December 12th 2007
Trading Bases
This is the first part in my five part series on the patterns I trade.
In technical analysis, there are 10’s of patterns, with 100’s of indicators and about a million ways to interpret what it all means. With all these options, it’s easy for a would be trader or investor to suffer from information overload. After all, we all want the best, most profitable setup and we spend hours researching books, blogs, and newsletters to find the best system.
I’m going to say something that should give you some peace. You can make a career as a discretionary trader with only one pattern, one setup. If you’re just starting out, or you haven’t had the success you would like, take a step back, read this series, then pick a setup. Study its eccentricities, when it works, and in what context.
The first of my patterns that I trade consistently is the base. A base occurs when price moves tightly in a horizontal direction. I don’t place a time restriction on the pattern. I do like the base to stay relatively flat. If it begins to form at an angle then it has become a flag.
The base formation is the pattern I started out trading. Let me rephrase that. I started out trading every pattern under the sun, but after losing much money and with mentorship, I quickly realized I needed to step back and simplify.
Lo and behold, I focused strictly on the base. I guess it just seemed like the easiest to learn, and I was right. With the right context the base is a consistent winner.
So what is the right context for trading the base? Well, there are 5 things we need to look at.
1. Market direction. You always want to trade in the direction of the trend. Even after trading for several years, I still adhere closely to this rule. Occasionally I will take a trade that is in the opposite direction of the trend, and even after all the years of trading I still typically lose money in those trades.
2. Support and Resistance. I’m constantly mentioning support and resistance in my posts, but they’re important. I couldn’t trade without them. Typically, the best trades off bases will occur when the base hugs a line of support or resistance. When going long you want support to be underneath you and resistance far above you. The opposite holds true when shorting.
3. Volume. It is the key indicator. Volume should decline as the base is formed. There should be less and less churn.
By now you’re probably saying, “Thanks Captain Obvious. Tell me something I don’t know!” Ok fine, the last two are what sharpen my edge.
4. Extremes. Repeated here at this blog, but it must be stated again: Extremes mean opportunity. Extremes come in several forms. Stocks that Gap at the open and then form a base. Stocks that run up or down for three or more days in a row and then form a base. A marubozu followed by consolidation. Why are extremes a big deal? An extreme move to upside signals that the stock is being bought, a base is your low risk opportunity to jump on the money train.
5. Support from Multiple Time Frames. I wrote an article last week about merging time frames to make more money. The reason why using merging timeframes works is that you are adding increased probability that your trade will move in the desired direction. It leverages the fact that other traders are looking at similar trades in the same direction, but on different time frames.
So, the day trader may be looking at the 5 minute base whose entry matches the entry on the 60 minute triangle, whose entry matches the bull flag on the daily chart.
The great thing about technical analysis is that patterns repeat themselves. A base pattern is no exception. When I scan through my charts nightly, there’s a ton of junk out there. I give myself some rules to focus my efforts and increase my edge.
The 5 rules I have laid out will increase your edge, and keep you focused on those trades with the highest probability for success.
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10 Comments »
HPT on 12 Dec 2007 at 1:10 am #
Look forward to seeing your posts on setups, make sure you make a link to these setups on your sidebar for future use.
Bubs on 12 Dec 2007 at 7:20 am #
Great post also looking forward to the future posts
Will Kellner on 12 Dec 2007 at 1:44 pm #
Good post. Have you read HCPG blog? They wrote about a lot of these concepts last year, merging time frames, support and resistance, and of course their base and break pattern. They don’t seem to be blogging much this year anymore.
I’ll def add you to my feed. Looking forward to more posts.
Jonathan on 12 Dec 2007 at 2:25 pm #
@HPT Thanks. I sure will.
@Bubs Thanks again!
@Will Oh crap. There goes my thunder. Actually I haven’t been by HCPG, but I’ll check them out. Thanks for the add!
NoGreedNoFear on 12 Dec 2007 at 2:25 pm #
Great start to your new series. Looking forward to Part 2.
Thanks for sharing.
JasonR on 12 Dec 2007 at 10:43 pm #
I’m still a little bit of a newbie to this whole trading thing, but have enjoyed your posts and found much food for thought here :-). I hope you don’t mind me asking what may be a silly question. Might a base with falling volume also indicate the possibility of a reversal? I would think this is especially likely after an extreme like you mention. Am I off base here (hehe), or are there some things to avoid that might signify a reversal?
Jonathan on 13 Dec 2007 at 7:06 am #
@NoGreedNoFear Thanks for the complement!
@JasonR I look at declining volume and no price movement as lack of conviction. If you look at the context of a base, declining volume is indicative of a continuation of the previous move. For an up move, declining volume in a base means that despite the pause in stock price, sellers were unable or unwilling to knock the price down. Buyers didn’t need to exert any activity to keep the stock price flat.
Whether the preceding move was up or down, when looking at a base, you want to keep in mind that volume must explode when price finally breaks out.
If volume is heavy inside of a base, that is indicative of churn (lots of buying and selling with no price movement either way). I would rather buyers exhaust their buying power when the stock is rocketing up, not before it even breaks out. Could price break out and continue higher? Sure, but keep in mind you want to trade stocks with the best chance for success. Volume is another filter I put on when evaluating potential trades.
Hope this helps.
Michael on 19 Dec 2007 at 7:21 pm #
I’m also fairly new and I really enjoy reading your posts. Frankly, my biggest problem it seems like (and it might sound dumb), is that I can’t figure out how to consistently evaluate the support and resistance.
For example, you used the IBM example and in a good setup, the resistance should be far above but when I look at the IBM chart for the year, it seems like, back in July, we were right there underneath the resistance, no?
Evidently, I’m not seeing something obvious
Jonathan on 20 Dec 2007 at 6:48 am #
Hi Michael,
The way I determine support and resistance is as follows:
When Price is unable to break above/below a certain price that’s support or resistance. The more times price touches this “area”. The more powerful the support/resistance is thought to be. Also, Support/resistance on larger time frames are thought to be more powerful than smaller time frames.
You can also use tools like pivots points and whole numbers, but in general if price can’t get above/below a certain area than there must be support/resistance there.
In the case of the IBM example, there was definitely resistance at the 108 area. On 5/21 IBM stopped at the 108 level and then on 5/31 it tried again, but couldn’t even make it back to 108 area.
IBM broke through resistance on 7/6 and for the following six trading days, printed a tight, horizontal price pattern(base). The resistance at 108 had now become support. Note that price never broke the 108 area. I saw the base as a low risk opportunity should it break out.
Remember that support and resistance are zones and they are also somewhat subjective. After looking at enough charts you start to see where prices stall. What constitutes are break of support/resistance? Again very subjective and should be the subject of another post.
Hope this helps. Let me know if it didn’t I can talk more about support and resistance in the future.
Michael on 27 Dec 2007 at 5:59 am #
Thanks Jonathan,
I think this helped. I was looking for a resistance on a wider timeframe. It makes perfect sense now. But in essence, it seems like a base has to be near a recent high for it to be considered at a local high, no?
Happy Holidays! Your blog and help are awesome