Trading Pros
Short On A Down Tick!!! (You can if you trade currency)
How To Calculate Tomorrow's Probable Trading Range
By Kevin Haggerty
TradingMarkets.com
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), 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.
1 When 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.
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