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.

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.

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.

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.

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.

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.

You’ve probably noticed that recently I seem to be showing a slightly larger picture of market action. Actually I try to look at this every day, but since right now I can’t follow the market in real time (and may not be able to for another month), the larger picture is what I see first. And it has been providing interesting information.

On Thursday I pointed out the Trader Vic 2B Top. They don’t always work out, but since they allow a close stop, I never ignore them. They are, of course, a specialized instance of the Spring patterns I like to trade. Since the pattern took over a day to form, it was a warning that the larger trend had probably changed to down.

Friday and today completed what is called a Downside Triangle with a downside break after about four hours of trading. Triangles of any type usually break with a strong price surge, and today was no exception. One thing I watch for in all patterns, but particularly in triangles, are internal Fibonacci measurements. The better the Fib setup, the more likely the triangle is to work as expected.

I have three peaks numbered in the chart representing the three rallys making up the triangle. The second rally is 62% of the first, and the third rally is 62% of the second. That type of symetrical pattern seems to make the breakout more likely to reach its minimum target. In this case the target is the parallel to the upper edge of the triangle which we hit near the close.

The triangle itself is made up of an A-B-C pattern which has passed the two first logical Fibonacci targets. Notice how it tried to bounce at 100% and 162%. If it continues, the next target will be 262% which usually creates a bottom. And if it develops into any kind of panic move it could drop to 426%. Check out a longer term chart and you’ll find old congestion near these levels.

Which doesn’t mean we won’t turn around tomorrow morning. Fibonacci targets are not predictions, but if you’ve read this commentary for very long you are aware of how often they work out.