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Archive for July, 2012

Chart of the Day: Bullish pattern in the AUDJPY

by Adam on 27/07/2012 in Chart of the Day, General Comments, Pullback with 2 Comments

This is potentially a very bullish pattern on the AUDJPY, targeting a move into the high 87′s over the next several weeks. Trades should be entered on strength above the trendline (roughly 82.00 in today’s trading) against a stop somewhere in the 77.00-79.00 area. (Remember, a closer stop is more aggressive.) Initial profits could be taken at a point equal to one times the initial risk on the trade, with further reductions as the trade plays out.


Reader Questions: Volume and Support&Resistance

by Adam on 26/07/2012 in General Comments, Individual Self-Directed Traders, Readers Questions with 3 Comments

Reader Andre asks two questions in response to my post on the failure test trade:

It seems that you do not take in consideration any kind of volume information when analyzing the price behaviour around the support/resistance level, is that correct? (like for example the volume on the second level test)

Correct. I know that many authors and gurus talk reverently about volume, but I have been unable to verify its importance. Now, understand carefully what I’m saying—I’m not saying that volume has no importance. I am saying that, through many years and many, many quantitative tests, I have yet to see a single shred of evidence that supports the importance of volume. I know that this is one of the sacred cows of traditional technical analysis, and I know there are many logical reasons why volume should be important. All I can tell you is that I haven’t been able to prove that. (Perhaps my tests are flawed, or there could be many other explanations.) Furthermore, I know other people have had similar results when they try to verify the importance of volume. Thomas Bulkowski (see Encyclopedia of Chart Patterns) was surprised to find that, when he separated chart patterns into those with and without the “correct” volume cues, there was no difference in the quality of the pattern.

You can and should verify this yourself. Here’s an idea:

  • Find many (more than 200) examples of a particular pattern on the timeframe you use, without paying attention to volume.
  • Go through the patterns a second time, separating them into two groups: those with good volume patterns supporting the chart patterns, and those without.
  • Now, go through each of the groups, and somehow score the patterns. From a quantitative perspective, we would look at returns following the pattern (for instance, mean return and standard deviation of those means), but you might just score them 1-5, ranging from 1= great winner to 5=big loser.
  • Compare the outcomes from the two groups with and without volume support.

The answers to all your market questions are right there in front of you. Don’t accept anything because a book or a guru tells you—verify it yourself. As one of my mentors used to say time and time again, “let’s ask the data.” Go to the market and see what it has to say.

Should we consider support/resistance as a fixed price or more like a region? Sometimes it is not clear for me where a specific good support/resistance price is.

In almost all cases, support and resistance areas should be thought of as broad “zones” or regions rather than precise price levels. If you’re drawing in a chart, a crayon or one of those jumbo pencils children use might be the right tool, rather than an architect’s pen and straightedge. I spend a lot of time in the book talking about support and resistance levels, and practical issues in identifying and using them. You’re correct—this is not as easy as it seems.

Thanks for the great questions. As always, please feel free to drop me an email adamhgrimes@gmail.com with any further questions and I’ll see if I can use them in a future post.


Video Blog: the Failure Test

by Adam on 24/07/2012 in Failure Test, General Comments, Individual Self-Directed Traders, Technical Patterns, The Book with 6 Comments

This video blog is a follow up from this post, and digs into some of the details behind the Failure Test trade in a little more depth.


Trading Pattern: the Failure Test

by Adam on 24/07/2012 in Failure Test, General Comments, Individual Self-Directed Traders, Institutional Mangers/Traders, Technical Patterns, The Book with 1 Comment

I want to do a small series of posts looking at some of the most important trading patterns I’ve used over the years. Rather than go in-depth with multiple examples, I’ll keep these posts as a high level, introductory overview and will focus only on the most important points of the patterns I’ve found most useful in my own trading. Today, let’s begin with the failure test.

There are many names for this pattern. Victor Sperandeo immortalized in his excellent books (here and here) as the “2B” pattern, and many other authors have since used that name. Wyckoff used slightly more confusing terminology, calling a failure test below support a spring (prices “spring” back above support) and a failure test below resistance and upthrust. (The latter term is confusing, but prices “thrust above” resistance and immediately failed. Furthermore, if you’re interested in Wyckoff’s work, this little volume is an excellent introduction.) In The Art & Science of Technical Analysis, I used the term failure test for trades both at support and resistance, in the interest of simplicity.

Figure 1

The failure test is a simple pattern. Take a look at Figure 1, which shows a theoretical market bouncing around in between support and resistance. At point A, prices poked above resistance, and immediately failed back below in a classic failure test or Wyckoff upthrust. (Don’t worry about exact triggers or entries at this point, just understand the fundamental concept.) At point B, the market traded briefly below support, and quickly recovered back above, triggering another failure test (or a Wyckoff spring.) Note also that the short trade at A would have probably been very profitable, while a long trade entered at B might have been a loser. It’s always important to build awareness of how patterns can resolve—both for and against the intended direction. In other words, study many examples of losing patterns.

Figure 2

The best way to enter these failure test trades is often the simplest. Look for a point where price trades above resistance and immediately fails back below on the same bar, and enter short on that bar’s close with a stop just above the high of that bar. (See figure 2.) It is also possible to enter on the following bar (i.e., a bar closes above resistance, but the next bar reverses and fails back below resistance); in all cases, the stop must go at or just beyond the new high set on the movement. For long entries, simply flip everything to a test below support and close back above.  Conceptually, one of the main reasons markets exist is to create trading activity. Think about that for a minute–markets exist to create trading volume, so they will naturally seek out levels where there may be orders clustered. (This is also tied into the reasons that markets are essentially designed to cause traders to make mistakes.) Many of those forays to find volume will discover nothing more than a few stop orders with no conviction beyond the level. This pattern lets you take this potentially treacherous market tendency (to seek your stops) and turn it to your advantage with a tight entry against a clear risk point.

One final, and perhaps the most important consideration, is risk management. I tend to trade failure tests in two main contexts: in trading ranges, on pure tests of support or resistance; and in trends, as counter-trend entries—essentially an attempt to catch the reversal off the high of an uptrend or the low of a downtrend. Both of these situations are potentially risky: liquidity can be low in trading ranges, so it’s not uncommon to have a gap opening against your positions. In trends, “gap and go” beyond the trend extreme (and, ahem, your stop) is also a possibility, and these are gap openings that do not tend to reverse. You must be prepared to accept larger than expected losses on some subset of these trades, so I suggest trading them on smaller size and risk than most of your other setups. Also, if you have an adverse opening against your position, be prepared to take action, as things often only get much worse as the trading day goes on.

I’ll follow up with a post tomorrow looking at some examples of this pattern in action.


 

 

Chart of the Day: The need for entry triggers

by Adam on 23/07/2012 in Chart of the Day, General Comments, Pullback with 3 Comments

This is why we have entry triggers. I posted this chart pointing out a bear flag in EL on the day marked with an arrow, suggesting that a good entry would be to enter on a weak close. A few days later, the stock is higher, but disciplined traders should never have taken the trade. Think about it like this: the pattern shows the potential in the market, but the entry trigger assures that short-term conditions are favorable for the trade—in other words, we’re jumping on a train that is moving in the right direction. Identifying potential patterns in the market is part of the problem, but you will likely find your results improve dramatically if you add an entry trigger to the trade.


Chart of the Day: Russell 2000 Index

by Adam on 20/07/2012 in Anti, Chart of the Day, Climax, General Comments, Relative Strength with No comments

I tend to believe it’s usually counterproductive to do too much in-depth technical analysis on different market cap or sector indexes. Everything is so tightly correlated anyway, so differences often become a matter of analyzing noise. Looking at retracement ratios and trendlines on these instruments and trying to make market calls is, largely, an exercise in futility–you can often get better information from a solid analysis of a single index.

However, once you have derived a basic market call, sometimes it is most clear in a particular index. In this case, the Russell 2000 index (using the IWM here) shows the pattern most cleanly from a trade management perspective: the small parabolic exhaust above the parallel trendline, followed by a subsequent selloff and consolidation, sets the stage for a nice short entered on a weak close (or intraday.) Note also that we have been monitoring the R2k/S&P 500 spread; weakness there suggests more bang for your (short) buck in the midcaps compared to large caps, should the market sell off.

 


 

Tracking the Stock Market Intraday

by Adam on 19/07/2012 in General Comments, Individual Self-Directed Traders, Institutional Mangers/Traders, Relative Strength, The Book with No comments

One of the main challenges for stock traders is understanding the ebb and flow of the broad market on the shortest timeframes. There is so much noise in price movement at this level, and so many instruments are traded, that it is hard to know what is important. Some traders have their go-to bellwethers and market leaders that they track, but this can result in a process that is a little myopic and subject to the whims of that trader’s taste and experience. Other traders simply watch the broad indexes, but a lot of detail is lost at that level.

This screenshot shows a tool that I have found to be very useful for understanding strength and weakness on the shortest timeframes. This information is less useful on a multi-day horizon, but, for understanding what’s driving the market on a particular day, there’s no better tool. This tool presents broad market and sector indexes (though not shown, it also extends down into sub-sectors. For instance, some sectors are divided into 15 sub-sector indexes.) ranked by their percent change on the day (first numerical column.) Next, a volatility-adjusted standard deviation spike number is listed along with a rough overbought/oversold (on the daily timeframe) measure. Last, and perhaps most important, is a graphical representation of where the instrument sits within its current day’s range. (This tool, with exact steps to produce it, is discussed in the book.) Basically, the vertical line shows the current price within the day’s range indicated by the dashes. The colon, for reference, shows the opening print of the index, though this is often less useful in cash indexes.

This tool allows you to see what is driving as the market presses to new highs and lows. (Combine with audio indicators for new highs and lows on the major indexes and you have a very powerful tool.) You can also see, at a glance, where indexes are trading relative to their opening print. This tool has implications for traders trading broad indexes—for instance, the market just made a new high, but what if we only see 1-2 sector indexes also pressing to new highs, and, furthermore, we see that they are very defensive sectors? This would be a warning to be careful of longs. It also can give both swing and daytraders some insight into what is actually going on with specific positions, though this requires some finesse and artful understanding of how to balance many competing factors.

It is not important that you replicate this screen exactly, but you may want to at least consider the following core concepts:

  • Intraday strength and weakness can be gauged by where a set of related markets sit in the current day’s range.
  • When the broad market makes a new high or low on the day, seeing what sectors are also making highs and lows can give some good clues to market direction.
  • Simple percent change on the day can be a misleading measure of strength and weakness.
  • The move off the opening print is also a valuable tool.

Tools like this can give a trader a much better perspective and can round out the information already provided by other tools.


Chart of the Day: Bear Flag in EL

by Adam on 19/07/2012 in Chart of the Day, General Comments, Pullback with No comments

The daily chart of Estee Lauder Companies Inc (NYSE: EL) shows a clear bear flag, which sets up a potential trade on any breakdown. Note that this is only a setup, and still requires an entry trigger. In this case, shorts could be initiated under the previous day’s low, with a stop perhaps in the 56.00 – 58.00 range. This is an example of a simple pullback, one of the patterns explored in detail in my new book, The Art & Science of Technical Analysis. Entering a trade like this is relatively easy, but exits and trade management are even more important. In this case, beware of a weekly close back above 52.00 which could set a bear trade (or failure test) on the weekly chart.


Two Modes of Market Behavior (1/2)

by Adam on 18/07/2012 in General Comments, Individual Self-Directed Traders, Volatility with No comments

When trying to master any complex subject, it can be helpful to reduce things, as much as possible, to basic elements. Price movements in markets are very complex; so many competing influences and timeframes, combined with a good dose of randomness, conspire to hide any simple tendency that might be present. I want to present an extremely simplified model of price movement today by considering one simple question: A market has made a large move in one direction and then has paused. What do you do? Do you expect the move to continue or to be reversed in the future? Consider this diagram that shows a market that has just made a large move and then gone flat (black line) with two possible future price paths:

So, in this simplified model we only assumed two options. In reality, there are a few others if you include the possible fakeouts or that the market may simply go sideways. Even then, at some point the market will make another move, and that move can only either be in the same direction, continuing the previous movement, or it can reverse it. Over a large number of trades, we would find that about half of them resolve in either direction, showing no edge in such a simplified model, but this, in many ways, the key question of technical trading. Should we be looking for continuation or reversal?

Fortunately, there are some conditions that can sometimes give us an edge, that can sometimes let us know that one resolution is more likely than another. Range expansion is characteristic of trend, and it makes most sense to play for range expansion in markets that are not overextended and show strong market structure to support further trend legs. (Reading that market structure is as much art as it is quantitative.) Mean reversion is more common in overextended markets, and there are other cues that can set up and support these trades. Another thing, that not many developing traders realize, is that the balance of mean reversion and range expansion is different in different asset classes. In many ways, the single most important task of technical analysis is to try to understand whether the environment is setting up to favor range expansion or trend reversal–trades that are correct in one environment are exactly wrong in the other.

So, how do we do this? How do we know whether to be positioning with the trend or looking to trade against the trend, to play for continuation or reversal? There are a few different ways to do this: looking at price patterns, market structure, related markets, etc., but they all depend on one thing–the nature of volatility itself. We’ll dig into that a little bit deeper tomorrow.


Chart of the Day: A Difficult Environment

by Adam on 18/07/2012 in Chart of the Day, General Comments, Individual Self-Directed Traders with 2 Comments

One of the advantages of using properly calibrated bands is that they can show when markets reach emotional price extremes. It should be rather unusual for a market to go from being outside one side of the band to the other, as happened on this 5 minute chart of the S&P today (7/17/12.) When this happens, it is indicative of great uncertainty, impact of a macro event or headline, perhaps lower liquidity, and, overall, a very treacherous environment. The normal expectation after this occurs is usually consolidation (often, a triangle pattern within the range, but that is not what happened this time) until the market finds equilibrium. I have saved a lot of money by avoiding trading in environments like this; consider how you might apply this pattern on your timeframe and in your chosen markets.


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