This is the first in a series of lessons that will take you through some specific trade logic that helps you identify high-probability trading opportunities.

In this lesson, I will show you a sequence in the DIAs (proxy for the Dow Jones 30) from the September 1998 low of 73.875 to a recent buy opportunity as the DIAs formed a defined triangle pattern as volatility contracted.

You will see the following key factors in evaluating trades: RSI Divergences, Retracements, Trendlines, Patterns, Multiple Time Frames, Volatility and Same Index Same Stock.

I will start with the weekly chart of the DIAs that has both a 10-week and 30-week EMA in addition to RSI 14 period. (See Figure 1.)

Figure 1.

The DIAs rallied from the 9/98 low of 73.875 to Peak 1, 111 1/2, on confirming RSI. It is when the DIAs made three drives to a top at 113.75 that you identified the negative RSI divergence. The three drives to the 113.75 top was in conjunction with a lower 1, 2, 3 sequence in RSI which is a strong negative divergence.

Institutions are very aware of stocks with these longer term divergences and will usually take action. Peak 3 at 113.75 was still above both its 10- and 30-week EMAs. When you got the third peak, you drew the trendline from the 73.875 low through the low preceding the 113.75 peak which was essentially a one-year trendline. The breaking of this trendline was an excellent short entry in the DIAs or a similar stock with the same pattern.

After the isolation of the trendline, you would determine the retracement (Fibonacci) levels which would be alert levels to closely watch for a change in direction. Frame the DIAs from 73.875 to 113.75 gave us alert zones of .38 98.60, .50 93.81 and .618 of 89.11. The DIAs hit a bottom at 99.56 almost exactly at the .38 level. From there, they rallied to a new high at 117.50.

The rally back above the 10- and 30-week EMAs was confirmed by a rising RSI which had broken its downtrend line but at the 117.50 new high there still existed a negative divergence in RSI as you see on the RSI chart from Peak 1, to where the RSI is labeled 117.50 high.

Once the DIAs traded above the 113.75 peak, it set up a potential 1-2-3 reversal top which is an excellent pattern to get you in a high-probability trade. The explanation of a 1-2-3 Reversal Top is located on the site under the Pattern Section.

Higher highs on declining RSI on weekly charts is the key for identifying this pattern. When the DIAs traded back down below the 113.75 peak, you would take selling action but definitely when the DIAs recrossed both the 10- and 30-week EMAs on the downside.

What you should do in this scenario is frame the DIAs from the 73.875 low to the 1,2,3 Reversal Top at 117.50. This gave you a .38 level at 100.92, .50 at 95.68 and the .618 at 90.54 that you see on the chart.

The DIAs made a bottom at 96.84 just above the .50 level of 95.68 then proceeded to rally taking out the previous 99.56 low (see chart).

From the 96.84 low, the DIAs rallied to 114.53 and that is where the contraction of volatility started forming two well-defined patterns. On the chart, you see the larger symmetrical triangle that formed with the upper line drawn from the 117.50 top through the 114.53 reaction top. A breakout of this top would be above 110 to the upside. Within this larger pattern, a smaller narrow-range triangle formed with the upper line drawn from the 114.53 peak. A breakout from this pattern was above the 105.75 - 106 level which in fact would re-cross both EMAs to the upside, which is positive. This pattern is an excellent situation for a straddle that would be actively managed on the breakout.

As you identified this pattern on the weekly chart, you should see what's going on with the daily chart. (See Figure 2.)

Figure 2.

Looking at the daily chart of the DIAs, you see that a similar narrow-range triangle right at the 50-day EMA and just below the 200-day EMA had formed. You would also have observed that the daily RSI was rising prior to the breakout from this pattern, as it was on the weekly chart. Looking at the daily chart, we see that the Bollinger bands (13 period, 2 ST deviation) had narrowed to its tightest level in some time.

The stage was now set for a very strong move of some duration. The setup day on the daily chat was 6 (July 6) and you entered at the 105 7/8-106 level on July 7, which took the DIAs above the 50- and 200-day EMAs, at the same time breaking out of the smaller weekly triangle pattern. As you can see on both charts, the price breakout was conferred by RSI breakouts.

In order for an index to form a defined pattern, it means that some stocks within that index would have a similar narrow-range pattern. In this example, we are looking at the Dow Jones 30 stock index, so we look to those 30 stocks for a pattern. My next thought is to look for an uptrending stock above both its 50- and 200-day EMAs and heavily overweighted by the Generals.

Looking through the charts, you find General Electric (GE | Quote | Chart | News | PowerRating) which is in the top 10-15 holdings of all the large mutual funds. It had an excellent narrow-range-triangle pattern above its 10, 50 and 200-day EMAs. (See Figure 3.)

Figure 3.

As you can see on the chart, GE had a WRB (wide-range expansion bar) on significant volume at month end June 30 (report-card time), then contracted as the RSI was rising. July 6 (6) was a three-bar pullback after the range expansion and on July 7, the DIAs broke out of its triangle pattern. Entry in GE should have been taken above the July 6 high of 51 as it crossed above its 50-day EMA of 50.80 on July 7 (7). July 8 gave you another good trade, entering above the July 7 high of 51.50.

Figure 4.

Whether you took the DIAs, GE, or both, it was an excellent opportunity for a day trade, position trade, or combined.

I hope by outlining the thought process used to evaluate the current status of an index or a stock, it will enhance your ability to identify high-probability trade opportunities.

Key Points to Take From This Lesson

• RSI negative and positive divergence
  

• Trendline confirmation
  

• Defined patterns in multiple time frames
  

• Retracements are key alert levels
  

• Identify strongest stock with same pattern as index (reverse for sells)

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