technical
strategy volume 2: January 2010-December 2010 Anthology of the SFo magazine monthly column
technical strategy Low-risk Efficiency
2
Trading the 3-Day RSI Model
4
Base Breakout
6
OOPS! Trades
8
By Kirk Northington
By Ed Carlson, CMT By Harry Boxer
By Michael J. Carr
“The Cowboy” Gap Fade
10
Hidden Divergence in the Forex Market
12
New Uptrend Detects Winners
14
THE ALL-STAR ENTRY
17
BUY LOW-RISK BREAKOUTS
19
Time Axis Offers Key to FX Trades
21
The Avalanche
24
“The Heat” Gap Fade
26
By Scott Andrews
By James Chen, CMT By Kate Stalter
By Sam Seiden
By Todd Krueger
By Jamie Saettele By Toni Hansen
By Scott Andrews
This series was originally published from January to December 2010. © 2010 SFO Magazine. All rights reserved. No part of this publication may be reproduced or transmitted in any form by any means, electronic or mechanical including photocopying, recording or by any informative storage and retrieval system without the written permission of Wasendorf & Associates Inc.’s president. This publication is strictly the opinion and conjecture of its writers and is intended solely for informative and educational purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade in any commodities or securities herein named. This publication is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Information is obtained from sources believed to be reliable, but is in no way guaranteed. Further, there is no guarantee of any kind that is implied or possible where projections of future conditions are attempted. The publisher is not liable for typographical errors. Commodity futures, securities, options and forex trading involve risk and are not suitable investments for everyone. Any investment should be carefully considered in light of an investor’s personal financial objectives and risk tolerance. Articles and/or advertisements contained herein may provide hypothetical or simulated performance results. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, because the trades have not actually been executed, the results may have over- or undercompensated for the impact, if any, of certain market factors such as the lack of liquidity. Simulated trading programs are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. Further, past performance does not guarantee future results.
Low-risk Efficiency By Kirk Northington January 2010
Managing risk is what separates traders who are successful over the long term from those who experience success only briefly. This strategy illustrates an example of gaining trade efficiency with low risk.
Background In the November 2009 issue of SFO, I introduced the Northington RSIV indicator. I demonstrated how it should be used specifically for identifying efficient trend entry points. In this case, I combine it with another volatility measuring tool to find an efficient trade entry. In the week prior to Oct. 12, 2009, the S&P 500 Index completed a 46-point advance, equivalent to 4.5 percent. Consequently, the broad market was entering the second half of its
Exit bar
10/19/09 12:30
Entry bar
10/12/09 12:30
Figure 1: VF Corporation (VFC) 60-minute Chart
80 79 78 77 76 75
F3 F2 F2
F2
F2
74
F3 F3
S&P 500
73
1,110
Resistance
72
1,100
71
1,090
70
1,080
AA
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1,070
Northington RSIV (40, 30, 100, 75, 25, 0, Red, Green, 7, Black) 75 50.21 25
65 45 25 10/6
10/7
10/8
10/9
10/12
10/13
10/14
10/15
10/16
10/19
10/20
10/21
10/22
Source: TradeStation
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10/5
2
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short-term swing cycle. Going forward, I expected to see an increase in whipsaws and pullbacks. So, I looked for a stock with a beta (volatility measurement) that did not exceed one.
Getting In I found just such an opportunity with VF Corporation (VFC), which had a beta of 0.93. I determined adequate trend strength in a daily chart timeframe via other means. Figure 1 shows how price had resumed its uptrend on the hourly chart but had pulled back slightly. This is indicated by a close of more than two units of average true range beneath the stock’s 40-period linear regression line. The “fabric” lines represent deviation from the 40-period continuous linear regression plot, using increments of average true range. Meanwhile the Northington RSIV indicator was below an extreme threshold of 25. This shows how price is oversold within a trend-compensated measurement. These two conditions mean that if I believe the uptrend will continue, this is likely to be a highly efficient entry point. Therefore, I took the long position at $75.06. These two indicators are available for open download at MetaSwing.com.
Getting Out I am a swing trader who lives within a two- to five-day trade duration. As such, I look for a way to leave as little money on the table as possible within my timeframe. To determine the best exit point, I based my decision on MetaSwing volatility-based resistance for the S&P 500 Index and for VFC itself. Oct. 19 I determined that the S&P would see hourly resistance at 1,098, and VFC would encounter daily resistance at $77.91. Therefore, I made the decision to exit at either of those two points, whichever occurred first. When the S&P crossed 1,098 (see Figure 1 inset), I exited the trade at $77.80; the day’s high went on to be $78.08
Bottom Line So how can you beat the index with a sub-one beta stock in a high-risk market? Across the time duration of this trade, the S&P 500 gained 1.86 percent, while VFC made a 3.65 percent profit. This strategy produced a profit that was double that of the broad market, and it was done with a low beta stock. Further, it performed with a trade entry efficiency of 82.3 percent and a trade exit efficiency of 92.4 percent. Kirk Northington is the owner of Northington Trading LLC and the creator of MetaSwing, a MetaStock and TradeStation add-on. He is the author of Volatility-based Technical Analysis: Strategies for Trading the Invisible. He is a private trader and uses the technical analysis methods of MetaSwing exclusively. Reach him at
[email protected].
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Trading the 3-Day RSI Model By Ed Carlson, CMT February 2010
The three-day RSI model is an extremely short-term trading model I created that presents the trader with a nice opportunity once or twice a month. Its goal is to find days when the market has become too stretched in one direction and there is a high probability of a “snap” back to the trend.
Background The model uses Welles Wilder’s Relative Strength Index (RSI) set to three days, rather than the 14 days that is commonly used. The three-day RSI is overlaid on both the S&P 500 Index (SPX) and the Volatility Index (VIX).
Figure 1: S&P 500 S&P INDEX (1,098.64, 1,098.54, 1,086.16, 1,091.06, -6.84993)
1,100 1,050 1,000 950 900 100 95 90 85 80 75 70 65 60 55 50 45 40 35 30 25 20 15 10 5 0 100 90 80 70 60 50 40 30 20 10
MKT VOLTLYNDX (21.5500, 21.7600, 20.9000, 20.9000, -0.59000), Relative Strength Index (4.66364) (MKTVOLTLYNDX)
Relative Strength Index (54.1851)
July
6
13
20
27
3 August
10
17
24
31
8 Septmeber
14
21
28
5 October
12
19
26
Source: MetaStock
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SetUp Buy signals are generated by a simultaneous move below 20 by the SPX three-day RSI and over 80 by the VIX three-day RSI. Sell signals are given by the opposite setup (SPX three-day RSI over 80 and VIX three-day RSI under 20). I normally use options to make these trades profitable as the period is short and the market move from this signal tends to be small. Using options, rather than index funds, can make for a highly profitable trade. I check my charts 15 minutes prior to the market close every day looking for this setup. If the opportunity presents itself, I enter the order just before the close. Sometimes, the market will snap back before the close, and I exit a profitable trade that day. However, my normal game plan is to be out of the trade before the close on the following day.
Very Short Term Despite the examples in Figure 1, it must be stressed that this is a short-term trading strategy. By short term, I mean the holding period is one day, two at the maximum. Under no circumstances should a position taken from this model be allowed to turn into a longerterm holding. Not all trades are profitable, of course, but losses can be minimized by remembering the discipline to sell quickly. Figure 1 shows, from top to bottom, SPX price, the VIX three-day RSI and the SPX threeday RSI. I have noted with ovals and dashed, vertical lines those days when the RSI indicators simultaneously exceeded the extremes noted previously. The chart shows not only the short-term nature of the model, but two failures as well. The first failure (mid-July) could have been avoided through a filter I use. I watch the daily advance/decline line for breadth thrusts. I define a breadth thrust as a move exceeding 1.5 standard deviations over its 20-day moving average (Bollinger bands). This filter does not work in the opposite direction. That is, do not use a dip below the advance/decline line’s lower band to filter out buy signals, as these are actually excellent buy signals in their own right! The other failure occurred in October … a good reminder that no indicator is perfect.
Ed Carlson, the creator of the Carlson confirmation model, is an independent trader and consultant based in Seattle. Previously, he spent 20 years as a stock broker. He is a chartered market technician and hosts the Market Technicians Association Podcast Series (a weekly audiocast featuring interviews with recognized industry professionals). He manages a technical analysis blog directed at financial advisors at SeattleTechnicalAdvisors.com. Reach him at
[email protected].
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Base Breakout By Harry Boxer March 2010
Breakouts of long bases on strong volume are frequent harbingers of continued price appreciation. Another predictor after the initial leg up is a low-volume, orderly pullback toward support. An analysis of Sourcefire Inc. (FIRE) seen in Figure 1 illustrates this strategy. As the daily chart indicates, in April 2009 FIRE broke out of a base pattern that went back to early 2008. Some traders who missed entering early may have given up on the stock when it increased more than 50 percent from nearly $8 to more than $12 during the month, but a closer look at the chart shows why it had more room to move. FIRE’s pullbacks were orderly, coming on lower volume and holding near its moving averages, a key sign of more upside to come. The pullbacks in the rising channel that continued to extend into late December, the time of writing of this article, typically hugged the 21- and 50-day moving averages and even remained close to the 10-day. The pattern was breakout and flag—and had been just about every month for this period, with the most distinct breakouts after April coming in late July and then December where price continued beyond the time of this chart to greater than $27 by month-end, or almost 3.5 times its pre-April breakout.
Figure 1: Sourcefire Inc. Daily Chart $35.92 $27.86 $21.61 $16.76 $13.00 $10.09 $7.82 $6.07 $4.71 $3.65 $2.83
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A LT M L
08
FEB MAR APR MAY
Volume: OBV
JUN
JUL
AUG SEP
OCT NOV DEC
09
FEB MAR
APR MAY JUN
JUL
AUG SEP
OCT NOV DEC
28.93% 17,905 8952 0 100 0 -100
Source: Worden
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BOP: MS
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Volume on each pullback was a small fraction of the level of the breakout, and a shallow decline just grazing the moving averages suggested a continuation of the upward trend.
Key Factors As a stock in a rising pattern pulls back, look for several factors to portend the continuation of the pattern. First, search for extremely low volume on the pullback—between 10 percent and 25 percent of the average volume of the past 90 days. Second, watch for the decline to flatten near the 20- or 40-day moving averages on the hourly chart in a quiet, narrow flag-type formation.
Getting In and out When the breakout comes, buy on the initial thrust out of the flag pattern. This means a sudden dramatic change in price accompanied by heavy volume. The price does not necessarily have to increase to more than the top of the flagpole (i.e., the previous rally high prior to the consolidation). It only needs to be a price bar that is at least many times the size of the previous several bars on the chart. Wait to add to the position until the stock takes out the top of the flagpole, which is key short-term resistance. This will protect against a head fake, which is a move that starts out dramatically but quickly fizzles price- and volume-wise after just a bar or two, has no follow through and, in particular, does not make it through the top of the flagpole. On FIRE’s May consolidation, for example, this resistance level was near $12, which it broke through by the end of the month. The next level came around the $13 line in Figure 1. The break through this level sent the stock up toward $20 quickly, which in turn became resistance in the August consolidation. Set a stop below the bottom of the lowest level reached during formation of the consolidation or flag pattern out of which it has broken. For FIRE, this was just near $10 in May, $11.80 in July and then $17.75, which became support in the September, October and November consolidation ahead of the December breakout. FIRE illustrates the potential that chart patterns such as high-volume breakouts from long bases and low-volume flags can have in predicting price appreciation. Harry Boxer is the author of The Technical Trader, which features a real-time diary of Boxer’s minute-by-minute trades and market insights, plus annotated technical charts and stock picks, based on his nearly 40 years of experience as a Wall Street technical analyst.
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OOPS! Trades By Michael J. Carr April 2010
Larry Williams’ Oops! trade has been written about for at least 20 years, but it still works. The Oops! signal takes long or short positions against the direction of an opening gap. Williams called it Oops! because he noticed that when a market reversed an opening gap, the price move tended to accelerate in the direction opposite to the opening thrust. He thought many traders entered positions on the gap after reading classic technical analysis books and would assume that gaps occur at breakouts. When prices quickly reversed, they would be stuck with losing positions, and Williams could picture the traders saying, “Oops!” as they exited their positions with a small loss. Any opening gap, whether up or down, offers a potential signal.
GETTING IN AND OUT • Long: On a gap down, place a buy-stop at the previous day’s low. • Short: On a gap up, place a sell-stop at the previous day’s high. You can exit trades on the close or with a first profitable opening (FPO) exit, another tool discovered by Williams. His testing shows that you consistently make more money by holding
Figure 1: S&P 500 60-minute Chart
1,100
Gap up on open
1,095 $1,950
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1,080 1,075 1,070 Source: TradeNavigator.com
1,065
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Close on 1/28/2010
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a position overnight. With an FPO stop, you exit the trade the first time a position opens with a profit. You also need a stop loss, just in case markets move dramatically. A wide stop of at least $3,500 a position works best.
SOME RESULTS Testing this idea on the S&P 500 futures contract since the beginning of 2000 reveals 78.4 percent of trades would have been winners. Figure 1 shows a trade example where an exit on the close would have increased profits. Test results using the same basket of futures contracts used in “Another Look at Futures Trading” (SFO January 2010) has a similarly high winning percentage of 74.2 percent. This system is only in the market a small percentage of the time and can be combined with other strategies to increase trading profits. Michael J. Carr is chief market strategist at Dunn Warren Investment Advisors. He is editor of the Market Technicians Association’s Technically Speaking and author of Smarter Investing in Any Economy. Reach him at
[email protected]. This article is for information purposes only and is not intended to be investment advice.
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“The Cowboy” Gap Fade By Scott Andrews May 2010
I am a gap fader. I trade the opening gap in the direction opposite of the overnight price movement, looking for prices to retrace to the prior session’s close, thereby filling the gap. Historically, more than 70 percent of opening gaps in indexes such as the S&P 500, Dow Jones Industrial Average, NASDAQ-100 and Russell 2000, have filled the same day. Unlike stocks, the diverse composition of indexes makes it difficult for a single economic report or earnings announcement to sustain opening prices for an entire session. Once regular trading hours commence and volume kicks in, the initial move often reverses.
The Setup One of my favorite gap fade setups that has a high probability occurs the day after an index sells off and finishes below its open and under the low of the prior day. This forms a red candle on charts. After such a day, it is not uncommon for the overnight session to trend upward as speculators build long positions in anticipation of a rally during the next session. However, buying is often limited and selling may occur right after the opening bell as overnight longs lock in profits and speculative shorts appear in anticipation of another leg down. Sometimes energetic buyers will run over those who shorted the open. In fact, I have nicknamed this setup the cowboy because it often requires one to hold on and ride the trade as if it were a bucking bronco. See Figure 1 for a recent example of a winning cowboy setup that I traded. The buying normally wanes as prices approach the lows of two days prior and sellers reappear en masse, overwhelming buyers. The result is often an impressive reversal and a rapid gap fill. This price action is often referred to as a dead cat bounce.
Getting In My preferred entry is to short the open with a market order precisely at 9:30 a.m. ET with a stop
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equal to at least 30 percent of the five-day average true range. For this particular setup, larger stops are generally better and ideally can be placed above the lows of two days prior. An alternative entry is to wait for a reversal above the open and near the low of two days prior. I have tested both entry techniques and prefer the first approach because it catches all of the winners. The second approach misses the easy wins, but it does result in bigger profits and smaller losses. 10
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Figure 1: E-mini S&P 500 10-minute Chart
1,100 1,108 1,106 1,104 1,102 Enter short here
1,100 1,098 1,096 1,094 1,092 1,090
Exit here at gap fill
12:00
14:00
1/25
12:00
1,088
14:00
The black line is the opening price. The blue line is the prior daily close. The red line is the prior daily low price. Source: TradeStation
Getting Out Market conditions dictate my profit-taking plan. If the market has been selling off for several days prior, then I generally target a price just in front of the gap fill area. If the downtrend is just beginning, then I may scale out near the gap fill and hold some for an extended target that is below the prior day’s close. In the trading world, there is nothing more fun than being short when longs are panicking and trying to exit all at once. Ride’em cowboy! The cowboy gap fade can be quite rewarding for those who are prepared. Just remember, high probability does not equal certainty, and risk management and proper position sizing should always take precedence. Scott Andrews trades gaps for a living and is president of MasterTheGap.com, an education service that provides daily probabilities and tools to help traders more profitably play opening gaps. He is the author of Understanding Gaps. Reach him at
[email protected].
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Hidden Divergence in the Forex Market By James Chen, CMT June 2010
Price-oscillator divergences represent some of the most prevalent, high-probability trading opportunities available in forex and other financial markets. These regularly occurring chart signals should be heeded for their capacity to warn of either price momentum changes or trend continuations.
BACKGROUND Divergences occur when there is an imbalance between price action and an oscillator, which is a mathematical derivative of price. Examples of common oscillators include: stochastics, relative strength index (RSI), moving average convergence divergence (MACD), MACD histogram, rate of change (ROC), Commodity Channel Index (CCI) and many others.
Figure 1: Bullish Hidden Divergence
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Source: FX Solutions—FX AccuCharts
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Under normal circumstances without divergence, an oscillator that measures momentum should follow price. The extremes (peaks and valleys) in both price and the oscillator should be in relative agreement. Higher highs, higher lows, lower highs and lower lows on the oscillator should correspond with those of price action. Once divergence occurs, however, the indication is that price and the oscillator disagree with regard to momentum. This temporary aberration can be a significant indication of events to come. Every technical trader should be aware of two types of divergence. Regular divergence indicates the potential for a reversal in current momentum, resulting in a possible trend change. Conversely, hidden divergence indicates the potential for continuation of the current trend momentum.
HIGHER ODDS As regular divergence is more well-known, in this column I only discuss the lesser-known type: hidden divergence. Many traders believe that of the two types of divergences, the hidden variety is a higherprobability potential trading setup. This is due to the fact that hidden divergence is an indicator of potential trend continuation as opposed to a potential reversal indication. Trading with the trend is considered by many technical analysts and traders as a higherprobability type of trading than attempting to pick tops and bottoms, which is essentially the type of trading approach encouraged by regular divergence signals. Like regular divergence, hidden divergence is a technical imbalance between price movement and oscillator movement. But instead of signaling a potential reversal, hidden divergence is used primarily to signal a possible continuation in the prevailing trend.
BULLISH and Bearish SIGNALs Two basic manifestations of hidden divergence occur. As shown on Figure 1, bullish hidden divergence usually happens during uptrends and is characterized by price making a higher low while the oscillator makes a lower low. In this case, price and the oscillator diverge in their signals. The net signal that should be taken is for a potential continuation of the higher lows in price, which is essentially a continuation in the prevailing uptrend. In contrast, bearish hidden divergence usually occurs during downtrends and is characterized by price making a lower high while the oscillator makes a higher high. Once again, price and the oscillator diverge in their signals. The net signal is for a potential continuation of the lower highs in price, essentially a continuation of the prevailing downtrend.
THE TRADE Once an instance of hidden divergence occurs, cues can be taken from other technical indicators to enter a trade in the direction of the trend. One of the best ways to enter a trade after a hidden divergence signal involves waiting for a breakout of a key support or resistance level or countertrend trendline in the direction of the prevailing trend. Supported by hidden divergence, these trend-following breakouts often carry a
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higher probability of success than if divergence were absent. James Chen, CTA, CMT, is chief technical strategist at FX Solutions, a leading forex broker. He is also a registered commodity trading advisor and chartered market technician. Chen is the author of Essentials of Foreign Exchange Trading and Essentials of Technical Analysis for Financial Markets.
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New Uptrend Detects Winners By Kate Stalter July 2010
In every new market uptrend, a fresh crop of innovative, young companies emerge as leaders. After the major indexes clawed out from the bear market in March 2009, early gainers included Apple, Priceline.com, Green Mountain Coffee Roasters and Baidu. These stocks—and many others—went on to become some of the market’s biggest leaders during the next 12 months. What else do those companies have in common? Each went public sometime in 1999 or later.
NEW NAMES New innovators, not the more mature companies, are typically the names that show the most explosive earnings and sales growth in a new cycle. That, in turn, spurs price increases. This leadership from the innovators has been evident in every market uptrend since the 1880s.
RESEARCH SHOWS Notice something important about the growth of these winners? These big gainers also launched strong runups in spring 2009, when the market itself was also turning higher. Investor’s Business Daily’s research has shown that three-fourths of stocks follow the market’s direction. So it stands to reason that the best time for buying stocks is during a market uptrend. (See Figure 1 for just a few of the stocks that began big rallies after the market went into a confirmed uptrend March 12, 2009.)
CONFIRMATION So after the market has been in a downturn, how can you tell for sure whether a new uptrend has been confirmed?
Figure 1: stocks with big rallies since 2009 GAINS 2009-APRIL 2010
Baidu
237 percent
Priceline.com
186 percent
Home Inns
94 percent >
STOCK
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Figure 2: NASDAQ in 2006 Nasdaq Composite - 2006 Index Index Scale Scale
2500 2,500
2,400 2400
2300 2,300
2 2200 2,200
3
2100 2,100 RS
2
3 2000 2,000
1
Volume (00) 10,200,000 5,000,000 2,400,000 24
7 April
21
5 May
19
2 June
16
30 14 July
28 11 August
25
6 8 22 20 September October
3 17 November
1 15 December
29 12 January
26
9 23 9 February March
23
Source: Daily Graphs Online
A proven way of making that call is with the follow through day. That is a day when at least one of the major indexes—Dow Jones Industrial Average, S&P 500, NYSE Composite or NASDAQ— notches a significant percentage gain. Volume must be heavier than the previous session. Look at Figure 2, a chart of the NASDAQ from summer 2006.
CHART ANALYSIS • Point 1: On July 18, the index fell to a new low, and then began rallying higher. That was day No. 1 of a rally attempt. • Point 2: The next session brought a big price gain in heavier volume. But that was too early to be a follow through day. The follow through generally happens after day No. 4 of the rally attempt. That is because false signals can occur in the early days of a rally. It is common to see huge buying immediately after fresh lows. But if it is too soon, the index often falls again, reaching another low. • Point 3: On Aug. 15, the NASDAQ climbed 2.2 percent in heavier volume than the prior session. That follow through came 21 days after the rally attempt began. This may seem like a long time to wait, but it is a perfectly acceptable span according to IBD. That particular follow through resulted in a successful market uptrend, which lasted until February 2007.
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BE ALERT A caveat: About 25 percent of follow through days fizzle, so be especially alert for selloffs in the early days after a new uptrend is confirmed. If the uptrend is fragile, you will generally see heavy selling within just a few sessions. Every new bull market since the 1880s has started with a follow through. It is absolutely necessary to see heavy volume buying to confirm an uptrend. In the days and weeks immediately 15
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after the follow through, you will see the strongest stocks—those young innovators—begin their big price moves.
WORDS OF WISDOM It is worth considering a few words from IBD founder William O’Neil in his book How to Make
Money in Stocks. “A follow-through [sic] signal doesn’t mean you should rush out and buy with abandon. It just gives you the go-ahead to begin buying high-quality stocks with strong sales and earnings as they break out of sound price bases. ... Remember, no new bull market has ever started without a strong price and volume follow-through confirmation. It pays to wait and listen to the market.”
Kate Stalter is a market writer and commentator at Investor’s Business Daily and Investors.com. She hosts the daily Market Wrap video at Investors.com.
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THE ALL-STAR ENTRY By Sam Seiden August 2010
The key to selling anything for a large profit is to sell to a novice buyer who does not know or understand the real value of what you are selling. The best traders master this skill. Here I present a simple rule-based market timing strategy that focuses on buying from and selling to novice traders who do not know how to assess the real market value of something. I call it the all-star strategy due to its potency as a low-risk, highreward and high-probability entry technique.
Figure 1: Research In Motion, 60-minute Chart
-75
Short Entry Supply
-74
-73
-72
T1
-71
-70
T2
-69
Demand
-68
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May
5/4
5/5
5/6
Source: TradeStation
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4/13 4/14 4/15 4/16 4/19 4/20 4/21 4/22 4/23 4/26 4/27 4/28 4/29 4/30
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BACKGROUND The all-star entry uses two high-probability tools that when combined help identify high-probability turning points in any market. These are: • Proper supply (retail price) and demand (wholesale price) analysis • Bollinger bands
THE SETUP Look at the supply level shaded in yellow at the top of Figure 1. This is a supply level because price moved lower from that point in strong fashion, which tells me that supply exceeds demand at that level. Next, notice that when price rallies to this level, it pierces the upper Bollinger band. This suggests three things: 1. Price is reaching a level where supply exceeds demand. 2. Price is piercing the upper Bollinger band, indicating that statistically price is at an extreme and likely to revert to the mean. 3. Novice buyers are purchasing at the supply level. This information suggests price is likely to turn lower at that supply level. The combination is what makes this a high-probability event. The yellow area at the bottom of the chart is the nearest demand level below the short entry point. The distance between supply and demand is the profit margin. The profit targets for this shorting opportunity are the midline of the Bollinger band (the mean, T1) and the demand level (T2).
THE LOGIC When it is time to sell short—at supply—who are the buyers? They are novice market speculators, and we know this because they are committing the two mistakes every beginner makes: 1. They are buying after a rally in price and outside the upper Bollinger band. 2. The traders are buying at a price level where supply exceeds demand (retail prices). These novices do not know how to quantify real supply and demand in the market, and these are the people with whom we always want to trade, just like selling anything in life outside of trading.
ALL-STAR RULES When price reaches a key supply level and pierces the upper Bollinger band in the context of a downtrend while there is a significant profit margin below, sell short at the supply level with a buy stop just above the supply level. Profit targets are first the midline and then the opposing demand level. The opposite rules are true for long (buying) opportunities.
BOTTOM LINE Back to Table of Contents
Profitable traders buy at wholesale prices and sell at retail prices like Wall Street. Novice traders buy at retail prices and sell at wholesale prices. Learn to spot the novice trader to attain low-risk, high-reward and high-probability trades. Sam Seiden is director of education at Online Trading Academy. He has more than 15 years of trading experience. Reach him at
[email protected]. 18
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BUY LOW-RISK BREAKOUTS By Todd Krueger September 2010
When I first started trading in 1985, upside breakouts had a decent success rate. But currently they seem to fail far more often than they did previously. Upside breakout trades have become a mechanism for professional traders to trap retail traders into losing positions. Retail traders buy an upside breakout hoping that the price will launch higher after it breaks above a previous high price level. The great news is that retail traders can learn to read a chart to determine when the market professionals are also interested in higher prices after a breakout. When the smart money is not selling into the breakout, the odds of a successful long trade for a retail trader increase dramatically.
The SETUP Traders should look for very specific conditions to set up this trade successfully: 1. Price must have declined so significantly from the previous price high that price is now breaking through it. See Figure 1, which shows 126 pips in this example.
Figure 1: The S&P 500 SPDR (SPY) Daily Prices and Volume
Entry on open
$1.518 $1.516 $1.514 $1.512
Previous price high
$1.510 $1.508 $1.506
Close above trendline Doji Test
$1.504 $1.502 $1.500 $1.498
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$1.496 $15,000 $10,000 $5,000 $0 06:00 07:00 08:00 09:00 10:00 11:00 12:00 13:00 14:00 15:00 16:00 17:00 18:00 19:00 20:00 21:00 22:00 23:00 00:00 01:00 02:00 03:00 04:00 05:00 06:00 07:00 08:00 09:00 7/12/2010 7/13/2010
Source: Stockcharts.com
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2. The breakout candle must occur with high volume. 3. Traders should watch for price to retrace to slightly above or below the previous high. 4. On the retracement, volume must be diminishing, which shows that the smart money is not participating in the minor down move. 5. Preferably I would like to see a Wyckoff Candle Volume Analysis (WCVA) pattern around the horizontal line. In Figure 1, an arrow points to a doji test candle. This WCVA pattern indicates that the smart money is not actively selling, and the price is expected to move higher.
GETTING IN Because there will be instances where traders do not receive a confirming WCVA pattern (but all of the other conditions outlined above are met), an alternate entry technique works in all market scenarios. Notice the downward sloping trendline on the small retracement below the horizontal line. I have also drawn the same trendline on the volume histogram below the chart so readers can see the dramatic reduction in trading activity on the retracement. This trendline is used as a trigger to enter an upside breakout trade. A trader should enter the market immediately after a candle close above this trendline. This occurred at 1.5084 in the example. A market structure stop should be placed just below the lowest low of the minor retracement (1.5064 is the low in this example, so one would go three pips below with the stop).
GETTING OUT The profit target is based on a point and figure count objective of 1.525. Once price achieves this, a trader should scale out of 50 percent of the trade size and keep trailing the stop if price continues to move higher until he or she is stopped out. In the example, the trader would have a 166 pip profit objective with a 23 pip protective stop, and the reward-to-risk ratio would be an outstanding 7.2-to-1. Todd Krueger is a full-time professional trader, creator of the Wyckoff Candle Volume Analysis methodology and is the founder of Traders Code LLC, a company that provides trading tools and education for the retail trader. Reach Krueger at
[email protected].
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Time Axis Offers Key to FX Trades By Jamie Saettele October 2010
Most traders pay little attention to the time at which they execute trades. The majority focuses entirely on price (the Y-axis on the price chart) and ignores time (X-axis). Ultimately, a trade is successful if one buys at a lower price and sells at a higher price. Seasonality across multiple timeframes indicates a tendency for price extremes (highs and lows) to occur at the beginning of the timeframe in question: yearly, monthly, weekly or daily (broken into three sessions: Asian, European and North American).
Figure 1: Euro/U.S. Dollar Equity Curve, May 25, 1998-Aug. 17, 2010 Equity Curve Detailed - EURUSD Daily (01/05/98 16:59 - 08/17/10 16:59) 70000
60000
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30000
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-10000
6/13/00
11/21/02
5/4/05
10/16/07
3/31/10
Source: TradeStation
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Equity ($)
40000
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THE BREAKDOWN I have compiled statistics specific to the euro/U.S. dollar that detail: • The distribution of yearly price extremes by month from 1980 (using Deutsche mark rates preeuro) to 2009. • The distribution of monthly price extremes by day since 1999. • The distribution of weekly price extremes by day since 1999. • The distribution of daily price extremes by hour since 2005 (the past five years).
THE NUMBERS Since 1980, the high for the entire year has occurred in January 11 times. The low for the year has occurred in January seven times. Stated differently, January has produced the yearly high 38 percent of the time and the low 24 percent of the time. In a random environment, one would expect a price extreme (high or low) to occur just 8 percent of the time (1/12 = 8.33 percent). Since 1999, the first day of the month has produced the high for the month 13 percent of the time and the low 14 percent of the time. In a random environment, one would expect a price extreme to occur just 5 percent of the time (1/20 = 5 percent). Since 1999, the first day of the week has produced the high for the week 30 percent of the time and the low 30 percent of the time. In a random environment, one would expect a price extreme to occur just 20 percent of the time (1/5 = 20 percent). Friday produces the opposite extreme 30 percent of the time.
FX TIME ZONES From 2005 to 2009, the first hour of the trading day (22:00 GMT, the Asian open) produced the high for the day nearly 8 percent of the time and the low 6 percent of the time. In a random environment, one would expect a price extreme to occur just 4.17 percent of the time (1/24 = 4.17 percent). The 6:00 GMT to 7:00 GMT period (the European open) produces the high and low 11 percent of the time, compared with 8.33 percent for a random environment. The 12:00 GMT to 15:00 GMT period (the U.S. open and when economic data is released) produces the high and low 21 percent of the time, compared with 12.5 percent for a random environment.
USING THE DATA I can imagine countless scenarios in which this information is useful. For example, a longerterm trader would look to establish positions only in the beginning of the year, month or week. Short-term traders should establish and exit positions during the opening range hours previously outlined.
A SYSTEM
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A simple swing system would buy at Monday’s high and sell short on Monday’s close. The trade would be held until Friday and a limit order would be placed to exit a long position at Thursday’s high or a short position at Thursday’s low. Although Fridays are more likely to produce a price extreme, there is also a tendency for a Friday pullback following a test of Thursday’s price extreme.
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EasyLanguage foR TradeStation if dayofweek(date) = 1 then buy next bar high stop ; if dayofweek(date) = 1 then sellshort next bar low stop ; if dayofweek(date) = 4 then sell next bar high limit ; if dayofweek(date) = 4 then buytocover next bar low limit ; THE TAKEAWAY The fact that opening ranges at multiple degrees of trend produce an inordinate number of price extremes over time is fractal and offers insight into the psychological workings of markets and herd behavior. Jamie Saettele is an active trader, senior technical strategist at Forex Capital Markets LLC in New York and author of Sentiment in the Forex Market. His technical strategy focuses on sentiment indicators, seasonality and Elliott wave theory, and is published at DailyFX.com. Contact him at
[email protected].
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The Avalanche By Toni Hansen November 2010
Novice traders quickly learn that “the trend is your friend” and that the highest-probability trades will be in the direction of the larger, underlying trend in the market. So, if the market is in an uptrend with higher highs and higher lows, then we should be looking for buying opportunities. Trends do not continue forever, however, and even the strongest ones need a chance to rest. Some of the strategies I favor are those that take advantage of these corrective stages in the markets. About a dozen years ago, I was studying my trades and noticed that many of the corrections taking place within a larger trend bore a strong resemblance to each other. Continuations of those corrective moves were often even stronger than the initial drop from highs. It seemed fitting to call such a strategy an avalanche™. The structure of the avalanche setup is similar to a mountaintop, followed by ledges that often accumulate snow, producing conditions favorable to avalanche formation. Sometimes this
Figure 1: 5-minute Prices of Cognizant Technology Solutions Corporation CTSH.5:Main - Cognizant Technology Solutions Corportation - Class (MBT:MBT:ZFNU:3500
stop level short trigger moving average crossover (10 & 20)
$65.50
$65.00
uptrend $64.67922
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initial target zone
10
20
$64.50 $64.26009 $64.188045
secondary target zone volume drop & confirmation
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$64.00
100,000
9,777 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 15:00 15:30 16:00 10:00 10:30 11:00 11:30 12:00 12:30 09-30 Thu
Source: MB Trading Navigator Pro 1.1.0.14
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strategy will be a part of a larger reversal pattern, such as a head-and-shoulders reversal. How the avalanche setup is managed, however, is quite different.
The SETUP One of the first criteria I use for recognizing a developing avalanche deals with trend placement and price extension. The further advanced a trend is, the easier it becomes to develop a larger reversal pattern. Strong overhead resistance is also ideal. In Figure 1, the highs established in Cognizant Technology Solutions Corporation (CTSH) Sept. 30 corresponded to the upper trendline of a larger uptrend channel that had been in play throughout the month. After striking resistance, I watch for a sharp reaction to that resistance zone. Ideally, the security will pull back more quickly than the previous rally. On CTSH that rally is not as evident due to the gap, but the pullback into 10 a.m. ET was still stronger than average when compared to action in earlier sessions. This pullback off the highs should fall sharply into a support zone. The most common is a 20-period moving average. The ideal setup will hug support on declining volume. Two smaller waves of upside within this period of congestion are common, such as in CTSH. Prices can become wedged between the 10- and 20-period moving averages, and their convergence is a sign of an imminent trigger. The trigger, however, tends to occur prior to the moving average crossover.
GETTING IN The easiest way to enter is when the lower trendline from the congestion along the 20 MA breaks. A more aggressive trigger occurs when the channel of the second bounce within the congestion breaks lower. A stop is placed above the highs of the congestion.
getting Out The exit strategy varies according to the larger trend placement of the setup and strength of the initial descent. I typically use the 20 MA on the next larger intraday timeframe based on using the two-, five-, 15-, 30- and 60-minute charts. A 15 minute, 20 MA would be the target for a five-minute setup. This came within 2 cents of the gap closure on CTSH and was near the five-minute 200 MA, resulting in an initial target zone near $64.70. The momentum of the descent, however, was stronger than average, and the larger trend placement allowed CTSH to fall into a secondary target zone of $64.10 at the lower end of the larger daily trend channel.
Profit from Playing corrections Although trend trading is a profitable way to trade, understanding the nature of trends themselves is vital to your success. All trends need to correct and those adjustments alone can offer high returns when played properly.
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Toni Hansen is president and co-founder of Bastiat Group Inc. and author of Simple Steps to Trading Discipline. A leader in market education, she has worked in conjunction with some of the world’s top financial exchanges, as well as major industry conferences, with global syndication of her daily market commentary.
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“The Heat” Gap Fade By Scott Andrews December 2010
I am a gap fader. I trade the opening gap in the direction opposite of the overnight price movement, looking for prices to retrace to the prior session’s close, thereby “filling the gap.” Historically, more than 70 percent of opening gaps for indexes such as the S&P 500, NASDAQ 100 and Russell 2000 have filled the same day. Unlike stocks, the diverse composition of indexes makes it difficult for a single economic report or earnings announcement to sustain opening prices for an entire session. Once the regular trading hours commence and volume increases, the initial move often reverses.
The Setup One of my favorite high-probability setups occurs after the markets have made a strong move to the upside. Specifically, this trade occurs the day after an index rallies and
Figure 1: 5-minute E-mini S&P 500 Prices 1,110 1,108 1,106 1,104 1,102 1,100 1,098 1,096 1,094 1,092 1,090
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1,088 1,086 1,084 13:00
14:00
15:00
6/15 10:00
11:00
12:00
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6/16 10:00
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Source: TradeStation
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finishes above its open and the high of the prior day. After such bullish momentum, the overnight price action often trends downward. However, buying may occur right after the opening bell as overnight shorts take profits and buyers appear in anticipation of another leg to the upside. Sometimes motivated sellers will run over those who bought the open. In fact, I have nicknamed this setup “the heat” in part because it often requires you to hold through adverse market conditions, or heat as I often call it. The selling generally wanes as prices approach the low of the prior day or the highs of two days before and buyers reappear en masse. The result is often an impressive reversal and gap fill. Tip: Do not let the nickname fool you. Since 2000, 189 of 229 heat gaps (82 percent) have filled the same day. See Figure 1 for an example from June 2010.
Getting In My preferred entry is to buy the open with a market order and a stop equal to at least 30 percent of the five-day average true range (ATR). Larger stops generally work better and ideally can be placed below the lows of the prior day or the highs of two prior, whichever is higher. An alternate entry is to wait for a reversal below the opening price. I have tested both entry techniques and prefer the first because it catches all of the winners. The second approach misses the easy wins and has a lower win rate, but it also has larger winning trades and smaller losses.
Getting Out Market conditions dictate my exit plan. If the market has been rallying for several days, then I generally target just in front of the gap fill area. If the uptrend is just beginning, then I may scale out around the gap fill and hold part of the position for an extended target near the prior day’s highs. It often pays to be on the opposite side of short traders when they are stuck and getting burned (yet another reason I call this the heat gap). When it starts lighting up the shorts, watch out above. Remember: wild fires move faster uphill than down. “The heat” gap fade can be quite rewarding for those who are prepared. Just know, high probability does not equal certainty, and risk management and proper position sizing should always take precedence.
Scott Andrews is a private trader, president of MasterTheGap.com (an education service that provides daily probabilities and tools to help traders) and author of Understanding Gaps. Reach Andrews at
[email protected].
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