Trading What I See

For those having trouble accessing the site yesterday, evidently the server holding Trading What I See was having high load issues. It took me several hours to post yesterday’s comments. When I checked, the web host was working on the problem. My access seems much faster today, so perhaps it is solved.
Lowell

Today the Russell 2000 had the fifth narrowest range so far this year — 5.9 points. And that range occurred right at the top of the daily rectangle. Actually this could be good news.

When price makes a continuous move from deep inside a pattern and then immediately breaks out, the odds favor a failure. Too much of the rally strength has been expended inside the pattern. However when there is a pause near a pattern’s edge, then a high-volume breakout is much more likely to succeed. But right now I’m waiting to actually see that breakout before I get excited on the upside.

Not much else to say on today’s action. We turned up at a Measured Move (C=100%) and developed a triangle formation. However the breakout had no volume behind it, and price reversed just above yesterday’s high before coming anywhere close to the triangle target. Not surprising with the lack of volume.

Another indication of the slow trading. The NYSE Tick ($Tick) never hit either a plus or minus 1000 today. I only watch the Tick at critical points, but most days one direction or the other will have some bias. And I would expect to see a high reading there when we finally break from this consolidation pattern. Maybe Monday.

The more you can structure your trading the easier it is to make decisions during the day. I use Fibonacci and trendlines as guides, but in yesterday’s comments John asked an Elliott Wave question. Elliott is another way of adding structure, and in many ways it is similar to what I do. Today the market was kind enough to give me a good example. (Elliott Wave traders — forgive me for some simplification.)

In Elliott Wave theory a strong move usually has three pulses in the direction of a trend (circled waves 1, 3, and 5.) An Elliott rule says that the middle wave (3) cannot be the shortest wave. Another says that wave 4 may not drop below the peak of wave 1 (although this rule is sometimes relaxed in commodities and futures.)

A general Elliott guideline also says that waves 2 and 4 will normally be different in some way — either in the depth of correction or in the number of bars in the wave, and often both are true. If you examine today’s chart you will see that all of these rules and guidelines are met.

Unfortunately, as nicely as this chart matches the rules, I have to agree with Robert Miner — in real time you can only find moves that follow clear Elliott Wave patterns about half the time. That’s why what I look for often resembles Elliott, but doesn’t depend upon complete patterns.

Let’s look at the same chart as I describe it in my commentaries. I expect the first pullback to be relatively large (50% or greater) and the second pullback to be smaller (usually 38%.) [Waves 2 and 4 are usually different.]

In a continuing move, the second rally will usually exceed 162% of the first rally. [Larger third wave.] That’s when I start looking for a third rally after the next pullback. A healthy move will also respect the support of previous pivots. [Wave 4 doesn’t enter territory of Wave 1.]

As you can see, there is a lot of similarity between what I do on this blog and Elliott Waves. But when I think in Elliott terms I tend to make predictions, and for me predicting the market often costs me money. So I use Elliott as just another tool — it gives me levels where setups may occur, just like trendlines and general Fibonacci measurements.

For example, at point 4 today we bounced off the pivot support from point 1. Because the second rally had exceeded 162% of the first rally, there was a stronger expectation of more strength ahead. Add in what looks like an Elliott sequence and it just gives more confirmation to the setup.

A basic understanding of Elliott Waves can give you one more profitable way of looking at the market. My favorite EW book is listed below.

Robert Prechter’s Elliott Wave Principle

Most of you should know by now that I try to not make predictions. I draw my trendlines, put in Fibonacci measurements, and ask myself “What if” the market decided to turn here. And then I take action if I find a setup.

If you don’t know why I take a close look at 423% retracements of the first pullback in a large move, read this recent post. And no, I’m not calling a bottom here with this 15 minute chart. But I’ll certainly watch very closely in the morning. (Don’t try to compare prices on the 3 and 15 minute charts - contract rollover today and I didn’t change my chart.)

The market acted well on the 3 minute trading chart. The first pullback from “X” was 62% (normally a large pullback) and the pullback to “B” was the normal 38% smaller retracement. All of the internal measurements in the downtrend were Measured Moves (in yellow) allowing you to fine tune any possible entries.

The mid-day bottom had numerous signals — a Fibonacci cluster as well as bouncing off a parallel trendline. Even the afternoon reversal in magenta had lots of reasons to consider a trade.

It was the largest pullback of the day, and as is often the case, retraced 50% of the entire down move. It was also a 78% Fib retracement of the decline from “B”, and if you check the small internal Fibs, you’ll find it was a 262% external retracement of the first pullback in the rally. Another nice Fibonacci cluster with a Gravestone Doji candlestick at the top. Very good signals all day long.

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.

Today’s range just about overlapped Friday’s range — meaning there was little room to trade and lots of time to look at longer term charts. And last night I received an e-mail asking if these techniques really work on longer time frames. Let’s take a look at the chart I call my “Roadmap.”

For trading I use a three minute chart while keeping a 15 minute handy on a second monitor. But when I want to study the longer trend I use a 45 minute chart. As I’ve explained before, 45 minutes divides evenly into the 6 3/4 hours of trading for the Russell 2000 futures, giving nine equal bars for each day.

A Fibonacci measurement I pointed out yesterday was that very strong moves tend to reverse at a 423% external retracement of the first pullback. Notice the six day rally leading to point “A.” It’s a perfect hit of the 423% external retracement of the first pullback. Yesterday you saw it on a three minute chart — today on a chart fifteen times longer.

All of the other calculations work also, but first I want to point out something on this chart I don’t believe I’ve discussed in a commentary. A change of trend is often followed by a minor pullback before the move gains any strength. If you draw a trendline from a bottom reversal to this first minor pivot (bottom yellow trendline), it often seems to go off into space and have no relationship to price. By the time we reach point “B” most traders have forgotten that trendline.

You’ll find that point “B” is not a direct hit of a Fibonacci retracement from the earlier bottoms, but that trendline worked perfectly. That’s why I use multiple techniques in my trading. On the longer term charts I’m looking for potential reversal points — then I watch for setups on my trading chart.

Of course after a pivot such as point “B” I always tell you to draw a parallel trendline (in this case yellow.) Two days ago I showed how an upper trendline on a 3 minute chart pointed out the top of a move. On this chart that trendline is show in blue. And where the blue and yellow trendlines meet we have the completion of a large A-B-C with “C” equaling “A” for a Measured Move. Lots of reasons to anticipate the top that occurred on Friday morning.

Since that top on Friday we’ve moved sideways and are now bumping against the blue parallel. I don’t know which way we’ll go from here, but a combination of trendlines, Fibonacci, and a few chart patterns will help me find setups that continue to work. On any timeframe.

If you compare today’s chart with yesterday you’ll see almost the same pattern. There was a gap up followed by a rally and an A-B-C pullback that bounced from a natural support level (previous high instead of close.)

The pullback was 50% instead of 78%, but the same A-B-C Measured Move was there, and inside the larger moves there were smaller down-up-down patterns. And once again the parallel channel defined the turning point. At a quick glance the two day’s trading looks about the same.

The real difference was how to anticipate the intraday top. Yesterday it was by using a trendline extension on the 15 minute chart. Another way is by marking the external Fibonacci retracements of the first pullback in a move.

I check for external Fibonacci retracements every time a pivot is exceeded, but this is a special case. Often in an extended move, the first well-defined pullback will be retraced by 262%. Panic moves will shoot through the 262% level, but will usually run out of steam at 423%.

Sometimes these will lead to complete reversals; other times just to an A-B-C correction. As is often the case, this is not a trading setup by itself — just a great place to look for one.

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.