Quick Observation on This Week's News Events

In regard to this week’s news flow, apparently the market doesn’t think whatever it was that went on in Syria matters for US corporate profits. At the onset of the bombing Thursday evening S&P500 Futures fell 20 points, but within a couple hours prices had completely reversed and were nearly flat on the session. We also saw a softer than expected Jobs Report for March. With the combined military action and weaker than expected economic report I would have expected the market to be lower by at least 1%. That simply wasn’t the case at all as for most of the day prices flipped into the green multiple times and ended flat on the day.

It is some very interesting price action we are seeing. Nobody is committed to selling this market. In the face of bad news on multiple fronts it simply shrugged and relatively strong stocks continued to rally. The recent action overall has been softer for the past month, this “event” seemingly should have caused raucous noise and very volatile trading, yet it didn’t. Be sure to note that behavior. It is suggestive of great strength in the underlying price action. 

Retests or Bull Traps?

Something we always need to watch out for are when bullish patterns go through their inevitable pullback/retests; we want to watch that the pattern formation doesn’t fail. Pullbacks and retests are very normal price behavior following breakouts and rallies. They are normal so long as the pattern doesn’t break and set a lower low.

When bullish patterns trigger we expect price to remain firm and hold the higher swing low created by the new breakout. If the pattern is to stay intact price will resume higher after the period of consolidation.

Take a look at CLF as an example of this:

CLF Weekly 

Since the trend reversal in early 2016 the stock has been in a steady trend of higher highs and higher lows. The stock pulls back into the rising 20 Week SMA and then resumes higher with a strong reaction breakout. Each pullback forms a higher swing low compared to the prior low keeping the pattern valid.

Currently we are seeing the fourth such pullback since 2016. What we need to watch for is does CLF hold the prior low near 8.25 and resume higher with another breakout (as it has done each time in this rally) OR does this pattern fail by breaking through the prior low?

Unfortunately, we don’t have a crystal ball so we can’t know with certainty whether this is the time the pattern fails or if it just resumes back higher like the previous instances. What we can do is identify character change in the market. For more than a year CLF has rallied, tripling from the first bull flag signal in April 2016 ($4 to a high of over $12), the trend of higher highs and higher lows has remained intact this whole time. If this trend were to change and price makes a lower low, we will have proof that something is changing. Maybe it’s a temporary change or maybe it completely reverses the new positive trend, we can’t know that either.

 It is our job as risk managers to avoid the situations where no pattern exists and to stick with those that do. As long as CLF can maintain its recent higher low the pattern will be intact and we will stick with the bullish pattern. If it fails we will stop out and take our gains. 

Keeping the signals and strategy simple is what gives us our edge; being able to identify with clarity what the situation is at any given time helps align us with the market. We need to be watchful of these changes in character. The individual stocks will give us the early indication of the overall intentions. When we begin to see many bullish trends fail we know that the underlying support for the market is weakening. Until the patterns break however it means we need to stick with the market as the overall trend remains intact. 

Fractal Trading Using CELG

You may have heard before that markets are "fractal". Well what does that mean and how do we apply it?

A Fractal is defined as: a curve or geometric figure, each part of which has the same statistical character as the whole. Fractals are useful in modeling structures (such as eroded coastlines or snowflakes) in which similar patterns recur at progressively smaller scales, and in describing partly random or chaotic phenomena such as crystal growth, fluid turbulence, and galaxy formation.

Simply put patterns in nature seem to repeat in similar shape or dimension on any scale. We see this fractal behavior occur in financial markets as well. Seeming chaos can actually be reduced to simple patterns that play out across multiple timeframes and in different magnitude.

For an example of this phenomenon lets take a look at Biotech giant Celgene (CELG):

Monthly

 On the long-term Monthly chart we can see this "flag" like formation following a strong rally. After the stock moves higher it undergoes a period of rest in an orderly and somewhat "flag" or triangle like pattern.

Weekly

The Weekly chart zooms in on the larger Monthly pattern and we can see following the sharp November rally price then underwent a rest period in a similar "flag" shape as the larger pattern above. 

Daily

 Taking the timeframe down a step further to the Daily it shows another sharp rally to end January and is now in a period of rest in a similar pattern.

Hourly

 Finally zooming into the intra-day action on the Hourly chart we can see today's action with a sharp rally at the open of trading and then a rest period for the remainder of the day. 

This "flag" pattern is not unique to the fractal phenomenon, there are many other examples of how patterns repeat across all timeframes in financial charting. But it should be noted that any of these formations can be traded within their own time periods for similar relative results. 

I prefer to use these patterns as confirmation of each other. When I see a stock displaying similar behavior on all major timeframes it gives a hint to how it will trade moving forward. None of this is directly predictive but it gives us a method for managing risk and making effective moves within a seemingly meaningless set of lines on a graph. 

In this game pattern recognition and risk management are the two most important aspects of success. It is critical to understand how prices behave across multiple timeframes and how to position in sympathy with that action until it changes.
 

Home Depot "Higher Range" Base

HD Weekly

Home Depot has been in a fairly wide and loose weekly trading range since the end of 2015. Each time price has reached the upper end of the range it has reacted lower, leading to a deeper pullback. 

Over the past several weeks however as price reached the upper range resistance it did not turn lower. In fact the stock held rather tightly against the resistance level and this past week powered to new Weekly closing highs. 

This behavior by the stock is what I like to call a "higher range base", meaning the stock is trading in a larger defined channel, but instead of continuing to move from the upper range to the lower it stops and settles near the highs. What this new price behavior tells me is that the stock is now comfortable with the higher price level and is due to resume an upside rally. 

The Higher Range Base is a symptom of a strong underlying bid for the stock where any viable sellers have already made their moves and are now giving up. The stock simply will not sell off anymore at this level and appears to want higher. 

UNP Rhyming like its 2010?

I can't help notice that the setup in Union Pacific is oddly familiar to how it looked in 2010 following the '08-'09 bear market. The rally following that bottom reversal was nearly a 4x gain from the March 2010 buy signal. It appears a similar setup is in place once again. This doesn't mean it will rally to $500, but to ignore the pattern may be costly.

Monthly chart '07-'10
with MACD and Fibo of pullback

Monthly chart '15-'17
with MACD and Fibo of pullback

In both cases the stock endured a sizable correction for multiple months. As UNP began to recover to the 61.8% Fibo retracement of the correction the stock put in a few month base and then broke above the Golden Ratio line. When that resistance is broken I find it becomes a high probability trade for the stock to drift toward the prior high. In UNP's case it tends to trade back to the correction highs and then substantially higher. This pattern has repeated multiple times since the stock has been trading.

Something I look for when determining risk/reward is the position of the long-term MACD. Certain patterns in the indicator are more favorable to large rallies than others. Identifying when these patterns are in place can improve accuracy and returns over time. Just as food for thought, compare in both cases above how the Monthly MACD was positioned just prior to the large correction and how it then looked once the new buy signal took place. The posture of momentum looks very different currently to how it looked at the top before rolling over. This is what we try to identify, are we buying a stock closer to its top or closer to its bottom? I think the case is quite clear here.

Consumer Discretionary Looks to Have Some Mojo

When looking for setups I like to see multiple timeframes aligned supportive of the same conclusion. Consumer Discretionary stocks (XLY) appear to be in position to rally substantially from here. I know, I know the market is extended too far for any more upside to occur and we are going to crash any day now. Well quite frankly underlying Sectors and stocks don't suggest that posture currently.

Looking at XLY on multiple timeframes it has the structure in place to put the risk reward in our favor.

Monthly

The setup always should start with the Monthly chart. The structure here is very positive. Price continued to test the 81-82 resistance for much of 2015 and then all of 2016. Each test of this resistance was followed by a "higher low" pullback. As they say, the more times a level is tested, the more likely it is to be broken. This works for both support and resistance.

Each time a resistance level is tested people sell the stock because that tends to be a high probability trade, to sell into resistance. Every successive test of the level fewer and fewer sellers exist at the area, supply of the stock is drying up. This also works for buyers at support levels; when a stock trades down to a support level new buyers step in. Each time the stock returns to the support fewer and fewer buyers want more of the stock because they are simply running out of money and patience with a stock that makes little headway. Eventually demand becomes weakened and the stock breaks down.

I prefer to trade at the areas of support and resistance where the imbalance shifts. I'm always watching for the place where sellers wear out and also where buyers breakdown. The momentum that can follow such a change in trend is often very powerful.

Currently XLY is in the process of expanding higher after sellers have weakened.

Weekly

Another key principle of supply and demand is once a level is broken it tends to act as a new floor or ceiling for prices on subsequent tests. This is called polarity and a throwback or retest of the prior breakout should hold this new level.

XLY made multiple peaks over the past 18-months and in November broke through those highs, shifting the balance between buyers and sellers. Buyers are trying to take control of the stock and change the intermediate-term trend.

At the end of the year price revisited the prior resistance level but coming from above resistance rather than below. The first week of January showed polarity as buyers stepped in to support the stock and confirmed the change in trend. A bull flag pattern was triggered and this week we saw initial follow-through on that pattern. This is a high probability pattern and should not be ignored.

Daily

Gap resistance from December which contained the price action for the last 4-weeks has now been reclaimed with this Friday's firm move. Thursday was a Hammer bar off the 20 Day SMA and Friday's follow-through confirmed the rejection of lower prices.

Hourly

If we zoom into the intraday action on the Hourly chart we can see the structure of this "retest or throwback" move. The action has formed yet another bullish pattern; an Inverse Head/Shoulder formation is now in motion which adds additional confirmation to our bullish thesis.

It is a very good sign when price patterns on multiple timeframes all confirm the same thinking. We always want to see this alignment. It doesn't mean prices have to go higher, but the odds tip considerably in our favor when they do so.

Trading Goals for 2017

When setting goals for a new year it is most helpful to set attainable goals. It is important to be realistic of what we can reasonably control and what we cannot. For example a realistic trading goal for 2017 is "I want to place even more emphasis on identifying higher quality setups". An unrealistic goal for 2017 is "I want to make 30% this year". Maybe we will make 30% profit this year, but that is not exactly in our control, and if we fail to achieve our goal it would be seen as a disappointment. We have no control over what the market may or may not do in the new year. What we do have control over is how we will respond to its signals along the way. I can't control the number of opportunities that will present themselves, but I can control the quality of setups I choose to take. That is a realistic market goal

My Trading Goals for 2017:

-Focus on finding value setups during normal sector rotations

This is something I try to do anyways but also feel I can improve my patience and focus to exploit the best risk/reward scenarios even more efficiently. What I want to look for are stocks that have Monthly uptrends (the price is trading at or above its rising 20 Month SMA), but have pulled back for multiple months to fill the "air" between price and the moving average.

Most of these moves will appear to be from weak or lagging groups, the financial media and shorter-term traders will be bearish, yet the stock will simply be undergoing a very normal rotation back to its long-term trend average. This is where we want to be hunting.

-Focus on using multiple timeframe analysis to really drill down into a potential blooming trend

I generally look at multiple timeframes when following a stock. But in the past I have been more hesitant to really begin to build a position based on these more speculative short-term setups. In 2017 I want to utilize the shorter-term charts more to kick-off new positions.

How this would look for example would be when I find a stock with "value" (see above) on the Monthly chart within an uptrend, I will then look to the Weekly chart for any possible bull-flag consolidation or inside bar. Then move down into the Daily/Hourly charts for the most specific turn in the action. I may be looking for a gap reversal or a very large candle that rejects lower prices and ignites a fast turn in the direction of the long-term trend. I will try to "get a piece" of the position on any notable reversal and then look to build that position with a follow-up buy or two as the higher timeframes begin to confirm the setup with their own reversal signals.

If we can accumulate these Monthly pattern turns as they emerge on the shorter timeframes and then add to the position once the Weekly/Monthly resume the prior trends, there will be a lot of money to be made with strong risk/rewards.

-Stick to my process of cutting losing trades fast and keeping risk/reward in my favor

This goal is all about my discipline to stick to my plan, don't hold and hope with losing trades, and seek the strongest risk/reward trades as possible. Following this goal is the most important part of my potential success in the new year.

We traders are nothing without our process and discipline. We need to be able to ignore noise suggesting that we alter our strategies in the face of volatility, and we need to listen to the market as best we can because the market is ultimately what pays us. Our opinions, research, news flow, macro-headlines do nothing for our bottom line. We can have all the opinions in the world, can research a stock for days and days, but if the market doesn't go along with our plans we will lose money. Its that simple.

Those are my trading goals for 2017. I hope you can create attainable goals that focus on your own process as a trader. The purpose of this exercise is to recognize your inherent faults and where your process could use improvement. None of us have all the answers, we all have plenty to learn. But only by attempting to make yourself a better participant can you have any hope of achieving long-term success.