Charting Man Dan Explains Tightening Patterns and Risk-Reward Scenarios

Charting Man Dan McDermitt, founding partner and analyst with the Chart Guys, explains the relationship between tightening patterns and periods of volatility. Technical analysis shows that after periods of volatility, investors consistently see tightening stock ranges. He notes that investors look for these patterns because ranges can only tighten so much before breaking. He indicates that while traders do not know which way a trend will break, trend breaks bring volatility and volume spikes. McDermitt discusses the allocation of risk and details how traders assess the odds of a break against the risk-to-reward factor. Charting Man Dan walks viewers through the CV Sciences Inc (OTCMKTS:CVSI) chart as a recent example of an acceptable reward-to-risk move. McDermitt examines the Tilray Inc (NASDAQ:TLRY) (FRA:2HQ) chart and acknowledge that while the stock has not established many support levels, the conditions are right for a solid bounce once a bottom is reached.

Transcript:

James West:   Hey, Charting Man Dan joins me now from TheChartGuys.com. Dan, how are you today?

Dan McDermitt: Wonderful, James, how are you doing?

James West:   Yeah, I’m great. It’s good to see you.

Dan McDermitt: You as well.

James West:   Okay, so let’s, today, let’s talk a bit about some of the tradeable patterns that technical analysis yields to people like you who have developed expertise in what can only be described as acute pattern recognition. So tell me about some of the patterns you’re seeing today in some of the stocks, and rather than just dive in straight technically what’s happened, tell us what it is about the pattern generally that you like.

Dan McDermitt: Absolutely. So a consistent pattern that we see in the market is, after periods of large volatility, the market will generally give us tightening ranges as it’s a bit of price discovery. So if we see, you know, a 10 percent move, we usually get tighter and tighter and tighter, and we look for these tightening patterns, because when they break, they get a spike in volatility again.

So it’s almost like going from a period of volatile action, to calming down, reaching an equilibrium of a really tight range, and then we get a volume and volatility spike, and that’s a trading opportunity that we jump on. So while we don’t know which direction those patterns are going to break, we look for the signals, and we’ll talk a little bit with some examples here in just a moment of how we establish trade game plans based off of support and resistance levels, and how to act on those.

James West:   Okay, how do you allocate odds, or risk, in terms of – so, when you see a tightening pattern, do you say, do you try to establish a scenario in your head where you say, OK, there’s a 70 percent chance that this is going in the direction I think it’s going to, with a 30 percent chance that I’m completely wrong, in which case I hedge my bets with stop losses. Is that kind of part of your process at all?

Dan McDermitt: Yep, absolutely. So just want to differentiate: risk to reward would be a little bit different than the odds of a break, and I’ll distinguish between the two. The odds of a break, we’re going to be looking at individual little pieces of the puzzle, whether that’s volume or indicators like RSI or information like what the preceding trend was doing, and even fundamentally, you know, how the sector is reacting. Maybe we had some bullish reaction in earnings from someone else in the sector, something along those lines; these are all little pieces in the puzzle that have slight shifts in the percentage odds of which direction we’re going to break, or how confident we are in the pattern – and I’m certainly more confident in some patterns than in others.

Now, risk to reward is when we’re looking at what is our risk before we get stopped out of the trade, and what is the potential for upside that we could see if we get the follow-through? So I have an example where we’ll look at risk-to-reward for a specific trade here in just a second, but they’re a little bit different in terms of one is based off of support and resistance levels, and the other is based off of pretty much a library of historical information in my brain.

So if I’ve looked at 50,000 charts in my life, I’ve seen these patterns play out many, many times, and if you have a good memory, you start to develop, you know, what is most likely to happen in different scenarios, because you’ve seen it before.

James West:   Hmm, yes, you know, that’s interesting. I had a good memory when I was, till I was about 42, and then it really started to go south, and it’s not because I, you know, I actually drink incrementally less than I ever have, I certainly don’t really care to smoke too much cannabis anymore, so it’s like, I guess it’s just one of those age things, but I’ve noticed that my ability to retain pattern recognition signals has diminished with age.

So you’ve got 50,000 patterns or charts that you’ve seen in your head – that’s great, Dan, but I’m lucky if I can remember five at this point.

Dan McDermitt: So you’re saying that in a decade, I’m going to be out of a career?

James West:   Well, I just think that you’re going to have to rely more on your charm and good looks more so than your memory. [laughter]

Dan McDermitt: All right.

James West:   Okay, so Dan, let’s talk a bit about that. Why don’t we go to the charts now, and you tell me exactly what you’re talking about.

Dan McDermitt: So as always, we want to know what the broader market is doing; first things first. And we can see that over the last seven days, we have seen a higher low on the S&P500 every single day. So that’s obviously a very strong trend; we are at the 2019 highs, and we zoom out to the weekly time frame and look at the bounce that has taken place. And again, it’s pretty flabbergasting at this point, but we’re looking at all-time highs, and we are less than 2 percent away from those all-time highs. So we know that any price action that has happened in the Canadian or US marijuana space in the last three plus months, since the lows of December, has been the ideal environment for bulls to trade in.

Last time we were at all-time highs, the Canadian MJ sector was running crazy, going blue-sky breakout. So we have to just preface everything knowing that this is the ideal environment for bulls; it will not always be the case that this is, you know, this strong of a bull market, but for now, that’s where we stand.

So going back to what we were talking about just a bit ago in terms of risk to reward and basing entries off of support levels and tightening ranges: so, a very common tightening range is the equilibrium pattern, which is marked by higher lows and lower highs in a tightening range, and like I said, it comes after periods of high volatility. So CVSI here, is CV Sciences; it’s a CBD play in the US, and they just made a monster bull move, where the size of this move in just a week and a half was almost a 50 percent move.

So big-time move, and then we start to consolidate in a tightening range. We have the high of the move, and the low of initial consolidation. That is now our range; we bounce, and we anticipate a lower high is going to form, because tightening ranges are most likely. Now, those little details that I talked about in terms of what could change the percentage chance of what’s most likely to happen: if, on this bounce, if we were seeing increasing, solid bull volume in line with the volume on the original move-up, we could definitely see continuation. But because the bull volume is unimpressive, and because we already know that the most likely scenario is a lower high, we look for that to happen.

So then as we pulled back, we head back to our key support level, down at 5.50; that’s the low of the pullback. So yesterday, the low of the day hit 5.53, and I made an entry into CVSI, as did some other members, based off of this support level. We know that we are fairly likely to hold that 5.50 support, and when we were down testing that level, the RSI on the hourly timeframe was oversold. So that tells me that in oversold conditions, we’re more likely to hold a support level. So I made an initial entry in the low 5.60’s; a little bit more patient traders would have made an entry in the 5.50s, but let’s just say for example case here that we have an entry at 5.60 and a stop loss below 5.50. You’re risking about $0.11, $0.12 if you were to get stopped out, and if we were wrong that the bounce is not going to take place, and this is not a tightening pattern.

So we’ll say a $0.12 risk, so what is the reward for the trade? Well, we’re going to anticipate that if this support holds, the bulls are going to bounce and form another lower high compared to 6.21. In the end, we did get a tiny bit of follow-through this morning, not significant, so a pretty unimpressive follow-through move after the strong close yesterday, but even with that being the case, the entry from 5.60 would have resulted in $0.30 of possible upside. So my risk is $0.12 and my reward is $0.30, so that’s about a 2.5 to 1 reward-to-risk ratio, which I always want to have as a guideline, a rule of thumb, 2:1 risk-to-reward. Because if I’m risking $0.12 and I’m only looking to make $0.12, that’s not really the ideal kind of trade we want to be in. We want to be able to see moves that have reward bigger than what the potential loss is.

So another example of tightening ranges: here’s CRON on the hourly time frame, and it’s just been tightening the last few days, and we’re actually right at support right now, where we have our low of the pullback, high of the bounce, higher low, lower high, and if we turn off extended hours that just makes it a little bit cleaner, where it’s just a tightening range. We formed another higher low at 18.16; we have a lower high at 18.53, so we can see three days in a row of lower highs, but we also have the higher lows forming. And we did just break 18.16 support, but only by a penny; so whenever we’re entering a trade, we want to ensure there are stop losses allow for enough space for a couple cents of wiggle room at least, because right now, if you’re making a trade based off of the 18.16 support, we’re seeing a tiny bounce at this point. If we’re going to stay in this equilibrium pattern, the bulls have to see a bounce back up to the 18.30s, and then we would look for a break on Monday, because we get to a point where we get so tight that we can’t possibly stay in the tightening pattern any longer.

And right now, if we do close today or see some bounce follow-through into the 18.30s, we will stay in this pattern into Monday. So it’s making an entry perhaps based on support, or if things get really tight, I personally just wait for the break, because the break usually sees a volume spike associated with it, and then direction and momentum. So I want to be profitable in a trade as soon as I enter, so if I wait for these resistance levels to break on increasing bull volume, that’s going to ensure that I am likely going to see a profitable trade and follow-through as soon as I enter.

So now we’re going to look at TLRY which is in all-out dump mode, and we got plenty of red flags that we were going to be entering an area with a lack of support after the exponential run-up from when we started trading, we’re now falling back into that zone, and we did not establish many support levels on the way up. I’m looking at 55.55 and then down to 49.50, and you can see there’s all these gaps mixed in here and just an area where there’s a lack of support. We can see RSI levels get overextended. So I love oversold bounces; it’s one of my edges. I’ve had years of practice and I can see from my statistics that I perform well in oversold bounces. I certainly do not suggest that newer traders try and play oversold bounces without a lot of experience, because it’s a great way to be playing counter-trend and to be stuck in positions without having any idea of when to exit, and then that’s when things can get ugly.

So for me, I’m going to be looking to begin scaling into TLRY potentially starting next week, because the daily RSI is down in the low 20s; the four-hour RSI is down in the low 20s; the hourly RSI, down in the low 20s, and when we get a scenario with all these longer-term time frames lining up oversold, we generally get a solid bounce. So whenever we do find a bottom, we’re going to expect a 10 percent bounce off those lows just as a conservative rough number, but there’s no sign that the bottom has been set yet. So personally, I scale into these trades, and let’s say I make an entry on $59 support breaking; that’s one of three entries. I’ll then reserve a second entry for 57, and then a third entry to 55, and if were to drop down towards 55 in the next two trading days, RSI levels would be at all-time lows, and we would just be getting ready for that short covering and bulls getting in for that quick oversold bounce.

So again, certainly higher risk in terms of not being an easy trade, playing counter the trend, but it is something that I’m watching into next week, TLRY, and we’ll see if this bounce plays out.

So those are some examples of using support and resistance to establish some trade game plans to limit your risk and hopefully maximize reward in these trades. Thanks for having me on, James. I’ll see you next time.

James West:   All right, Dan, that was great. Thanks very much for joining us; as per usual, your contribution is much appreciated. We’ll see you soon.

Original article: Charting Man Dan Explains Tightening Patterns and Risk-Reward Scenarios

©2019 Midas Letter. All Rights Reserved.