Trading What I See

Sometimes the obvious Fibonacci targets don’t work the way you expect. That’s the time to remind yourself that the objective is to make money — not to be correct.

The market opened without much volume and tried to break out above yesterday’s high. To be convincing, breakouts need volume, and without it the reversal wasn’t all that surprising. A breakout that immediately reverses is called a Spring, and I find a tradable example several times a week.

Whenever I see a reversal I anticipate an A-B-C move, so the bounce up from “A” was not a reason to exit. And the turn down from “B” was logical. It was a 50% retracement and occurred at the yellow trendline that was drawn from two earlier peaks. But that’s where things got interesting.

As soon as we turned down from “B” it was time to draw the yellow parallel as a target for the first profit taking level. Since it matched yesterday’s close I expected a turn there. But it wasn’t at a Fibonacci measurement. And there was no Stochastic divergence. Maybe it would be worthwhile to keep part of the position.

When the second hit of the parallel trendline matched the 100% Fib extension I again thought we would bounce, but we didn’t even slow down. Time to draw the next Fib target at 162%. As you can see, we didn’t stop there either.

Now for something you won’t find in many technical analysis books — look at the purple trendline. That is drawn as an exact parallel to the yellow trendlines, but starts at the next pivot I could find. When the market is creating parallel channels and then breaks outside, a surprising number of times price will stop at another parallel to the original channel.

I don’t ever initiate a trade at this point, but in this case you are looking for an exit to retain as much profit as possible. I also found another Fib measurement that pointed to the bottom. The original A-B-C didn’t stop at a good level, but if you will examine the “C” leg it is also a smaller a-b-c. And that purple “C” is the 162% extension of the smaller pattern.

This example is why I always try to trade in multiple contracts. The first half I will exit at a target — the second half with a trailing stop. And when I see a potential reversal, instead of exiting, I just move the trailing stop very close to the price.

After the bottom the market created another nice channel. Unfortunately I can’t see any good entries. But finally at 11:30 we made another reversal with three indications that it might happen. We had retraced 62% of the morning’s drop, we were hitting the top of a well-defined channel, and also running into resistance from a previous pivot.

Another A-B-C that was a Measured Move, and also matched a 62% retracement of the rally, created the last pivot bottom of the day. More lines than usual, but this is what my charts often look like before I clean them up as posts to the blog.

The more Fibonacci measurements I can find for a pivot point, the better I like the possibilities for a trade. Today’s bottom pivot gave quite a few.

We started the day with a sideways movement, and although the reversals look good now, it wasn’t until the small red “c” that the first setup occurred. Any time I have an up-down-up movement I’ll check the Fib measurements looking for 62%, 100%, or 162% reversal levels. As we hit each level I’m watching for confirmation of a potential turn.

There was a confirmation as the pullback stalled at the blue downtrend line, but if you’ve followed me for very long you will understand why I passed that short sale. We had reached the end of the first hour of trading, and it looked like we were stuck inside the morning range. That usually leaves me watching.

The drop moved to the parallel trendline, as it should, and there we got multiple signals as various Fibonacci measurements lined up at the day’s low. There were five reasons for a long entry.

(1) It was a 38% pullback of the rally from the bottom pivot. (2) It was a Measured Move (the blue A-B-C equals 100%) from yesterday’s top. (3) It was another small a-b-c that again ended at 62%. (4) The previous move had reached its target by touching the bottom of the trend channel. And (5) there was a clear divergence in the Stochastic oscillator.

Did this mean we had to go up? Of course not. But it was easy to place a close initial stop right below the pivot bottom, and to then trail a stop below the blue moving average. It’s too bad today’s range was so small, since that trade captured almost all of it.

You always wonder whether a long weekend will make a difference. Will Fibonacci calculations still work using the old data? Do you have to change your trading tactics?

Last week we had slow holiday trading. Then we had a day off for New Years. Yesterday there was a market closing for a state funeral. Today the market continued from where it left off as though there were no break at all.

Let’s start with a 15 minute chart to show some measurements. The gap this morning went up to the high of last Friday and couldn’t get any higher. Even on a 3 minute chart, no bar was able to close above that level (point B.) When we get to a shorter term chart you’ll even find a divergence there.

If you are not already doing it, always mark in the highs and lows of the last few days — most software packages will do this for you, but if not, draw them in by hand. Like Fib levels and trendlines, how the market acts at these levels is critical trading information. When the market couldn’t break that level and it corresponded to failure at the yellow down trendline, your trading bias should have switched to the short side.

Still working from last week’s data, the turn at point “C” happened at a logical set of Fibonacci measurements. The distance from “X” to “A” multiplied by 1.618 is exactly the distance from “B” to “C.” That’s called a Fibonacci extension, and the most common measurements are 0.618, 1.00, and 1.618.

And whenever price exceeds a previous pivot point (passing point “A”) you should measure external retracements — those are retracements over 100%. The most common is 127%, but if price doesn’t stop there it is likely to go to 162%. Point “C” just slightly exceeded a 162% Fibonacci retracement of the “A” to “B” distance.

Now let’s look at my trading chart - a 3 minute timeframe. At “X” you can see that there was no real breakout above Friday’s high (green line.) From there until just after lunch time (first blue arrow) it looked like we might just go sideways for the rest of the day.

But by 10:00 (Pacific time) my moving averages were starting to move downwards, and we were hitting a downtrend line drawn from “X” to “B”. Add to that a pullback to the blue declining moving average, and a short sale with a very close stop is possible. I like close stops, and will often use the blue (13 period) moving average as a trailing exit in case I’m wrong.

Two more pullbacks to the moving average (arrows) could be used for additional short trades, depending upon your trading style. All of them would have been profitable. The question is why I haven’t marked the last pullback (after “C”), which would have been a loser.

Here’s a Fibonacci measurement you won’t see talked about much, and it keeps me out of this kind of bad trade. When we’ve had a strong move, I’ll go back to the first pullback and draw a Fibonacci extension. A strong move will pass the normal reversal points (.0618, 1.0, 1.618, and 2.618) but it’s an unusual move that can get beyond the next level (4.236) without a good correction in the other direction.

Combining this with the 15 minute chart, point “C” is the target for three Fibonacci measurements - a good reason to quit chasing the downside for a while. It looks like a few days off didn’t affect the market’s memory at all.

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.

Have you ever noticed that when you start thinking about something that you haven’t seen for a while, it will suddenly appear? Last Friday I received an e-mail asking if I knew about the Bull and Bear Crown trading patterns (similar to small head and shoulders.) I said I thought I had heard of it, but I might be confusing it with the Triple Crown pattern, which is different.

Today, with a boring market, I was spending more time looking at longer charts, and what should appear but the Triple Crown. I usually have most of the Fibonacci retracements and extensions drawn on my 15 minute chart, so it’s just a matter of watching price approach the various lines. Today at 11:30 (Pacific) a pullback dropped right into a Fibonacci cluster.

Fibonacci clusters are price areas where a number of Fibonacci relationships from different pivots appear in a relatively narrow band. The theory is a Fib cluster is more likely to be a turning point than a single Fibonacci measurement. Point “C” on the chart was a 62% retracement of the move from “A” to “B”. But it was also a 78% pullback from point “a” to point “b”. In addition (although not show to keep the chart readable) the move from “B” to “C” is a down-up-down move where the second drop is 162% of the first. That’s one nice Fibonacci cluster.

Now you don’t have to know this is a Triple Crown in order to trade it, because a good Fib cluster is always a setup. But since I had just looked at the pattern in Derrik Hobbs’ book Fibonacci for the Active Trader on Friday, it was hard to miss.

The pattern requires an overlapping pullback with a specific Fib setup. From the lowest bottom (”A”) price must come down to the range of a 50% to 62% retracement. And from point “a” the 78% retracement must fall between those two numbers. You can see this with the red smaller retracement falling inside the larger yellow retracement. Derrik calls this one of his favorite setups, and says:

It is a specific combination of these three Fibonacci retracement levels that identify potentially powerful reversal areas in any tradable market with liquidity.

He even gives you a first target - the 127% retracement of the “B” to “C” move. His actual trailing stop procedure doesn’t take profits here, but locks in half the profit and tries for more.

You might have trouble finding Fibonacci for the Active Trader unless they decide to re-publish it. Several months ago I saw it listed used on Amazon for about $2,000. (Not a misprint.) However if you hurry, it looks like Ebay has an auction going with the present bid just under $100. But as you can see, the Triple Crown can be traded without the book.

Watch for this and similar clusters. They may become one of your favorite setups.

After an absence of good channels and Fibs yesterday, we again have lots of good trendlines and Fibonacci relationships today. It’s too bad we didn’t have any range to go along with them — total high to low was 7.3 points.

We opened with a gap above yesterday’s high, and although it doesn’t show on this chart, if you were watching the pre-market trading it actually went just a bit over the 127% retracement of the distance from the previous day’s high to point #1 on this chart. But it only held the high for about a minute. A parallel to the gray upper trendline stopped the first drop, but the bounce didn’t go anywhere.

Another plunge out of congestion that looks much like a triangle gave us our second bottom pivot of the morning. That calls for drawing the yellow lower trendline, followed by the yellow parallel. Before seriously moving in that direction we had one more drop, reversing again at the 127% retracement of the move from point #1 to #2. Notice that the Stochastic oscillator gave a nice divergence for an entry there.

Divergences sometimes result in very quick moves, and it took only one bar to get up to the yellow parallel trendline at point “a.” Drawing the blue trendline from “x” to “b” gives us another quasi-triangle, but the move up didn’t make it to the blue parallel. But it still stopped at a logical point, resulting in a Measured Move. The distance from “x” to “a” is matched by the distance from “b” to “c”.

How do you know not to wait for price to hit the parallel trendline? What you do at Fibonacci levels, at parallels, and at any kind of support or resistance depends on your trading plan. Mine calls for always taking either partial profits or moving a stop very close at any potential support or resistance point.

A few weeks ago I was stressing the importance of leaving trendlines in place as long as they kept having an effect on price. Notice what happens with the long yellow trendline. From “a” until the long breakout bar the trendline acted as resistance, holding price down. After the drop from “c”, the same line acted as support. You’ll read that resistance becomes support after being broken, but most people don’t understand that the same is true of trendlines.

One day before the election, and everyone seems to be waiting. However today was a good example of the relationship between trendlines, channels, and chart patterns. The early gap held for less than three minutes, and although I could make a case for an entry about 6:50 (Pacific), the Russell was lagging badly, so I just watched.

By the end of the first hour we had set up a trading range, and I drew the yellow horizontal lines. As I’ve mentioned before, when I can’t find an entry I like in the first hour I’ll often wait for a breakout before considering a trade. And those early pushes through the top line are not breakouts.

Notice the lower blue line that can be drawn shortly after 7:30 from point #1 to #2. This and the parallel drawn from point #3 are created long before we know if the day’s high will create a level of strong resistance. But when it does, you have the shape of a well-known chart pattern — the upside triangle.

So which line do you use — the top yellow line creating the triangle or the blue parallel? The correct answer is to use both. When a triangle breakout occurs, the first target is the parallel of the side opposite the breakout. That’s just another way of saying that price channels make natural targets. If I hadn’t already drawn the upper blue line, I would put it on the chart as soon as I recognized the triangle pattern.

I can already hear a voice saying “But it didn’t reach the parallel.” That doesn’t prevent a profitable trade. My procedure is to move a trailing stop very close to price when we approach a parallel, so the fact that we didn’t quite get there doesn’t mean I give back much of the accumulated profits.

But in this case, there were none to give back. I didn’t like the “upside” triangle because of the irregular top, and the breakout had very little volume. Low volume upside breakouts are prone to failure. Some low probability setups work out just fine, but I’d rather have more odds on my side.