Trading What I See

Today I was tempted to take at least one trade, but decided against it. Let’s look at some longer term charts and I’ll show you why. First the Daily.

I last showed a Daily chart when we broke out of a four month up-channel. Since that time we have been traveling sideways in what looks like a rectangle. We’ve had some new highs in various indexes, but not in the Russell. If I were trading the daily chart I’d probably be on vacation. One tip worth remembering — according to Linda Raschke, the longer a consolidation takes, the more likely it is to be a reversal.

On a 45-minute chart you can see why I didn’t get excited when we broke down this morning. After a slight gap up to the longer moving average (white,) by 7:00 AM we had dropped and bounced off a rising trendline. Notice that the moving averages are crossing back and forth, showing that this time frame is also in congestion. Add that down trendline and it sure looks like a triangle to me.

Finally to the 3-minute trading chart. If you’ll remember yesterday I called the small gap up and the reversal as a tradable setup when it crossed the moving averages. I hope you don’t consider this a similar situation. Yesterday we poked through resistance — a requirement for a Spring. Not today. Yesterday we were hitting Fibonacci resistance. Not today. Yesterday there was a divergence. No trade for me here. It would have made money, but it doesn’t fit my trading plan.

As you saw on the 45-minute chart, we bounced where it was expected, and this placed us back in some tangled moving averages. Congestion is now showing on three time frames. And as I’ve mentioned several times in the past, when I can’t find a tradable move in the first hour I will tend to wait for a breakout from this range. In this case the range was set in the first 30 minutes of the day.

Over the next three hours we formed a rectangle, and my only temptation was to take this breakout trade at the end of the day. If you don’t normally trade chart patterns, here are my requirements for a rectangle trade. First the volume must decline, with the only exceptions being false pokes through the boundaries. Second, the actual breakout must have a nice increase in volume. And third (many don’t agree with me on this one,) I want a pullback to the top of the rectangle for my entry.

All of these happened today, and we quickly reached the first target in about 20 minutes. But it was Friday. And we are in congestion. And a lot of traders had already left for the weekend.

If you want to learn more about chart pattern trades, I still think the best book available is Edwards and Magee’s Technical Analysis of Stock Trends (see my review.) It’s also the most-used book in my trading library.

Edwards and Magee’s Technical Analysis of Stock Trends

Street Smarts: High Probability Short-Term Trading Strategies

This is a book full of short-term trading setups, and I think it should be in every trader’s library. Linda Raschke usually gets all the credit for this book, but Larry Connors was the co-author, and they take turns explaining some of their best short term trading techniques.

You’ve probably heard of Linda’s Holy Grail setup, and this is the book that made it famous. It is one of the most well-known (but not necessarlly well-traded) short term methods for playing pullbacks in very strong trends. Like all good trading setups, Linda gives you the exact settings for entry and exit, while using the Average Directional Movement indicator (ADX) to define the trend.

Like many of the strategies in the book, the Holy Grail (and most of the others) works on almost any market and in any time frame, whether you are a day trader or only look at charts on a weekly basis. The 25 chapters have over a dozen devoted to single techniques, with several that cover trade management and general market indicators. And as Linda points out in the introduction:

All you need is one pattern to make a living! Learn first to specialize in doing one thing well. We know two traders who do nothing but trade the “anti” pattern from a five-minute S&P chart.

That resonates with me, because one of my main entry techniques almost always triggers at the same time as an Anti pattern. The Anti is one way of defining a trend, and then trading pullbacks against it. The Holy Grail is a slightly longer term method of doing the same thing.

But a good trading toolkit will have more than just pullback patterns. Turtle Soup attempts to catch trend changes just as they happen. Momentum Pinball looks at the changes in direction in the three day market patterns identified in the Taylor Trading Technique. And Historical Volatility Meets Toby Crabel show one way to take advantage of the NR7 narrow range days.

Originally aimed at Swing traders, there are a number of the techniques that I use in my intraday trading from a three minute chart. Besides my version of the Anti, I’m constantly looking for Three Little Indians showing an exhaustion pattern with three symmetrical peaks. Or an 80-20 pattern that occurs at pivots.

And this is where I first ran across the Wolfe Wave pattern which, although I don’t trade it the way Bill Wolfe teaches, sometimes provides the overall structure giving definition to my own trades.

No matter what your trading style this is a book worth reading. You’ll probably find that you keep going back to it until certain sections become second nature, giving you a both a trading edge and a better understanding of the markets.

Some days the market will get into a rhythm, and if you are watching closely you can take a few nice trades before the pattern breaks. And often these rhythms will provide recognizable patterns that offer relatively clear entries.

We started with a quick move down that reversed at the 50% retracement of yesterday’s last rally. After a nice run to the upside, we turned down at very close to a 100% measured move. But as that move was ending it created a small pattern you can sometimes turn into a nice trade.

I call it Three Pushes, but it’s certainly not my discovery. Jeff Cooper and Larry Pesavento call it the Three Drives Pattern (although Larry has Fibonacci requirements for it also,) and Linda Raschke calls it Three Little Indians. All require some symmetry to the pattern.

In this case the symmetry is in time. The three peaks that end the move are an equal distance apart (seven bars), and the look is similar. I like the pattern to have a divergence, and if you look at the Stochastic, there is a nice one. Time for a correction.

It’s a little harder to see, but the move down also ended in a symmetrical setup — this time each bottom is exactly nine bars apart. Neither of these by itself would convince me to trade, but the top also had met a Measured Move target and had the divergence, while the bottom reversal turned right at a 62% retracement AND a 162% Fibonacci extension.

The following rally also ends at a Fibonacci cluster. It retraced 78% of the drop, and made another 162% Fibonacci extension. There was no danger of entering early at a 62% retracement, because the market didn’t slow down there. The Stochastic has also reached a clear overbought condition, and we made a swift move down to a longer term trendline copied from a 15 minute chart.

The next action is a setup I like but often have trouble entering, usually because I am still in a trade in the opposite direction. Richard Wyckoff (a trader from the first half of the 20th century) called this pattern a Spring. It allows a close stop, and often results in an explosive move.

Notice the strong support line (yellow) connecting the last two bottoms. A Spring will break support, and almost immediately reverse. Anyone that opened a position on the break will immediately be losing money, and as they close their positions the market will make a fast move. And notice the nice divergence in the Stochastic.

By this time you can observe the market in a nice cycle mode. The distance between bottoms has been 43 and 40 bars, and the two tops were 38 bars apart. When this bottom comes at 40 bars it’s time mark your charts for the next potential reversal. And that is what happens, as the market goes into rectangle mode. (And another Spring to make sure you caught the move.)

Will the time pattern continue? Who knows. You have to be careful not to depend on cycle patterns, because they have a habit of disappearing with little notice, but you should treat them like you treat trends — trade them until they end.

I saw a nice entry early this morning based on yesterday’s market action. Linda Raschke calls it Three Little Indians, but my setup also requires a DIVERGENCE on the last peak and there wasn’t one on my 3-minute chart. But looking over at the 15-minute timeframe, there was the divergence I wanted.

So I entered the trade. From the 3-minute chart. And was stopped out. Oh well, sometimes a good trade takes a second entry. And sometimes the second entry gets stopped out too.

My trading plan doesn’t call for third entries, so I watched as the market moved down to my target. The losing trade doesn’t bother me nearly as much as having made a basic mistake — mixing up time frames.

Knowing what is happening on a time frame above and below your trading chart is important, but each time period has it’s own patterns. The longer the interval, the farther away the stop will be. This trade worked if taken on a 15-minute chart, but it would required a 3 1/2 point stop, which is more than I will accept while daytrading. But that doesn’t mean I can move the setup to a shorter period just to get a closer stop. And I know that.

Alan Farley, in his excellent book The Master Swing Trader, calls this a Trend Relativity error. “They see their trades in one time frame but execute them in another. This trend relativity error often forces a new position just as the short-term swing turns sharply against the entry.” Sure did, Alan.