Trading What I See

Evidently the market decided it wanted to spend some more time working inside the daily rectangle. In fact, today we dropped back almost to the center of the pattern. With a gap down opening, price built a floor just under the 850 level and went sideways until after the lunch hour.

When there was no trade in the first hour, I marked off the range and waited for a breakout (A) and a possible pullback (B.) Then I passed the trade that turned into a Measured Move.

On pullback trades I want to see a decrease in volume before I’m comfortable with a trade. Sometimes volume doesn’t make a difference, but over time I get better consistency when I insist on either correct volume or multiple reasons to take a trade. At least I got a lot of paperwork done today.

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

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

Whenever I enter a position, after setting a protective stop loss I begin looking for my first exit level. My compromise between getting out too early and holding a position too long is to trade multiple contracts.

Sometimes finding a logical point to take some profits can be difficult. I don’t automatically exit at Fib or support/resistance levels, but use them as areas to watch price closely for reversal indications. And sometimes I’ll use points that others may not consider “correct.”

After a nice Spring setup just after the open (complete with a Stochastic divergence), price re-visited a resistance area created yesterday, making a third reversal at exactly the same level. Although there is only a single bottom pivot, I’ll probably start to treat this area as a potential rectangle.

A “correct” rectangle will have at least two pivots at both top and bottom, but notice what happens when the bottom support breaks. There is an immediate pullback to that support, just as often happens with a “real” rectangle. If you’re willing to trade “almost” patterns, that pullback was a nice entry for a short sale.

For those not familiar with the quote used as today’s title, here is a more complete version:

If it walks like a duck and quacks like a duck, you can be reasonably sure it is a duck.

For my trading the same thing applies to rectangles, triangles, and many other patterns. If it acts like a rectangle, I’ll certainly mark off a rectangle measurement for a target even though it doesn’t meet all the normal requirements.

And that rectangle target is where we got a nice reversal today. We eventually moved somewhat lower, but first targets don’t necessarily mean the end of a move. But they are certainly good places to take partial profits.

One of the most difficult things about discretionary trading is deciding how much leeway to give patterns and levels. If you are just starting out, my suggestion is to require very strict adherence to the “rules”, but after you have analyzed thousands of charts you’ll begin to see more “almost” patterns and discover that they often work.

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%.

My apologies to those on the east coast, but the blog entries for the next few days will probably be posted quite late.

I’ve mentioned a number of times how the 162% external retracement determines the way I look at the short term trend. When the market rallies or declines I usually mark a potential reversal zone between the 127% and 162% retracements of the last rally or decline.

If we can get beyond 162% I assume the trend has actually changed. Today was an example of this situation. Yesterday’s low held for the first hour, and then we temporarily broke down. At first glance this might look like a Spring, but for that particular setup I expect the reversal to happen almost immediately. Today we broke below the low and traded there for an hour and a half.

But notice that we also broke a two day downtrend line (blue.) As will often happen, price pulled back to that line. I want first pullbacks after a potantial trend change to exceed 50%, and this one did, so any reversal trigger could be bought. After we resumed the uptrend, the 162% Fib level comes into play.

When price reached the 162% external retracement of that first pullback it looked like another reversal had set up. At this point I might exit at least part of any position I was holding, but without a divergence or some additional evidence of a turn I would probably not sell everything. Remember that the market will usually make some sort of hesitation at any important Fib level even if it is going to continue.

In yellow I have arrows marking the 78% pullback and it’s external retracement. After the hesitation, price finally exceeded the 162% level. Whether I’m in a trade or not, my bias is now up.

After we finally reach the top at 11:15 (Pacific) the market makes a small A-B-C pullback. It turns out to be a Measured Move, and also retraces 38% of the last large rally. I see this as a fairly strong buy area because we have exceeded the 162% level. Drawing the upper yellow trendline allows me to have three reasons for a buy — an A-B-C, a 38% Fib pullback, and hitting the yellow parallel trendline.

Of course if you entered at the 78% pullback you might still have a partial position through the end of the day.

We’ve ended the day at another 162% external retracement (blue arrows.) It’s a logical place for a pullback, but until we break out of that Daily rectangle I really consider the larger trend sideways, which means taking setups in either direction.

Today was an inside day with little movement, and the few setups that occurred couldn’t manage a break of the first hour’s range. As I’ve pointed out before, a narrow first hour often keeps me from trading unless the market changes character during the session.

The small move up from the open looks as though it stopped at the 127% retracement of yesterday’s last drop, but it was actually higher than that during pre-market trading. There was little volume as everyone waited for the ISM report at 7:00, and evidently that was a minor disappointment.

By the time the report was released we were too far from the pivot for a close stop, so I waited for a pullback that never occurred. Once a narrow first hour range is set, the market will often respect that high and low for the rest of the day. My procedure is to wait for either a breakout or a good setup that looks as though it may break from the range. End result — no trades today. But there still are some examples of setups that I like under better market conditions.

Although the yellow trendlines look like a triangle, I never trust one that keeps going sideways to the apex. They seldom turn into successful trades. But during the lunch hour we broke the bottom trendline and made a 50% pullback. Pullbacks to broken trendlines allow close stops, and often become nice trades when the trend continues. I also like them when the pullback reverses at moving averages that have just changed direction.

Of course we were stopped by the first hour’s low and a longer term trendline that was visible on the 15 minute chart. When the market couldn’t go down it decided to try the other direction. Notice the same setup as we broke another trendline and pulled back into the cup formed by the moving averages.

I use the same rules for trendline breaks that I use on patterns — if the break is to the upside it must have increasing volume; to the downside volume isn’t that important. And of course they shouldn’t occur in congestion like we had today.