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USE OF SUPPORT AND RESISTANCE TO DEFINE ENTRY POINTS
Figure 9.1 is the familiar chart that was used frequently to demonstrate various indicator combinations and settings in an uptrending market. In Chapter 5, "Conventional Use of Online Indicators," it was pointed out that even though the dual settings used with the stochastic indicator were effective in reducing the number of trading signals, the signaling of many trades taken against the major trend remained an annoying problem. In this example we illustrate the use of Category 2 support and resistance as an entry definition tool, eliminating nearly all the unprofitable trades against the trend of the day. This same tool also defined the most profitable trade of the day, entered on the long side shortly after the noon-hour correction.
For purposes of clarity, I have replaced the position arrows used previously to designate stochastic buy and sell points with the larger black dots labeled "Dual Stochastic Buy Signal" and "Dual Stochastic Sell Signal" on the chart. The arrows are used on this chart at the point where both long and short trades are actually entered using this trading formula.
Note that on this uptrending chart there is a sell window opened
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ategory 2 Support"
Dual Stochastic Buy Signal
i32-9:32 1002 10:37 11.02 11:32 l2:02 12:32 l:02 j:
32 2:02 2:3?
Figure 9.1 Dual stochastic has opened first a buy window and then a sell window, after which positions are taken as support or resistance is broken. Chart created with TradeStation® 2000i by Omega Research, Inc.
by the dual stochastic indicator combination for most of the first half of the trading session. This window stays open for the entire period since the rally is of sufficient magnitude that there are no intervening buy signals issued for the duration of the price move. You will also notice that there is a steady string of Category 2 support points identified along the way. Had the market moved down through any of these support areas we would have had a valid short entry.
In fact, that is what happens when the market enters what turns out to be a correction in an overall uptrend during the noon hour. Underlying support is broken as identified by the short entry designation appearing shortly after 12:00 noon.
Just before 1:00 p.m. a new buy window opens up, the first such indication on this uptrending day A Category 2 resistance point is placed 24 minutes later as the market puts in a minor correction from the persistent uptrend. As you can see, when the market breaks the buy stop placed slightly above our new resistance area, we are entered into a long position as our buy stop is activated.
Although we have taken a small trading loss as we are reversed from our first short position to the subsequent long entry at a slightly higher price, the gain from the long position taken late in the day and held into the close more than offsets this minor setback for our trading account. For purposes of comparison, think what the net result would have been had all the sell signals being issued as the market rallied all morning been taken. Chances are that most traders would have been discouraged by the series of losses generated by these trades and would no longer be trading when the best signal of the day surfaced after the minor downside correction. These short trades are never entered as support is not broken. In this manner we are able to take significant advantage of using our dual stochastic indicator as the primary trade entry indicator while also employing our knowledge of support and resistance as a filtering tool to generate our actual entry points for trade entry.
In Figure 9.2 we are using our familiar CMVT chart from October 6, 2000, to demonstrate the use of the dual stochastic entry method combined with the use of Category 2 support and resistance to define an exact entry point.
Early on the chart note the steady decline of the successive locations that mark our Category 2 resistance points. The highs of these Pivotal bars that make up the resistance formation are used for
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IjiC1, j ". Dual Stochastic Sell Signal .................................
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FastD(70,1) 61.00 30.00 70.00 FastD 7 (90,0) B3.17 10.00 90.00
-105.000 -T04.000 103.000 -102.000 -101.000 100.000 99.000
i5™ 9.02 9:32 10:02 l0:32 11:02 11:32 12:02 l2:32 l:02 l:32 -4Sj
Figure 9.2 Dual stochastic combines with Category 2 support and resistance
to dictate entry and exit points for two trades.
Chart created with TradeStation® 20001 by Omega Research, Inc.
placement of our buy stops for actual trade entry. Note that, as a result of these points being defined at a lower and lower level, we are not able to enter the long side of a declining market, even though we are getting repeated buy signals from the dual stochastic indicator. Since the price does not trade up through our buy stops, slightly above resistance, we are not able to enter the market. We enter on the long side only when the market finally violates our buy stop at 11:34 a.m. at the 100.25 price level. The short horizontal line on the chart identifies the placement of the buy stop.
A considerable amount of the discussion of this scenario involves a small section of the chart. Figure 9.3 is simply a blowup of the prime area of interest on Figure 9.2, included to illustrate more clearly the points of interest.
Only two bars after our long entry we are presented with a dual stochastic sell signal. At this time note that the Category 2 support points plotted beneath the price bars are creeping steadily higher in tandem with the modest uptrend that is slowly trying to establish itself. As soon as the dual stochastic sell signal appears we look to the most recently plotted Category 2 support level to establish an entry point for a reversal to a new short position, or, more conservatively, establish a stop loss position for our long trade. Whether this point is
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CMVT HST-2 min 10 2000- C=98E25 -20.0O0-16 80% -
Dual Stochastic Sell Signal
Category 2 Support
Duat Stochastic Buy
-106.000 105.000 104.000 -103.000 102.000 101.000 1 DO 000 -99.000 90.000 97.DD0 •96.000
FastD(70.1> 61.60 30.00 70.00
Figure 9.3 A long position is reversed to short by the activity of dual
stochastic and Category 2 support and resistance.
Chart created with TradeStation® 2000i by Omega Research, 1 .
used as a point to reverse the trade or as a point simply to exit the long trade to wait for another opportunity is up to the discretion and individual trading style of the trader. For the purposes of the explanation of the sequence at hand we will assume that we are reversing the current position to a new short position in this market.
As you can see, the new short position is taken almost immediately as the market violates our buy stop placed at 100.625. Recall that our Category 2 support and resistance points are not available for use until two bars have formed after the pivotal bar in the formation. In this case the support point was available for use at 11:48 a.m, just four minutes before the market passed through this level, reversing our position to short.
Following our short entry the market cooperates nicely by entering a steady decline. Note on Figure 9.2 that our Category 2 support points follow along as each ensuing upward correction is met with renewed selling pressure. Also notice that the market action is now generating buying signals from our dual stochastic routine. Fach time these buy signals appear, we are obliged by our system rules to place a reversal buy stop at the most recent Category 2 resistance point. Obviously, none of these stop prices are violated by the downtrending
116 combining DUAL signals, SUPPORT, AND RESISTANCE
market; thus we are able to maintain our profitable short position for a considerable portion of the remainder of the day,
Looking at these successively lower resistance points from the perspective of the placement of a protective trailing stop, one can readily appreciate the manner in which this use of market-generated resistance points can be an effective technique for the protection of more and more profit as the trend progresses. If this scenario for profit protection and eventual exit is the one being used, the trader simply places his or her stop at the most recent resistance point plotted on the chart. As a lower resistance level is uncovered by the appropriate chart formation, the protective stop is canceled and replaced at a lower level. This process obviously comes to an end when the market goes through the stop or the trade is exited at the end of the day. This regular cancel and replace routine works very well with the advent of electronic order entry, as orders can quickly be changed without placing undue burdens on trading desks and floor personnel.
Later in the day the probability of entering a new day trading position and exiting with a significant profit becomes less and less likely. This is simply due to the fact that there is less and less time available for our expected scenario to play itself out during the time remaining in the trading session. One can certainly use the rules established here to enter into positions that may be held over into subsequent trading sessions, but since our emphasis here is on day trading we will assume that there will be few, if any, positions established in the last hour of trading. Halting the entry of any new day trades during the last hour of the session is certainly not a hard-and-fast rule, but the 60-minute time frame will serve as a good rule of thumb. Again, this concept is better served as a function of the users individual trading style. Each individual will soon determine the proper time to cease placing new market entries concurrent with the method of trading being used and the market under consideration.
Assuming no new positions will be entered in the last hour, we then look to our Category 2 resistance points for locations at which to place our stops in an effort, in this case, to protect a significantly profitable position in CMVT. It is particularly important to use these types of stops at the end of the day, especially if the day has experienced a major trend, either up or down. On days such as these it is highly likely that there have been many new positions opened throughout the course of the session that are now profitable to one degree or another.
Many traders finding themselves in this position will elect simply to claim their profits for the day before the market closes. These exiting trades can put a noticeable pressure on the market in the direction opposite the trend that has been established for the day. Also, and possibly more significantly, those individuals who are caught on the wrong side of a trending market are becoming increasingly uncomfortable with their losing positions. Faced with the possibility of further losses should the market continue its trend during subsequent sessions, these traders are likely to panic, throwing orders into the market to exit at any price, just to stop the accumulation of red ink on their trading statements. This can have the same trend reversal effect on the market as those liquidating profitable positions. In either case, one can make a convincing argument for the use of protective stops at the end of a trending day. One can easily see all the profits that were accumulated throughout the day quickly evaporate in the face of one of these late-day corrections if a proper protective strategy is not implemented.
As you can see in Figure 9.2, near the end of the trading day a protective stop placed at the most recent Category 2 resistance level was in fact activated as the market traded through it at 2:06 P.M. In this case the use of the protective stop was of little consequence as the market closed relatively near our earlier exit point.
In these two brief examples I have illustrated how dual oscillator indicators can be used in conjunction with market-defined support and resistance to reduce significantly the number of losing trades generated by using the dual oscillators alone. Chapter 11 will deal with the use of the dual oscillators in combination with the Directional Day Filter, which restricts trading to only the major trend of the day. Finally, Chapter 12 will deal with the use of combinations of the Directional Day Filter and dual oscillators along with support and resistance.
1. Buying and selling windows are opened when various combinations of oscillator indicators identify a general area in which trading signals may be generated.
2. Positions are actually taken when the market violates previously defined support or resistance areas.
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