BULL'S EYE TRADING. by Joe Duffy. A trading champion's guide to pinpointing tops and bottoms in any market

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2 BULL'S EYE TRADING A trading champion's guide to pinpointing tops and bottoms in any market by Joe Duffy Trading futures and options does involve financial risk. Contact us for a discussion of the potential risks and rewards.

3 ABOUT THE AUTHOR Joe Duffy began his career in the investment business as a stock and commodity broker in After five years of trading, he entered the U.S. Trading and Investing Championships on three separate occasions. He finished in the Top Ten every year he entered, with annualized returns of 121%, 243% and 432%. As a direct result of his performance in the trading contests, he was contacted by a publisher to reveal his strategies and market analysis. He subsequently wrote The Trading Advantage and Turning Point Analysis. Both books have appeared on Futures magazine's list of "Best Books for Traders." From 1991 to 1996, Joe worked as a proprietary trader and technical analyst for a large multinational institution where he initiated and managed multi-million dollar positions. A the end of 1996, he made the decision to leave his prestigious position to pursue his goal of trading from home and editing a newsletter for traders. Joe appears regularly at seminars on trading and market analysis and he edits a nightly newsletter for traders called Joe Duffy's KeyPoint Advisory Service."

4 INTRODUCTION By writing this booklet, my goal is to provide you with the most information possible and explain each concept as best as I can. I hope I am able to balance these two factors for your maximum benefit. As a suggestion, however, I believe you will get more out of the information in this booklet if you read it several times. What you are about to read is only a small fraction of the methods I use in my market analysis. You will be interested to know that some of the strategies in this booklet are the same one I use to finish in the Top Ten in the U.S. Trading & Investing Championship three different times. Recently, I've been developing some exciting new strategies that I believe are so good, I'll never reveal them to anyone at any price. Even so, I want you to possess a basic understanding of some of the techniques and strategies I use in my personal trading. The contents of this booklet are not intended for general circulation. For that reason, I must ask that you please hold the information in these pages in the strictest of confidence. WHAT WE ARE GOING TO COVER What I am about to show you is just part of what I use to trade every day. There are many different styles of trading and, in my opinion, no one style is right or wrong. If you read Jack Schwager's Market Wizards books (which I recommend highly), you will learn that there are literally dozens of different ways to make money in the financial market. The unfortunate corollary for this is that there are also many ways to lose it! I'm telling you this to help you understand how I trade. My way may or may not be the way you want to trade. It may be close to your style, or it may be just close enough that you may only want to use a few of my ideas. My point is that there is no right or wrong way to trade. I am not telling you this is the best way to trade it just happens to be what works best for me. I thoroughly enjoy teaching others how to trade. However, there is another important reason why I decided to share some of my ideas: writing them down helps me improve my trading results. 1

5 Sharing my knowledge forces me to organize my concepts and thought completely so they can be passed on to people who are seeing them for the first time. By organizing my thoughts, I am able to stay more focused during my own trading. This raises an important point about writing things down. Each day you should physically write down your potential support and resistance points. I also like to write down other reasons why I want to take a trade. Once I write it down, however, I almost never back out by second guessing my decision during the trading day. Writing things down helps me summarize what is important, and what I must do is follow my plan. This is absolutely vital to your trading success. To conclude my introduction, I'd once again like to reiterate that what I am teaching you here are techniques, not systems. One of the best analogies I have heard compares successful trading to gourmet cooking. There is always a recipe, but the dish is always different depending on what ingredients are available. With that in mind, my method of trading features definable, empirical things that I look for. However, it also allows for some personal input in deciding exactly what combination of ingredients I will use. This concept should become more clear as we progress. And as you will soon see, there will be some trades that will seem obvious to you those being the high confidence, high-probability "no-brainer trades!" Now let's move on to the nuts and bolts of some of my trading techniques. IDENTIFYING HIGH PROBABILITY SUPPORT AND RESISTANCE ZONES The main focus of this booklet is to show you how I identify high probability support and resistance zones. High probability support zones are low risk places to buy. High probability resistance zones are low risk places to sell short. It really is as simple as it sounds. The philosophy I use to identify high probability points is also simple: I look to integrate techniques and integrate time frames. The techniques in this booklet are the simplest and most direct. 2

6 When I combine them on different time frames, I look for a confluence of evidence at the same approximate price level. This confluence of evidence is an important concept that should become very clear as we progress. PIVOT POINTS The first technique I will show you is the "Floor Trader Pivot Points." These points have been around for years and every floor trader knows precisely where they are. You should too. The formulas are as follows: Pivot Point = (High + Low + Close)/3 1 st High Pivot = Pivot Point + (Pivot Point - Low) 1 st Low Pivot = Pivot Point - (High - Pivot Point) 2 nd High Pivot = Pivot Point + 2(Pivot Point - Low) 2 nd Low Pivot = Pivot Point - 2(High - Pivot Point) 3 rd High Pivot = Pivot Point + 2(Pivot Point - Low) 3 rd Low Pivot = Low - 2(High - Pivot Point) Most any technical analysis software package can be set up to calculate these numbers for you. (If you are trading only one or two markets, however, an old fashioned hand calculator works just as well). I calculate each of these points using daily, weekly, and monthly data. Obviously, when using monthly data, the calculations only need to be done at the start of a new month. When using weekly data, the calculations are done at the beginning of each week. The daily calculations are done each day. Again, it is important to integrate time frames. If we have 2 or more pivots from different times that are the same or very close to each other, this is a good setup from which to start. If you have 3 pivots, that is all you need. 3

7 PIVOT POINT CHANNEL What you are about to learn is something that is being introduced for the very first time. It is completely new material and I truly believe it is the very best channel or trading band method there is. I say this (is) because it combines the best features of the different types of channel indicators that are currently most popular with traders. The band is smooth like a straight moving average trading band, but it also has the ability to adjust for market volatility like a Bollinger band. Notice in the accompanying charts how the width of the trading band increases gradually as the market becomes more volatile. This smooth and controlled self adjustment is key. Some of those reading this may be familiar with the pivot point techniques discussed in the last section. Now I will take this technique one more step and use it in a broader context to create the Pivot Point Channels. To create the Pivot Point Channels, I use a 7-day exponential moving average of the Pivot Points as a base. An exponential Moving Average is a little more sensitive to recent data than a straight simple moving average, however the basic principle is the same. Next, calculate the average difference between the first Pivot Low 4

8 and the first Pivot High for each of the last 7 days. To do this, you subtract the first Pivot Low value from the first Pivot High value for each of the last 7 days. You then add up the difference and divide by 7. This gives you the average value of the difference between the first high and the first low pivots. The final step involves adding this average of the differences to the moving average of the pivots to get the resistance line. As well, you subtract the average of the differences from the moving average of the pivots to get the support line. This creates a channel for the first support and resistance. You can use the same technique to calculate a 20-day exponential moving average of the Pivot Points. This time, instead of averaging the first Low Pivot and the first High Pivot, employ the average difference between the second Low Pivot and the second High Pivot. This will give you a second wide trading channel for support and resistance. (see chart) The Pivot Channel boundaries can be used as support and resistance just as the Pivot Points themselves are used. The Pivot Channels also lend themselves to other strategies, including identifying markets that are likely to be in a trending mode for a while. We do not have enough space to cover this subject fully, but some of it should be more clear by looking at the charts. As Yogi Berra once said, "You can see a lot just by looking!" Finally, remember that almost any of today's popular software programs have a formula builder that will calculate and display this information on your chart. 5

9 MARKET SYMMETRY Basically, this concept involves using simple trendlines to determine potential support and resistance. I do this two different ways. First, I use just the last two bars to draw trendlines. I join the last two highs and the last two lows, as well as the low to high and high to low. These lines are extended to give me our potential support and resistance points for the next day, week, or month, depending on the chart on which I was working. To emphasize again, I integrate time frames by using this technique on the daily, weekly and monthly charts. The second way I look for straight line symmetry in the market is by looking for old fashioned trendlines. I do this particularly on the 1/2 day chart. The 1/2 day chart seems to highlight the potentially significant support and resistance very well. As with any trendline technique, a trendline with more points is a potentially stronger support or resistance level. And remember that old support lines, once broken, become resistance and vice versa. As always, I make a written list of the potential support and resistance point using the monthly, weekly, daily and 1/2 day charts. Again, it is extremely important to integrate time frames to see if there are any levels that are the same. If there are two or more levels clustered together, this level is potentially a more powerful support or resistance level. One final important thing about trendline(s) is that I never look for them to break. They are always either potential support or potential resistance and, therefore, I expect they will hold. This way of looking at things takes away the anxiety and questions traders often feel as the market approaches a trendline (and relieving this question is no small benefit, believe me). Before I act on any trendline, however, I need to see a convergence of evidence from other techniques and time frames. Trendlines represent a straight line symmetry or geometry in the markets. Markets do follow repetitive patterns and markets often display symmetry. The concept of trendlines is so basic that it often is forgotten or overlooked by the majority of traders. (Who do you know who actually trades off of trendlines?). This is simple, but very effective. The next few pages provide more examples of the type of situations I look for in the market. 6

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11 FIBONACCI Leonardo Fibonacci was a 13 th century mathematician who discovered what is known as the Fibonacci ratio. The Fibonacci ratio is the division of any space into a 61.8% and 38.2% division. I also look for a 50% and 50% division of space. It really is as simple as that. The Fibonacci ratio and related concepts are found repeatedly in nature. In financial markets we simply borrow the concept. To use the Fibonacci ratios in trading, I simply look for a market to retrace 38.2%, 50% or 21.8% of a previous move. The chart example illustrates this straightforward concept. In using retracements, I again go back to the basic concept of confluence and integration to make this method useful. I like this method best when I can find a confluence of two different retracements coming in at the same level. The chart example I've included illustrates this point well. Again, I look to integrate Fibonacci retracement levels with potential support or resistance levels using other techniques. If I can get additional evidence to indicate support or resistance at the Fibonacci retracement levels, then I have a high probability trade in the works. Once in a while you will get three Fibonacci retracement(s) coming in all at the same level. When that happens, you do not need much else. REAL-TIME TRADING EXAMPLES Examples of some actual trade set-ups follow. The first example is the trade set-up from page 3 that says, "How to Buy Here!" You'll notice that virtually everything I have taught you in this booklet so far is setting up at that low. I hope you agree that anyone who knows this material would almost have certainly bought here! The great set-ups like these do not occur very often. It is worth noting, however, that the amount of evidence supporting a potential high or low is directly related to the confidence level of success. In other words, set-ups like these have an extraordinary high ratio of probability. Therefore, you should try to avoid the marginal trades and concentrate on the good setups with the largest confluence of technical evidence. This is especially true when you are starting out. 8

12 Here is an example of a real trade in the D-Mark. The following techniques indicated support at these levels: Monthly Low Pivot = 6607 Daily Low Pivot = 6498 Short-Term Pivot Channel = % Retracement = 6505 Natural Squared = N/A Weekly Low Pivot = 6505 Long-Term Pivot Channel = Day Low to Low = % Retracement = 6499 Cardinal/Corner = /2 From this we see a real confluence of support around Look to buy just above that support or 6510 or so. The low was 6507 and away we go! The logical stop loss on this trade is the furthest support number in the area which is the Cardinal/Corner at

13 Here is an actual example of a trade. It is not the ideal set-up of the previous one, however it is more like what you are going to get most of the time. Daily High Pivot = /32 Weekly Pivot Point = /32 Gann Cardinal Corner = /32 Trendline Horizontal Resistance = /32 50% Retracement = /32 I am selling around /32. I am using a stop above the next resistance level at /32. The latter is both the 3 rd high pivot and the 61.8% Fibonacci retracement. The high for the day was /32. Subsequently, the bonds dropped to /32 that day and opened the next day at /32 and traded /32 within a half hour. 10

14 Here is another trade from the same week. Once again, it turned out to be a successful one. Daily Low Pivot = 6980 Weekly Pivot Point = 6972 Daily Low to Low = (%) Retracement = 6973 Gann Cardinal Corner = 6973 This is a marginal situation as there are enough potential areas, but they are spread apart more than we would like. However, we have to make a little allowance for this as the D-Mark has been so volatile. My strategy here was to buy near the top of the range of support at the daily low pivot of The stop would be below the bottom of the range of support at 6962, so use a stop of 6950 or so. 11

15 DAY-TRADING SECRETS Finding support and resistance for a day-trader can keep him alive in a volatile market. Here's one idea, implemented with others, to find those target areas. My personal preference for day-trading and short-term trading is to buy dips and sell rallies. Two components are needed to make this strategy work. First, you have to be trading in the direction that gives you the best chance of success. Second, you have to be able to identify potential support or resistance for that trading day. I'll discuss one technique from each of these components that make up my day-trading approach. The first step is to determine which way the market is likely to go today in other words, is the trend up, down or sideways? One method to determine the market trend involves a couple of old standby technical indicators that are available on virtually any charting software: the Moving Average Convergence Divergence (MACD) and the stochastic indicators. These oldies but goodies really can be useful if used in the proper combination. Look at both the MACD and the Slow Stochastic on a daily chart to determine in which direction you want to trade the next day. For the MACD, I use a little longer time value for my inputs than the standard say, around a exponential moving average combination. I also use a slow stochastic indicator with an input value of somewhere around 20 days. Both of these indicators should be displayed together under the price data. Look for situations when both the MACD indicator and the stochastic indicator are on the same side of the signal line. If both are above their respective signal lines, then trade the buy side. If both are below their respective signal lines, trade the sell side. Quite often you'll find the MACD and the stochastic indicators are on the opposite sides of their respective signal lines. In these cases, avoid the market. The accompanying charts show this simple combination eliminates a lot of noise from the market and identifies those times when the market has the best chance to make a trend move. Throw these indicators up on any chart together, and you will see this combination works infinitely better than either indicator alone. 12

16 The alignment of the MACD and stochastic indicators together shows you the market trend. When both indicators are below the strength line, as they were in early December for both the S&P 500 Index and T-Bonds, you should be a seller; if both are above the signal line, as they were in early February, you should be a buyer. Once you've determined the direction to trade, the next step is to find support if you want to buy or resistance if you want to sell. There are several ways to do this, and my usual strategy is to employ several methodologies to come up with a confluence or a "keypoint" highprobability trading zone. Here is one methodology that is being described for the first time. Unfortunately, there is no neat name for this indicator, so I'll just call it the 3x5ATR. To construct it: 13

17 By combining the five-day average true range with simple three-day moving averages of the highs and lows, you can create the 3x5ATR indicator to find support and resistance areas that can be used in a day-trading strategy of buying on dips and selling on rallies. The S&P charts above and the above, left T-Bonds chart show examples of support lines using the 3x5ATR. 1. Add up the true ranges for the last five days and divide by five. This is the 5ATR. 2. Calculate a three-day simple moving average of the highs and a threeday simple moving average of the lows. 3. To calculate the 3x5ATR for potential resistance, add the 5ATR to the three-day averages of the highs. 4. To calculate the 3x5ATR for support, subtract the 5ATR from the threeday averages of the highs. An important point is that this is not a total day-trading strategy. Look to combine other techniques that identify potential support and resistance points. A good rule to live by is to look for a confluence of support or res istance by integrating analysis techniques and integrating time frames. 14

18 2001 Joe Duffy All rights reserved TradeWins Publishing P.O. Box 1010 Wilkes-Barre, PA