Our two SPY ETF examples to walk through the signal attributes:
The weekly reversal of October 7, 2011 (left) vs. a 5-minute continuation signal setup at 8:40 PST today (right).
1) Bullish reversal: Reaches a bar lower low therefore it is not an inside bar | Bullish continuation: Does not break to new high or just marginally. Ideally it is an inside bar or a series of inside bars.
2) R: Significantly breaks below the previous bar or the previous set of bars, trapping bears who joined the move too late - the best reversals overlap the previous bar 60% or less. | C: 70% or complete overlap with the previous trend bar.
3) Bullish reversal: Closes above the close of the previous bar(s) or even better above their highs.
4) R: Closes above the middle of the total span of the bar. | C: The close does not matter much although white candle (close above the open) has a couple of % better chance to succeed than a black one.
5) R: The RSI low corresponding to either the signal bar or the last bear trend bar is at 38 or above. | C: The RSI reading is above 50 at the close of the preceding trend bar and stays at, or above the 9-period MA during the pause or short pullback.
6) R: There is no, or just very small, upper shadow compared to the size of the signal. In other words the reversal bar closes at, or near, its high. | C: Any bottom shadow adds to the reliability of the signal.
7) R: Large span. The height of the bar matches, or close to matching, the size of the strongest trend bars in the previous downtrend. | C: It is a narrow range bar - a classic pause bar.
8) R: The volume catches up on the reversal bar or in the bar before. | C: Setback in volume; you feel like the trading has been halted in the market.
9) R: The reliable reversal bar is preceded by some bullish attempt to reverse the trend. | C: The best it is when there were no bear attempts against the ongoing bull trend leg, or at least we are further away from a larger time frame target.
It takes more than a single candlestick, or pattern, to enter a trade, even if it meets an optimum set of criteria. Candlestick patterns are just one signal that we utilize to alert us when the short term price action lines up with the long term context. As Jeffrey Kennedy from Elliott Wave International puts it:
“I only commit myself to the market when the market commits itself in the direction of my expectation.”Jeffrey Kennedy
In fact, the Trader Skillset process means we first want to know the context, or where prices are within the dominant market cycle. Only then, will we have made our judgment call about the trend, in what direction we’d like to trade and we’ve also estimated the probability of success. But, even then, we still have not answered the question,
“When do we enter the trade?”
The short answer is obvious: Enter a trade when the move that we expect shows it first signs, and we can define a mathematically reasonable risk/reward ratio.
As we get close to opening a new position, we have to lose the visionary theorist, or our inner Elliott wave analyst, and focus exclusively on a very objective set of traits of the most recent bars. These bars have to be able to tell us whether the necessary criteria for entry has met – or not.
Objectivity and simplicity are important at this stage because we are just about to put capital at risk, and as we get closer to the execution moment emotional excitement might get in the way. Without objectivity, we might get analysis paralyses, or become over eager foiling our great context related work. Our mathematical edge will be lost if emotions get in the way of proper trade execution. So, instead, Trader SkillSet has a systematic method to interpret each bar, so we can seize the trading opportunity, or let it pass by. This method is our own quality control.
We have nine easy-to-determine attributes that separate a trade from a pass. Actually, it is two parallel checklists – one reversal, one continuation. One defines the ideal “reversal” at the end of a trend, and the other defines the ideal “continuation” in a paused, but otherwise ongoing, trend.
The more traits that are present the better the signal is. Be careful though! You almost never come across the perfect signal. I’ll explain how one can compromise depending on the context in a future article. But, for now, just focus on the checklist as this gives you what you need to read the most recent price action.
Use the slider above as a step-by-step tutorial to explore our proprietary checklist for signals. The bullish reversal under magnifying glass is a weekly bar from October 2011. My choice of continuation signal for the comparison developed on a 5-minute chart, 2 hours into today’s trading session.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.