A Day of Divergences and Interesting Trades

Apr 22, 2008: 9:20 PM CST

As I always recommend, take a look at your chosen market and chosen time frame and annotate the action and ideal trades for the day, so you can better analyze these patterns in real time.

Let’s look at the DIA (Dow Jones ETF) on the 5-minute chart (any of the 3 major US Stock Indexes have similar intraday patterns).

Let’s take it point by point.

The day opened up with a downside gap of 30 Dow Points, which would lead you to enter a ‘gap fade’ trade. Unfortunately, this trade didn’t ‘work out’ as expected and many traders had their stops hit.

1. A large resistance area, and moving average overlap trade (combined with a new momentum low ‘impulse sell’ trade) triggered a potential ‘short-sell’ entry (target: intraday low or just beyond)

Price then began to falter beneath the key 20 period moving average, and with negative breadth, led you to continue to trade to the short side.

2. Annotation #2 identifies what I call an “F You!” trade (for those who are curious, the “F” stands for “fade“). I was short going into this trade and had a tighter stop than I should (combined with a larger position than I should) and a quick upthrust in price nailed all ‘properly placed’ stops and zapped away positions in less than a minute. Actually, ideal stops should have been placed beyond the falling 50 period average, but in the heat of trading, we don’t always do what we should.

I’m fine with stops, but not fine with trades that complete an “F You” pattern. This occurs when there is an obvious set-up and obvious stops that quickly comes up and fills the liquidity of resting stop orders and THEN reverses extremely rapidly and quickly back IN the direction that people expected. This development tends to frustrate traders and sometimes disillusion them.

These occurrences are rare, but if you miss them, then they can provide elegant entries. I had to chase the market down, which also was probably unintelligent, but this is why I write “idealized trades of the day” – to allow me (and you) to see patterns in calmer times outside market hours so that we can recognize them and trade them with confidence during market hours.

3. Following the large downward impulse (as expected), there was a slight retracement that resembled a 45 degree angle. That’s a bear flag! The flag broke down just before reaching resistance and achieved its price target, which wound up being the intraday low

4. Price also retraced to the falling 50 period moving average, setting up the potential for a ‘final’ trend trade as price began to build a base to trade higher and reverse. Notice the numerous positive momentum divergences that developed through the day.

5. Finally, price consolidated beneath the key 20 and 50 period moving averages, and this highlights how MAs can serve as support and resistance. Also, breakouts from consolidation can lead to higher prices (especially following positive momentum divergences).

Today was a great and interesting day that – like most days – provided many opportunities for profit. Print out your favorite chart and market and annotate it based on your understanding of trade set-ups and likely price behavior so that you can be ‘quicker on the draw’ during the trading day.

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