TRADING PRICE ACTION
To get started, look at the last hour or two of the previous day’s action and see if a trendline can be drawn, or if there is a horizontal or sloping trading range. Then, as the current day’s bars form, look to see how they relate to the pattern from the prior day.
In “Range to gap” (right), a previous-day large trading range preceded the current day’s gap down, creating a breakout below the range. One way to view a gap on the open is as a single invisible bar, so a gap down can be considered a bear trend bar. A gap often results in a trend in either direction, but the larger the gap, the more likely the day will continue in that direction.
The first bar of the current day was a bear trend bar (a close below its open), which indicates that the bears owned the bar. At this point, look for evidence that either the day could start to trend up or down from the first bar. Alternatively, there will be a pullback into the gap and then the bear will resume. This is a breakout pullback short setup. Finally, the breakout could fail after a few bars down and then trend up (a failed breakout).
The second bar had a bullish body, but it had an unremarkable range and it closed in the middle, indicating that the bulls were not strong. The third bar (Bar 1) was an inside bar, indicating hesitation or balance between the bulls and bears, and a breakout therefore was likely within a bar or two. The bar closed on its low and this was evidence that the bears were stronger. If you are ever going to trade a trend-from-the-open setup, you must be prepared to enter on one of the first bars of the day.
This setup has a great risk-to-reward ratio. The bar is three ticks tall, so if you entered at one tick below its low and put a stop at one tick above its high, you are initially risking five ticks ($77.625), and you stand to make maybe 20 or more. That means that you have to be right only 25% of the time to break even.
In the case of the current example, given the bear gap and bear bars, the odds that this setup would result in a profitable short likely were much higher. The Bar 1 entry bar opened on its high and closed on its low, which is evidence that the bears were strong. The next bar was a large bear trend bar that broke below the low of the first bar of the day. This presented an opportunity to take some contracts off with eight ticks of profit or hold the entire position for a possible significant move down. If you are right, you are short at five ticks from the high of the day, and the average daily range has been about 20 full ticks.
In bar-counting vernacular, Low 1 is the first time that a bar goes below the low of the prior bar if that prior bar is a pause or pullback bar. Low 2 is the second time in a bear flag that the market tries to go down. High 1 and High 2 are entries in bull trends. Bar 2 was a Low 2 short setup (this is the second attempt to go down after a small pause or pullback, and the Low 1 short occurred three bars earlier), and a small double top. The market could not rally to the breakeven stops on the Bar 1 shorts, and it formed a second Low 2 short and larger double top at Bar 3. The market trended strongly down from there to the small three pushes down (or wedge) at Bar 4. You could exit at that small climax with 35 ticks of profit, take partial profits or continue to hold to see if the bear extended further.
In “Running higher,” the previous day had a protracted bear move into the close. The current day’s open broke above the trendline, but the first three bars were small dojis, which represent small trading ranges. These are usually not reliable signal bars, so it is prudent to wait for more price action to unfold.
The third bar of the day was a High 1, but the dojis make waiting for more price action the best choice. Bar 1 was a High 2 long following three consecutive inside bars (an iii pattern), but the day has been in a tight trading range and the pullback has not yet tested the moving average, so it is reasonable to wait some more. The test of the moving average formed a double bottom and was followed by another iii, with the signal bar having an up close and three of the four prior bars had up closes, and the market has been unable to close below the moving average. This double bottom formed a higher low following the breakout above the trendline of yesterday and it could become the low of the day (a breakout pullback long).
A long here risks five ticks to one tick below the small inside bar. You could take half off after eight ticks of profit and hold the remainder with a breakeven stop for a possible bull trend day. Once Bar 3 broke above the wedge, the market was likely to go up for at least a measured move because the bears who shorted the wedge gave up and there was no one left to short. The market closed about 48 ticks higher, earning longs $750 per contract, with an initial risk of under $90.