How To Calculate Tomorrow’s Probable Trading Range

September 5, 2002
Kevin Haggerty

Trading is
searching for high-probability opportunities, as, regardless of your holding
period, you are always striving to gain an edge. I have found that
convergence of indicators such as support,
resistance,
trend
lines,
moving
averages, Fibonacci
levels and volatility
bands also give you an edge and chance for a high-probability entry.
You can be very successful by buying pullbacks in uptrends (the reverse
is true for
sellers) when they coincide with convergence.

This lesson will
demonstrate the interaction of convergences from an intermediate period
on the daily chart with the one-day volatility bands. (To better
understand the lesson, you should first read my article, “Short-Term
Volatility Trading Bands,” in the Trading
Strategy section on the site.)

As I have mentioned in
my previous commentary, in order to maximize use of this strategy, you should always
have your key stocks or indexes framed in advance so that you may take
advantage of any airpockets that occur which might give you good entry.

On
the Jan. 20 daily chart of General Electric
(
GE |
Quote |
Chart |
News |
PowerRating), I have framed the
key reference points, so follow along on the chart as I address them.

X1 is a significant bottom in October 1999 at 114.625.

X2 is a significant top on Dec. 27, 1999, at 159.50.

X1A is a minor bottom at 130.

After you have marked the significant top and bottom, you can
calculate the Fibonacci retracement levels between 114.625 and
159.50.

The levels are as follows:

.38
142.44

.50
137.06

.618
131.76

.786
124.22

Draw your key trend lines. See TL 1 and TL 2.

Identify the key EMAs on the daily chart. Most software packages
have the ability to interface the EMAs of your choice and also
enable you to get your Fibonacci retracement levels. The key
exponential moving averages (EMAs) are as follows:

50-day EMA 144.48

200-day EMA 124.85

The EMAs and the Fibonacci RT levels are located bottom right on the
chart.

Identify support or resistance levels. In this example, I have
marked the following support levels that come into play:

S3
142.56

S2
130.00

If S1 was penetrated, we
would be looking to short so it doesn’t come into play for this
example except as the initial point to draw the intermediate TL
1.

Please note that the S3 level
pf 142.56 was made just above the 50-day EMA which was 141.84 on
Jan. 5, the day S3 level was confirmed. As you can see on the chart,
the 50-day EMA also acted as support at the S1 and S2 levels. You should also observe that these pullbacks all consisted of 3, 5,
8 or 7 day retracements after swing-point highs. (See footnote on counting pullback
days.)¹

The S3 support level was made at Trend Line 1. The next convergence
of S3 was that it occurred just above the .618 RT of 141.27,
measured from the XIA bottom of 130 and X2 top at 159.50.
(This is not marked on the chart.)

I threw the curve at you to make the point that these convergences
are important to recognize at both significant and minor bottoms. Some of
your major home runs will come when the .38 level of the major leg
coincides with the .618 level of the minor leg in addition to the
other convergences. If you get a good entry from convergence and it
coincides with a VIX signal for the market, it makes your trade even
stronger.

Remember, these reference points are just alerts, not
absolutes. You must then watch for a reversal entry pattern
that puts you in the trade. This might be a doji or hammer if
you are into candles or a close above the high of the low day, a
three-bar reversal, a 1, 2, 3, 4 or even a 180. (See The TRADEHARD.COM Guide to Conquering the
Trading Markets, 1999, M. Gordon Publishing Group, Los Angeles,
California.)

Regardless of which reversal pattern you use it is about getting in
the trade when you see it changing direction, not picking a bottom
or top because it fits a number which are just alerts. You should be
looking for buying pressure to take the upper hand as price and
range expand on increased volume.

Now that you have framed GE on the daily chart, let’s review the key
points you should be focusing on. After we do that we will combine
these convergences with the Jan. 20 intraday chart. On Jan. 20, GE opened at 149.68, traded down to 142.625,
then rallied from this key level to 147.125 and this was your
high probability trade.

A look at the daily chart shows me the following convergences:

The .38 RT level of X1 to X2 is
142.44.
S3 support level is 142.56.

GE rallied last time from the S3 level of
142.56 which was
right at the 50-day EMA and Trend line 1. The 50-day EMA on Jan. 20 was 144.48.
(See daily chart bottom right.)

The S3 level of 142.56 where the rally started after
an 8-day pullback was just above the .618 level as measured form
X1A level
at 130 to the X2 top at 159.50.

The .618 RT level of 131.76 coincides
with the S2 support level of 130.

The .786 level
of 124.22
coincides with the 200-day EMA of 124.85

The key reference points which we have framed are enough convergence to have
entered the trade on Jan. 20, assuming you had a reversal pattern entry. We
will have more confirmation when you see it combined with the Volatility
bands.

It is also important to observe the X2 top reversal. GE made the 159.50
top on lighter volume and formed a dynamite triangle pattern as
volatility contracted which usually precedes a strong move. This is
an excellent narrow-range pattern. The tighter it gets, the bigger
the move in most cases. GE broke out of the pattern to the downside
in addition to trading below TL 2 and closed below the past 5 days’
lows. This was a sell signal for any traders that were long and
possibly a short entry for experienced traders only. The question of
whether you should short stocks in strong uptrends is another topic
and not part of this lesson.

Next, we will talk to the Jan. 20 intraday chart of GE where the low
on that day of 142.625 converged with the .38 RT level from
X1 to X2 on the daily chart in addition to the other convergences we
mentioned.

GE developed an airpocket on Jan. 20 as they reported record
earnings but there was confusion about a one-time gain and misplaced
fears that the earnings were inflated by the one-time gain. (Dow
Jones News).

The overreaction started immediately as GE traded down to a low of
142.625. Any short-term longs were stopped out and sold, some of the
trigger happy institutions let some go because they are all
overweighted in GE big time. The married puts helped accelerate the slide as the specialist was
obviously going to let the stock fall to a level that attracted
buyers which it eventually did.

Hopefully you will soon become one of the few traders that take
advantage of these convergent opportunities.

In
order to follow along on this intraday five-minute chart of GE, you
should have a copy of “Short-Term
Volatility Bands” in your hands. The calculations are
explained in that strategy.

This
example of convergence is to take a high probability day trade because
on the chart I have labeled the price bands from 1 to 2
standard deviations based on one trading day. The calculation to get
the one day constant is .

You
divide 1 by 365, then take the square root of the result and you get
0.0523421. Any calculator with a square root function will do.

I
have also marked the % probability that price will be contained within
the volatility band and probably revert to the mean. Translated, it
means we are looking for trade entries at the bands.

In
this example, the 2.0 standard deviation band is 143.22 and there is a
95% probability that price will be contained by this band. This
assumes no unusual news such as fraud or accounting irregularities.

Just
so there is no confusion, I will do the calculation that gives us the
143.22 volatility band.

GE closed
at 148.72 on Jan. 19, 2000.

Take the
IV (Implied Volatility) of the ATM (at the money) call and ATM
put, add them together and divide by 2.

In this example, we used the most recent month options, which is
February expiration. I used the 150 strike price because GE was
closer to 150 based on its close of 148.72.

The result of this calculation gives you the combined IV
of .354.

The
constant is 0.0523421 and the combined IV is .354.

Example:

2.0
(standard deviation x .354 (combined IV) = 0.708

0.708 x
148.72 (GE) = 105.29

0.0523421 x
105.29 = 5.541 points

148.72 –
5.51 = 143.21 (2.0 SD, 95% band)

Note: You just
add 5.51 to 148.72 for the upper 2.0 SD band.

You do the same calculation for each different volatility band,
starting with the 1.0 SD.

GE dropped like
a knife without a rally and gave a buy reversal entry at B1 with a
stop below the low of that first bar below 143. When it moved above
144, you moved your stop up to break even, which was 143.50, the entry
price.

The stock then dropped to
142.625, which was just above the .38 RT level on your
daily chart and just above the S3 support level of 142.56. GE gave an
excellent reversal-entry pattern at this level and the market
dynamics were also better. You got a wide-range bar (WRB) expansion,
which was an outside bar that closed in the top of its range, above
its open, above the previous bar’s high and above the previous two bar
closes, and also closed above the previous low of the first entry
pattern.

Once you
entered at B2, there wasn’t a reversal sell pattern until you got to the

147.125 level and reversed the lows of the previous 3 bars. Net net,
you got back in at 143 1/2-5/8 and you had a defined exit at 146.75
assuming you took the reversal exit pattern.

Combining time
frames and convergences will definitely improve your trading or
investing as you can do the same framework with mutual funds, with the
exception of intraday bands. As you read this, you might think it is
time-consuming to frame, but it really isn’t. Get some software that
gives you Fibonacci retracement levels on your daily chart and frame
your key trading stocks or whatever stock shows up on your stock
selection list. If you are just trading intraday, you can frame the
stock during the day and look for entry points.

It is much
stronger when you combine it with the intermediate trend. When you
calculate the volatility bands, start with 2.0, then 1.5, 1.28 and
then 1.0. The best trades will usually come from the wider bands.
Please E-mail me on any questions you might have. There is no such
thing as a stupid question.

Good trading.

¹When
you count those 3, 5, 8 and 7 bar pullbacks, you arrive at the number
by starting with the most recent bar or the preceding bar in a
situation where you are buying a pullback in an uptrend (reverse for
sellers)). If you have a
double bottom, you count that as one bar. More than that, you will be
in a consolidation pullback.