When to pull the trigger on a trade

Swing trading is very much like a hunter stalking a prey. You need to tread carefully and only fire when the prey is well in your sights with little chance of missing.

Because a hunter has a rifle and knows there are deer in the vicinity, that doesn’t mean he or she can open up on anything that moves. That would be a waste of expensive ammunition!

So it is with trading. Shooting off trades willy-nilly is a guaranteed way to waste your trading funds (ammunition). Like a hunter, your trades must be stalked and then you open fire only when there is little room for error.

So today, I want to take you through this process by showing you a trade I am stalking in the Dow.

Markets rarely cooperate

On Wednesday, I offered my best guess for the Elliott waves in the Dow:

Dow Jones spread betting chart

I had already identified the wave 1 as an impulsive five-wave move with an extended fifth wave. The rally off that low was in a clear A-B-C form with equality of the A and C waves. The scene looked set for an immediate resumption of the downtrend.

But markets are rarely so cooperative! We often find twists and turns that spoil the expected immediate outcome. And so it was after I wrote Wednesday’s post. The huge rally that day caused me to amend my Elliott wave labels, but it still hasn’t erased the message of the original five down off the 14 May high.

And that message remains that with high probability, the top is in and rallies are counter-trend.

Where is the market headed?

There are two candidates for my best guess of where the market is headed.

Here is the first (and my favourite):

Dow Jones spread betting chart

This was the picture yesterday morning. The move down to last Thursday’s low is a valid impulsive five waves down and now the relief rally is a large A wave (which contains my original A-B-C). The new low is a B wave, and the rally to yesterday’s high is my C wave. This is also a valid Elliott wave count.

When I took that screenshot yesterday, the market had retraced a precise Fibonacci 62% of the entire decline to the B wave low. This is the most common place where relief moves terminate and that gave me confidence the rally had stopped there.

This was a natural place for me to enter a short trade, expecting the decline to resume.

My protective stop could then be entered very close to entry and placed a few pips above the Fibonacci 62% level for a very low-risk trade. Remember, I am only interested in trades where I can enter a close (and logical) stop. That is a key requirement. The prey must be well in my sights!

Also, the C wave was a five-wave affair with a good negative-momentum divergence at the fifth wave. Here it is in close-up on the 15-minute chart:

Dow Jones spread betting chart

And even the third wave contains a clear five sub-wave pattern, as per textbook.

The market was retreating from the Fibonacci 62% level and the trade was going to plan.


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Surprises can spoil the party

We must always be alert to surprises when trading – and sure enough, the party was spoiled later yesterday by the appearance of a rally, just when the market appeared ready to collapse.

Here is the picture this morning on the 15-minute chart:

Dow Jones spread betting chart

If the Fibonacci 62% level will hold, then the market will start to move down off current levels. A move below yesterday’s low would confirm this picture.

But because of the spike move yesterday, which shows up well on the chart, good buying entered at that point, and that may be enough to propel the market up to the next Fibonacci level, the 78% level.

Be prepared for anything

This is my second option:

Dow Jones spread betting chart

I have re-labelled the five waves down. The rally off wave 5 is an A-B-C with wave C in progress.

If the 62% level is breached, the next target is the 78% level – or perhaps the 2/3 level – and if a negative-momentum divergence appears at that point, that would most likely indicate the rally termination.

That means of course, that my protective stop would be hit and I would suffer that loss – albeit a planned small one which is well within my 3% rule.

So now, I have to wait for what the market offers up. But I am prepared for any eventuality – and that is what a trader must always do.

Trading on hope is all too often the style adopted by many. This is a formula for failure. Hope springs eternal in most areas of life, but not in trading.

Incidentally, no deer were harmed in writing this post.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading
Advanced tramline trading
An introduction to Elliott wave theory
Advanced trading with Elliott waves
Trading with Fibonacci levels
Trading with 'momentum'
Putting it all together

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2 Responses

  1. 23/05/2014, adatherton wrote

    Superb analysis John, and the DJIA should indeed have reversed at the 61.8% fib, but for another dovish FOMC. I am building a short from 16600 with a stop at 16660

  2. 23/05/2014, ljn wrote

    Absolutely right, its stalking time.
    However, the third scenario, maybe unlikely, that we cannot yet discount is that the Dow has been tracing out an ending diagonal since the early Feb wave 4 low. An ending diagonal is a five wave impulsive move where waves 4 and 1 overlap and each wave is itself a three wave pattern. An ending diagonal, which is pretty unusual, signifies the terminating of a trend before a reversal.
    IF this interpretation pans out (and we won’t know for sure until we see a bit more of a wave 5, or not) wave 1 end on 4th April, wave 2 end 13th April, wave 3 end 13th May, wave 4 end 20th May. IF there is a 5th wave it will subdivide into 3 waves and must be shorter than wave 3 (wave 3 cannot be the shortest of 1,3,5).
    This scenario, if it were to unfold, implies a new high, possibly an overshoot of the diagonal line connecting the waves 1 and 3 highs. Draw the 1/3 and 2/4 diagonals on the daily chart and the diagonal scenario doesn’t look so crazy.
    Under this interpretation we are likely still in wave A of 5, with two waves to come, and 62% of wave 3 would see wave 5 to just above the 16,800 mark just and just above the diagonal, possibly a week away?? A fall below the 16340 mark makes this scenario less likely.
    A third possible scenario, might not happen, but let’s be prepared.
    LJN

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