QQQQ Trade Setup

01/07/09 01:02:28 PM

by Alan R. Northam

In defining when a trade should be taken, the trader looks for a valid trade setup, a high-probability area to enter the trade known as a trigger, and a high-reward area known as a target. The PowerShares QQQ Trust has provided such an opportunity.

Security: QQQQ
Position: N/A

Figure 1 shows the daily bar chart of QQQQ. This chart shows a downward sloping Intermediate-term trendline drawn in red. This chart also shows an upward sloping short-term trendline drawn in green. From late November, the QQQQ has rallied upward until it ran into resistance from the Intermediate-term downward sloping trendline. Over the next four trading sessions, the high of each session ended right at this trendline. On December 22, QQQQ traded downward and closed below the short-term upward sloping trendline breaking this line of support. The breaking of a trendline is a signal of a change in trend. It does not, however, signal a trend reversal. In the case of QQQQ, it has signaled a change from an upward sloping trend to a horizontal trend known as a trading range. Trading ranges are periods of consolidation after a trend and usually signal the continuation of the previous trend once the period of consolidation has run its course. However, trading ranges have on occasion been reversal signals, especially after a weak trend, so we have to be on the lookout for a reversal in trend as well. With the breaking of the upward trend and QQQQ entering into a trading range, this then is a valid setup.

FIGURE 1: QQQQ, DAILY. This chart shows trendlines as well as support and resistance lines. This chart also shows the average true range indicator below the price chart.

Graphic provided by: StockCharts.com.

Figure 1 shows a green support line drawn off the December 12th price low marked as SL1. A close below this line of support will signal a trend reversal. Figure 1 further shows a red resistance line drawn off the price peaks of December 9 and 16 marked as RL1. Note that QQQQ has managed to close just above resistance line RL1 over the last two trading sessions. Normally, this would constitute an upward breakout. However, I do not consider closes marginally above a line of resistance to represent a decisive breakout. Many times I have seen marginal breakouts like this immediately turn back down into the trading range. Therefore, I like to put a filter on marginal breakouts. The filter I like to use is to define a decisive breakout as one average true range (ATR) above the line of resistance. Therefore, I have added the average true range indicator below the price chart. The average true range is one. Therefore, I have added a second resistance line one ATR above resistance line RL1 and have labeled it as RL2. A close above RL2 will then signal a decisive upward breakout of the trading range and will signal the continuation of the upward corrective rally. The breaking of either the support line SL1 or the resistance line RL2 will therefore constitute a valid trigger to enter a trade. Should QQQQ close above resistance line RL2, a long position should be taken. A close below the support line SL1 will indicate a short position should be taken. It is my opinion that a long position should not be taken if triggered for this trade, as it would constitute a countertrend trade, which is a low-probability trade situation. As a trader, I only want to make high-probability trades. Therefore, I would only take the short trade as it is a trade in the direction of the major trend, which is a high-probability trade.

In determining price targets, minimum price targets can be identified. These are price targets that the trade has a high probability of attaining but not necessarily the price point at which a trade should be terminated. Rather, should the momentum of the move continue to remain strong once the price target is reached, the trade should be allowed to continue until momentum has run its course so as to maximize profit. In the case of QQQQ, if there is a breakout above resistance line RL2, the trade setup will be considered invalid, as it would represent a low-probability trade. In that case, a new trade setup and trigger would have to be established so we will not define a price target in this direction. However, if QQQQ turns back down and closes below SL1, it would signal that a short trade should be taken.

If QQQQ breaks through SL1 and just barely closes below this line of support, then I would wait until QQQQ has traded below SL1 by one average true range. The minimum price target for a break to the downside would be the price minimum made in November. In other words, we can expect QQQQ to fully retrace the rally off the November lows. (Minimum expected price returns after the completion of a corrective rally is 100%.) However, QQQQ should trade lower than this minimum price target and should make a new lower low price if the downward trend is truly going to continue. For this reason, it is wise to allow the profit to run as long as the downward momentum is increasing.

In conclusion, QQQQ has presented itself as a valid trade setup. However, QQQQ has not yet provided a trigger to enter a short position. Once a trigger has been signaled, the trade can be executed. The expected minimum price target calls for a complete retracement of the corrective rally off the November price low, or $25. However, if selling momentum is increasing once this minimum price target is reached, the trade should be allowed to continue so as to maximize profit. This trade setup is shown for educational purposes to show how to identify trade setups, triggers, and targets, and is not a recommendation to enter into this trade.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.