Trading What I See

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.

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

Yesterday’s market showed multiple parallel lines, but even a single parallel will often confirm a target. This is particularly true when price breaks out of a triangle.

Last week ended inside a small triangle (magenta lines), and today’s first bar made the third touch of the pattern bottom. Triangles without decreasing volume have a much greater failure rate, but as you can see with today’s action sometimes they work anyway.

There are several ways to create a target for a triangle, but the simplest is to draw a parallel to the side of the triangle opposite the breakout. Price will often stall or reverse when it reaches that line as it did today. But targets are not necessarily reversal points — just places to take partial profits.

Today is a good example of how I continually change my trendlines and parallel channels as the day progresses. After the breakout there was a small pullback that allowed drawing the lower yellow trendline. The pause at the triangle target ended as we hit the extension of that line. As soon as we continued higher, the yellow parallel could be drawn, and the next pivot top occurred at that parallel.

Once again we went sideways instead of reversing, and if you looked at a one minute chart you would see a small down channel could be drawn using parallel lines. When we broke through the top of that channel the upmove continued, and a new trendline (blue) could be drawn through the pivot at “B.”

A parallel to this blue trendline also confirms a logical turning point just as price reaches a Fibonacci extension (C=62%.) I draw most of these lines during the day, but often erase many of them to reduce confusion when I post a chart. Even the parallels that are never reached give important information about the momentum of a move.

A book I often recommend (Edwards and Magee’s Technical Analysis of Stock Trends) gives step by step directions on how to draw these ever changing channels that help guide you through the trading day. Add a little Fibonacci and you get confirmation of signals from two entirely different methods.

Edwards and Magee: Technical Analysis of Stock Trends

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

Today is another example of the importance of leaving trendlines on the screen. And, of course, using Fibonacci measurements that include more than just today’s data.

We began with a small pop above the controling trendline from yesterday. Trendlines, when tested several times, work just like any other support or resistance levels — they can be hard to break, but when broken they tend to resist penetration from the other direction.

And, like S&R levels, when price breaks through a trendline, it is supposed to continue - not to reverse. A pullback to the trendline is common, but re-crossing a trendline can be a reversal signal.

In this case price reversed at the resistance of the previous pivot. It is also just over a 127% external retracement (not shown) of yesterday’s final drop. Remember that I consider anywhere between 127% and 162% as a potential reversal zone.

As soon as we went back through the blue trendline it was time to label the chart with the first two letters of a large A-B-C. The three most likely reversal levels for the “C” move are 62%, 100%, and 162%. When you are trying to pick tops or bottoms, it is useful to look for internal measurements — in other words an a-b-c inside a larger move, and that is what we got.

Price looked as though it were going to reverse at the red line I’ve marked Support. That would have made the larger (Red) A-B-C turn at 62%, but that level only held for two bars before continuing downward. By the time we approached the low of the day the labeling was obvious, but in real time it is much more difficult.

If price had turned up from the support line the larger move would have been 62%, and there was a slight bounce there. The next likely turning point was 100%, and again the market tried to stage a rally. This is why I never use the Fibonacci levels themselves for entry. At each potential turning point I watch price closely for indications of an actual turn, using candlesticks, moving averages, divergences, and anything else I observe at the time.

Finally when the smaller A-B-C hit 62% and the larger A-B-C reached 162% we got a Fibonacci Cluster and the market reversed. Another thing I noticed at that level was that we had just duplicated the distance I have marked with Support and Resistance labels. It is not a rectangle, but after spending years working with pattern recognition I sometimes look for targets even when the original “pattern” doesn’t fit the rules.

From the bottom we made another A-B-C to the upside. Notice that the trendline from yesterday reversed the market. The “B” move retraced exactly 50% (forgot to mark it), and the final rise again stopped at 62%. That tends to happen often on sideways days.

On more item that is seldom presented in Technical Analysis books appears at the end of the day. By 10:30 (Pacific time) we had a strongly defined downtrend line (Blue), and then the market started ignoring it. This is usually one of the earliest signs of congestion, and an indication that not trading might be the best choice.

We got the correction I mentioned yesterday (or perhaps only part of it.) The potential WEDGE formation broke downwards as it should, but the movement towards the target (point #5) was not as direct as it is in most wedges. This five minute chart only shows yesterday’s wedge and its completion.

Pattern targets are best used to determine reward/risk measurements, and in this case I would not have taken the trade. But assuming an entry, what do you do about targets? Actually, you treat the trade just like any other, using trendlines, support and resistance, and Fibonacci measurements. Whether or not you get to the “official” target depends on trade management.

Today’s first move after a small gap was up to the day’s high at point “0.” After the trade triggers, a Fibonacci cluster develops at point “C.” Remember that Fib clusters require several measurements to show almost the same level. These were so close together that drawing multiple lines just makes the chart hard to read.

Point “C” is an 89% Fibonacci retracement of the move from “5″ to the top at “0.” It is also a 127% retracement of the move from “X” to “0.” And the third measurement is a Fibonacci extension; measure from “0″ down to “A” and you will find that it is duplicated by the distance from “B” to “C” — a Measured Move.

All of these targets are available an hour before we reach point “C”, so there is plenty of time to decide whether to take partial or full profits there. It all depends on your trading plan.

Did we reach the wedge target? Some would say we missed by over half a point because they are under the misconception that trading is always exact. I measure targets on wedges the same way I treat tests of top or bottom. If we get inside the range of the extreme bar at the beginning of the pattern, I count it as a hit. So as far as I am concerned the wedge pattern would have been a successful trade.

Occasionally there is a situation where trade setups could be taken in either direction, and your decision can make the difference between a winning or losing day. Let me walk you through my thinking process for this morning’s action.

We ended yesterday’s trading inside a well-formed rectangle, and this morning’s first bar made a breakout move. I’ve shown in yellow the rectangle, and the upside price target that it created.

It seemed like everything except the Russell 2000 was making a big rally, but one item kept me from taking any long entry. It was the rectangle target. It wasn’t that we were too close — we had already traded right to that price. It just happened before the “open.” (Trading on the Russell e-mini futures only stops for a 15 minute maintenance period on weekdays, and on Monday morning it opens an hour before stocks.)

Often this “overnight” trading will provide important support and resistance areas, and I wanted to see that one broken before looking for an entry. But it never happened.

By 8:00 (Pacific) we had not only moved back into the rectangle, but we broke to the downside on an increase in volume. As we bounced off the 127% retracement level there were two potential trades. If we moved back up through the resistance created by the rectangle bottom, it would form a Wyckoff “Spring” (see yesterday’s post.) But it could also be stopped by that resistance and continue downward. Decision Time!

First the trade I didn’t take. I consider entries on three types of reversal trades; strong divergences, Trader Vic 2B SETUPS, and Springs. The last two are similar in that they occur just after a breakout. For my entry I use a technique that Teresa Lo used to teach — wait until price exceeds the bar that actually created the breakout. I’ve marked that with a blue arrow.

It came within a tick, but never hit my entry order. I had actually put in two entry orders by this time, the other one for a short sale if resistance held. I don’t necessarily recommend this procedure, and in fact seldom use it myself since it’s possible to end up with losing trades in both directions.

But remember this morning’s context. There were probably a lot of traders that had entered on that failing rally that I ignored. If they had to exit their positions, those disappointed traders would give an extra push to the downside. Like we got for the rest of the day.

My entry stop for the short sale was hit as we pulled away from the blue moving average. When we hit the 162% retracement level I took profits on half of my position and moved my trailing stop to above the blue moving average on the rest. Since this 162% Fibonacci retracement matched Thursday’s low, I really expected us to turn back up, but there were no divergences, and both moving averages were showing a strong downward bias.

As you can see, the trailing stop was much more profitable than an exit at that point. That’s why I try to run a wider stop after I’ve taken my first profits on a move.

The chart, so I could show detail, only has part of the trading day. After overrunning the 262% level a bit, we went more or less sideways for several hours, and then continued our downward course. Where did we stop? What Fibonacci level comes after 2.618? The next Fib is 4.236. And that is precisely where we reversed today.