146 1
0.09090.08990.0903
0.05620.05560.0558
14
'i'iRQ144
?11
377
0 0170o hlR?o hlROO.oIRIO hl RO0.6180
0 1RIRo 1R?0o 1R1Q0 1R20o 1R?00.3820
0 2100o ?1hlo ?1h10 2101
o ?1hl0.236130
O�·14SR
0 1<1'iQo 14'iQ0 1459o 1<1'i90.1459
0 0901o OQm0 09020.0902o 090?0.0902
0 0SS7o 0'i'i70 0'i'i70.OSS7o 0'i'i70.0557
RSI: The Complete Guide
These ratios quickly approach equilibrium where the result barely changes. Wecan take these numbers and create a table of retracement levels that are based upon theFibonacci number sequence. This is the Retracement Table.Table # 8
-
Fibonacci Retracements Table
0.05570.09020. 14590.23610.33330.38200.50000.61800.66670.76300.854 10.90980.9443To summarize, the Fibonacci sequence of numbers were discovered more than800 years ago. The relationships are based on naturally occurring phenomenon thatappears in fixed sequence. The primary way traders use the series is not the numbersequence itself, but the ratios that ate created when the numbers are divided into apreceding Fibonacci number. The decimal products of these numbers are used inretracement theory. Using retracement theory, we can enter into a new position or addto an existing position. Once prices bounce, we can use the "bounced price" as a stopprice.
BASIC RETRACEMENT TnEORYWhen looking at a price chart, it is readily apparent that prices fluctuate up anddown. These fluctuations seem to occur at random. As you become more comfortableworking with the concept that there are multiple timeframes being reflected in any chart,this apparent randomness becomes more understandable. However, it is important thatyou understand when price retraces its prior move and finds support or resistance at14.6%, 23.7%, 38.2%, 50%, 61.8%, 76.3%, or 85.4%, the market is telling you that ithas "discovered" a key number. This is a key number that you should remember whenplacing your trailing stop.31
John Hayden
If the market is rallying, we can expect that at some point the Bulls will get tiredand prices will retrace a part of their preceding rally. This retracement will be more than5.5% and less than 38.2% of the move, if the trend is strongly up. If the trend ismoderately strong, the retracement will be 38.2% to 50%. The retracement will bebetween 50.0% and 66.7% if the trend higher is in danger of failing. If the retracementfalls between 66.7% and 85.4%, the trend has a high probability of failing.For our purposes, there are three types of basic retracement - shallow, me­dium, and deep. Understanding basic retracement theory will help us to identify whethera trend is strong, moderate or weak by the percentage of its retracement. In addition tobasic market retracement, there are complicated retracements that involve multipletimeframes consisting of longer or shorter time cycles. These complicated retracementswill not be discussed in this book. Before using retracement theory, we must allow theprice to move a certain amount of points and time. For example, if we are following arally in the S&P and are looking at a 30-minute chart, then we want the rally to movemore points and last longer than on a 5-minute chart before attempting to use retracementtheory.The question that arises most often is what amount of price movement is re­quired before retracement theory can be used effectively? To some degree, the answeris subjective. Prices retrace lower after rallying because traders in the timeframe thatstarted the rally are tired and have overextended themselves in the rush/push to higherprices. We want to determine what amount of price movement for each dominanttimeframe (day, 30 min., 5 min.) would indicate that these respective timeframes areoverextended. We are looking only at price movement in the amount of points - notprice patterns. There are two ways to accomplish this objective.First Method: Determine the average price movement for the average rally/decline in the timeframe that we are looking at. This is accomplished by examining atleast the previous 100 or so rallies, and plunges in the timeframe to be studied. Byobserving the number of points before a retracement occurs on average, we can accu­rately judge when a move is probably over and ready to begin a retracement. Forexample, if we observe that for the previous 100 rallies prices in a 5-minute chart movedan average of 7 points - then we know that after market prices have moved 6 points, theprofessional 5-minute traders will usually be looking to take profits.Second Method: Calculate the average price range for each bar in a longertime interval and use a percentage of that range to indicate what amount of price move­ment is needed before using retracement theory. The longer timeframe to use is onewhere "one time interval" in the longer timeframe consists of 13 shorter time intervals.
32
RSI: The Complete Guide
Imagine looking at a 30-minute chart of the cash S&P. We know that there are390 minutes in the average trading day or 1 3 30-minute bars. In order to use retracementtheory on a 30-minute chart, we need to know when the 30-minute traders are probablytired. We can examine many significant prior rallies on the 30-minute chart or we cantake an average range of the high and low in the next significant longer timeframemultiplied by a factor of 1 3. In this case, it would be a daily timeframe as it takes 1 3 barsin the 30-minute chart to create 1 bar in the daily chart.Using the 1 0-day average range of the S&P to indicate when the 30-minutetraders are tired will tell us when we should begin to expect a market retracement. Ifwe are using a 5-minute chart, we can use a 65-minute chart to calculate the l O baraverage range. It is important to use the average range of bars where each bar consistsof the total number of smaller bars. If you were to use an average range where some ofthe bars consisted of less time, then the average would be in error. There are 6 hoursand 30 minutes in each S&P day session. Ifwe are using 60-minute bars to determinethe l O bar average, we must not use the last bar in the trading day in the calculation todetermine the average range as it only consists of30 minutes. It is important to know inadvance how much any rally or decline must move before you consider using retracementlevels.If you are monitoring the average range of a longer timeframe in real time andit begins to compress, then a shallow retracement will probably be insignificant. Typi­cally, the average range of a longer timeframe will not decrease. Knowing this, we canuse the retracement level as a good indication of trend strength. If the market findssupport with a shallow retracement (less than 38.2%) then prices should easily take outthe previous high or low (if a bear market). When the retracement is deep (50% to6 1 .8%), it is an indication that the market is weak or weakening, and that the trend couldbe ending. Prices will fmd it difficult to take out the previous high ifthe market is rallyingor low if the market is declining. Retracements of .6 1 8 to .854 show signs of extrememarket weakness and should be viewed as an indication that the trend is probably re­versing. A deep retracement also tells us that a longer timeframe has noticed theprevious price movement and it was the longer timeframe traders who faded the move.Before the trading day begins, it is important to examine the daily chart to beaware of key numbers that the longer-term traders are watching. Here are items toexamine on the longer-term or daily chart:Daily Chart Exam for determining major trend.1 . What are the major support and resistance numbers using prior rallies anddeclines?
33
John Hayden
Was there a reversing rally or decline? What was the major resistance/support level?3. What would be the price for a 38%, 50% or 66% retracement from the mostrecent rally high or decline low?4. What is the 1 0-day average daily range?2.
30 Minute Chart Exam for determining the intermediate trend:1 . Is the market making higher highs and higher lows indicating an up-trend?2. Is the market making lower lows and lower highs indicating a downtrend?3. Is there an up or down move that approaches 1 00% of the 1 0-day averagedaily range?a . If true, the 30-minute timeframe traders are probably exhausted orover-extended.b. If the move is less than 1 00% of the daily average range, then wewill focus our attention on the next smaller timeframe.5-Minute Chart Exam for determining the short-term trend.1 . Has the price moved 40% of the 1 0-day average daily range?a. If true, we know the 5-minute traders are probably tired.b. Should the 5-minute chart be indicating an entry, we will drop to a 1 minute price behavior for our trigger.Basic retracement theory is only applied when the market is trending up ordown. If the market is choppily trading sideways, we should not use retracement theory.If price has moved 40% of the 1 0-day average range on a 5-minute chart, we canexpect that the shorter time frame traders are tired and that a shallow retracement isimminent. Should the retracement not be shallow, it is because the longer timeframetraders decided to fade the rally. In a 5-minute chart, a rally of more than 50% of the 1 0day average range is a huge move and is usually indicating that a stronger trend willdevelop. However, a 50% move of the 1 0-day range in a 30-minute chart is only amoderate move.Assuming that we have a solid uptrend that exceeds 50% of the 1 0-day dailyaverage range on a longer timeframe (30-minute or daily) chart and see a retracementofless than 38% on the shorter timeframe 5-minute chart, then we must only trade in thedirection of the intermediate trend.
34
RSI: The Complete GuideTable # 9Trend Strength
Maximum Retracements
14.6% to 23.7%38.2%
Very StrongStrong
38.2% to 50%
Medium Strong
SOOIo6 1 .8% to 50%
MediumMedium Weak
61.8%
Weak
85.4% to 76.3%
Very Weak
Chart # 1
Chart # 1
Trend Strength as Indicated by Percentage of Retracement:
-
-
-
Upside Targets
(downside targets are inverse)A to B added to CA to B added to C
Comments:Easily exceed B
Easily exceed B
80% of A to B added to C80% of A to B added to C
Should Easily exceed B
80% of A to B added to C
Possibly exceed B
80% of A to B added to C80% of A to B added to C
Basic Retracement Theory
-
Possibly exceed B
Probably will not exceed B
using a 30 minute chart of cash S&P
Description on the following page.
35
Should Easily exceed B
John Hayden
In retracement D 1 , prices collapsed from 1 023 to 98 1 . Then, prices rallied to1.D 1 a, which is a 50% retracement. We know that the strength of the bear market is onlymoderate from this retracement. We know that the high at point A should not be vio­lated if the Bears are in charge.At this point, we don't know who or what timeframe is in charge. We will draw2.another up retracement U 1 . We know that if the Bulls buy at a 38% retracement, thenthey are probably in charge. This is exactly what happens at 994 at point B. We cantake the difference between 1 003 and 98 1 to get an upside target of 22 points which isadded to 994 giving us an upside target of 1 0 1 6.A s prices rally to C at 1 009, the Bulls encounter resistance. This coincides with3.the 6 1 .8% retracement of D 1 and a downside breakaway gap. Upon seeing the downclose, we could draw another retracement U2 and we see that the Bulls defended the3 1 % and 50% level. The rally from point B to point C is very small and we shouldn't useit on this 30-minute chart.The ensuing rally to point E totally negated the downtrend, D l , before encoun­4.tering resistance at 1 032. Once again in drawing our retracement levels, we can see thatthe Bulls prevented any retracement under 1 027 ( 14.6%) telling us that the trend is verystrong.The rally from 1 027 to 1 040 is labored. We draw another retracement U4. The5.price behavior is different than previous tops at points A and C and to some degree pointE. Notice the lack of upper shadows at F. Looking at retracements, we can see that atpoint G, the Bears were able to close under the 38% level and just above the 50% as theBulls seemed to be on vacation. The trend has significantly weakened from "VeryStrong" to "Medium." It is not "Medium Strong" because of the down close near the50% retracement with an intra-bar low under 50%. At this point, should the Bulls fail toprotect and prevent any price extension to the downside below point G, the rally wouldprobably be over. Additionally, point G is important as an important swing point - noticethe 2 higher lows on either side of it.6.The Bulls managed to rally prices to 1 039.85 at point H. Prices made a newintra-bar high at 1 039.85 and failed to close above its open. At this point, we knew thatthe rally was probably over. When the Bears were able to close the market below pointG and making a breakaway gap lower, the Bears were the dominant force. If we weretrading in a smaller timeframe, we should have been short. However, in the 30-minutetimeframe it is not apparent that the market had shifted. We must wait to see how theprice behavior unfolds. Draw another retracement, U5, from the 98 1 low to the 1 040high. From this retracement, we can identify important support within the context of alonger timeframe.36
RSI: The Complete Guide
As prices fall below point G, we begin drawing our new lower retracement D2.7.When prices establish a new low at 1 026, we knew that the Bulls would be gunning forthe breakaway gap and should they fail to close above that level, the market wouldcollapse once again. We know this because there were no other significant retracementlevels nearby. The nearest long term support on U 5 was 1 0 1 7. This indicates that thelow of 1 026 was only a temporary low.As the Bulls rushed to close the breakaway gap in the 1 036 area, the market8.closed above the 6 1 % retracement level. The last significant resistance area for theBulls was at 85%, which the Bulls were unable to hit. From this information, we knowthat the Bears will probably hit the 1 0 1 7 target and possibly) O l O.When prices fell under point I at 1 026, it was possible that we were at the9.beginning ofa major bear market if the Bulls failed to defend support at 1 0 1 7 (38% buyretracement), or 1 0 1 0 (50%). Prices continued to fall finding temporary support at 1 0 1 7and finally coming to a halt at 1 0 1 1 . Drawing our new retracement D3, we can see thatour 38% sell retracement would be at 1 02 1 . On the next bar, the Bulls rally prices to1 0 1 9 before closing just off of the intra-bar low. For the next 3 bars, the Bulls are unableto close above the 1 4.6% sell retracement level. At this point, we know that the spike to1 0 1 9 was nothing more than a bull rally in a smaller timeframe than 30 minutes. Weknow that the bear trend is "very strong" with no close above the 1 4.6% retracement.In addition, we know that the bear market would become major as 1 0 1 0 level was the50% retracement of the previous rally. If the Bulls were going to buy, NOW was thetime. The fact that they abandoned ship was all too obvious by the large black candlethat closed under 1 0 1 1 . When prices closed under 1 0 1 1 , we knew that the Bears weredominant and would push prices towards a target of 993 as calculated by [ 1 0 1 9-( 1 03 71 0 1 1 )] . This price was close enough to the 6 1 % retracement level of the previous bullrally that it confirmed that prices would hit 990 before finding any support.Prices hit a low of 99 1 at point M . Then, they stayed in the 1 4.6% retracement1 0.level before selling off once again. The close above the 1 4.6% retracement line isignored because it is so close to that level. We can once again project the new low to968 from [996-(1 0 1 9-99 1 )]. Price once again hits the target. The low at point M (99 1 )was significant as many traders began thinking that perhaps a double bottom was form­ing. However by using basic retracement theory, we could tell that the bear markettrend was still "very strong." Why would anyone even think about buying it?Prices broke through major support at 98 1 stopping out all of the long traders11.who thought a double bottom was forming and found support at 970. This is where weforecast the low using retracement theory. The next bar saw the Bulls buying themarket pushing prices back above 98 1 retracing 50% of the prior plunge in one bar. At37
John Hayden
this point, we would draw our retracement levels, D5, and because it could also be asignificant low we would draw a retracement level D6. Prices rallied to 1 002 after theyrallied above 986, which was the 6 1 .8% retracement for D5. At this time, we knew thatthe Bear trend had changed from "very strong down" to "weak." Here we begin tofocus our attention on retracement level D6.Prices rallied to point P at 1 002 before encountering resistance. This price was1 2.just above the 3 1 .8% retracement level of D6 and the 6 1 .8% level. From our analysis,we know there is a very good possibility that the Bears in the longer timeframe than 30minutes were once again going short - just as the Bulls should have defended 1 0 17,1 0 1 0, and 1 003. Look at the chart and compare the price action at points P and R versuspoint K. In any case, once we see the down close we draw up retracement level U5. Inthe next bar, prices collapse to point Q at 987 where we find Bulls that push priceshigher as indicated by the 'hammer' formation. The 50% re-test level of U5 was 986.We can determine the upside target of 1 002 from [ 1 002-987)+987].13.Prices rallied to point R at 1 005, which was the 50% re-test level of the majordecline D6. It is at this point that the Bears must prevent the Bulls from pushing priceshigher and should start hitting the bid in their rush to get short.
38
RSI: The Complete GuideChart # 2
-
ES I):! L�· 3 mm
Basic Retracement Theory - using a 3-minute chart of S&P futuresJ.
e=974.15 -47.00 -4.60" 0=975.00
1 005.0
04.15
6114102N
H
1 000.0
8 15
999.5999.5
995.01995.0
M
9.).5
--+__.-. -!- . 81.15:
__
0
t
L
---> .9J.a o
____
Chart # 2
-
Description:
1.At point A, we can see that the high is 1 000 just before making a triangle, whichisn't visible on the 30 minute chart. The price action falls out of congestion to make anew low. This move from 1 000 to 979 shows up in a 30-minute chart just as obviouslyas on a 3-minute chart. With the low price of 979, we can know that many sell orderswere resting just under 980 and that the floor traders were gunning for them. Whathappens next in a smalVshort timeframe will tell us what to do.2.The Bulls rally prices to point C, which is a 6 1 .8% retracement from point A topoint B. We know that the Bear trend is "medium weak" to "weak." The indecisioncomes from the high wave line made at C. This is normally an indication that a top is in,which would make the Bear market "weak" instead of "medium weak." Do we buy,sell, or wait? I would wait to see what happens next as the 6 1 .8% retracement occurswithin 3 bars. If the Bulls find support at or above the 3 1 .8% re-test level, we buy.
39
John Hayden
Otherwise, we short the market on the next rally. Prices fmd support at point D at987.75. 3 1 .8% support is at 987.25. An order to buy at 988.25 or better could havebeen entered because ·of the -low from 2 bars previous. However, the safer bet wouldhave been to wait or use a smaller timeframe for analysis. We can calculate the upsidetarget at 1 00 1 from [(992.25 - 979.0) + 987.75] .Prices run up to 995.5 at point E making a double top in a I -minute chart where3.they encounter resistance. Prices correct down to 990.75 at point F where we enterinto a long trade. A buy order should have been placed at 99 1 .5, which was a 50%retracement of point D to point E and a double bottom in a smaller timeframe. Our stopwould have been just under the 6 1 .8% retracement level at 990.5. At point F, we knowthat the point A to point B Bear plunge is probably over as prices have retraced morethan 6 1 .8%. This makes the Bear trend in the longer timeframe "weak." We know thatthe current bull rally is "strong" as measured by point B to point E. We also know thatthe swing point at point E is significant because there are 2 lower highs on either side ofpoint E. We also know that with the Bulls closing prices at 995.5, they negated a minorswing point the Bears had made earlier at 994.5. Therefore, we are able to rest easy inplacing our limit order at 99 1 :5. We can predict that the upside rally should take prices to1 007.25 based on [(995.5-979.0)+990.75]4.Prices rally to point G at 997.5 before encountering more resistance. Onceagain, we draw retracement levels and see that the Bears are unable to push priceslower than the 3 1 .8% re-test level, so we know that the up trend is still strong.When the market spikes to point H, we know that the Bulls are in trouble. We5.know this for several reasons. First and most important is that prices consolidate atpoint G for 5 bars before breaking out of the consolidation pattern. Ifthe Bulls are firmlyin charge, as basic retracement theory tells us, the market should close the bar near thehigh. Second, we can see that at point A the high was 1 000; we have a double top andshould encounter resistance there. Third, the reason the floor didn't push it higher wasbecause there were probably a lot of buy orders and the floor would become net short.If the floor thought th�t pri.ces would ultimately trade above 1 000, why would they wantto generate a lot of buy orders making them short? It would be better for them toestablish major long positions and trigger the buy orders, allowing them to either estab­lish shorts or go flat. In any case, with the close at point H or 995.5, we must sit tight andsee what the next bar tells us.6.
The next bar is black with the closing price under the open and below the closeof point H. It is at this point that we have to decide whether to take profits or move ourstop order up to breakeven? The safer course of action in this case is to take our profitsand look for another opportunity. If so, our trade made 5.50 points.40
RSI: The Complete Guide
As the rally to point H created a new high, we must re-draw our retracement7.levels from point F to point H. We can see that the 50% retracement level is within thelower part of the consolidation pattern. If the floor wants to panic the novice traders andmake them sell, they will have to take out these lows. We know that for the up trend toremain intact the retracement should not exceed 6 1 .8%, which cOrfesponds to 994. Ifwe did exit our position or if we want to add to our long position, we should place ourlimit order to buy at 994. The question is, "Where do we place our stop?" Generally, Ilike a I -point stop, but where is support? We know that point C was at 992.25. As longas the Bulls keep prices above 99 1 .5, which is 38.2% of point B to point H, the longerterm up trend remains "very strong." I would place the stop order at 993 becauseeverything else is too far away.8.After making a low at 993 .5 at Point I, we can re-calculate the upside target to1 0 1 4 from [(999.5-979.0)+993 .5]. Prices rally to point J making a high at 1 005 beforeencountering resistance. Do you remember the upside target levels? We have targetsat 1 00 1 , 1 007.25, and 1 01 4. As prices rallied up through 1 00 1 , we would move our stopto 996.25, which is the 6 1 .8% re-test level. Ifprices hit our upside target of 1 007.25, wewould have taken our profits. However, that was not the case as 1 005.0 at point J wasthe high. We can tell that prices hit resistance. The question is "Where do we exit ourtrade?" We know that the 38.2% re-test level on the point I to point J move is 1 000.5.Since big money is made by hanging tough with a winning position, we cannot exit untilthere is proof that the trend strength has changed. After making the high at point J andclosing down for the bar, which itself is a bad sign. Prices sell off for a second day. Thelow of this second bar becomes the low of the third day making a double bottom in asmaller timeframe. The close of the third day is near the daily high. It is here that wecan clearly identify support on the three-minute chart - the lows of the last two bars. Weare able to move our stop order to just under these lows at 1 002.25. We would exit thetrade with a stop order at 1 002, giving us an 8-point profit, if the Bulls fail to defend1 002.25.In summarizing basic retracement theory, the level of the retracement is astrong indication of the trend strength. Retracement theory categorizes the psy­chological strength of the Bulls versus the Bears using Fibonacci ratios. Forexample, a retracement that is less than 38. 2% is a strong indication of strongbullish beliefs. Before we can use retracement theory, we must have a valid movehigher or lower. The easiest way is to measure or determine a valid move is to usethe average range in a timeframe that is 13 times longer than the timeframe we areusing. We can use this average range or some fixed percentage of that range, totell us when the shorter-term traders are probably getting tired and prices should
41
John Hayden
retrace. Put another way, we can only apply retracement theory after prices havemoved enough where the traders in the smaller timeframes are probably tired.Once prices have either rallied or declined to where these shorter timeframe trad­ers are overextended, we can apply basic retracement theory. This helps us deter­mine price levels that we can use to enter or add to our positions and levels wherewe might want to exit our positions. We are using the contra-trend to tell us whatwe should do. We will use these retracement levels as key numbers for our stopplacements. A thorough understanding of basic retracement theory will help ustremendously in using Momentum Discrepancy Reversal Points.
42
CHAPTER 7
SUMMARY OF SECTION IThe primary concepts from this section are:1.
Prices reflect the perceptions of all traders who are actively buying and/orselling.2. The current price might reflect reality or it could reflect a mass delusion.3. There is no way to tell from the price what type of trader is bidding to buy oroffering to sell.4. Sometimes the small producer has a better feel for the price of com than alarge institution - sometimes not.5. The market consists of marginally capitalized to very well capitalized traders.6. The better a trader is capitalized the more contracts they must trade in orderto obtain an adequate return on their investment.7. Because larger capitalized traders must trade more contracts, they are forcedto look at the "big" picture, i.e., a longer timeframe.8. In order for the large institutions to avoid a lot of slippage, they must adopttrading strategies