I
thought it would be helpful to
analyze a recent trade that I put out in my March
2 Commentary on Nokia (NOK | Quote | Chart | News | PowerRating). We will take you through the
process that I used to select Nokia as a pattern setup. The procedure
begins with stock selection, pattern identification and entry. This is a
good example that demonstrates multiple patterns and how to select the
earliest entry for a high probability trade.
Stock
Selection
Pattern
Identification
The
first thing I look for in selecting a good pattern setup is a stock that
has pulled back at least three days, closed above the open and above
the midpoint of its daily range. Ideally, the stock should close in the
top 25% of its range. An exception to closing above the open would be if
both the open and close were in the top 25% of the range and the close
was slightly below the open.
Having
looked at thousands of charts over the years, I will tell you that the
most frequent pullback in uptrends are 3, 5, 8 and 13, which are Fibonacci
numbers. The next most frequent is 7.
For
short-term trading, we are looking for pullback to no lower than the
50-day EMA. The strongest stocks will trade above the 20-EMA.
Looking at the daily chart
below, of Nokia (Figure
1), I see the following indications of a high probability
trade.
- Three-day
pullback (PB) to the 20-day EMA in
an uptrending stock. (You count the days by starting with the
current day or the day preceding it. If you were looking for shorts,
it would be the subsequent day. A five-day pullback had preceded it
to give you an example of how to count.)
- The third day of the PB
closed above the open and exactly at the top of its range. I also
observed that the prior two days closed in the top of their ranges
and above their opens, despite having lower lows and lower highs.
This was positive and indicated a market-related PB and not much
selling pressure by the Generals. Volume was basically neutral.
- The third pullback day was
a narrow-range inside day which in itself is a pattern. It was also
the narrowest-range day of the past 15 days. Volatility had
contracted and this usually precedes explosive moves in either
direction. In the case of Nokia, you would only take the trade in
the direction of the trend, which is obviously up.
- Looking at the stock's
activity for March 1, which is the narrow-range day labeled #3, I
see the following: Open 199.50; High 201.50; Low 198.50; Close
201.50. Entry is planned on March 2 at 201 5/8 (or slightly above,
if needed) which is 1/8 above the previous day's close.
Nokia opens on March 2 at
200.50, with an intraday low of 200.375. You get trade-through entry at
201.625 and the stock traded to an intraday high of 215.875.
When you are looking for daily
entry
after a pullback, you want to enter on the change in direction, which is
usually above the previous day's high. Nokia exploded after entry at 201.625 on
excellent volume and a wide range bar expansion (WRB) to new all-time
highs. The follow-up day to the WRB also gave you good entry and a
multipoint move.
For those of you that read our
trading guidebook, you will recognize this pattern as a 1,2,3,4 setup
which has two lower lows and an inside day. This is an excellent pattern
in itself as it got you in at the earliest change in direction.
The key point is to enter on
the change in direction because not all tradable pullbacks fit a pattern
mold.
Figure
1. Nokia Daily Chart.
The
following charts of Cisco (Figure 2) and BEA Systems
(Figure 3) show very clearly the most
common pullback days in strongly trending stocks.
Figure
2. Cisco Daily Chart.
This is an
excellent chart to see the 5, 8 and 7 day pullbacks. X1 is a swing point
low and A5 is a five-day pullback to the 50-day EMA. Cisco made a strong
reversal off the 50-day EMA, closing above the open, at the top of its
range, above the prior day's high, above the previous three closes, and also above the 20-day EMA. This is
a powerful reversal. It is also a key outside reversal day. The next day
was a multipoint move with good entry.
Cisco
rallied to X2 of 139 from X1 of 100, before retracing eight days to B8,
still managing to close above its 20-day EMA.
The
move from X2 to B8 retraced .41 of the X1 to X2 top at 139 before
exploding to new highs the next day. Cisco didn't close in the top of
its range or above the open on B8 but the next day (Feb. 23) it opened
at 127 up 3 points, which was right at the previous day's
high of 127 1/16. It only pulled back to 126 5/16 intraday before
reversing the 127 1/16 high and trading up to 139. The S&P futures
were strong pre-opening and it was a strong rally day for the S&P
500.
Following
the WRB explosion to new highs, Cisco consolidated in a seven-day
pullback to C7. All the bars were within the
wide-range bar (WRB). C7 closed in the top of its range, above the open
and above the 20-day EMA. The next day was a multipoint move on a
pullback entry after a gapped open.
BEA
Systems
This chart gives
you a different look at a combined five-and eight-day pullback, but ends
the same way, giving you good entry and a multipoint move.
Figure
3. BEA Systems Daily Chart.
X1 was a
significant low (68 7/8) and a five-day pullback to the 50-day EMA. It
rallied to the X2 high of 157.75 without any pullback until the WRB key
reversal day at X2. BEAS had a five-day pullback (B5) on wide range bars
with the last three closing in the bottom of the range. The stock held
above the 20-day EMA. This five-day pullback retraced .44 of the X1-X2
move.
After three days
of consolidation, the eighth bar (C8) closed above the open, above the
previous day's high, above the previous four closes and in the top 25%
of its range. This stock gave you multiple indications of a high-probability trade. The previous day's high was 131 1/8, so in your
trading plan, you set entry at 131 1/4. The next day you got a
trade-through entry and BEAS traded as high as 138.
I tried to have
you look at the pullback trades through my eyes and thought process. You
must cycle through the daily charts every day to find these patterns. I
suggest you start looking at the high RS and EPS stocks that have closed
in the top 25% of their range and have had an increase in volume over
the previous day.
The following
charts highlight the multiple patterns in Nokia that were in place at
the same time we took our entry in Nokia at 201.625.
The chart below
of Nokia (Figure 4) is a Three-Week
Symmetrical Triangle with four defined points that is an excellent
pattern. Longer-term players might have waited for the break out around
206 before entering the trade.
Figure
4. Nokia Daily Chart.
The next chart
of Nokia (Figure 5) illustrates an Ascending
Triangle which is only because you
prefer to look at it that way. This is also a breakout that is just a
touch above the symmetrical triangle.
Figure 5. Nokia Daily Chart.
Another trader
might have looked at the Nokia chart and seen it as a Cup and
Handle (Figure 6).
The retracement down from the high was on declining volume and it picked
up a bit, forming the downward pullback handle.
Figure
6. Nokia Daily Chart.
The next pattern
(Figure 7) is a strong favorite of mine because it leads to explosive moves after a
breakout of this Dynamite Triangle. The day preceding the breakout is
usually a narrow-range inside day with a stop right below the low of
that day which gives you a high-probability trade with excellent risk
reward. Following the breakout, you often get a good move from two to
eight days.
Figure 7. Nokia Daily Chart.
I hope you will
benefit from this Trading Lesson because profitable trading is, in
essence, based on price relationships that put you in high-probability
situations.
If you have any
questions regarding any of this material, please feel free to email
me with your questions.
