Trading What I See

Wedges usually appear during the final surge of a larger move, as a last gasp rally or decline before a reversal. Yesterday’s WEDGE was an exception, since it was pointing against the recent downtrend.

But all the identifying features were there. It made three touches of the bottom trendline and two of the top, creating converging lines. Each of the internal moves can be seen as a small A-B-C. The second major pullback doesn’t find support at the peak of the first wave (overlapping moves.) And volume declines throughout the pattern.

We broke out of the wedge at the open, had a pullback to the rising trendline for a potential entry, and made a relatively fast move to the wedge’s initial target — the very beginning of the pattern.

A wedge will usually reach target in half to three-quarters of the time it took to form. Normally that won’t be the end of the move, but there was a nice divergence (double bottom) warning that at least a strong bounce might occur over the lunch hour.

Like a triangle, a wedge will often reach its target (and sometimes reverse) at the same time the pattern lines cross. That’s certainly a place to take at least partial profits.

The afternoon trading was just a sideways move, perhaps caused by traders unsure of what would happen during the aftermarket rebalancing of the Russell 2000. That’s what caused the spike just after the market closed. It’s interesting that it went just high enough to complete an A-B-C=100% close to the week. Maybe there’s something to this Fibonacci stuff after all.

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

Each of the last four days has had less volume as we keep edging higher, and for the last two days my attention keeps returning to a 15 minute chart. I’ve been watching a WEDGE pattern develop as each upward move becomes weaker and weaker.

First the disclaimer: This is not a prediction. I don’t pretend to know what is going to happen in the future, but when I see a classic chart formation develop I certainly pay close attention.

A wedge occurs when two trendlines pointing in the same direction converge. In order for the pattern to be valid, it is important that the volume contract. Wedges will often be seen at the end of a major move, but sometimes they happen during pullbacks in a trend. That is what seems to be happening now.

There is no question that this wedge meets all the requirements — the question is whether it will act as expected. Wedges have very specific minimum targets. They will quickly move to their starting point, which in this case is the 770 level.

If tomorrow morning the upper trendline is broken (yellow “X”), that does not mean the pattern has failed. A wedge will often have one false breakout before heading for its target. It will be interesting to see how this one plays out since the FOMC policy announcement will be at 2:15 Eastern time tomorrow.

If you want to see a good example of a completed wedge, here is the daily chart leading into the big market break last month. In that case the market took back over 30 days of gains in five trading sessions. Wedges, when they work, can lead to fast profits.

Edwards and Magee: Technical Analysis of Stock Trends

What started with a reasonable setup turned into a do-nothing session, with the narrowest range in about ten days. We began with a small gap below yesterday’s low, and almost exactly to a 127% external retracement of the rally from yesterday’s final pivot bottom. The first bar reversed the move and created a divergence in the Stochastic.

This type of setup often leads to a nice rally, but they are not supposed to retrace 89% as happened by the 7:30 pullback. They also don’t go back outside of the previous day’s range. From that point I became very cautious and just watched for the rest of the day.

By lunchtime it was obvious that the market was forming converging trendlines which can set up a WEDGE pattern. I like wedges for potential trades, but the best ones will form after an extended move. Today, with the small early range, I wanted the additional confirmation of a divergence on the pullback that occurred right at the point of the wedge. The pullback occurred, but the divergence didn’t.

By the time we got a triple top and a divergence I didn’t trust the pattern, although it finally retraced the entire height of the wedge to meet its expected target.

I was a bit hesitant from the start today, since my data provider showed the Russell trading for two hours Monday (with almost no volume) when the U.S. markets were closed. That means that I had to choose between drawing trendlines and Fibonacci measurements either using this additional data or ignoring it. Neither ended up giving good signals so stopping early, although frustrating, wasn’t a bad decision.

The end of a move will usually show a marked decrease in momentum, and this will often show up as either a WEDGE or a DIVERGENCE. Either is a warning that the trend may be ending. Today was full of wedges.

Wedges are more reliable when preceded by a strong directional move, but they should never be ignored. Whether or not you use them for an actual trade depends on the particular situation.

Today’s first wedge (yellow letter A) seems to have at least temporarily ended the decline that started last Thursday. A wedge has a target — they will normally retrace the entire height of the pattern, and often do so in a single thrust. Today’s retracement took two thrusts to hit target, which could have been a warning that we were turning sideways rather than actually reversing. It also created another wedge.

One nice thing about wedges. You don’t have to do anything special to have them show up on your charts except draw the regular trendlines. If the upper and lower trendlines start to converge, you have a wedge. Edwards and Magee, in Technical Analysis of Stock Trends [see my review], warn against trading inside of convergent trendlines, since your opportunities for profit become smaller and smaller as the lines get closer together.

Today’s market gives a good example, particularly in the magenta wedge labeled “B.” The second thrust falls well short of a 100% Measured Move, and to me that indicates either a potential reversal or a sideways pattern. Since there wasn’t a “move” to reverse, sideways was not surprising.

I became cautious at the bottom this morning because of the converging trendlines, but since there was no divergence I didn’t enter a reversal trade. By the time we finished the second thrust of wedge “B” I was guessing the day would end sideways, and split my time between paperwork and watching the market.

There were several potential Fibonacci and trendline entries during the day, but they happened during times of flat moving averages or the trendlines were converging again. In either case I tend to pass.

Wedges are useful, and I like to trade them when everything lines up. But today they just served to keep me from wasting money.

Edwards and Magee’s Technical Analysis of Stock Trends

Both Tuesday and Wednesday had their best moves start right at the open, and since I’m not fond of entering at the open without a clear setup, I would have had trouble trading them. I’m not trading this week, but that doesn’t stop me from trying to figure out the charts.

On today’s 15 minute chart I’ve marked two patterns, one as a flag, and the other tentatively labeled a WEDGE. Whether you like trading patterns or not, there is some useful information in the angle of the congestion that followed the opening moves yesterday and today.

The flag sets a nice example. Perhaps you’ve heard the saying “the flag flies at half mast.” Points #1 to #2 represent the flag pole or “mast”, and points #2 to #3 are the flag. After the breakout above the flag, the next stop is at #4, repeating the distance of the original flagpole. It’s really just another example of a Measured Move.

The key is that a good flag will either be flat, or more often will lean against the trend set by the flagpole. In other words, it will create a pullback.

But look what is happening from points #5 to #6. The correction is leaning the wrong way. That is more likely to be a wedge formation, although with the low volume this week I’m not completely happy calling it that. But I wouldn’t be surprised to see a pullback here, even if the Santa Claus rally is going to continue.

If this is a wedge, it won’t be confirmed until the lower trendline is broken (although I know traders that will enter on the reversal of that “false” breakout at point #6.) And even then, the target would only be the level of point #5, which isn’t much room for profit.

Whether this actually works as a wedge or not isn’t the issue. In the short term, corrective action that struggles in the direction of the trend can show the market is losing momentum and is often a sign of weakness. But during low volume holiday periods anything can happen, so just trade what you see.

The opening gap (4+ points) looked like it was going to continue down, and there was a strong temptation to chase the move. Whenever I get that feeling I just remind myself that when I think I know what is going to happen, I am usually wrong. It misses a few good trades, but overall saves me money.

At about 7:30 (Pacific) we got a pullback with an overbought Stochastic oscillator with an entry some time after point #1. Then came a very slow move down to point #2. Remember that when a second move has much less momentum than the first, the target is usually 62% of the original move. It overshot by about six ticks. Here’s why that was the only trade I took today.

I spend most of the day drawing and erasing trendlines and Fibonacci measurements, because these are things I trust. Combined with several other indicators, they give me almost all of my setups. They also tell me when not to trade. Point #1 was a 25% pullback (not a Fib) from yesterday’s high and a 50% pullback from the high of the first bar. Combined with the Stochastic that was an acceptable trade. But then the market refused to go down.

Between point #1 and point #2 I drew and erased several trendlines, ending with what you see on the chart. Notice that the lines converge. Although the volume is wrong, it looks too much like a WEDGE, which is a reversal pattern (see earlier post on Wedges.) Another problem was the half-hour bar ranges that I watch.

Because of the gap, volume was running higher than normal, but look at the ranges of the first four 1/2 hour bars when compared with their averages: 100%, 44%, 66%, 66%. There was also an absence of heavy selling in the NYSE tick readings. Time for me to watch rather than trade.

The patterns played out, but with limited enthusiasm. The “wedge-like” pattern hit its target (blue arrow), and price stalled at the 127% retracement of the #1 to #2 measurement. (This was also the first 1000 tick reading of the day.) After a short pullback price moved to the next Fibonacci level — 162% and another plus 1000 tick reading — and stalled again. The pullback to point #3 would have been a nice entry on a better trading day.

Notice that the normal Fibonacci external retracements of 127% and 162% were good profit taking targets (if you were in the trade), but they didn’t stop the overall move. Too many traders don’t trust Fibonacci levels because they don’t always work. In real trading they give you “potential” reversal levels, just like other forms of support and resistance.