Understanding Charts 101

The current market is acting as if it were a lesson in a book on how to trade stocks. I am not sure why this is, but I think it is because the only guys left in the markets right now are people who need to sell and traders who are trying to make a few bucks each day.

Fibonacci Levels
If you read books on how to trade using stock charts, you are taught that markets tend to retrace specific percentages of a move before they initiate a new move. These levels are called Fibonacci Levels and are 38.2%, 50%, 62.8% and 76.4% of the low to high or high to low of the last move.

http://www.investopedia.com/terms/f/fibonacciretracement.asp

Trend Lines
Trend lines are essentially where you play connect the dots between the tops of a trend or the bottoms of a trend. The line formed by the tops becomes resistance and the line formed by the bottom becomes support.

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:trend_lines

Consolidation Patterns
Periods were the markets trade in a tight range are called consolidations. These times of low volatility trading normally appear as triangles, flags, rectangles or wedges. Consolidations are normally followed by violent moves. They normally appear as a pause within a strong trend. So a violent move in one direction is followed by a consolidation pattern and then another violent move occurs in the same direction of the move which preceded the consolidation.

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns

So why am I boring you with this stuff?
Again, because the markets are trading as if the charts are lessons in a book. I want to show this to you so all you can get an understanding of how institutional traders make a living.

Moreover, because I have an understanding of this stuff, I am able to manage risk by knowing when I have a high probability of making money and when I should be getting out of the way. Also, I don’t overreact when the market makes big moves one way or the other, because I know where the high probability reversal levels are.

Take a look at the Dow Jones since the 10/10/2008 low –
See how the tops were getting lower and the bottoms were getting higher (green lines)? That was telling me to be ready for a big move in one direction or the other.

The Dow spent the majority of 10/21 between 9004 (50%) and 9270 (61.8%).



Now take a look at how the market traded today! You can’t make this stuff up.
On this chart I have included the retracement levels from the 10/10 low to the 10/13 high (Blue Lines).
When the Dow Jones finally broke below 9,004, it then sold off 200 points in 15 minutes (Red Arrow)!
When the Dow took out 8,608, it sold off 275 points in about 20 minutes (Blue Arrow).
I figured that the 76.4% level of 8,328 (Blue Line and Purple Arrow) would come into play today on any break of 8608, and was ready to start to lock in profitable short positions at that level. The problem was that a hell of a lot of other traders had the same idea and the Dow rallied about 280 points in 12 minutes!
Guess where the rally stopped? That’s right, the rally stopped right at the broken uptrend line (Green Arrow), or 8,552.


The only question is how does the market open up tomorrow?
My guess is that the Dow will open tomorrow at or about 8,610. That would set an interesting wrestling match between 8,610 and 8,552. Maybe we get some new bailout package from the Fed over night and the market gaps up hard above 8,833. Nothing these days surprises me.