Trading What I See

After a relatively flat opening, the Dow and S&P futures decided to go down while the Russell and the NASDAQ tried to go up. That made it difficult to find a convincing entry until about 8:30 (Pacific) when the various markets finally quit arguing about direction.

The trend (as shown by the longer moving average) was still up from yesterday, and after two hours of waiting the Stochastic finally got oversold. I don’t trade the Stochastic by itself, but there were two other reasons to consider a long position at point “C”.

Depending upon the strength of a move, the three most common pullbacks are 32%, 50%, and 62%. At 8:30 we hit the 50% retracement of the rally from the morning low. At the same time we had just completed what some call a Measured Move. The distance from B to C is within two ticks of the distance from X to A.

Oversold condition, 50% pullback, and a Measured Move — three reasons to consider a long position here. My entry would have been the crossing of both moving averages. The question is whether your trading plan would allow you to hold through that overly strong first pullback. A stop below the pivot would have kept you in for the move.

Move to where? If we go to a new high, I always look for potential reversals at 127% of the depth of the pullback. Unless there is a lot of momentum, that is where I pull my trailing stop up close.

The first thirty minutes today continued yesterday’s decline. When the market is trending strongly in either direction, many traders have conflicting emotions. There is the desire to enter the trend, to take part in the quick profits they see being made. And there is the fear of getting into a position just as the market reverses. Anticipating logical reversal points may help you make a profitable decision.

If the trend has been in effect for several days, you must go to longer term charts to find possible turning points. Sometimes it involves looking at previous pivots that become support or resistance. And sometimes it matches a Fibonacci external retracement or a Fibonacci extension. Today it was an extension.

The three most common Fibonacci extensions are measurements of 61.8%, 100%, and 161.8% times the previous move in the same direction. The large blue arrows on the chart show where the last two down moves came within one tick of an exact price match of 15.5 points — the 100% extension.

You use these Fibonacci levels just like support and resistance. If you’re lucky, you’ll get a DIVERGENCE there, but today that didn’t happen. What you don’t do is open or close a position just because a Fib level is reached. Today we bounced, and I didn’t try to turn the bounce into a short sale because of where it occurred. The 100% extension, or measured move, is often a powerful turning point.

If we had broken through, I would have looked to the next support, Fibonacci or otherwise. If it were far enough away for a reasonable profit, then I’d look for an entry trigger. Fibonacci measurements and support or resistance are just landmarks on the charting terrain. But if you combine these landmarks with entry or exit triggers, you’ll have some powerful tools to improve your trading.

Today was a good example of why watching a longer timeframe is a good idea. It’s not to make entries, but to observe the context for setups on your trading chart. Tuesday I showed the way a longer chart can influence your trade timing in a negative way. This example shows how they can save you money.

The first 3-minute bar broke through yesterday’s high, and although price turned down within the 127% - 161.8% danger zone, the move looked pretty strong. The pullback stopped right at the .618 retracement just as the Stochastic hit the oversold area, and price was still above my longer-term moving average. A good setup. So why did I pass the trade?

Because on the 15-minute chart, that break above and then below yesterday’s high produced a Trader Vic 2B SETUP (see example.) The 2B occurs at trend reversals — in this case from up to down. My good setup is now in the wrong direction, and as you can see, taking it would have been a mistake. Instead I started looking for an opportunity to join the new downtrend and found two before lunch.

Someone asked me today whether using longer timeframes meant trading in the direction of the longer term chart. Not always. The trend is going to change first on the shorter timeframe, so the goal is to understand how your chart fits into the larger picture. In today’s situation the 15-minute chart showed an uptrend, but the pattern told me that below the surface the direction had probably changed to down. Even if this trade had worked out well, for me passing was the right decision. Good trading is always a matter of assessing risk.

Yesterday I mentioned the possibility of a breakout today, and it looked like it was happening — for a few minutes. We started with an almost five point gap on fairly good volume. Price opened above the highs of the last two days on the Russell, which has actually been the weakest of the indexes I follow. Three minutes later we were on our way down. Predictable? Not by me. But the move gave two different short sale setups within a few minutes of the open.

The first setup is most easily seen on a longer term chart. While many watch an hourly chart, I don’t really like them. If you are trading stocks, there are 6 1/2 hours to the trading day. Index futures have 6 3/4 hours. In either case the last hour of the day is shorter than the rest. Am I being picky? Probably. For that general time frame I use a 45 minute chart for futures, and there are exactly nine of them in a trading day. (I used to use 65 minute charts for stocks. With computers, you can make the rules.)

The setup is from Victor Sperandeo. If you haven’t read Trader Vic — Methods of a Wall Street Master, you’ve missed a great trading book. The pattern is called the 2B SETUP. I won’t go into much detail, but the essence is that a trendline break followed by a new high and a failure is almost a definition of a trend reversal. It’s easiest explained with a picture, so here it is. This pattern alone is worth much more than the price of the book.

The second setup, occurring at exactly the same time, comes from Larry Williams. He calls it the Oops! pattern. It requires a gap above the previous day’s high that can’t hold. In other words, it fails soon after the gap is made. And all the traders that took the breakout say “Oops!” He trades it as a one-day trade, holding until the next day’s open. We won’t find out until Monday if his trade works. I take my profits a lot earlier.

The Oops! pattern doesn’t really require a chart to understand, but you’ll still want to look at this one. Once you had convinced yourself that the true direction was down there were multiple patterns, Fibonacci measurements, and pullbacks for trade entry and exit. Too much to explain in one post, but this is what the Trading What I See Blog is all about.

Today there was a nice rally starting about 7:45 (Pacific). The question wasn’t whether you caught the beginning of the rally, but how soon you decided that the direction had reversed. There were four pullbacks before price topped about 10:15. All were tradable, but only after you saw the change of trend.

Although I trade a 3 minute chart, a 15 minute chart often gives me hints of potential turning zones. Not trading signals, but suggestions of what might happen. I watch for both equal moves and various Fibonacci relationships. When the 15 minute Stochastic became oversold about 7:30, this morning’s downmove looked much like what occurred late last week. A quick check showed a 12 bar drop matched by a 13 bar drop. The measurements were 9.9 points versus 10.4 points — only a 5% difference.

Buy? Not this trader. But the potential for a reversal from this level allowed me to consider each of the following pullbacks as possible uptrend entries on a 3 minute chart rather than as a continuation of the downtrend. Notice how the equal moves produce a parallel channel. Trendline traders could have caught this even without counting bars.

Echo, echo, echo …. This looks much like a repeat of Monday’s (8/28) action. A quick, tradable pullback followed by a day of sideways oscillation. The range was a little wider, and if you play divergences it was possible to catch several of the swings.

The pullback over the first 30 minutes gave a tradable entry as the moving averages showed a strong uptrend from yesterday. A very clear stochastic pattern marked this second rise through yesterday’s high (green line.) Five points later, and the moving averages start intertwining for the rest of the day.

At 9:30 (Pacific) there was what I call a weak DIVERGENCE for another long entry. [Weak because price didn’t make a lower low.] I wouldn’t take the stochastic signal half an hour earlier because it was below both moving averages. For that I will usually wait for a divergence.

The new high at 10:30 came on lower volume and with another stochastic divergence. By the time you get the bottom at 11:45 you could have recognized the pattern as a rectangle, and it bounced to the top of the range in a straight line. Once again, the clearest and best trades are coming in the first hour. Tomorrow and Friday may be non-events as everyone heads out for the last three-day weekend of the summer. I think I’ll join them and post again next Tuesday.

One-a-day may be the best prescription until after next weekend (Labor day). It seems as if every other day has a single good trade. And of course Friday brought down the average. Fifteen minutes into today’s session set up a nice DIVERGENCE trade. But unless you use something as sensitive as my moving averages, by the time you identify a trend, it’s too late.

I’ve put ADX on the chart, and it was just over 20 as the first trade triggered. But from my point of view, an ADX of 20 has to be rising to call a trend. This one was flat. I missed that first trade, not because of an ADX reading, but because I was so sure today would be as flat as Friday.

By the time we got to the next three pullback or divergence trades, my moving averages said FLAT. Good thing, too, because the trades had quite small gains, and I almost always lose money on those. Happy to be flat all day long. (Actually, I really would have liked that first trade.)