Today's Trading Lesson From TradingMarkets

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Brice

I thought it would be helpful to analyze a recent trade that I put out in Nokia (NOK). We will take you through the process that I used to select Nokia as a pattern setup. The procedure begins with stock selection, pattern identification and entry. This is a good example that demonstrates multiple patterns and how to select the earliest entry for a high probability trade.

Stock Selection

• Nokia is on the big-cap Core Trading List because it is one of top 10 to 20 most widely held stocks by the institutions (Generals), which means it is overweighted and has excellent sponsorship.
   
• The stock is trading over its 20, 50, and 200-day exponential moving averages (EMAs).
   
• The 20-day EMA is above the 50-EMA, which is above the rising 200-EMA. It is a very strong uptrend.
   
• Nokia is a 91 EPS and 84 RS in Investor's Business Daily. The group strength is A, as are the sales, profit margins and ROE (Return on Equity).
   

• The ADX is rising (which is more important than the actual number). ADX number was 28 as of the close on March 1. 
   

 Pattern Identification 

The first thing I look for in selecting a good pattern setup is a stock that has pulled back at least three days, closed above the open and above the midpoint of its daily range. Ideally, the stock should close in the top 25% of its range. An exception to closing above the open would be if both the open and close were in the top 25% of the range and the close was slightly below the open.

Having looked at thousands of charts over the years, I will tell you that the most frequent pullback in uptrends are 3, 5, 8 and 13, which are Fibonacci numbers. The next most frequent is 7. 

For short-term trading, we are looking for pullback to no lower than the 50-day EMA. The strongest stocks will trade above the 20-EMA. 

Looking at the daily chart below, of Nokia (Figure 1), I see the following indications of a high probability trade.

• Three-day pullback (PB) to the 20-day EMA in an uptrending stock. (You count the days by starting with the current day or the day preceding it. If you were looking for shorts, it would be the subsequent day. A five-day pullback had preceded it to give you an example of how to count.)
   
• The third day of the PB closed above the open and exactly at the top of its range. I also observed that the prior two days closed in the top of their ranges and above their opens, despite having lower lows and lower highs. This was positive and indicated a market-related PB and not much selling pressure by the Generals. Volume was basically neutral.
   
• The third pullback day was a narrow-range inside day which in itself is a pattern. It was also the narrowest-range day of the past 15 days. Volatility had contracted and this usually precedes explosive moves in either direction. In the case of Nokia, you would only take the trade in the direction of the trend, which is obviously up.
   
• Looking at the stock's activity for March 1, which is the narrow-range day labeled #3, I see the following: Open 199.50; High 201.50; Low 198.50; Close 201.50. Entry is planned on March 2 at 201 5/8 (or slightly above, if needed) which is 1/8 above the previous day's close.
   

Nokia opens on March 2 at 200.50, with an intraday low of 200.375. You get trade-through entry at 201.625 and the stock traded to an intraday high of 215.875.

When you are looking for daily entry after a pullback, you want to enter on the change in direction, which is usually above the previous day's high. Nokia exploded after entry at 201.625 on excellent volume and a wide range bar expansion (WRB) to new all-time highs. The follow-up day to the WRB also gave you good entry and a multipoint move.

For those of you that read our trading guidebook, you will recognize this pattern as a 1,2,3,4 setup which has two lower lows and an inside day. This is an excellent pattern in itself as it got you in at the earliest change in direction.

The key point is to enter on the change in direction because not all tradable pullbacks fit a pattern mold.

 Figure 1.  Nokia Daily Chart. 

^next^

The following charts of Cisco (Figure 2) and BEA Systems (Figure 3) show very clearly the most common pullback days in strongly trending stocks.

Figure 2. Cisco Daily Chart.

This is an excellent chart to see the 5, 8 and 7 day pullbacks. X1 is a swing point low and A5 is a five-day pullback to the 50-day EMA. Cisco made a strong reversal off the 50-day EMA, closing above the open, at the top of its range, above the prior day's high, above the previous three closes, and also above the 20-day EMA. This is a powerful reversal. It is also a key outside reversal day. The next day was a multipoint move with good entry.

Cisco rallied to X2 of 139 from X1 of 100, before retracing eight days to B8, still managing to close above its 20-day EMA.

The move from X2 to B8 retraced .41 of the X1 to X2 top at 139 before exploding to new highs the next day. Cisco didn't close in the top of its range or above the open on B8 but the next day (Feb. 23) it opened at 127 up 3 points, which was right at the previous day's high of 127 1/16. It only pulled back to 126 5/16 intraday before reversing the 127 1/16 high and trading up to 139. The S&P futures were strong pre-opening and it was a strong rally day for the S&P 500. 

Following the WRB explosion to new highs, Cisco consolidated in a seven-day pullback to C7. All the bars were within the wide-range bar (WRB). C7 closed in the top of its range, above the open and above the 20-day EMA. The next day was a multipoint move on a pullback entry after a gapped open.

BEA Systems

This chart gives you a different look at a combined five-and eight-day pullback, but ends the same way, giving you good entry and a multipoint move.

Figure 3.  BEA Systems Daily Chart.

X1 was a significant low (68 7/8) and a five-day pullback to the 50-day EMA. It rallied to the X2 high of 157.75 without any pullback until the WRB key reversal day at X2. BEAS had a five-day pullback (B5) on wide range bars with the last three closing in the bottom of the range. The stock held above the 20-day EMA. This five-day pullback retraced .44 of the X1-X2 move.

After three days of consolidation, the eighth bar (C8) closed above the open, above the previous day's high, above the previous four closes and in the top 25% of its range. This stock gave you multiple indications of a high-probability trade. The previous day's high was 131 1/8, so in your trading plan, you set entry at 131 1/4. The next day you got a trade-through entry and BEAS traded as high as 138.

I tried to have you look at the pullback trades through my eyes and thought process. You must cycle through the daily charts every day to find these patterns. I suggest you start looking at the high RS and EPS stocks that have closed in the top 25% of their range and have had an increase in volume over the previous day.

The following charts highlight the multiple patterns in Nokia that were in place at the same time we took our entry in Nokia at 201.625.

The chart below of Nokia (Figure 4) is a Three-Week Symmetrical Triangle with four defined points that is an excellent pattern. Longer-term players might have waited for the break out around 206 before entering the trade.

Figure 4.  Nokia Daily Chart. 

The next chart of Nokia (Figure 5)  illustrates an Ascending Triangle which is only because you prefer to look at it that way. This is also a breakout that is just a touch above the symmetrical triangle.

Figure 5.  Nokia Daily Chart. 

Another trader might have looked at the Nokia chart and seen it as a Cup and Handle (Figure 6). The retracement down from the high was on declining volume and it picked up a bit, forming the downward pullback handle.

Figure 6. Nokia Daily Chart. 

The next pattern (Figure 7) is a strong favorite of mine because it leads to explosive moves after a breakout of this Dynamite Triangle. The day preceding the breakout is usually a narrow-range inside day with a stop right below the low of that day which gives you a high-probability trade with excellent risk reward. Following the breakout, you often get a good move from two to eight days.

Figure 7. Nokia Daily Chart. 

I hope you will benefit from this Trading Lesson because profitable trading is, in essence, based on price relationships that put you in high-probability situations.

Kevin Haggerty