A Handy Guide to My Technical Analysis

 | Dec 05, 2012 | 3:00 PM EST
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Making money with my type of technical-analysis work comes down to a relatively simple formula:

  • Setup + trigger = entry
  • Setup - trigger = no trade

Step One: The formation of one of three trade setups

Fibonacci price cluster setup: This is the coincidence of at least three Fibonacci price relationships that come together within a relatively tight range. Such clusters identify a key support or resistance decision.

Symmetry setup: The definition of symmetry, as it pertains to my technical-analysis work, is "similarity or equality of swings in the same direction." We find symmetry setups by running a 100% price projection, or "measured move," of a prior swing. Then we project the results from a new high or low, depending on what direction we're coming from.

The only symmetry setup I like to use is that in which swings are similar or equal within the context of the trend. For example, if a stock is in a clear uptrend, I will measure the prior corrective declines within that uptrend and project 100% of those from any new high. That, in turn, helps a trader enter the market in the direction of the trend. A single symmetry projection is considered a setup, though other price relationships may overlap these projections -- which only strengthens the trade.

Two-step pattern setup: This also involves a Fibonacci price cluster. It requires the coincidence of at least three Fibonacci price relationships, but it's in the context of a zig-zag pattern.

Step Two: Watch the setup zone and wait for a test of the zone

It does not have to be a perfect hit of the zone, but it should be relatively close. For example, it should be plus or minus $0.20 to $0.80 in a stock setup -- though sometimes I will give it a little more room.

If the price does respect that level, I then dial it down to a lower-time-frame chart in order to look for a trigger entry. This refers to activity that suggests that it is worth placing a bet against the setup zone.

Now, the trigger you use will depend on whether you are taking a day trade or a swing trade. For day trades, I use anything from a tick chart to a five-minute chart in triggering an entry against one of the setup zones. For a swing trade, the aggressive chart is the 15-minute. Otherwise, I wait for a trigger on the 30-minute chart. (Keep in mind that aggressive triggers entail more stop-outs on average. Only use this if you feel rather strongly about a setup.)

For a buy setup, the trigger I use on all of my intraday charts is the takeout of a prior swing high. For a sell, it's when the stock takes out prior swing low. The trade also needs to be confirmed by a crossover between the eight- and 34-day exponential moving averages. For a bullish play, we need the eight-day to cross above the 34-day, while a bearish play requires a downside crossover. It does not matter whether the trigger or the crossover happens first -- just that both of these things occur.

Step Three: Some post-entry options regarding stops and risk

The closest I would place a stop would be right behind the high or low that was made prior to a firing-off of the buy or sell trigger. Another popular option would be placing it just behind the price level from which that the trade originated.

As far as trade management is concerned, this can take a bit of explaining, but one point I'll make is that I like to get to a breakeven stop as soon as I can. I also like to start to use a trailing stop if the trade starts to go in my favor. You don't want to move a stop so quickly that you stop yourself out of a good setup. (I may address this further in a future article.) You can also teach yourself through experience, and first test what works for you.

Now, regarding trade exits, you can close these positions at the initial targets if you like. Since trades don't always make the targets, a trailing stop should, in that case, take care of your exit. For all of my trend-trade setups, target 1 is 1.272 of the swing into the setup zone. Target 2 is 1.618 of that same swing. Target 3 is 2.618 of the same swing.

If you need targets beyond that, you can go to a higher-time-frame chart -- or let a trailing stop take you out of the market. The case for the trailing stop is that it can sometimes be very frustrating when you take profits at the 1.272 extension, and then the price continues to the 2.618. I have definitely lived through that experience before -- and a trailing stop may keep you in for a nice run beyond the first target.

Applying the Rules: Caterpillar

Now let's take what was just discussed and look at a current trade setup in Caterpillar (CAT). On the daily chart here, I had a sell zone at the $86.47-to-$87.22 area. Note that the recent high was made at $86.48, a price that lies directly within this zone. This setup has already triggered a short for a day trade and a swing trade, but there is still downside potential through the $78.44 area. Typically if the initial entry against a setup is missed, I simply set up a pullback and look at a secondary entry there.

Caterpillar (CAT) -- Daily
Source: Dynamic Trader

To give you an example of a day-trade trigger in this case, see the five-minute chart below. This chart illustrates where Caterpillar tested the key daily resistance, and then where it triggered a short entry once the $86.10 swing low was taken out. The initial stop could have been placed either above $86.48, or above the price cluster zone at the $87.22 area.

Caterpillar (CAT) -- Five-Minute Chart
Source: Dynamic Trader

If you had only been taking a day trade, you'd have wanted to be out of the position by the end of the session. But if you'd been waiting for a swing trade trigger on the higher time frame, your goal would have been the 1.272 extension of the prior daily swing, which comes in at 78.44. Meanwhile, if you'd waited for the 15-minute chart trigger, the entry would have been around $85.59, rather than $86.09 or so. If you trade options, you can take this target into account, as it will help you decide what strike prices you may choose for the trade.

I hope this helps you understand the method to my madness. Remember: setup + trigger = trade entry, or NTNT: no trigger, no trade!

For more information about trades and triggers, please refer here.

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