Directional Indicators

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9 POWER PATTERNS FOR HIGH PROBABILITY TRADING SIGNALS

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GENERAL DISCUSSION:

If you don't understand or remember the definition of DIRECTION, FAILURE, or MOVEMENT, you'll make it a lot easier on yourself if you review these concepts in CHAPTER 2, before going on.

A Directional Indicator is usually, but not always, a pattern of some kind. Certain of these patterns are defined by the 3X3. Don't confuse the concept of trend with that of direction, even though the 3X3 is used for trend delineation as well as the criteria for certain of the Directional Indicators we will use. Directional Indicators are not Trend Indicators, irrespective of how they are derived. If there is a conflict between what a Trend Indicator and a Directional Indicator is telling you, follow the Directional Indicator. Direction overrules Trend.

In recent years, a greater percentage of my trades have been based on Directional Indicators rather than Trend Indicators. This is as much a reflection of my maturity as a trader, as it is my increased patience level. Perhaps philosophically speaking, those aspects are one and the same. Directional Indicators require patience, as they must manifest on their own, while a Trend can always be found. Directional Indicators are typically very powerful and highly reliable. They are in keeping with my overall philosophy:

LOSS OF OPPORTUNITY IS PREFERABLE TO LOSS OF CAPITAL!

THE "DOUBLE REPENETRATION SIGNAL" OR "DOUBLE REPO" FOR SHORT

The following Chart 6-1 shows an idealized Double RePo. It has specific, identifiable features.

1. The Double RePo signal bar must be preceded by a minimum of 8-10 periods of thrusting market action; 15 or more is better. Just what constitutes thrust is far easier to visualize than to define. This is good news, since it will make it tough for programmers to specify. Therefore, it should continue to "work" for some time to come.

CHART 6-1

2. After the up thrust, we need closes below, above, and again below the 3X3, before the sell signal is given. The reverse is true for down thrust.

3. The top (or bottom) formed by the bars as specified in the chart shown, should be reasonably close to one another.

4. The width of the top (or bottom) from the initial penetration to the subsequent penetration (after the retracement) should not exceed 8-10 bars; three or four are much better.

5. The signal remains intact until either a major Logical Profit Objective (to be defined later) is achieved (point 'M' on the chart), or until the .618 retracement '*' from the furthermost extreme of the consolidation area (after the second penetration) to the furthermost extreme on the thrust, has been exceeded on close. When we get into Fibonacci analysis, the last sentence will be easier to understand. In terms to be defined later, you create a resistance series and look for the '*' retracement level to be exceeded on close.

6. The periods I use for Double RePos are daily, weekly, and monthly, although many of my clients have reported excellent results on 30 minute and hourly charts .

Let's review each of the criteria on this idealized chart, to be sure you understand the criteria, before we get to actual market examples.

ITEM 1

Market action is in a thrusting up move, remaining (primarily but not necessarily) in an up trend (above the 3X3 on close) for 13 periods.

ITEM 2

We finally achieve a close below, above, then below the 3X3, yielding the signal bar. Note the circled closes. The second of the two is the signal bar.

ITEM 3

The tops formed by the highs of the consolidation area are acceptably close to one another.

ITEM 4

The number of bars in between and including the two closings below the 3X3 are clearly less than the maximum.

ITEM 5

The signal would be negated if the market closed back above the Fibonacci level shown as '*', or if the market achieved the profit objective point 'M.' Neither situation has occurred yet.

IMPORTANT POINTS TO NOTE:

The criteria as defined in Items 1 through 5 will clearly satisfy many of you, and utterly disappoint some of you. The level of specificity as applied to the accompanying real charts should be more than adequate for those of you who are psychologically suited to judgmental trading techniques. I will endeavor to be as specific as possible with the Double RePo as with all of the subsequent Directional Indicators. It's important for you to note that just because the exact criteria are not met, it does not mean that the market will not act as if the criteria have been met. See "Look-Alikes" later in this chapter. In workshops, I sometimes refer to a Double RePo "look-alike" as one Double RePo not being as "pretty" as another. A Double RePo does not need to be a Barbie doll to add significant width to your wallet.

It's also important to note that a Double RePo on a weekly or monthly chart can be a serious event. It can signal the termination of a major bull or bear run.

Chart 6-1A shows typical market action after a Double RePo has occurred.

DOUBLE REPO

CHART 6-1A

FREQUENTLY ASKED QUESTIONS: Haw didyou come up with the signal?

Like all of the Directional Indicators in this chapter, the criteria were developed by my personal experiences in trading, some of which were blistering events! When dramatic price action occurred, I wanted to know why, and since I typically had my own, real money riding on the event, I was a highly motivated researcher. When I thought I learned something, I looked for the market to replicate the action again, and again, and again, and that's right, again, before I would consider adding what I thought would qualify as a directional signal to my trading arsenal. The standard of reliability was high, since my trading action subsequent to its identification was immediate and strong. The Double RePo signal was actually identified originally by me on the first chart shown in the series of actual market examples, Chart 6-2. It has been an incredible trading resource since

1986!

Can you anticipate the close on a Double RePo and lake a position based on what might happen?

Yes. If, for example, the price on the signal bar shown on the idealized chart is below the 3X3 but the market hasn't closed, it is okay to get short. You could even anticipate the move through the 3X3 if your intraday trend signals, the MACD/Stochastic, were convincing enough. As with any anticipated or unconfirmed signal, however, you say adios to the trade if you lack confirmation at the close of the period.

Aren't you simply showing a double top?

No, I am defining a specific type of double top or bottom.

What markets does this signal work in?

All liquid markets. That includes stocks, mutual funds, and cash currencies. But, let's exclude wheat and pork bellies to be on the safe side.

Do I take a signal on close and simply wait for a profit objective?

You can take a position on a confirmed or unconfirmed signal, but you have to be aware of the "get out" point on the loss side as well as the anticipated profit. You can also apply all the other aspects of trade entry we have yet to discuss. One way to approach trade entry for multiple contract players would be to lay on some contracts unconfirmed, more on a confirmed signal, and still more according to other criteria we have yet to discuss.

What if we have a Double RePo and then close above the 3X3, but we do not exceed the Fibonacci point marked '*'?

In the scenario you describe, the Double RePo signal has not been negated. Remember, you not only need to exceed the Fib point at '*', but you must also do so on close for a confirmed get out. As for the Trend confirmation up (confirmed by closing above the 3X3), you ignore it, since Direction overrules Trend.

What if you exceed point '*' on close then turn around and subsequently close back below the 3X3?

At this point, you're probably unhappy and counting some losses. Triple RePos don't exist in my trading plan in the overall "applicability" and "high reliability" sense that Double RePos do. However, I have observed a number of instances where such market action has occurred in U.S. bonds. The bond market has a nasty habit of doing this after very extreme thrusting moves. I trade such action similarly to a Double RePo. This would be classified as a "look-alike."

Why do you limit the periods you use to daily and longer ?

They are the most reliable. A number of my clients use intraday charts for the Double RePo trade as well. If you want to see what one looks like, there's an example of a Double RePo on a 30 minute S&P in CHAPTER 4, Chart 4-5.

Can you explain what is actually happening in the market that makes this signal work?

I can try. The day after day of thrusting moves demoralizes and panics the shorts. Longs that have exited are pulling their hair out from feelings of greed. Most lack the ability to get back on board. The first pull back is bought by these groups, while the second pullback eventually turns into capitulation or even panic, if the preceding up move is confined by the '*' Fibonacci barrier. The important point of this psychological discussion of what's happening is understanding that the length of the initial thrust must not be unduly consolidated by the width between the 1st and 2nd penetration of the 3X3. In other words, 18 days of up thrust consolidated by six days is a lot "prettier" than eight days of thrust consolidated by eight days. Too much consolidation works off the greed and fear. We don't want that.

MARKET EXAMPLES:

Each of the following charts will attempt to identify and clarify the Double RePo Directional (change) Indicator.

Double Repenetration Chart

CHART 6-2

Chart 6-2 shows two Double RePo signals in the S&P, occurring in 1986. I had my proverbial lunch handed to me just before the first signal. The locals in the S&P had their lunch handed to them just after the second signal. We both learned something from the experience. I learned about the Double RePo signal. The locals learned to keep their hands in their pockets when the S&P freight train barreled through.

The second signal (on the sell side) is picture perfect. It was preceded by beautiful thrust, had near equal tops, and the span between the first and second close below the 3X3 was narrow.

The first signal (on the buy side) certainly worked. The down thrust preceding it however, was strong, but not as relentless as the up thrust that preceded the second signal. What we prefer to see in terms of thrust is continued pressure, as in the idealized example, rather than a single big move, consolidation, and another big move. While the levels of the double bottom were acceptably close, they were not as "pretty" as the double tops preceding the sell side signal. The span of days between the first and second closing above the 3X3 was also a bit wide, given the extent and nature of the preceding down thrust.

CHART 6-3

Chart 6-3 illustrates a perfect Double RePo right at the top of the weather market we experienced in corn in 1988. For those of you who haven't been involved with weather markets, they are among the most vicious of all markets. The dots on this chart do not indicate illiquidity brought about by lack of interest; they are limit moves!

The next Chart, 6-4, shows weekly continuation data of corn, preceding and including the crop shortage period in 1996. Note the clear Double RePo occurring near the $5.00 level. How would you have liked to have been short a ten lot when that happened?

The next Chart, 6-4, shows weekly continuation data of corn, preceding and including the crop shortage period in 1996. Note the clear Double RePo occurring near the $5.00 level. How would you have liked to have been short a ten lot when that happened?

CHART 6-4

Realize that if you had a position on, it would have been in September Com, not on the continuation chart. The Double RePo showed up there as well. The continuation chart was necessary, however, because it presented you with a cleaner picture. This thinking is similar to that used in an upcoming soybean meal trade, detailed in CHAPTER 15. In the meal trade, I entered on July meal but the context was taken from the weekly continuation chart.

Next, we'll see daily soybeans (Chart 6-5) during and after the floods in 1993.

Next, we'll see daily soybeans (Chart 6-5) during and after the floods in 1993.

CHART 6-5

Just for a change of pace, let's see how this Directional Indicator works in the stock market.

Just for a change of pace, let's see how this Directional Indicator works in the stock market.

CHART 6-6

Microsoft (Chart 6-6) peaked at the introduction of Windows® 95 and made an almost perfect Double RePo. From there, it fell to a precalculated Fibonacci profit objective. Not only was this an opportunity to book weekly-based profits on the sell side, it was also a time to get long on a monthly reaction to an ongoing up trend. It would not serve you to skip ahead now, but some very interesting charts on Microsoft in the monthly time frame are just ahead. For those of you who are still having trouble internalizing the concepts of Time Frame, Trend, and Direction, these upcoming charts should be very helpful.

How about crude oil? Well, it's certainly a liquid market. It's also a volatile market, and that's what we want. Let's see what happened when Saddam did his thing back in the summer of 1990.

Edward Magee Newsletter Charts

CHART 6-7

Chart 6-7 shows the 3X3 containing trend all the way up to the $40 level, then a Double RePo and subsequent break through the 25X5. This Double RePo was the first time since the invasion of Kuwait that it was "safe" to go short. The previous breaks of the 3X3 (SI & S2) were single penetrations only, primarily due to the vast difference between the two tops (Tl & T2) made prior to each penetration. These dips presented buying opportunities as you will see when we cover our Bread and Butter directional signal.

If you had misinterpreted these single penetrations as a Double RePo, you would have shortly reversed and more than made your money back when the '*' Fibonacci level (not shown) was exceeded. This is called a Double RePo Failure. It will be the next directional signal we cover.

In Chart 6-8, we have a monthly based, Double RePo buy in the German bund.

CHART 6-8

I could go on and on with these examples, but you should have enough here to recognize this Directional Indicator when you see it. I've stressed your understanding of the Double RePo since your understanding of its formation is critical to your understanding of the Double RePo Failure as well as Bread & Butter. Before we leave this topic, however, I want to show you a very interesting Chart (6-9) of monthly gold.

CHART 6-9

I didn't know about the Double RePo back in the early 80s when this event took place. I wish I had.

The original move up to 875 certainly qualified as thrust. The dissimilar tops were a bit hard to live with but the fact that the second peak was held back by Fibonacci '*' resistance made it more palatable. The sell signal was given at about 625. The subsequent fall was a move down to about 280! I'm certainly not suggesting that anyone trade this monthly chart with what might be a $200 stop. What you need to understand is that the monthly set up can be used for weekly-based mutual fund switching or daily-based commodity trading. Another reason I wanted to show you this chart is so you can see what I'm looking for in the current stock market rally before I get excessively bearish. If we get a monthly Double RePo sell on the Dow or in the S&P, say good-bye to stocks! If the ensuing monthly pullback returns to the .618 retracement from the beginning of this bull market, we could be looking at a loss of over 4000 points!. If we only achieve the .382 retracement, we're still looking at something over 2500 points! For those of you who don't think this is likely or at least possible, gaze at Chart 6-9 again.

THE "DOUBLE REPO FAILURE":

1. First, you must have a Confirmed Double RePo, as shown in Chart 6-10.

CHART 6-10

2. The Double RePo signal fails and is negated when the closing price exceeds the Fibonacci '*' level. This is your signal bar. The expected subsequent action should be strongly up.

3. Your exit is at a significant Logical Profit Objective or a Confirmed Trend signal as defined by the 3X3 that does not confirm the action expected from the Failure.

Note: This signal is one of the few instances when you would reverse your original position. It would also be acceptable to aggressively enter (initiate a new position) against the high of the Double RePo Failure signal bar, after even the smallest of pullbacks. The point is, this is a Directional signal. You don't play with it. You get out of the way and go with it! In Chart 6-10, we clearly have a Double RePo which fails by exceeding Point '*'. Once you're in the trade to the long side, you have two ways to exit. Point COP (not shown) would be your Fibonacci precalculated, profit objective. Penetrating back below the 3X3 on close is your protective exit. This protective exit could turn out to give you a profit or a loss on the trade, depending on when and where price action crossed the 3X3. You could also use the stop placement methods discussed in CHAPTERS 8 through 11. Regardless of alternative tactics, the signal stays in play until a significant Logical Profit Objective is achieved or you get a Confirmed Trend against the anticipated Movement.

FREQUENTLY ASKED QUESTIONS:

Once (he Failure is in place, how aggressively do I treat it?

You immediately get out of any existing positions that are counter to the action anticipated by the Failure. You may initiate new positions aggressively, or by criteria yet to be described (dropping the Time Frame and entering at a Fib retracement or Confluence area).

Can I use the MACD/Stochastic Trend indicator to determine the protective exit rather than the 3X3, if the Failure doesn't go my way?

Yes, a Failure should move now, and keep moving. If it doesn't, something is wrong.

Chart 6-11 weekly bonds has two Double RePo Failures as well as a Double RePo. I've identified one Double RePo Failure and the Double RePo. Can you find the other Failure?

CHART 6-11

Chart 6-12 shows a Double RePo Failure in the daily bund. The price action to the right of the top does not qualify as a Double RePo, since there was not adequate thrust. Note how nicely the 25X5 contains long term Trend.

CHART 6-12

THE "SINGLE PENETRATION" OR THE "BREAD AND BUTTER" SIGNAL:

I'd like to say this is a "lay down" but of course nothing is in trading. This trade is designed to book you some nice comfortable profits with little risk. Unfortunately, it requires a good understanding of advanced Fibonacci Retracement Analysis to implement, so you will need to reread this after D-Levels™ are covered. Some of the terms, of necessity, must be broad.

1. Like the Double RePo, the Bread and Butter must have a minimum of 8-10 periods of thrusting market action. More is better. Just what constitutes thrust is far easier to visualize than to define. This is good news, since it will make it tough for programmers to specify. Therefore, it should continue to "work" for some time to come.

ENTRY

STOP

CHART 6-13

2. After the initial penetration of the 3X3 on close, look for an intraday Fibonacci (support) retracement level, at a significant Fibnode, to enter the market in the Direction of the original thrust. This level should occur within one to three periods of the initial Confirmed break of the 3X3. I recommend daily, weekly, and monthly periods, although this strategy will also have merit on intraday charts. The retracement Fibnodes which are the basis of your entry as well as your stop, should be calculated from the hourly (and higher) Time Frame charts, if you use the periods I suggest.

3. Once the trade is entered, set your stop loss beyond a deeper Fibonacci retracement level, and your profit objective a bit before the 618 retracement '*' of the entire contra move, i.e. the move that is opposite the original thrust.

Let's take a look at the monthly gold Chart 6-14, as an example of our buy and sell points.

CHART 6-14

Before you have a coronary over the prospect of that $200 stop, let me point out that this is a theoretical example. It could be made practical, however, if we used the monthly Direction for weekly-based mutual fund switching or even daily based Fib entry. Context! Context! Context! Plan your trades as you would any other important financial endeavor. I'd give you more examples, but we haven't covered how to arrive at the Fibonacci entry and stop levels yet, so the exercise would have limited relevance.

Before we leave this topic, however, let's look at our friend Microsoft, Chart 6-15. time we'll view it in a monthly Time Frame.

This

There's no inconsistency in being a seller on a weekly Double RePo, as discussed earlier, closing the trade at the Logical Profit Objective shown in Chart 6-6, and then being a buyer based on a monthly Bread and Butter signal. If this seems inconsistent to you, you don't fully understand price vs. time charts or Time Frames. A review of the Trend discussion in CHAPTER 2 may help.

CHART 6-15

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CHART 6-16

Notice how the monthly MACD Confirmed the ongoing monthly up trend, while the Stochastic gave us a great buying opportunity, once the profit objective shown in Chart 66 was reached.

Note the consistency between the Bread and Butter monthly buy and the MACD shown above. What is not shown is a daily Double RePo Look-alike on the buy side that occurred at the same time! This is what highprobability trading is all about!

PATTERN FAILURES:

The idea behind these directional signals is not to follow everyone else, but rather to fade those pattern players when you are sure they are wrong. Typically, newer traders are looking at the standard Robert Edwards and Magee trading patterns1 for trading signals. They make an excellent group to feed off, if you can determine what they are doing and when they are likely to panic. These signals work best when these traders have the time to get in the trade the wrong way. That's why I look at daily, weekly, and monthly pattern Failures. While the higher Time Frames hold the more secure probabilities, some pretty dramatic results can be achieved from certain intraday pattern Failures.

THE "HEAD AND SHOULDER FAILURE":

CHART 6-17

The above idealized example illustrates a clear H&S with a break of the neck line, a bit of consolidation below it, then a close back above it. The subsequent action is expected to be strongly up because the short selling pattern players are caught wrong, and must

1 Robert Edwards and John Magee, TechnicalAnalysis ofStock Trends unwind their positions. The lower portion of the consolidation after the break of the neck line may be supported by a significant Fibonacci level. If it is, you will have some advance warning that a Failure is coming and you can enter according to the Fibonacci tactics taught in CHAPTER 13. It isn't necessary however, that such support causes the subsequent Failure. What's necessary is that (he Failure occurs. Anticipate this pattern at your risk. If you anticipate this signal before it crosses the neck line, you will be trading against a classic pattern and you would also likely be against the prevailing trend. Remember, you are not taking the classic sell signal, rather the Failure (buy), if it happens.

CHART 6-18

The bond weekly Chart 6-18 shows a picture perfect example of this phenomenon. We have strong Fib support below the neck line. Time for players to "get wrong" (two to three weeks) followed by a subsequent sharp move up, trapping those pattern players. This weekly action would be the set up for the trade. You would enter on the daily Time Frame.

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CHART 6-19

The daily chart illustrates how powerful and rewarding this signal can be. The idea is to drop your Time Frame to enter the trade, once the setup is apparent.

If you are observing the pattern Failure on a weekly chart, you can enter on the daily. If you are observing the phenomenon on the daily, enter on the hourly. The specific entry techniques you would use will be covered later in this book. If you hesitate, you can easily get left behind!

NOTE: These types of pattern plays are particularly rewarding if they are widely promoted in a specific market, particularly on TV programs, or in a widely-followed newsletter, or fax service.

THE "TRIANGLE BREAKOUT FAILURE" OR "OOPS":

CHART 6-20

The Triangle Breakout Failure or OOPS can take a variety of forms. The key is that traders have recognized that the triangle pattern exists and they have had time to act on it, thereby getting in the wrong way. It can't be too subtle. All the same reasoning applies as with the Head & Shoulders Failure.

"FADING POPULARITY" OR "THE VULTURES DELIGHT":

In the early 90s, when Candlestick charting was new in the U.S. and aggressively promoted, I had a studious client call me whenever the strongest of the Candlestick signals occurred. I never took any of the signals. I simply asked him, as a dedicated devotee of Candlestick patterns, when his Directional signal would indicate that he was wrong. That was my Directional signal. Soon he understood what I had been trying to teach him about how powerful Failures can be.

THE "RAILROAD TRACK":

This is a top notch Directional signal that can occur in any Time Frame. Its wide applicability is likely responsible for the glowing comments from my clients. It's as easy as it gets to apply and profit from, with a minimum of effort. For those of you who have studied Steidlmayer's work 2, the Market Profile®, and understand "rejection of price," the underlying concept of why this works will be apparent. To those of you who are unfamiliar with these concepts, just imagine a half a dozen ocean-front homes in Santa Barbara, California suddenly going up for sale at $100,000 each. Boom, they're gone. Professional investors and Realtors snap them up and the price is back to the more normal range, perhaps higher since overhanging supply is now absent.

The idealized Chart 6-21 depicts a typical Railroad Track. With the extensions down as shown, we would expect a strong up move. Notice how the extended two bars are out of close proximity with the others bars. We call this "Railroad Tracks in the country", i.e. nice, scenic, and pleasant. Railroad tracks in the city are congested, unhappy events, potentially dangerous to cross, smoggy, and unsightly. As futures traders, what we want is space around the Railroad Tracks we select to trade. For rejection of price, we need price that is not common.

The Railroad Track (RRT) can take place in any Time Frame, from five minute to yearly. It is one of two directional signals which allows you to adjust the Time Frame to any desired amount. In other words, you may cause the data to fit into our perception of usability, by adjusting the Time Frame. So, let's imagine some variations that will all work, since they all represent the same phenomenon.

2 J. Peter Steidlmayer and Kevin Koy, Markets & Market Logic, (The Porcupine Press, 1986)

CHART 6-21

RAILROAD TRACK

NO CONGESTION

BUY STOP THE HIGH

BUY A SHALLOW RETRACEMENT

RAILROAD TRACK

NO CONGESTION

CHART 6-22 (TWICE THE TIME FRAME)

Chart 6-22 contains exactly the same data as Chart 6-21, only it is shown at twice the Time Frame. If Chart 6-21 was a half hour chart, Chart 6-22 would be an hourly chart. If Chart 6-21 was an hourly, 6-22 would be a two hour chart. The RRT phenomenon works exactly the same, since the price action is exactly the same. It just looks a little different.

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