Trading What I See

Yesterday’s 16 point range raised hopes that the market was finally moving again. The rectangle (magenta) created during the day should have acted as support if we were to move higher. Instead we gapped completely through the rectangle and then went sideways for the rest of the day.

There were Fibonacci retracements that I’m sure some traded, but here is why I ignored them. The first drop was to a Fib 38% retracement of yesterday’s entire range. But notice that the moving averages are flat rather than rising. Normally a 38% retracement happens late in a move, and the moving averages have a wide separation. In fact price is usually still well above the moving averages.

Then there is the simple matter of pivots. An uptrend will have higher highs and higher lows, and the opening price created a lower low. Not a good sign.

We pulled back up to the moving averages, and if they had both been declining it might have been an acceptable short entry. But the long MA is very flat, making the entire structure look like congestion.

When we dropped again, price stopped at a 127% external retracement of yesterday’s last rally, and it even had a nice Stochastic divergence. But where are we going? Right back into the congestion area.

The final drop of the day again stopped at a normal Fib retracement, this time 62%. If you look at the larger picture we have sideways moving averages, sideways moving prices. That means low probability trades.

When I think we are in a trend I’m looking for excuses to take trades. But when I have doubts about the trending action, I’m doing the reverse — looking for reasons to watch. Today I watched.

Trendlines are often the key for choosing which Fibonacci extension or retracement is going to prove significant. I traded trendlines and parallel channels for many years before I discovered Fibonacci, and using them together has made my trading much more accurate.

To understand today’s chart, remember that retracements can be a portion of the original move, or greater than that move. The first is call an internal retracement, and the second an external retracement. Let’s start with the white labels.

Yesterday we moved from “X” to “A” and then retraced to point “B” at the close. The pullback to “B” was a 50% internal retracement of the first move. Today we made a gap upwards and reversed at point “C.” The distance from “B” to “C” was 162% of the distance from “A” to “B.” It was larger than the A-B move, so it is an external retracement.

External retracements often reverse at 127% or 162% of the original moves. Sometimes you can tell that one Fib level is not going to stop price because there is no pause. Today you could also tell by drawing a parallel trend channel.

The first yellow trendline was drawn as soon as the pivot at “B” was obvious. And immediately afterwards, the parallel was drawn from point “A.” The fact that the 162% retracement occurred exactly when we hit that trendline made it an obvious point for a reversal. Add an overbought Stochastic and you have three reasons for expecting at least a temporary top there.

Another Fibonacci measurement that I use often is the extension. Instead of comparing moves in opposite directions, extensions examine the relationship between two consecutive moves in the same direction. Look at the labels in blue.

The distance between the white “C” and the blue “A” is exactly matched by the distance from blue “B” to “C.” This is a Fibonacci extension, and will usually be either 0.618, 1.00, or 1.618 of the first move. In this case it is 100%, or a Measured Move. How do we know which one to expect? Draw some parallel lines.

As soon as the blue “B” pivot is obvious, you should draw the upper yellow trendline, followed by the parallel line. Once again, price reverses when it reaches the conjunction of the 100% Fib and the parallel. Again it happens as the Stochastic becomes oversold.

Does this always work? Of course not. This afternoon’s trading didn’t have any Fib relationships that I really liked, but look at the parallel trendlines. Three times in one day it shows the limits of a move. That’s tradable information.

For the best book on really explaining trendlines and channels, see below.

Edwards and Magee: Technical Analysis of Stock Trends

Today was filled with one of my favorite Fibonacci sequences; what I call the A-B-C pattern. It’s an Elliott corrective pattern, but you certainly don’t have to understand any wave counts to use it. Just call it an Up-Down-Up or the reverse.

These patterns will often end in a tradable Fibonacci measurement, and if you can combine them with some other type of signal or trigger they are often successful.

We started with a small gap down and, although I intentionally didn’t mention it yesterday (no predictions!) I really expected a bounce from the 790 area. When it tried several times in the first 25 minutes and kept failing, the blue 13 minute moving average gave a “safe” short sale entry. Remember, for me a safe entry is when I can place a very close emergency exit — often just above that moving average.

And where did we stop? At a nice Fibonacci cluster formed from measurements on a 15 minute chart. One is a retracement of yesterday’s rally (in white) and the other is an A-B-C measurement starting from the top of the rally that began on January 9th. It was the Down-Up-Down pattern.

To get a target for an A-B-C, you take the distance traveled by “A” and multiply it by Fibonacci ratios — in this case 0.618, 1.0, 1.618, and 2.618. These measurement are added to (or subtracted from) the next pivot, called point “B.” The key is that you do not take action at these levels unless there is another reason for the trade! Sometimes this “other reason” can be other Fibonacci measurements that call for the same level — marking a Fibonacci cluster.

I prefer (but don’t always require) these trades to have one more factor; a divergence with some type of oscillator. As usual, I show a standard Stochastic oscillator on these charts, and the yellow lines indicate divergences with price. In this case it made a very nice exit. More aggressive traders may have also used it as a long entry.

The move back up is also marked with an A-B-C in blue. When price turns at the first Fibonacci measurement (0.618) it gives me added assurance that the move was only a correction in a continuing trend. That makes another short sale appropriate after the blue “C.” After the trade becomes profitable, the question is where to expect a reversal in order to take profits.

I’ve marked two potential A-B-C patterns for this last move — one in green and one in red. Which one do you chose? Since I was calling the mid-day pullback a correction in a continuing down move I expected a new low, and by the time we got there both patterns had formed. When in doubt, draw them both in. The final bottom was pointed to by both measurements — and we got a divergence there for the final exit.

There were actually other Fib measurements pointing to this last bottom, but the A-B-C patterns were very clear today. Any time you have an Up-Down (or a Down-Up) move, draw in the targets for point “C” and watch what happens there. I think you’ll be happy with the results.

I’m not sure whether to call today an inside day or not. It waited until the last three minute bar to poke its head above yesterday’s high, but I can certainly call it an uneventful day. Which makes it a nice time for a little review.

Many times a week I talk about Fibonacci extensions, usually with at least a minimal explanation of what they are. Today I want to go over them in more detail. The market was nice enough to provide examples of the three most common measurements.

A Fibonacci extension is sometimes called an Alternate Measurement, because what you are doing is comparing alternate swings. In other words, the two swings are consecutive movements in the same direction. At the beginning of today’s chart we would measure the length of the swing from “X” to “A” and compare it to the swing from “B” to “C.”

Sometimes you’ll hear traders talking about an A-B-C move, and this is what they mean. Another way of describing it would be an Up-Down-Up move, or the reverse, a Down-Up-Down move. The Fibonacci part is the stopping point at what I am calling “C.” There is a surprising consistency when you compare the “A” and “C” movements.

A common ratio is when the two moves are equal (100%.) We’ll often call this a Measured Move, and you can see this in the yellow Fibonacci extension marked on the chart. Often (but not always) the “C” move will have less momentum than the “A” move, and this leads to an oscillator divergence that I’ve marked in the lower pane. I like to take trades where a divergence occurs at one of the common Fibonacci extensions.

The second common measurement is when the second move (in the same direction) is 0.618 times the first move. I’ve market that in magenta. The B-C leg is 0.618 times the C-A leg. And again it ends with a Stochastic divergence.

When I see a Measured Move I think of the market as being in balance — about equal upwards and downwards pressure. When the market stops at a 0.618 extension I feel that shows a strong potential for a reversal, and today that was from down to up.

The measurement shown in blue is the third most likely ratio, with the “C” move being 1.618 times the “A” move. This obviously shows a bit more strength than either of the other ratios.

There are two more Fibonacci ratios that appear in these extensions. If price doesn’t stop at 1.618 it is likely to move on to 2.618. And a truly strong move will usually end at the next ratio — 4.236.

Of course sometimes the market becomes perverse and figures out some entirely non-Fibonacci level to turn, but that doesn’t happen as often as most people think.

If you look carefully, inside the marked moves on this chart you can see smaller A-B-C moves, and many of them are also these same Fibonacci ratios. When you have different sizes of Fibonacci measurements all pointing to about the same place on your chart, we call these Fibonacci clusters. When this happens it creates even better trades.

Just remember, you shouldn’t use Fibonacci levels as entry points by themselves. You need some additional kind of trigger. And sometimes a Fib level just means a pause rather than a reversal. But used correctly, Fibonacci extensions will give you one more type of market edge. And that’s what we need to trade profitably.

You always wonder whether a long weekend will make a difference. Will Fibonacci calculations still work using the old data? Do you have to change your trading tactics?

Last week we had slow holiday trading. Then we had a day off for New Years. Yesterday there was a market closing for a state funeral. Today the market continued from where it left off as though there were no break at all.

Let’s start with a 15 minute chart to show some measurements. The gap this morning went up to the high of last Friday and couldn’t get any higher. Even on a 3 minute chart, no bar was able to close above that level (point B.) When we get to a shorter term chart you’ll even find a divergence there.

If you are not already doing it, always mark in the highs and lows of the last few days — most software packages will do this for you, but if not, draw them in by hand. Like Fib levels and trendlines, how the market acts at these levels is critical trading information. When the market couldn’t break that level and it corresponded to failure at the yellow down trendline, your trading bias should have switched to the short side.

Still working from last week’s data, the turn at point “C” happened at a logical set of Fibonacci measurements. The distance from “X” to “A” multiplied by 1.618 is exactly the distance from “B” to “C.” That’s called a Fibonacci extension, and the most common measurements are 0.618, 1.00, and 1.618.

And whenever price exceeds a previous pivot point (passing point “A”) you should measure external retracements — those are retracements over 100%. The most common is 127%, but if price doesn’t stop there it is likely to go to 162%. Point “C” just slightly exceeded a 162% Fibonacci retracement of the “A” to “B” distance.

Now let’s look at my trading chart - a 3 minute timeframe. At “X” you can see that there was no real breakout above Friday’s high (green line.) From there until just after lunch time (first blue arrow) it looked like we might just go sideways for the rest of the day.

But by 10:00 (Pacific time) my moving averages were starting to move downwards, and we were hitting a downtrend line drawn from “X” to “B”. Add to that a pullback to the blue declining moving average, and a short sale with a very close stop is possible. I like close stops, and will often use the blue (13 period) moving average as a trailing exit in case I’m wrong.

Two more pullbacks to the moving average (arrows) could be used for additional short trades, depending upon your trading style. All of them would have been profitable. The question is why I haven’t marked the last pullback (after “C”), which would have been a loser.

Here’s a Fibonacci measurement you won’t see talked about much, and it keeps me out of this kind of bad trade. When we’ve had a strong move, I’ll go back to the first pullback and draw a Fibonacci extension. A strong move will pass the normal reversal points (.0618, 1.0, 1.618, and 2.618) but it’s an unusual move that can get beyond the next level (4.236) without a good correction in the other direction.

Combining this with the 15 minute chart, point “C” is the target for three Fibonacci measurements - a good reason to quit chasing the downside for a while. It looks like a few days off didn’t affect the market’s memory at all.

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

Occasionally there is a situation where trade setups could be taken in either direction, and your decision can make the difference between a winning or losing day. Let me walk you through my thinking process for this morning’s action.

We ended yesterday’s trading inside a well-formed rectangle, and this morning’s first bar made a breakout move. I’ve shown in yellow the rectangle, and the upside price target that it created.

It seemed like everything except the Russell 2000 was making a big rally, but one item kept me from taking any long entry. It was the rectangle target. It wasn’t that we were too close — we had already traded right to that price. It just happened before the “open.” (Trading on the Russell e-mini futures only stops for a 15 minute maintenance period on weekdays, and on Monday morning it opens an hour before stocks.)

Often this “overnight” trading will provide important support and resistance areas, and I wanted to see that one broken before looking for an entry. But it never happened.

By 8:00 (Pacific) we had not only moved back into the rectangle, but we broke to the downside on an increase in volume. As we bounced off the 127% retracement level there were two potential trades. If we moved back up through the resistance created by the rectangle bottom, it would form a Wyckoff “Spring” (see yesterday’s post.) But it could also be stopped by that resistance and continue downward. Decision Time!

First the trade I didn’t take. I consider entries on three types of reversal trades; strong divergences, Trader Vic 2B SETUPS, and Springs. The last two are similar in that they occur just after a breakout. For my entry I use a technique that Teresa Lo used to teach — wait until price exceeds the bar that actually created the breakout. I’ve marked that with a blue arrow.

It came within a tick, but never hit my entry order. I had actually put in two entry orders by this time, the other one for a short sale if resistance held. I don’t necessarily recommend this procedure, and in fact seldom use it myself since it’s possible to end up with losing trades in both directions.

But remember this morning’s context. There were probably a lot of traders that had entered on that failing rally that I ignored. If they had to exit their positions, those disappointed traders would give an extra push to the downside. Like we got for the rest of the day.

My entry stop for the short sale was hit as we pulled away from the blue moving average. When we hit the 162% retracement level I took profits on half of my position and moved my trailing stop to above the blue moving average on the rest. Since this 162% Fibonacci retracement matched Thursday’s low, I really expected us to turn back up, but there were no divergences, and both moving averages were showing a strong downward bias.

As you can see, the trailing stop was much more profitable than an exit at that point. That’s why I try to run a wider stop after I’ve taken my first profits on a move.

The chart, so I could show detail, only has part of the trading day. After overrunning the 262% level a bit, we went more or less sideways for several hours, and then continued our downward course. Where did we stop? What Fibonacci level comes after 2.618? The next Fib is 4.236. And that is precisely where we reversed today.