breakout should be considered as a potential exit signal.

I’ll be on the road all day tomorrow, so there is the possibility I won’t manage a post in the evening. If not, I should be back on Friday. Good Trading.
Lowell

Getting acceptable Fibonacci measurements at futures contract rollover can sometimes be problematic. For longer measurements, do you use the old contract or the new? There is always a gap at rollover, so the measurements won’t be the same.

Yesterday I had a nice 423% external retracement marked on the 15 minute chart for a potential reversal. Today, using the new contract, that measurement is off by about a point and a half. On the 32 point move that was being measured, that comes out to just under five percent.

My solution, for what it’s worth, is to try to base my new contract trading on very short term measurements until the weekend. You decide whether that potential reversal worked or not.

Today we started with a quick double fake-out — up, down, and then the rally. The move created a Spring entry combined with a 127% retracement of the quick upmove. After moving to what would later be labeled “A” there was a 50% pullback which eventually turned into a double bottom.

A trade at the first bottom probably would have been a loss (unless you left your stop below the pivot.) The second bottom (perhaps a re-entry) lead to a nice rally. Both the parallel trendline and the Measured Move pointed out the top at “C.”

Using the “First Pullback” measurement technique that I’ve illustrated several times this week (white lines), today’s top was at a 262% external retracement. The four external retracements I watch for are 127%, 162%, 262%, and 423%.

A fake-out reversal usually comes at 127%. A general reversal zone exists between 127% and 162%. When we pass 162% I watch for a normal move to 262% (as happened today.) And if there is a very strong move, there is often a reversal at 423% as shown yesterday.

Has this move topped? There wasn’t a divergence or a 127% move from the previous peak. But we did turn inside the reversal zone. And we have reached 262%. Not enough agreement to give me any type of bias. As usual, I’ll wait for Monday’s open and see what the charts say then.

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.

After testing the top of the daily rectangle yesterday, we gapped down at the open. This particular type of gap provides useful information whether you trade it or not.

Notice that the center of the gap is precisely 50% of the distance between the top and bottom of that swing. Also that the swing itself is the second pulse downward from yesterday’s top. When you see this pattern, there is a very high probability that the downmove is not complete.

The reason has to do with the internal structure of Elliott third waves, but all you need to know is that the next pullback normally makes a nice short sale. And since that pullback retraced a Fibonacci 38%, ran into resistance at a pivot from yesterday, and stalled at the bottom of the morning gap, there were three reasons for a reversal.

What followed was a nice A-B-C Measured Move for a potential 10 points of profit. If you didn’t get out at the first bottom, the next one had a warning divergence.

And notice once again how previous support or resistance levels (in this case yesterday’s low) are so important as reversal areas. It stopped the first decline (which could also be measured using the gap as a halfway point), and then stopped the rally when price hit it from the opposite direction late in the day, with the second touch forming another divergence.

Fibonacci, Support and Resistance, and trendlines give you the map. Lots of screen time and after-market analysis help you learn to see the setups in real time. Then it’s a matter of taking the trades that make sense to you as they occur. Of course that last part is always the most difficult.

Single Fibonacci levels often mark turns in the market, but it’s always more reassuring to have multiple reasons to consider a trade. If several Fib measurements line up at nearly the same price it’s called a Fibonacci Cluster.

Today started with a gap below yesterday’s range, with an immediate pullback to yesterday’s low where it met resistance. This was also a 38% Fibonacci retracement of the move from the previous close. Notice that the volume decreased on the pullback. An entry could either be a short-term trendline break, or the break of the faster moving average.

Then there was a quick drop into a Fibonacci cluster. When you are trading clusters you don’t know whether price is ignoring them until the farthest level is broken. This means that if you enter at the highest level, your stop should really be placed under the final Fib point. This is why I want a Fibonacci cluster to have the levels very close together.

In this case there were three Fibonacci measurements. I’ve placed the three arrows showing where they fall. The highest level was a Measured Move, where “C” was equal to “A.” Next came the 262% external retracement of the A-B move, and the actual turn was at a 38% retracement of the rally from the March 14th bottom. The three levels were within 1 1/2 points of each other.

But in this case the Fib range wasn’t an issue — there was no reversal green bar until after the bottom Fib. That was my preferred entry. The Stochastic divergence gave some additional support to the trade.

The move up made another A-B-C Measured Move, and again the Stochastic diverged from price. The yellow “C” is actually another Fibonacci cluster. I’ve left off two of the measurements to make the chart easier to read. It is an exact 78% pullback of the original drop, and there is a smaller Measured Move inside the “B” leg. The up-down-up action of “B” is another perfect a-b-c.

The market must have been making up for the lack of signals yesterday, because it finished with a third A-B-C, and once again there was more than one measurement to show the turn. It was a 62% retracement of the mid-day rally, and the A-B-C stopped at 162%. The only minor flaw in the pattern was that Stochastics waited for a second bottom before giving the divergence.

The market often will reverse direction when it gets new information. What continues to amaze me is how often those reversals occur right at chart points that correspond to support and resistance, trendlines, Fibonacci, or High-Low-Close levels. Today I’ve turned off volume and moving averages because I’ve left so many lines on the chart.

We had a slow start this morning as traders waited for the New Home Sales report. When the report was released, the market had just reached a 127% external retracement of Friday’s last decline. Any time you exceed a previous peak its important to have this 127% level marked, since this will often be the turning point.

These 127% levels often appear as a Spring formation where price breaks to a new high or low and is unable to continue. When this occurs along with a Stochastic divergence you have multiple indications of a potential trade. Then it just depends upon your entry technique. If you get a trigger, you have a trade.

When the numbers were worse than expected, the market dropped down to the day’s low where it created exactly the same pattern in the opposite direction. There was a low, a pullback, and 127% external retracement of the bounce. Again there was a good Stochastic divergence with price.

A high percentage of market movements occur in three pulses and I often mark them as A-B-C. The first move off the low stalled at the resistance of the previous pivot (A), retraced 38% (B), and then completed a Measured Move to point “C” which is the same length as “A.”

Before we got there I had drawn the blue trendline from the bottom to point “B” and the parallel trendline extending from point “A.” In addition to hitting the parallel trendline, there is the resistance of yesterday’s low (red line.) There was also another Stochastic divergence, making four reasons to look for another reversal.

The question was whether to exit or actually reverse to a short sale. Personally I thought we were going further down. But whether in a trade or just waiting for an entry I keep drawing my trendlines and Fib projections while watching for signals.

We broke the blue trendline, but stopped at the 50% retracement from the bottom. That was a logical place for a bounce, but there was no evidence of an actual reversal. As soon as the blue trendline broke, I drew in the yellow top trendline and its parallel. That’s where the market reversed again — yellow parallel, 2nd touch of the 50% retracement with a double bottom, and another Stochastic divergence.

That was enough to eliminate my downward bias, but certainly not enough to expect much higher prices. So although I didn’t trade after lunch hour, notice that the top reversal came at a parallel trendline combined with hitting yesterday’s close and a 78% retracement of the morning drop. Lots of signals today. How many you were able to take depends on your trading style.