Monday, January 28, 2019

Chart Setup and Annotation Methodology

Given the amount of volatility we’ve seen in the market over the past six months, I thought I’d give an overview of how I go about preparing a chart and then reviewing the current setup.  The chart I’m showing: Helmerich & Payne Inc (NYSE: HP) just happened to be one of the charts that popped up on a scan, yesterday.  I don’t have any position in HP at the moment.  Here's the daily chart we will review:

HP Daily Chart

 First, let’s look at the chart setup itself.  I use a daily chart for my primary analysis and only use the weekly chart for support and resistance analysis.  The chart is configured as follows:

•    Candlesticks – I use candlestick analysis very heavily when entering a trade and again to determine if it’s time to exit that trade.
•    Bollinger Band (20,2.0) – This gives me a nice 20-day moving average and also shows consolidation points that often result in a tradable explosive move.
•    50-day Exponential Moving Average.  This is a heavily watched indicator by swing-traders and is a very good bellwether of current trend direction.

The indicators that I use on the chart are as follows:

•    Volume – This is obvious.  Volume is the most important piece of information on a chart besides price itself.

•    I use a 63-day exponential moving average attached to volume.  This tells me whether we have something exceptional happening that may require a closer look.

•    On-Balance Volume – I plot OBV in the same pane as volume.  This is a great indicator that tells us if shares are being accumulated or distributed.  Attached to OBV I plot a 20-day exponential moving average that is used to signal when the trend in volume may be changing.

•    Commodity Channel Index (CCI) – I use a 20-day CCI as a trend indicator.  Readings above 100 indicate a bull trend is in progress and readings below -100 indicate a bear trend.  CCI is a leading indicator and is a powerful signal for trend-following strategies.

•    Relative Strength Index (RSI) – I use a 9-period RSI coupled with a 21-day exponential moving average for measuring momentum and – coupled with the MACD – as an entry indicator.  (Note that I find a 9-period RSI more conducive to early entry in a trend system than the default 14-period.)

•    Moving Average Convergence Divergence (MACD) – I use the MACD(5,34,5) histogram in conjunction with the RSI(9) as my primary entry.  Again, I find the 5,34,5 setting to be much more accurate for short-term trading than the default 12,26,9 setting.  Note that I’m primarily using the histogram, and not crossover signals.

•    Full Stochastic (5,3,3) – I use this as an early warning indicator that a trade entry opportunity may be imminent, and it’s my primary exit “canary in a coalmine” indicator.

•    I also have a 12-period Rate of Change indicator drawn, and I plot the strength of the stock vs the S&P paired with a 20 period EMA of the same.  These two plots show additional information about the relative strength or weakness of the stock, but they are not part of my overall signal strategy.

So now that you know what my charts look like, let’s review the steps taken to annotate the chart before analyzing any setups.

1.    Find the lowest low and the highest high on the chart.  In this case, the low was 31 August 2017 and the high was 9 October 2018.  Draw the Fibonacci levels from the low to the high.  You’ll see them on my chart in grey.

2.    Now find the highest high and lowest low of the current primary trend for the stock.  In this case, the high was on 9 October 2018 and the low of the current primary trend was on 26 December 2018.  Draw the Fibonacci levels from the low to the high.  You’ll see them on my chart in a light orange.

3.    Next, we need to add the horizontal support and resistance lines.  I use the following schema for drawing these lines.  Dotted thin light blue line is a simple (weak) support or resistance line.  Dashed thick light blue is a significant strong support or resistance line.  Dashed thick purple is a significant support or resistance line from the weekly chart.  Don’t forget the weekly support or resistance.  They produce very strong levels on the daily chart.

4.    We should now look for major trendlines.  I use a dashed green line to indicate an upward support trendline, and I use a dashed red line to indicate a downward resistance trendline.  Be sure to extend them to their extremes.  As you can see in February 2018, once the upward support line was broken, it became a major resistance line for the subsequent consolidation period.  Notice that the current trend is down (red,) although on 26 December we started a countertrend rally that entered a small consolidation phase on 10 January 2019.  That countertrend rally is shown with a green support trendline.

5.    Next, I add the Elliott Waves for the current primary trend.  These are indicated in bold black on my chart.

6.    Once we know where we appear to be in the Elliott Wave cycle, we can determine price targets for the next wave.  I show price targets using a Fibonacci extension plot in green.  Notice, in this case, that the 100% extension is just beyond a major weekly support line.  That’s no coincidence, and with this being the 5th wave in the cycle, that weekly support line would be a likely location for price to consolidate for an extended period.

So now that our chart is annotated, we can then look at the setup and determine what signals will tell us to enter or to walk away from the trade entirely.

1.    We see that we are in Wave 4 – a consolidation wave – of a downtrend.  This tells us we likely have one more downward wave to go before the cycle is complete.

2.    Notice the downward resistance trendline and the upward support line of the countertrend rally.  They are rapidly converging.  A break of the support line and/or a bounce off the resistance line will be a powerful signal.

3.    For an early warning indicator, I’m watching both the CCI(20) and the Fast Stochastic (5,3,3).  What will tell me an entry is imminent is if the CCI(20) drops below 0 and the Fast Stochastic(5,3,3) experiences a bearish crossover within a day or two of each other.  That puts me on alert for an entry signal.

4.    My entry signal -- in this case, for a short position - will be a bearish crossover of the RSI(9) and it’s EMA(21) within one day of the MACD(5,34,5) histogram turning negative.

5.    The entry trigger will be pulled if the signal occurs on a bearish candle, preferably with above average volume.

6.    The stop will be placed above the high of Wave 4, and the (imaginary) price target will be the weekly support line near the 100% price target I drew in step 6 above.  I say “imaginary” because we are not going to actually exit the trade with a pre-defined limit at that level.  Rather, we will exit the trade on a bullish reversal candle coupled with the Fast Stochastic (5,3,3) signaling a bullish reversal.

There you have it!  I hope this provides some insight into how I setup my charts, what indicators I use (and how I use them) and how I go about determining trade setups.

Happy Trading!