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

First Pullback measurements are always external retracements (see yesterday), but they are Fibonacci ratios that few seem to follow. You can mark the Fib levels for the next potential turn as soon a reversal pivot forms following the first significant pullback.

Today each of the major reversals turned at one of these levels (all shown with white lines and arrows.) The 7:30 bottom turned at 127% just as it reached the continuation of a trendline from one of yesterday’s pivots. It also had a Stochastic divergence, and lead to the best move of the day.

That mid-day rally also ended in the same manner, but this time at the 262% external retracement of the first major pullback. This is what I consider a “normal” move. Once again the turn also had confirmation from a trendline at the top of a channel.

After making the high of the day we had another move down. For the third time, the actual reversal near the close was a 262% external retracement of the first good pullback.

This doesn’t work every time, but that’s the case with all support and resistance or Fibonacci levels. They give you an area where turns are more likely to take place. It’s up to your trading plan to give you entries to take advantage of them.

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.

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%.

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.

If you’ve read this commentary for very long you already know I didn’t trade today. If there are no clear trades in the first hour and the range is small, I wait until it looks as though we are breaking out from the early range before trading. No potential breakout — no trade.

But whether trading or not, marking up charts with the potential Fibonacci turning points is good practice. In a narrow range the same patterns still appear, and the more screen time you can put in, the more of the setups you will catch in real time

However, when the market decides not to go anywhere it seems to like reversing at 78% and/or 89%. Maybe those larger pullbacks are just another way of showing a lack of direction.

Notice the nice Fibonacci cluster marked with the yellow “A.” The blue A-B-C turns at the 62% extension just as the smaller red A-B-C does the same. And that happens just as we retrace 89% of the morning drop. Add a nice Stochastic divergence and you have an excellent trade setup. Now all we need is some range.