Rookie Corner : Technical Tango Part V
We should by now have a very solid understanding of support and resistance at this point and we now know that we must find meaningful important levels on which to find high probability trades. Now, we are moving on to the concept of pattern recognition. The four basic patterns that we mentioned last week are the basis for building a solid trading business. These technical patterns repeat themselves over and over again and we can use this to our advantage by training our brains to recognize these patterns in advance and then making sure all the pieces are in place before making a trade. Performing our technical analysis in this way gives us an edge in trading and that is the most important thing in trading if you don’t have an edge then the other side of the trade does. If you can’t put the odds in your favor then the probabilities of trading will eat you and your account until there is nothing left.
This week we are going to look at the first technical pattern. That pattern is the Bullish Retracement. We talked about how an uptrend consists of higher highs and higher lows but we also understand that nothing goes straight up or straight down in the markets. It’s these little pauses in the upward movement that we can exploit. For a bullish retracement to be legit it must have the following features.
The first feature we need in a bullish retracement is the most obvious of choices, we need an uptrend. We talked about what an uptrend is and we can easily understand that without an uptrend then it would be very hard to get a pullback or retracement. A question that one may have is…will any old uptrend do? That is a great question. We are not looking for a garden variety uptrend, we are looking for very solid uptrends only! The next logical question is what is a solid uptrend? A solid uptrend is an uptrend that is expanding between pullbacks. What that means is that the uptrend is getting a bigger run each time before it pulls back. Some folks call this increasing momentum and this is ideal. You may not always find this expanding momentum but we definitely want to look for that and only default down if we have to.
This chart is that of United States Steel, symbol X. I have out a yellow line over the momentum that we are looking for. This momentum gives us an indication of strength and it will help us when it comes to a continuation of a trend. You can see from the yellow lines that they are getting longer and this tells us that this trend has some juice!
In addition to the expanding momentum, there are other features that we need to have a good bull retracement. As obvious as us needing an uptrend we also need a retracement to have a bullish retracement. It’s easy to remember what we are looking for because it’s in the name of the pattern. For us to have a retracement we need a certain number of down days in an uptrend to be considered a pullback. The bare minimum is three down candles. Pullbacks can go much deeper than three but that is the least we can accept, everything else is just noise in the markets. Much like when we are looking at an uptrend and we are looking for expanding momentum, in a retracement we are actually looking for it to slow down before we get involved. This makes sense if you think about it like you are driving a car. If you were following someone in your car and they made a turn you would expect a few things to happen. First, you would expect that person in front of you to slow down and then possibly signal before they actually turn. This brings us to the next thing we need for a bull retracement, that is we need a signal that it is ready to revert back to its uptrend. That signal is a reversal type candle.
There are several different types of candles that can signal a reverse is likely. Some of the most common reversal candles are the doji candle, the hammer candle, and a bullish engulfing candle pattern. Below is an example of each of these candles. These setups can give us an indication that an equity is ready to turn around. This is not foolproof but does occur enough times that we can use to our advantage.
There are two more items that can help us find a good bullish retracement. Those two items are declining volume on the pullback and also pulling back to a support level. If you are able to put all these things together then you will be looking at a higher probability trade setup and that is what we want when we put our hard earned money to work for us. So remember, for a bullish retracement we need an uptrend, a pullback, expanding momentum in the uptrend, declining volume and momentum in the pullback and a reversal signal or candle to let us know that it could be ready to reverse back us to the upside.
Next week we will look at the bullish breakout, we will make sure that we understand all the nuances of each pattern so that we can get into a groove when doing our technical analysis and put ourselves in the best position to be successful!