Before I get into the details of this post it’s time for another reminder that all posts on this blog, and all of my posts (tweets) on the VegaOptions Twitter account, are for educational purposes only. They are not trading advice! I know that’s a standard disclaimer but it’s something to take seriously. Don’t just copy other people’s trades! Learn the techniques and strategies and then see if and how you can apply them to your trading. Try to improve upon them. If you don’t really understand something, don’t trade it! Use a paper money account to learn the ins and outs before putting actual money at risk. Ok, enough of the lecture, on to the learning!
In the endless search for the perfect indicator that will actually indicate something useful many (most) traders overlook the clues that are hiding in plain sight on a simple candlestick chart! It’s not just novice traders making that mistake. I know of someone who has a paid advisory service who has been short SPX for the past 4 months! Why? Because the RSI has been showing negative divergences at many of the new highs as price grinds upwards. In an uptrend, negative RSI divergences at new highs are a regular occurrence and are a sign of strength in a market, not weakness! Those RSI failures are an important clue as to the likely direction of price. IF a bearish setup fails THEN price is likely to continue to rally! That last sentence is your introduction to my IF/THEN strategy for analyzing price action that shows up in many of my posts! Let’s start with a daily candlestick chart of /NQ which is the futures contract for the NASDAQ.
Below is the daily /NQ chart for the month of March with no added context. Looks just like sideways price action and, in retrospect, selling the high of the range and buying the low would be the profitable trade. Everything looks easy in retrospect! Let’s add some context to see if there was potential trade setups along the way.
Below I’ve added one line showing a prior high. Shorting a failed breakout above an important level is a good trade setup as long as there is a reasonable stop in place.
Below I’ve added a supply zone instead of a single line at the prior high. Supply and demand zones highlight areas where there a strong sellers and buyers. This is often an indication of institutional, pension, hedge fund, etc. involvement with the market. IF an institution wants to sell a large position they don’t just place an order to sell it all at once. They sell portions of their position in an area and wait for their fills. IF price refuses to breakdown and their selling is eventually completed, that area can become a demand zone because there will likely be short sellers located there who are trying to get out of a losing trade. One clue that a supply zone is losing it’s resistance strength is if the pullbacks from the zone get smaller as time progresses! That’s often an indication of increasingly motivated buyers!
Below is the best ‘indicator’ in my toolbox for identifying likely areas of support or resistance in the future. That is the Fibonacci (Fib) retracement tool. When a candle, on any time frame, looks like a potential reversal candle, I draw the Fib retracement on that candle and use the 50%-61.8% zone as the area to initiate a trade. So what does a potential reversal candle look like? It would have a unusually long wick (compared to other candles) extending above the body (bearish reversal) or below the body (bullish reversal). They visually stand-out on a chart. If price closes near the low of a bearish reversal or near the high of a bullish reversal that’s an even stronger reversal setup. If it’s a potential bearish reversal the Fib zone is drawn from the top of the candle to the bottom and if it’s a potential bullish reversal the Fib zone is drawn from the bottom of the candle to the top. I then wait to initiate a trade when/if price reaches the retracement zone. It often happens in the next candle but sometimes it takes several candles and sometimes it takes many candles in the future. Leave that Fib zone on your chart until price negates it by closing a candle (closing 2 candles is even better) beyond that Fib zone. When I take a trade using the Fib zone to initiate the trade I use a hard stop above the high of the bearish reversal candle or below the low of the bullish reversal candle. I also typically use what I refer to as a soft stop if price finds acceptance (spends time trading) above the 61.8% Fib level. Sometimes price will push to either the 78.6% or even 88.6% level before reversing but those are not as common. No exceptions to that hard stop rule!
The prior Fib resistance zone from the above chart eventually failed to keep price down (after a very profitable short trade) and was replaced by a new bearish reversal which also has resulted in a profitable short trade. However, one of the nuances in reading the price action is to evaluate the momentum of the price move following a rejection. Compare the subsequent decline in price following candle #3 in the above chart with the momentum of the current decline from candle #2 and #3 in the chart below. Sellers seem less motivated currently or, perhaps more accurately stated, buyers appear to be more motivated then before. That nuance would have me expecting the bulls to have the upper hand here. As with all my biases, it’s up to price to prove or disprove it.
Below shows the Fib retracement support zone of the rally from the 18006 low to the 18709 high. Fib retracements of a price range are also significant! If a rally or decline last multiple periods (days in this case) then the Fib support or resistance zone of that range become a favorite target of algo’s (algorithmic traders). I expect that there will be resting orders to buy (bullish retrace) or sell (bearish retrace). When the Fib zone of a range lines up with the Fib zone of a strong bullish or bearish continuation candle then the setup is even better!
I’ve added the prior week’s high, low, and HB (Half-Back or midpoint of the range). Notice anything about prior week’s HB in relation to the low of the current pullback (so far)? Hmmm…a 3 point difference on an index trading above 18,000? Coincidence? I’ll let you decide but I’ll give you a hint, I’m not showing you anything in this post that hasn’t occurred many times in the past in almost all indexes, stocks, ETF’s, commodities, etc.
Now, what about that candle that found support at prior week’s HB? That had a relatively long lower wick and finished green on the day so can we agree that’s a potential bullish reversal? Slap a Fib retracement support zone (drawn from low to high) and let’s see if the next day’s price action treated it as if it were a true bullish reversal. See chart below. The low of candle #2 was within 5 points of the 61.8% Fib support level of #1. The concerning thing for the bulls would be that the day closed near that low. If I had taken a long at the Fib support zone I’d have that hard stop below the low of #1.
We know where current support is, what about expected overhead resistance? I’d use the Fib retracement of the decline from #1 to #2. As long as price remains below that level I can make the case that the bears have a slight advantage.
Now, let’s put all of the Fib pieces together to complete the puzzle. Below you can see the very important support zone below and resistance zone above current price. Would I be taking any big directional trades at the current level? I would not! I would definitely add long Deltas at 18348-86 and might add small short Deltas with a tight stop above the 18543-82 Fib resistance zone. I’m still leaning more to the bullish side here because price has now taken 6 daily candles to only retrace half of the one strong bullish candle at #1. That’s definitely more bullish than bearish!
I can’t end this post without also mentioning my favorite moving average indicator, the 8 SMA bands. The upper band is the 8 SMA of prior highs and the lower band is the 8 SMA of prior lows. If the bands are sloping up then price is in an uptrend and if they are sloping down price is in a downtrend. The angle of the slope and where the candles are closing in relation to the bands indicates the momentum. For example, in the chart below, notice how the momentum of the current rally is clearly weakening! Weak momentum is prone to reversal but weak momentum moves can continue longer than many traders expect so it’s important not to short a move just because momentum is weak.
I also use the 8 SMA bands as good location for a trade. See comments on the chart below.
I didn’t have time to discuss Fib extensions but you’ll find that covered in a previous post. If you have questions or comments leave them down below!
3/31/2024 Update: /NQ opened higher in the Sunday night trading session and has almost reached the Fib resistance zone of the bearish reversal candle marked #2 on the chart below. I’m expecting some selling there but am skeptical that sellers can hold price below that zone for long since it’s already been tested twice before on 3/22 and 3/26. IF seller’s were motivated THEN price would likely already be moving down without needing to test that resistance zone 3 times! That price action looks more like acceptance rather then a likely rejection!
