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Kangarootail.com

Technical Analysis of the Forex, Commodities, and Stock Markets

Trading Plan

Last Revision: 5-16-2010
Author: Carsten Mundt

Summary:

The forex markets often move in trends that last several days. My strategy is to identify and trade these trends early using chart pattern analysis, trend lines, moving averages, price channels, support and resistance, Fibonacci retracements, harmonic numbers, and the RSI indicator. I use the daily charts to determine the long term trend (if any) and the hourly charts to time my entry and exit. If the market is trading in a range on the daily charts, I use the RSI indicator and price channels to identify overbought and oversold conditions to trade the range.

Chart Time Frames:

My main time frame is the hourly (or 60-minute) chart. I use the daily chart for long-term trend analysis to guide the direction of my trades and analysis on the hourly chart. I use the 5-minute chart for fine tuning entries and exits only.

Trading Schedule:

I trade 1-3 hours in the morning, ideally during 6AM-9AM PST when the major forex markets are most active. I follow the markets occasionally during the day, and trade again about 1 hour in the evening to adjust trade positions and entry orders. Ideally I either enter trades in the morning, or set entry orders in the morning that I expect to get triggered during the day.  I try to avoid entering trades in the evening since I prefer observing price development right after I enter to potentially work out of a trade if price move against me. I also try to avoid entering trades in the low-volume Asian session.

General Trading Guidelines:

• Trade with the Trend. Start by looking at the long term chart (daily chart), and only trade in the direction of the long term trend, if any. Use 10 and 20 day exponential moving averages (EMA) to determine the presence and direction of a daily trend. Use 10 and 48 hour exponential moving averages to determine the presence and direction of an hourly trend. Always always always attempt to trade in the direction of either or both of those trends. If the market is going sideways, or is in the middle of a trend reversal, trade both directions with low risk entries near the hourly channel boundaries only. Only trade against the prevailing daily trend if there’s confirmation that the daily trend is turning and the market offers a low-risk entry with high profit potential. If the trend is down, for instance, the hourly chart has to be clearly bullish before entering a long trade and there has to be completion of a major bullish chart pattern offering a very low-risk entry. Always try to favor trades in the direction of the daily trend. Never pick tops or bottoms and never set entry orders catching a top or bottom.

Also plot 100 and 200 day and 100 and 200 hour simple moving averages since those are widely followed by many traders.

• Trade with Momentum. Enter with momentum, and with the trend. Never try to catch bottoms or tops. For instance, when going long near a potential bottom: wait for momentum to turn up, make a higher high, then turn, make a higher low, and turn up again. THEN enter, right after the turnaround of the higher low and when momentum picks up. Always trade in the direction the price is going, never against it. If the market keeps running past the previous low, get out (set your stop a few points below that low.)
• Trade Entry: Use the hourly chart as your main time frame for identifying trade opportunities and trade entry signals. Then look for chart patterns listed in the “Entry Criteria” table below that allow entering a trade in the direction of the hourly (and preferably also the daily) trend. Only then look for chart patterns that allow trading a reversal of the current hourly trend with a low-risk entry. In either case, the chart pattern must have completed. Do not trade in anticipation of a pattern completion.

A good trade entry is based on one or more clear confirmed signals (chart patterns), is in the direction of the trend, with momentum, and near major support or resistance. To quantify the quality of a trade entry, the following system of weighted scores is used. This system helps to reject weak trades, and to make good money management decisions:

Entry Criteria	Score
Chart Patterns Signaling Potential Trade
AB=CD Pattern Completed	2
Gartley Pattern Completed	3
Butterfly Pattern Completed	3
3 Drives Pattern Completed	3
Kangarootail  Completed	2
Head and Shoulders Completed	3
3-Candle EMA10-Crossing Signal Completed	3
Trading with the Trend
In direction of longterm (daily) trend	2
In direction of hourly trend	1
Pullback to daily EMA10 and/or EMA20 and trending	2
Pullback to hourly EMA10 and/or EMA48 and trending	1
Trading with Momentum
With daily or hourly momentum and momentum still young	1
Daily RSI 3x Divergence	3
Hourly RSI 3x Divergence	2
Break-away from long consolidation period (EMA convergence or range narrowing)	1
Entering near Support/Resistance
Near major trendline support/resistance	1
Near major historical support/resistance	1
Near Fibonacci level	1
Fibonacci Pattern Confirmation	2
Other Criteria in Favor of Trade
Follows similar complex pattern observed in the past	1
Reward/Risk ratio better than 3:1	2
Total quality score (max.):	40

Before entering a trade, characterize each potential entry using the above checklist of favorable criteria. Go through each item, and apply the weighting score listed for the item if it applies, and assign 0 if it doesn’t apply. Looks in both daily and hourly time frame, but not in 5-minute time frames. It is possible to find patterns in multiple time-frames, and patterns inside other patterns (e.g. an AB=CD and a kangaroo tail inside a Gartley pattern). Use the following rules for trade entry and money management based on the total score:

Trade Entry Rule	Total Score
Pass on trade	<10
Enter trade with regular position size	10..20
Enter trade with double position size	20..29
Enter trade with triple position size	30..40

• Stop and Target Placement: Set stop below/above at least one major support/resistance, preferably two. For risky or uncertain trades, place a tight stop below/above the nearest critical-turning-point support/resistance.

Pick a reasonable target based on support and resistance levels. Use channel boundaries as upper limits for target selection. Keep change of channel boundaries and EMA’s in mind, when using them to determine the target, extrapolate into the future based on the expected time it may take the market to hit your target.

Move stop up after a clear move past the first resistance/support has occurred, and only move it to the support/resistance at which you placed your entry. Don’t move it to the break-even point too soon. Give the trade room to develop, between your stop and target. Avoid stops that are too tight and get caught by regular market volatility, but look for low risk trades that allow placement of tight stops. Never place a trade without a stop.

When trading a trending market: use pyramiding of trades to get the most out of the trend. That allows you to let your profits run for each trade, and to make multiple entries within the trend during corrections. When the market finally turns, the last trade may get stopped out, but the profits for the other trades will be large. Use trailing stops for all trades that trail at a reasonably safe distance allowing for corrections around the hourly EMAs (determine the size of these trailing stops by studying past trends.)

When trading a ranging market: Enter near channel boundary, just after the market has turned again, but not at the very bottom. If there was a previous trend that was strong, preferably trade in the direction of that previous trend. Place conservative profit targets (take small safe sections out of the range, don’t go for profits that are too large, like the other range boundary). Keep the average daily swing in mind.

Technical Indicators:

• Daily Charts
  • 10-day exponential moving average
  • 20-day exponential moving average
  • 100-day simple moving average
  • 200-day simple moving average
  • 10-day RSI
• Hourly Charts
  • 10-hour exponential moving average
  • 48-hour exponential moving average
  • 100-hour simple moving average
  • 200-hour simple moving average
  • 10-hour RSI

Chart Patterns:

One of my main tools is comparative chart pattern analysis. Comparing the current price action with periods of past price action that have similar patterns and technical indicator dynamics allows me to improve my odds of predicting the next market move. I also focus heavily on trading a few well-known chart patterns with statistically proven success rate. The following sections list each of the patterns I’m trading, and a description on how I trade them. Examples are all from the EURUSD pair, the main instrument that I’m trading.

AB=CD Pattern:

Description: The AB=CD pattern’s signature is two equal legs (AB and CD), that are close to each other in length and time. The BC leg connecting them typically retraces to the 0.382 level of AB, but may also retrace to other Fibo levels depending on the strength of the trend. CD often ends at the 1.272 extension of AB.

Entry: The trade opportunity arises at the completion of the pattern (D) at which point price has a tendency to revert back towards A. The trade entry opportunity occurs after D is completed and price shows signs of turning. In the example above this is a buy opportunity after price turned back up and then retraced one more time below the EMA10 before rallying back towards the level of A.

Stop: Place stop more than 15 points beyond point D, and ideally also outside a historical support/resistance level. Remember that the CD leg may extend beyond the length of the AB leg (or beyond the 1.27 extension of AB), and 1.618 is often the next level. Either decide to place the stop below 1.618 to ride it out, or tight below 1.272 to try another entry in case CD goes beyond the 1.272 level.

Target: The main target is the 0.618 Fibo level of the DA range. An alternative exit (potentially used as 2nd exit when trading 2 positions) is the 0.786 Fibo level. Place limit orders just below these levels in a long trade, or just above in short trade.

Warning Signs: Long bars or gaps at the beginning of CD signal a longer CD leg. A faster CD leg (shorter time than AB) signals that it will be longer than AB.

Gartley Pattern (or “Failed Double Top Sell” and “Failed Double Bottom Buy”:

Description: The Gartley pattern’s signature is an AB=CD pattern that is trying to reach a previous peak (X) but falls short of it, usually at the 0.786 level of the previous XA leg it is trying to retrace. The Gartley pattern may not signal a major trend turn, but the likelihood of a move from D in the direction of A is high.

Entry: The trade opportunity arises at the completion of the pattern (D) at which point price has a tendency to revert back towards A. The trade entry opportunity occurs after D is completed and price shows signs of turning. Often times this pattern completes at the 0.786 Fibo retracement level of XA. Place entry order just inside the 0.786 level to catch a move to this level (shade the 0.786 level).

Stop: Place stop just beyond point X, and ideally also outside a historical support/resistance level. The pattern will be invalidated if D exceeds X.

Target: The main target is the 0.618 Fibo level of the DA range. An alternative exit (potentially used as 2nd exit when trading 2 positions) is the 0.786 Fibo level. Place limit orders just below these levels in a long trade, or just above in short trade. These targets are consistent with the AB=CD pattern targets.

Warning Signs: Long bars or gaps at the beginning of CD signal a longer CD leg that may extend beyond X and invalidate the pattern. A faster CD leg (shorter time than AB) signals that it will be longer than AB.

Butterfly Pattern (“Failed Gartley Pattern”):

Description: The Butterfly pattern’s signature is an AB=CD pattern with a CD leg that goes beyond the previous peak (X). It could be a called a “Failed Gartley Pattern”. The Butterfly pattern is often followed by a very fast reversal, as shown in the example above.

Entry: The trade opportunity arises at the completion of the pattern (D) at which point price has a tendency to move sharply in the direction of A and often beyond A. The trade entry opportunity occurs as price approaches the 1.272 extension of XA. Place entry order just inside the 1.272 extension level to catch a move to this level (shade the 1.272 level). In some cases the CD leg goes to the 1.618 XA extension level. In this case you can either use it as another entry opportunity after being stopped out attempting to trade the 1.272 level, or trade the 1.272 level with a wide stop outside the 1.618 level.

Stop: Place stop just beyond the 1.272 Fibo extension of  XA or beyond the 1.618 Fibo extension of XA. Ideally this stop also falls outside a historical support/resistance level. The pattern will be invalidated if D exceeds the 1.618 extension of XA.

Target: The target for the Butterfly pattern are higher than they are for the Gartley and AB=CD patterns since the Butterfly pattern often ignites a major reversal. The first target is the 0.618 Fibo level of the DA range. An alternative target (or 2nd exit when trading 2 positions) is the 1.272 extension of the DA range, and a third target would be the 1.618 extension of the AD range. Every one of those exit would have been reached in the example above, and exit one very quickly. The three long blue bars after the rally starts would have been an indicator of more upside to come. Place limit orders just below these Fibo extension levels in a long trade, or just above in short trade.

Warning Signs: Long bars or gaps at the beginning of CD may signal a longer CD leg that may extend beyond 1.272. A faster CD leg (shorter time than AB) may also signal a move to the 1.618 level or beyond.

3 Drives Pattern (also “Basic 5-Wave Elliot Wave Pattern”):

Description: The 3 Drives pattern’s signature is symmetric move consisting of 3 waves with the trend (or in the direction of the pattern) and 2 waves against the trend. It is essentially the basic 5-wave Elliot Wave pattern. It is typically followed by a correction retracing a good portion of this pattern, which is the trade opportunity.

Entry: The trade opportunity arises at the completion of leg 3 of the pattern at which point price has a tendency to move back in the direction of X (bottom of leg 2).The trade entry opportunity occurs as price approaches the 1.272 or 1.618 extension of leg 2. Which extension to use depends on whether leg 2 was a 1.272 or 1.618 extension of leg 1. Place entry order just inside the 1.272 or 1.618 extension level to catch a move to this level.

Stop: Place the stop 15 points outside the 1.272 level, or if risk is acceptable, just above the 1.618 extension of leg 2. Ideally this stop also falls outside a historical support/resistance level. The pattern will be invalidated if leg 3 exceeds the 1.618 extension of leg 2.

Target: The first target should be the 0.618 retracement of the 3-X distance, or 3-0 distance (entire pattern length). If the move will only be a correction, then this may be the only target that will be reached. But sometimes price exceeds X and/or O and in this case targets at the 1.272 or 1.618 extension of the 3-X distance could be placed. Place limit orders just below these Fibo extension levels in a long trade, or just above in short trade.

Warning Signs: Long bars or gaps and sharp momentum in leg 3 may be an indicator that a move beyond the 1.618 extension level may occur.

Kangarootail:

Description: The Kangarootail pattern is a single candle with a long tail (low or high) and a small candle body (open and close nearby). A bullish Kangarootail would have the open, high, and close price clustered on one end of the candle, and the low sticking out on the other end producing a long skinny candle (see example above, note that I’m using a daily chart this time). A bearish candle would be the reverse with the line pointing upwards (also sometimes called a dead-cat bounce.) This pattern  reflects the sharp rejection of one market bias and is often the beginning or final confirmation of a major trend move.

Entry: The trade opportunity arises after the Kangarootail has been confirmed. Confirmation is not very well defined, but at a minimum the kangarootail should be followed by 2 or 3 bars that stay above the upper half of the tail end. More confirmation would be obtained by waiting for a price move above (or below if bearish) the EMA10 line, as shown in the example above. There, price kept rallying after the tail was made, and consolidated above the daily EMA10 line. Kangarootails are more significant on the daily chart, and especially strong signals if they bounce off a major moving average, like the 100 or 200 bar simple moving average that is followed by many traders. Also, and this is important: don’t trade kangarootails that go against the trend. This pattern is a trend-confirmation pattern, not so much a reversal pattern. It is quite common to see a series of kangarootails on a sharply rising or dropping market, and they are not a sign of an impending trend reversal.

Stop: Place the stop 15 points beyond the tail, or outside a nearby major support/resistance level.

Target: The first conservative target should be the first retracement to the EMA10 line. After that use trailing stops, or exit on additional EMA10 line approaches.

Warning Signs: Once prices move half-way down the tail, consider it a failed pattern, and look for an exit.

Head and Shoulders Pattern:

Description: The Head and Shoulders pattern may easily be the most classic of all chart patterns, and is quite reliable. It is a major trend reversal pattern and is complete on the break of the neckline. It is easily recognizable, and may not always appear as symmetrical as in the example above. But the more symmetrical it is, and the more it follows typical Fibonacci retracement levels, the more likely it is to give a correct signal.

Entry: The trade opportunity that offers the most confirmation arises at the completion of the pattern with the break of the neckline. Ideally (as in the example above), price does not rally back above the neckline once it is broken. It may, however, and I consider this pattern failed only if price exceeds the right shoulder. An entry order could be placed below the neckline when the pattern is nearly complete.

Stop: Place the stop just above the right shoulder, or 15 points beyond the neckline (this stop may be too tight in many cases though, but may be chosen if the pattern very clear.

Target: The first target should be the 1.618 extension of the neckline-head range. A second target could be the 2.0 extension of the neckline-head range, shown as Exit #2 in the example above. This is the classic target for this pattern, and the interim bottom that price makes near Exit #2 reflects this fact (many traders took profit there.)

Warning Signs: A strong looking right shoulder may indicate that the neckline break may only be temporary. In the example above, the right shoulder looks weaker than the left one (only retraces to 50% of the neckline-head range, lower than the left shoulder), and this is in favor of the trade.

3-Candle EMA10 Crossing Signal:

Description: The 3-Candle EMA Crossing Signal is a signal I created after studying the charts for a long time. While price may cross the EMA10 line many times, there are a few crossings that signify major trend turns. For the bullish case: a buy signal occurs when there are two bullish candles in a row where the second candle crosses the EMA10 line, and the candle after the one that crosses closes above the EMA10 line. There are always three candles needed for a valid signal. The second is the one that crosses the EMA10, the third has to close above the EMA10 (it may be a bearish (red) candle as in the example above.) A sell signal is exactly reversed. The first two candles should ideally be long bodied candles, which signifies strong momentum. The third candle is often a retracement, and it’s not unusual for it to close just barely above the EMA10. But if both the 2nd and 3rd candles close high above the EMA10 then we have a very bullish signal.

Entry: The trade opportunity occurs after the pattern is completed with the third candle closing as outlined above. The third candle must be complete, don’t try to anticipate its closing. After the signal is confirmed with the closing of the third candle, you can either enter right away at the opening of the next candle, or wait for another pullback to the EMA10 line if momentum doesn’t appear very strong.

Stop: Place the stop afew (15) points below the next major low that preceded the signal.

Target: Use chart pattern and Fibonacci extensions to determine a target.

Warning Signs: Not every one of these signals should be traded though. A good filter is to look at the low or high made before the signal occurs. If it was a major new low or high without any comparative low or high nearby, then it is often a valid signal. The first signal shown in the chart above would be filtered out by this rule, since price has just come down from a long decline, meaning the high is not isolated enough for the signal to be taken.