Trade Logic
This is the
first in a series of lessons that
will take you through some specific trade logic that helps you identify
high-probability trading opportunities.
In
this lesson,
I will show you a sequence in the DIAs (proxy for the Dow Jones 30) from the
September 1998 low of 73.875 to a buy opportunity as the DIAs formed a
defined triangle pattern as volatility contracted.
You
will see the following key factors in evaluating trades: RSI Divergences,
Retracements, Trendlines, Patterns, Multiple Time Frames, Volatility and Same
Index Same Stock.
I
will start with the weekly chart of the DIAs that has both a 10-week and
30-week EMA in addition to RSI 14 period. (See Figure 1.)
Figure
1.
The DIAs rallied from the
9/98 low of 73.875 to Peak 1, 111 1/2, on confirming RSI. It is when the DIAs
made three drives to a top at 113.75 that you identified the negative RSI
divergence. The three drives to the 113.75 top was in conjunction with a lower
1, 2, 3 sequence in RSI which is a strong negative divergence.
Institutions are very
aware of stocks with these longer term divergences and will usually take action.
Peak 3 at 113.75 was still above both its 10- and 30-week EMAs. When you got the
third peak, you drew the trendline from the 73.875 low through the low preceding
the 113.75 peak which was essentially a one-year trendline. The breaking of this
trendline was an excellent short entry in the DIAs or a similar stock with the
same pattern.
After the isolation of
the trendline, you would determine the retracement (Fibonacci) levels which
would be alert levels to closely watch for a change in direction. Frame the DIAs
from 73.875 to 113.75 gave us alert zones of .38 98.60, .50 93.81 and .618 of
89.11. The DIAs hit a bottom at 99.56 almost exactly at the .38 level. From
there, they rallied to a new high at 117.50.
The rally back above the
10- and 30-week EMAs was confirmed by a rising RSI which had broken its
downtrend line but at the 117.50 new high there still existed a negative
divergence in RSI as you see on the RSI chart from Peak 1, to where the RSI is
labeled 117.50 high.
Once the DIAs traded
above the 113.75 peak, it set up a potential 1-2-3 reversal top which is an
excellent pattern to get you in a high-probability trade. The explanation of a 1-2-3
Reversal Top is located on the site under the Pattern Section.
Higher highs on declining
RSI on weekly charts is the key for identifying this pattern. When the DIAs
traded back down below the 113.75 peak, you would take selling action but
definitely when the DIAs recrossed both the 10- and 30-week EMAs on the
downside.
What you should do in
this scenario is frame the DIAs from the 73.875 low to the 1,2,3 Reversal Top at
117.50. This gave you a .38 level at 100.92, .50 at 95.68 and the .618 at 90.54
that you see on the chart.
The DIAs made a bottom at
96.84 just above the .50 level of 95.68 then proceeded to rally taking out the
previous 99.56 low (see chart).
From the 96.84 low, the
DIAs rallied to 114.53 and that is where the contraction of volatility started
forming two well-defined patterns. On the chart, you see the larger symmetrical
triangle that formed with the upper line drawn from the 117.50 top through the
114.53 reaction top. A breakout of this top would be above 110 to the upside.
Within this larger pattern, a smaller narrow-range triangle formed with the
upper line drawn from the 114.53 peak. A breakout from this pattern was above
the 105.75 – 106 level which in fact would re-cross both EMAs to the upside,
which is positive. This pattern is an excellent situation for a straddle that
would be actively managed on the breakout.
As you identified this
pattern on the weekly chart, you should see what’s going on with the daily
chart. (See Figure 2.)
Figure
2.
Looking at the daily
chart of the DIAs, you see that a similar narrow-range triangle right at
the 50-day EMA and just below the 200-day EMA had formed. You would also have
observed that the daily RSI was rising prior to the breakout from this pattern,
as it was on the weekly chart. Looking at the daily chart, we see that the
Bollinger bands (13 period, 2 ST deviation) had narrowed to its tightest level
in some time.
The stage was now set for
a very strong move of some duration. The setup day on the daily chat was 6 (July
6) and you entered at the 105 7/8-106 level on July 7, which took the DIAs above
the 50- and 200-day EMAs, at the same time breaking out of the smaller weekly
triangle pattern. As you can see on both charts, the price breakout was
conferred by RSI breakouts.
In order for an index to
form a defined pattern, it means that some stocks within that index would have a
similar narrow-range pattern. In this example, we are looking at the Dow Jones
30 stock index, so we look to those 30 stocks for a pattern. My next thought is
to look for an uptrending stock above both its 50- and 200-day EMAs and heavily
overweighted by the Generals.
Looking through the
charts, you find General Electric
(
GE |
Quote |
Chart |
News |
PowerRating) which is in the top 10-15 holdings of
all the large mutual funds. It had an excellent narrow-range-triangle pattern
above its 10, 50 and 200-day EMAs. (See Figure 3.)
Figure
3.
As you can see on the
chart, GE had a WRB (wide-range expansion bar) on significant volume at month
end June 30 (report-card time), then contracted as the RSI was rising. July 6
(6) was a three-bar pullback after the range expansion and on July 7, the DIAs
broke out of its triangle pattern. Entry in GE should have been taken above the
July 6 high of 51 as it crossed above its 50-day EMA of 50.80 on July 7 (7).
July 8 gave you another good trade, entering above the July 7 high of 51.50.
Figure
4.
Whether you took the
DIAs, GE, or both, it was an excellent opportunity for a day trade, position
trade, or combined.
I hope by outlining the
thought process used to evaluate the current status of an index or a stock, it
will enhance your ability to identify high-probability trade opportunities.
Key
Points to Take From This Lesson
RSI negative and
positive divergence
Trendline
confirmation
Defined patterns in
multiple time frames
Retracements are key
alert levels
Identify strongest
stock with same pattern as index (reverse for sells)
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