Trading What I See

After opening with a small gap above yesterday’s high, the market immediately reversed on the first one minute bar and closed the gap (not shown.) That looked like a Spring setup, but there was no confirmation — no Fibonacci level or divergence for the top.

The next two minutes reversed the reversal, and then the market topped out at the 127% Fibonacci external retracement. For those new to the site, that’s a measurement that retraces more than 100% of the previous move, shown on this chart with white arrows early in the morning and again in the afternoon.

Any time the market exceeds a previous pivot you should mark off the 127% and 162% external retracements, since these are the two most likely levels for a quick reversal. If we exceed 162% that’s a good indication that the move will continue for a while.

The turn at the high created another Spring setup as we broke through yesterday’s resistance but immediately reversed. This time the reversal occurred at 127% so there were two reasons to enter a short sale. If you missed that entry, the pullback at “B” was at a 50% retracement of the early decline. I like to enter after Dunnigan blue reversal bars if there is another good reason, since that often acts much like the Spring setup.

An A-B-C pattern (shown in blue) will often turn at 62%, 100%, or 162%. The two bar hesitation at 7:30 was at 62%, but there was no actual bounce. We went through 100% without a pause, and finally made the low of the day at 162%. Nice morning trading.

For the next four hours I can’t find an entry I like. I expect early pullbacks to be 50% or greater, but it never happened. I have a nice parallel trend channel marked in yellow, but without an entry you can’t trade it.

But it does point out the afternoon top, which is also a 162% external retracement and another refusal to move upwards after again breaking yesterday’s high. Not as clear as the morning reversal, but I would still consider it a Spring.

You might take a look at the daily chart before tomorrow’s open. We’re back at the high of a rectangle that has lasted over a month. For longer term traders tomorrow might be decision time.

Last Tuesday’s commentary left price just under a downtrend line (shown today in yellow) on the 45 minute chart. Since that level had also completed a potential A-B-C with “C” pausing at 62% of “A”, it was looking much like a top.

After pointing that out, my next sentence was “Of course a breakout tomorrow morning would change this pattern …” The magic of Fibonacci and trendlines is how often they work, not that they can predict the market. Part of successful trading is the ability to quickly adapt to new information. On the shortened trading day Wednesday price pushed through both the trendline and the Fib level. But look what happened next.

As soon as price exceeds a pivot point, you want to draw an external retracement measurement to show the 127% and 162% Fib levels. That’s where to start looking for the next potential reversal. And that’s where we closed on the three bars that eSignal shows occurring on the 4th. That doesn’t predict the downturn this morning — it just means it shouldn’t have come as a surprise.

As I have said many times, where there are two pullbacks in a move, the first one will usually be large (most often 62%) and the second one small (38%.) Today the second pullback turned right at the 38% Fibonacci level AND bounced off the support of the broken trendline. An obvious place for a turn.

On my three minute trading chart you can see the market made a nice A-B-C=100% Measured Move that hit the bottom of a parallel channel (in yellow). That gives today’s low two measurements from a 45 minute chart combined with two more from the trading chart. When multiple time frames agree on direction, you have a high probability trade.

Of course there are often more potential Fib and channel trades than I point out (or sometimes even see) that are available during the trading day. In Tuesday’s comments John explains how he used the $Tick reading combined with the magenta channel this morning to execute a nice short sale starting at “X” on the chart. Nice trade, John.

After a narrow range yesterday, the market made two tests of the top before turning down over the lunch hour. There was declining volume on the second test, but at that time it looked like the entire day would just move sideways.

As usual, when there is no setup during the first hour I’ll mark off the top and bottom of the range and wait for a breakout (magenta lines.) Of course when we broke down there was the obvious support of yesterday’s close and yesterday’s low, so I didn’t see that as a setup.

During the day there were three pullbacks, and each showed declining volume (all marked with yellow.) The earliest was inside the first hour’s range and didn’t threaten to break out. However the second was outside that range, and the low volume pullback turned at the 50% retracement level. That’s a potential setup with a short sale just after the yellow trendline break at the blue “B.”

Again there was a low volume pullback after yesterday’s pivot bottom was broken for another potential entry (yellow “B”.) I like the second entry much better, since by this time the moving averages are pointing down.

The eventual bottom came on a spike through the yellow A-B-C and turned at both the blue parallel and at the larger A-B-C where the “C” move equaled 162% of the “A” move. Not a great trading day, but still a good example of how declining volume on pullbacks is usually followed by continued moves in the trend direction.

Wedges usually appear during the final surge of a larger move, as a last gasp rally or decline before a reversal. Yesterday’s WEDGE was an exception, since it was pointing against the recent downtrend.

But all the identifying features were there. It made three touches of the bottom trendline and two of the top, creating converging lines. Each of the internal moves can be seen as a small A-B-C. The second major pullback doesn’t find support at the peak of the first wave (overlapping moves.) And volume declines throughout the pattern.

We broke out of the wedge at the open, had a pullback to the rising trendline for a potential entry, and made a relatively fast move to the wedge’s initial target — the very beginning of the pattern.

A wedge will usually reach target in half to three-quarters of the time it took to form. Normally that won’t be the end of the move, but there was a nice divergence (double bottom) warning that at least a strong bounce might occur over the lunch hour.

Like a triangle, a wedge will often reach its target (and sometimes reverse) at the same time the pattern lines cross. That’s certainly a place to take at least partial profits.

The afternoon trading was just a sideways move, perhaps caused by traders unsure of what would happen during the aftermarket rebalancing of the Russell 2000. That’s what caused the spike just after the market closed. It’s interesting that it went just high enough to complete an A-B-C=100% close to the week. Maybe there’s something to this Fibonacci stuff after all.

After a well structured five wave move like we had yesterday, a reversal of some sort is common. Not required, but certainly not a surprise. So when the market created a Spring setup at the open, the first red bar could be an entry for a short sale.

The Russell tried again to break above yesterday’s high, but didn’t exceed the first pivot — the most logical place for a stop. From there the market kept getting weaker all day long.

Since Spring setups can catch a lot of breakout players on the wrong side of the market, you will usually get at least an A-B-C move against the previous trend. After the 8:00 pullback price moved right to the parallel trendline just beyond where “C” would equal 100% of “A.” But then price couldn’t get back to the top of the channel.

Of course you couldn’t predict that in advance, but by the time we had reached the blue “X” on the chart, just by drawing trendlines and their parallels after each new pivot gave you a potential short entry at the top of the new channel. How much of the next move you could capture depends entirely upon your money management technique.

Over the past few weeks I’ve been pointing out Fibonacci external retracement measurements based on the first major pullback in a larger move (marked in white.) I look for reversal points at 127% and 162%. However if we get beyond the 162% level the most common turning point is 262%. As you can see, price didn’t even hesitate at that level.

What comes after 262%? In a runaway move there will often be at least a good bounce at 423%, and many times that will end the move. No — that is not a prediction. And no, I’m not carrying a position overnight. But I’ve already marked the 837.50 level on my trading chart for tomorrow — just in case.

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.

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.