Trading What I See

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.

Yesterday I closed the commentary without having any conviction about today’s market direction, but pointed out that continuing moves usually have a large first retracement (50% or more) followed by a smaller second retracement (normally 38%.) Since we closed with a second pullback of 38% there was certainly the possibility of additional rally.

Evidently the market overheard me, but after moving up again it refused to stop at my expected 162% level. Instead it gave a reversal signal using the Fibonacci 127% external retracement. External retracements are created when a move is retraced by more than 100%, and I feel that one of the most tradable reversals comes at 127%.

Think of this setup as being similar to a Spring. The previous top (the resistance) is slightly exceeded, and then price reverses. I like them even better when they are accompanied by a Stochastic divergence.

That’s what happened at this morning’s top, followed by a drop to the support of yesterday’s high. It was also a 50% retracement of the morning’s move. As soon as that pivot was created it was time to draw the lower yellow trendline and it’s parallel. That pivot also creates the rising blue trendline. The pullback stopped at the 78% Fibonacci level just as the yellow parallel was reached.

The next move down would have been difficult to trade because the moving averages are quite flat. There is also that rising blue trendline giving support. But shortly after it was broken the moving averages turned down.

I like to trade pullbacks to a trending moving average, and that occurred at what I have marked as the magenta “B.” The entry would have been just as price broke beyond magenta “A.”

The bottom around 11:00 (Pacific) had two markers — an A-B-C that ended at a Fibonacci 162% and another 127% Fibonacci external retracement of the morning rise. And at the second bottom there was also a small Stochastic divergence.

Drawing another trendline and its parallel gives you the “B” reversal, followed by a third 127% external retracement that matches the last A-B-C at 62%. Lots of multiple signals for entries and exits today, with three good examples of the importance of the Fib 127%.

Usually when I point out a setup, it’s a winner. If you’ve done any trading at all, you know how much easier it is to find the winning entries and exits after the market closes. And it’s easy to miss seeing the setups that fail. That’s why it is essential to either paper trade or trade small size (my preference) when trying new methods.

Today there was a nice Spring setup that failed. But let’s start at the beginning. There were two Measured Moves, first up and then down. A Measured Move is just an A-B-C pattern where the “C” leg is the same size as the “A” leg.

The pullback I have marked as a yellow “B” had a number of near misses as far as trendlines and channels are concerned, but the precise Measured Move was accompanied by a nice divergence for a pullback entry. When I have a cluster of levels that don’t quite match for a pivot I’ll often use the cross of the shorter moving average (13 ma) as my entry.

Then came the Spring. I see nothing wrong with it as a short setup. We broke above yesterday’s high and immediately reversed, and that top would have created a precise Measured Move A-B-C (in yellow.) There was even a small divergence in the Stochastic oscillator.

What do you do when a setup fails? If you trust the setup (and why else would you trade it?), you’re job is to forget the failure and re-evaluate the market. We still have a potentially large A-B-C, but with the divergence at the close it looks as though it may not hit the 162% Fibonacci extension.

But this pullback has just reached 38%, and a continuing move will normally have a large pullback (at yellow “B”) followed by a small pullback (the close.) I guess we’ll just have to wait for tomorrow and the next setup. After all, that’s what daytraders do.

We made a nice bottom mid-day, but whether it is just a bounce or an actual reversal remains to be seen. It’s another of those times when I’m glad I can make my decisions as the day unfolds. I’ve left a bit more information than usual on today’s chart, but perhaps it will help explain some shorter term tactics.

The first two bars moved up but ran into trouble as they hit a congestion area from yesterday (X), and it looked like the selloff was going to continue. But notice that the move down from “X” to “A” is actually a small A-B-C pattern. You know by now that this pattern will often stop at 62%, 100%, or 162% of the length of the “A” move. In this case it reversed from a Stochastic oversold condition at 62%.

The move up to the yellow “B” is also a smaller A-B-C, this time ending at 100%. This is also an 89% retracement of the “X” to “A” drop. By the time we start down again, you can draw the upper yellow trendline, and the eventual target is the lower yellow parallel.

I can’t justify any trading through this time period, since it was looking like a consolidation after a trend day. But let’s take a close look at the actual bottom. The yellow “C” is a 127% external retracement of the “A” to “B” move, and it also bounces from the lower parallel. That doesn’t make it a buy.

In a down channel you short at the top, but you don’t automatically buy at the bottom. Because of the geometry of a channel there is much more profit potential trading in the same direction as the trendlines. But when you get a divergence, the situation changes.

The second bottom gave a nice divergence with the Stochastic, we were still at the bottom of the channel, and there was a blue Dunnigan reversal bar. That second bottom is also a 127% external retracement of the last bounce. It’s also a Wyckoff Spring reversal, and I do like that setup.

The move to the high of the day created another A-B-C with “C” being 100% of “A.” That high price is also a 127% external retracement of the morning drop for a nice profit taking spot. If you missed the bottom reversal, the first pullback was a precise 50% retracement with the turn remaining above the longer moving average, so you could have caught the second half of the move.

What’s next? I have no idea. There is conflicting information on the chart. Notice that the blue trendlines converge. That’s called a wedge, although the volume doesn’t contract enough to make me trade it by itself. If the wedge happens to work tomorrow, we could see a quick re-test of today’s bottom. But there is a problem with that scenario.

After the market closed I compared the volume of the downmove marked in yellow with the upmove marked in blue. The number of contracts traded in the move up was four times the number traded in the move down. For the first time in two weeks we have some actual strong volume to the upside.

Short covering? Reversal? It’s a reason I like to day trade. I’ll decide when I see what happens at the opening tomorrow.

Even though I still think we are in congestion, I found a trade this morning that was hard to resist. When I find a setup that has multiple reasons for an entry and allows a very close stop, it fits into my trading plan.

We started the day with a small pop to the upside, made a quick pullback, and then moved up to the session high at point “X.” We turned down at a 127% external retracement of the previous decline (15 minute chart — not shown). This is a very common turning point, but moving back into congestion doesn’t suggest a trade to me. But what happened next created a nice setup.

The bounce from point “A” couldn’t get through yesterday’s high (green line), and on the second try it was completing a small a-b-c (up-down-up) pattern. The measurement on the second upthrust was exactly 0.618 times the first up movement. That Fib ratio is the most likely to turn into a tradable move.

Some other reasons: a previous day’s high, low, or close will often create important support or resistance, and price is stalling in the area of the high and close. Moving averages will do the same thing, and we are hitting the 13 period (white) moving average, which has turned down.

All of this makes point “B” an obvious short sale setup. Now I’ll start looking for a place for my initial stop. As soon as we turn down I can use the pivot at “B”, the white moving average, or yesterday’s high — all will give me a reasonable risk/reward ratio even if we only drop as far as point “A.”

I’m showing something new on today’s chart — a faster Stochastic. I normally watch a 14 period Stochastic, since so many charting programs use that as a default. I want to be aware of what many other traders are watching. But when I’m looking for divergences in a very short timeframe, I’ll switch to a 5 period Stochastic. And you’ll notice that at point “B” there is a very clear divergence.

Multiple reasons for an entry with a close stop. And the eventual target is a Measured Move — the distance from “B” to “C” exactly matches the distance from “X” to “A.”

The next three hours were sideways, and it ended by forming a nice rectangle. Some might complain that the three bottoms didn’t line up exactly, but I like the pattern structure. What I didn’t like was we are going back into congestion again, and there was no pullback. Until we actually get some momentum behind these pokes into new high territory I’ll continue to be overly cautions in my trade selection.

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.

The market has had plenty of opportunity to move higher over the last few days, but the Russell just couldn’t seem to build up any momentum after its breakout last Friday.

This morning gave an opportunity for an early short entry when it set up a nice divergence at the open. However, after the lack of carry through over the last week, I was perhaps too cautious and just watched for the first three hours. Until 9:30 it looked like we would just stay inside yesterday’s range.

The break below yesterday’s low produced a volume spike, and the next four bars tried unsuccessfully to pull back on low volume. I will only take a breakout to a new high or low under specific conditions, usually after a pullback to support or resistance. That allows a close stop on the other side of that level, and that’s what we got during the lunch hour.

Once in the trade, the only question was where to exit. I try to hold more that a single contract so that I can exit part at the first indication of a reversal. But what I am always hoping for is a move like we had this afternoon.

I’ve marked the likely turning points of an A-B-C pattern in yellow — 100%, 162%, and 282% of the distance from this morning’s high to point “A.” Each time we reached one of those Fibonacci levels there was no hesitation, and therefore no reason to exit.

After passing the 162% level it was time to use the faster moving average (13ma) as a trailing stop for half the position. The actual double bottom gave a nice divergence for a final exit. It turned out to be a nice finish to a very boring week.