Trading What I See

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

You’ve probably noticed that I try to point out turns that have multiple indications, since these setups are more likely to work out as expected. If three signals or indicators point to the same result, there could be three times as many other traders pushing price in your direction. Not everyone is looking for the same setups.

Today is an example of multiple versus individual signals. At the bottom marked “A” there were three reasons to expect a reversal at almost exactly the same point. At “B” there were also three potential reversal signals. But at today’s close I can see at least four different levels where a reversal would fit my trading style. And they are not the same.

At “A” we were making a double bottom with the pivot from June 8th. At the same time we finished an external retracement of 162% times the rise to “X.” That is often a Fibonacci turn measurement. And if you’ve learned how to use continuation gaps as a measuring tool, the distance from “X” to the center of the gap was exactly the same as the distance from the center of the gap to “A”. (For a refresher, see Trading Gaps from early April.)

Not only did the center of the gap mark the half-way point — it also provided resistance to the three-bar pullback after the gap. Each of those rising bars had less volume, so just from a chart-reading standpoint the first red bar could be an entry for a short sale.

At point “B” there was a 62% retracement of the entire move down from “X” just as we hit a trendline draw through the first pullback after the top. On June 4th I pointed out how forgotten trendlines drawn across first pullbacks will often mark later reversals — but you will only see them if you leave old trendlines on your charts.

Not shown (except for the Fibonacci level marked at the top) is an internal First Pullback Fib measurement. The top at “B” is at the “normal” 262% external retracement. That makes three reasons to suspect a reversal.

Contrast these pivots with the situation at the close. We have just hit the 127% external retracement of the rise from “A” to “B.” But if we fall a little farther, we’ll get to the yellow parallel. And if that doesn’t hold, there is always the long blue trendline that could turn prices upward. But before we get there it’s always possible that we’ll turn when “C”=100% of “A.”

Waiting for too much confirmation misses trades. But would you rather take a position at “A” and “B”, or take a chance at what will eventually become “C.” As soon as you see a potential setup, start looking for other indications of a turn. On good moves, it’s surprising how often there will be more than one reason to trade.

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.

The first market report I heard this morning talked about the drop in the Chinese markets, and suggested we might be in for a repeat of the February drop. The gap below yesterday’s low might have hinted at that outcome, but in less than 30 minutes we were back inside yesterday’s range. Oops!

A gap outside of yesterday’s range followed by a reversal sets up the Larry Williams Oops! pattern. As I said in a commentary last year, I don’t trade the Oops! pattern by itself, but will often use the setup as a trading bias for the rest of the day. I want a very strong signal before I will trade against it. Larry says in Long-Term Secrets to Short-Term Trading that

It is the most reliable of all short-term patterns I have researched and traded.

Today was an example of the setup’s power, and the reason for passing any possible short setups today.

After the Oops! pattern triggered (entering yesterday’s range) price completed a 78% Fibonacci pullback of the morning drop. Then it made a 50% retracement of the rally and couldn’t penetrate yesterday’s low. That bounce from support at the 50% level, combined with an upward bias, would be good for an entry at the first green bar for a rally to yesterday’s high.

The mid-day sideways pattern could have been seen as a Test of Top or perhaps even a Spring setup. But Don’t Bet Against Larry. His statistical research is excellent, and I would need a much clearer setup to consider a short here. The Oops! is a longer term pattern than my normal trading, so I would consider a trade against it as counter-trend.

One more 50% pullback to the support of a previous pivot and the market rallies into the close. One of the reasons the Oops! pattern works is because many traders get caught on the wrong side of the market. As price keeps rising, more and more of these traders finally give up and cover their shorts resulting in a day with no pullback greater than 50%. Thanks, Larry.

Larry Williams: Long-Term Secrets to Short-Term Trading

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%.

On May 1st I titled an entry “Time and Target” with an illustration of how a triangle will often give you a price level and a time projection. Most of my trading deals with recognizing recurring setups in the market, and with slight differences we had almost the same pattern today.

We started with a small surge to the upside, breaking through yesterday’s high and reversing. When a market breaks through resistance and can’t continue, it will often create a Spring setup. The next hour retraced yesterday’s final rally and stalled at a support level that was already on the chart. For a while it looked as though we were finished for the day.

The first pullback was 50% for a second logical short entry, but then the market couldn’t seem to break down. The key was to look at the volume. The combination of volume and price action forms the same downside triangle we saw on May 1st. Shortly after 10 (Pacific time) we broke lower on increasing volume. As often happens, there was a pullback to the broken support followed by a move to the triangle target. Another nice short sale entry with a close protective stop.

The first target is a line drawn parallel to the opposite side of the triangle (magenta.) And often this level is reached just when the two trendlines that create the triangle cross. Trading with Technical Analysis is just recognizing setups you’ve seen before, but doing it in time to take action.

For pattern analysis I still think the best book is one many call the “Bible” of Technical Analysis. Check out the link below.

Edwards and Magee: Technical Analysis of Stock Trends