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enters a sideways, resting mood, giving us little technical direction until the next support level is established at the dashed line marked 3. As the market temporarily tops out to begin a corrective phase we are presented with support points 4, 5, and 6 in a comparatively short time. Raising the stop level as each point becomes available, we are eventually stopped out of the trade as marked on the chart.
Since we are interested in trading from only the long side on this day, we regard the many sell signals issued as the market rises only with a passing interest, understanding the propensity of our oscillator indicators to give unreliable trading signals on a day during which a rally is expected to continue. We instead are examining all our trading tools for evidence of a downward correction in our progressing uptrend that will provide us another high-probability entry on the long side.
Our moment arrives during the noon hour as the market pulls back enough to open a buy window using the dual stochastic indicator (Figure 12.4). We then look for overhead resistance points where the market will define an accurate entry point. At this time, even though we are confident that the market is in an uptrend for the day and we feel we have just witnessed the exhaustion of a correction in the uptrend, we cannot be satisfied that the prime time has arrived for entry into the long side. There is yet one more criterion that must be satisfied before we are willing to risk our trading capital on an entry into the market.
As you will recall from our discussion of the construction of support and resistance levels, the market itself is responsible for the calculation of these points. Market activity is the force that creates the bars that in turn create the chart formations that result in the definition of support and resistance points. Thus, the remaining criteria to be satisfied for our entry into the trade becomes the ability of the market to overcome the resistance it has itself created. When the market is able to accomplish this feat, then we will be convinced that the renewed uptrend, in this case, is for real. To assure that we dont miss the boat, we place our buy stop slightly above defined resistance. When the market completes its final task of breaking above resistance that it has just formed by its own action, we are automatically entered into our long position as our buy stop is activated.
These events are carried out in our present example as a buy stop is placed at the initial Category 2 resistance area, which was formed a few minutes after the buy window was opened by the dual stochastic
jf TratieStatinn Chart - (CMVT) Coinwers*: Tcchnnloriy lrn; t.Aill 2 n
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- Category 2 Resistance *•
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....... ........:......:..... ; ;
:....... VI J.l. Stopped Out .. X j Category
category 2 support -Directional Day Filter-
Category 2 Support Close.
Dual Stochastic Buy Signal
116000 114.000 112.000 110.000 106.000
106.000 104 00! 102.QM
100.000 96.000 6 000
ast 0(45,70,1) 87.50 30.00 70.00 past D 7 BarQO.O) 66 27 10.00 90.00
10:52 11:12 11:32 11:52 12-12 124? n-<n 12 1- hi 7-17 141 2-52
Figure 12.4 Although we have establishedthatan uptrend for the day is in place and an exhausted correction has been identified, we willwaitfor violation of overhead resistance before initiating a long position.
Chart created with TradeStation® 2000iby Omega Research, Inc.
buy signal. Our new long position is filled as the market trades through our stop, as indicated on the chart.
We can now progress to step four of the process. Now that we are in a long trade we must make a decision concerning a high-probability exit for the trade. In this case we are fortunate in that the uptrend continues and we are able to exit at the end of the day with a profitable result. However, along the way we must be concerned with first defining an acceptable risk for the trade, and then, as things fortunately progress in our favor, shoring up our position regularly, locking in progressive reductions in risk and then additional amounts of profit.
Once again we turn to the concept I have emphasized regularly as the most important aspect of trading-short-term support and resistance.
Note on this chart that as the market rises there appear on a regular basis new, higher, support points under the market. These are excellent points that the trader may use to protect first the trading account, and then, later in the trade, profit.
The same concept, which was discussed earlier concerning trade entry, is equally valid for this application of support and resistance points. Again, the market itself is responsible for the creation of support and resistance. As the market rallies, regular attempts to correct or reverse the trend fail, creating support points in the process. As we know, should the market be successful in breaking one of these levels, we could experience a significant break in the market. It is therefore prudent to protect ones current position with the placement of appropriate sell stops slightly under these support points. Should the market break one of these points we will automatically be exited from the trade, because our stop order is activated when the market trades at our stop price.
The initial stop for our trade is placed at the dashed line labeled 1. This level is determined by the Category 2 support point that was placed at approximately the same time as the plotting of the dual stochastic buy signal.
In this particular trade, three Category 2 support points appear after the trade is entered, labeled 2, 3, and 4. Our trailing stop strategy moves our exit point up to each new level as these points appear on the chart. As each is formed higher than the previous point, there is no opportunity for the market to stop us out of the trade. Since we are not stopped out by our trailing stop, we simply exit the market at the end of the day. Later in this chapter you will find additional examples demonstrating this use of support and resistance for the placement of trailing stops.
We will now use a three-minute chart of Microsoft (Figure 12.51 for the next trading example, this time describing the steps as applied on a down day in the market. You may recognize this chart from previous uses in this book.
The first step, as always, is to determine the dominant trend for the day. Note that the majority of the activity one hour into the day is nearly entirely below the Directional Day Filter plot. Additionally, the close of the 60-minute bar is only slightly above the low of the day at this point. Therefore both criteria solidly point to a downtrend for the remainder of the session.
The next step is the determination of the minor trend. We are looking for a correction of the main downtrend as an opportunity to enter on the short side of the market. As discussed earlier, any of the oscillator indicators covered previously can be used for this purpose, preferably in their dual setting mode. Ideally, the trader will be monitoring the sto-
i□delation Chart - [MSFT Microsoft Corp LAST-3 n
IMSFT lA-i-J mill 1 02 0 •.".<( .< -9.750 -\ 4.17% 0=155 tB.fi H=70.875 I -f.F. 5F.S V-3C214300..
Dual Stochastic Sell Signal
-Directional Day Filter-
Short Entry ; ...Category 3 Resistance
Category 3 Support
zss 10102 9:03 9:33 10:03 1 Q;33 11 03 ,1 33 12:03 12.33 103 133 2:03 23
Figure 12.5 A sborttradeis generated by the four-step method. On two occasions, fading support or resistance when placing stops is criticalto the completion of a profitable trade.
Chart created with TradeStation® 2000i by Omega Research,Inc.
chastic, Percent R, and RSI indicators in combination with each other as he or she attempts to identify the prime exhaustion point of any corrections that occur. For the purposes of clarity on these charts we are only showing the activity of one oscillator combination to identify this exhaustion phase. Traders are encouraged to examine each oscillator or combinations of oscillator indicators on varying time frames of their favorite security or commodity contract. Only in this manner will the optimal entries be obvious when they appear in real-time trading.
The dual stochastic combination in use on this chart identifies the exhaustion point on the correction taking place during the 9:45 to 10:00 a.m. time frame. This sell signal is labeled as a slightly larger black dot on the chart. Appearing as it does on this chart, this indicator is especially significant when one examines the remainder of the chart and notices that this is the only sell window opened by dual stochastic during the entire session. Although the possibility certainly exists that our other oscillator combinations could have issued additional selling opportunities, the fact remains that if one had waited for a second chance at a short position on this day an excellent selling opportunity would have been lost. The market exhibited significant weakness for
the rest of the session. That weakness was strong enough that any feeble corrections were unable to trigger another sell window.
With the sell window now opened as a function of both the Directional Day Filter and the dual stochastic sell signal, we are now free to enter step three, the identification of a useful point at which to set our trap for a high-probability entry. Fortunately, we have such a point nearby. The market has created a support point for our use even before the slight uptrend had started. This correction is responsible for placing the dual stochastic indicator that opens the sell window. This support is again identified at the same level after the correction had run its course. These two points are labeled as Category 3 support levels on the chart.
It is quite significant that two Category 3 support points are found plotted on this chart at the same price level. Formations such as this one, referred to as a double bottom, are common and often eventually lead to a market reversal higher. A double bottom is usually more substantial than a single support point in that this price level has been successful in stopping a market decline on two separate occasions. When these formations are broken by market activity one can expect a greater reaction than what would be observed had the market penetrated only a single support point.
Our short position is entered as labeled when the market violates our support level. Note the comparative rapidity with which the market drops as it breaks through the price level of the double bottom formation just discussed.
With step three now complete, we must now move to step four to design a reasonable exit strategy for the trade.
Note the Category 3 resistance levels labeled on our chart. Again, as the decline progresses, normal market action creates lower and lower areas of resistance as attempts to correct the downtrend fail. These classic resistance points can be effectively used as trailing stop points initially to define our risk for the trade and then to protect profits. We place our stop at the level of the resistance point most recently formed before our market entry, as it is the closest available point at the time of entry. The effective level of the initial stop is marked by the dashed line labeled 1.
As the market declines further, another, somewhat lower, resistance point is formed, allowing us to drop our stop level to the level of the second dashed line. Note that shortly after the formation of the
I resistance point that is used to set this stop level, a second resistance I level is formed at exactly the same price level. It is significant that these two resistance levels appear at the same price that had previously caused the formation of two Category 3 support points just a few bars previously. Although the new leg down in this market has gained momentum from the plunge through the previous double bot-? torn, the inevitable correction eventually begins. It is quite significant that on two occasions between 11:30 a.m. and 12: 15, p.m. Microsoft makes a good effort at a corrective rally, only to be turned back by the price level that initially provided the impetus to the new leg of the downtrend. Previous heavy support has now turned into heavy resistance at the same price level. This is a specific chart pattern that the astute trader will observe often. The recognition of previous support turning into current resistance is a powerful force in the market. This phenomenon is responsible for the down move that persists for the rest of the session.
This instance once again illustrates the importance of "fading" stop placement around support and resistance points as first discussed in the previous chapter.
Had we placed our stop order at the exact level of the first resistance point in this series of two, there is a high probability that we would have been stopped out of our trade as the market reached this level before being turned lower again. By placing our protective stop slightly above resistance, or fading the price level, we force the market to break resistance before it is able to stop us out. Our entire theory is based on the breaking of support and resistance, not merely equaling it. The net result here is that we are able to maintain our position in the face of a significant market correction and continue to profit from the ensuing market drop rather than being stopped out near breakeven with nothing to show for our efforts but sweaty palms and a receipt for a commission.
As we move further through the trading session the market continues lower, fleeing from the selling pressure that surfaced at the double top marked by the twin Category 3 resistance points. Soon another resistance point is established as yet another corrective rally fails. This level is marked by the dashed line labeled 3, where we now place our stop. Note that at this point in the trade we have now locked in a profit.
The same scenario again repeats itself, allowing us once again to drop our stop, this time to the level designated by the fourth and final
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