TD Lines and TD Retracements

TD LINES AND TD RETRACEMENTS

Almost all technical analysts are familiar with trendlines and retracements. While the majority of these traders have used these indicators at some point in their careers, few have adopted a uniform application. Calculation of these levels are completely arbitrary and a function of one’s mood and market disposition. We introduce mechanical processes which removes emotion and permits the construction of these levels consistently and accurately. More notably, we present a series of breakout qualifiers to these market-timing indicators, enabling a trader to deter-mine whether a breakout is valid, and should be traded, or disqualified, and should be faded. We will also introduce two new indicators—TD Line Gap and TD Line Gap REBO—which will provide the reader with a new method of approaching and trading trendlines.

Qualified And Disqualified Td Lines

Practically all traders are trend followers. It is not uncommon for these traders to draw trendlines to establish the probable trend of the market. Unfortunately, there exists no widely accepted method or industry standard for the construction of these trendlines. Consequently, five different traders may draw five completely different trendlines on the same price chart. To confront this inconsistency, we developed an objective means of drawing trendlines, called TD Lines. This trading methodology can be effectively applied to price activity across a variety of markets and various time frames. By applying TD Line breakouts to underlying securities, a trader can then extrapolate from these breakouts that the options for these securities will likely behave similarly. While this approach is a legitimate means of trading options in a trend-following fashion, we have developed rules and other indicators that are designed specifically for evaluating contratrend option trading opportunities.

One of the biggest problems with trendlines is that while they may be useful in establishing points of market price resistance and support when drawn properly, they are often constructed arbitrarily and therefore they are unreliable and difficult to reproduce. The selection of these lines is many times a function of a trader’s bias, current trading position, or market outlook. We developed TD Lines to overcome these shortcomings and to introduce a degree of objectivity and consistency to trendline construction. In order to draw a trendline, one must connect two price points. For most traders, it is second nature to refer to the left-hand side of a chart to select a price point and then work their way to the right to connect to another more recent subjectively selected price point. It concerns us that this process is random and arbitrary. The price activity at the left-hand side of a chart is part of trading history. It makes more sense to rely upon more recent market activity for the selection of price points. Figuratively speaking, we do just that since TD Line price points (TD Points) are selected from the right side of the chart to the left side of the chart. We do not mean to imply that we draw our TD Lines from right to left, rather we simply review price activity from the right side of the chart to the left to identify TD Points and then to select the two most recent price reference points to draw our TD Line.

The first step in drawing a TD Line is to identify the two most recent TD Points. A Level One TD Point Low is a price low which is immediately preceded by one higher price bar low and immediately succeeded by one higher price bar low— in other words, it is a low that is surrounded by higher lows. Conversely, a Level One TD Point High is a price high which is immediately preceded by one lower price bar high and immediately succeeded by one lower price bar high—in other words, it is a high that is surrounded by lower highs. Once these objective points are identified, they can be connected to create a Level One TD Line. The distinction between Level One and higher-level TD Points and TD Lines is related to how many consecutive price bars immediately to the left and immediately to the right of the TD Point are required. For purposes of this discussion, we always refer to Level One which is the most basic.

A TD Demand Line is an upward-sloping trendline and a TD Supply Line is a downward-sloping trendline. To create a TD Demand Line, we connect the two most recent TD Point Lows. Because a TD Demand Line is upward-sloping, these TD Point Lows must be ascending, meaning the more recent TD Point Low is higher than the previous TD Point Low. Once a more recent TD Point Low is formed, a new TD Demand Line is drawn and becomes active. If the previous TD Demand Line was exceeded to the downside, the TD Line remains on the chart and a new TD Demand Line is added; if the previous line was not exceeded, the TD Demand Line is simply redrawn. To draw a TD Supply Line, we connect the two most recent TD Point Highs. Because a TD Supply Line is downward-sloping these TD Point Highs must be descending, meaning the more recent TD Point High is lower than the previous TD Point High. Once a more recent TD Point High is formed, a new TD Supply Line is drawn and becomes active. If the previous TD Supply Line was exceeded to the upside, the TD Line remains on the chart and a new TD Supply Line is added; if the previous line was not exceeded, the TD Supply Line is simply redrawn.

Figure 7.1 of Merck (MRK) illustrates both an up-sloping TD Demand Line and a down-sloping TD Supply Line. The two most recent TD Points at that time which were connected to construct these TD Lines are identified with asterisks ( ). Figures 7.2, 7.3, and 7.4 are all qualified TD Line trades. In almost every case, a validated breakout above a TD Supply Line or a validated breakout below a TD Demand Line was followed by a continuation of the trend. The horizontal lines identified on the chart are a series of TD Line breakout projections, which we will discuss later in the chapter. While we could trade these qualified TD Line breakouts, and would do so if we were trading on a small time frame, we prefer to trade longer-term disqualified TD Line breakouts—by longer-term, we mean that we look for disqualified breakout trades primarily on daily price charts, although any large intraday time frame can be utilized.

Even beginning trendline traders can recite instances when they drew a trend- line, witnessed a perceived price breakout, and entered a trade intraday only to see the breakout fail and price reverse. Naturally, a trader’s emotions elevate once price breaks out above or below a trendline. Unfortunately, it is just those instances in which a trader is most convinced that a breakout is genuine and warrants intraday entry that they fail. Just like other traders, we suffered with this affliction of buying and selling failed breakouts. Consequently, many years ago we examined the trading activity prior to a valid intraday breakout versus an invalid intraday breakout. This exercise highlighted a list of four important breakout qualifiers, any one of which would validate intrabar entry.*

Like other trendline approaches, TD Lines are trend-following in nature. However, by introducing qualifiers, one has an innovative way of trading breakouts above or below these levels. TD Lines can be either qualified or disqualified. Qualified TD Lines are treated as any other type of trendline and any intrabar price breakout is valid, suggesting that price will continue to move in the direction of the breakout. On the other hand, if a disqualified TD Line breakout occurs, an intrabar price breakout in the direction of the trend is invalid. Instead of trading with the

Figure 7.1. The two most recent TD Points (identifies by asterisks) are connected to create TD Lines. The ascending TD Line is called a TD Demand Line and connects consecutively higher TD Point Lows, and the descending TD Line is called a TD Supply Line and connects consecutively lower TD Point Highs.

Figure 7.2. This chart displays a series of qualified TD Line breakouts and each breakout is accompanied by price projections.

Figure 7.3. The 15-minute VIX Index chart displays a series of qualified TD Lines breakouts. The shorter the time frame, the more we rely upon qualified TD Lines than disqualified TD Lines.

Figure 7.4. This chart also Illustrates low TD Line can be applied intraday. In this example, each of the TD Lines are qualified and indicate a continuation of the trend.

trend, this latter trading event provides a trader with an opportunity to fade the perceived breakout. In other words, rather than buy an intraday breakout above a TD Supply Line which is not qualified, one would sell the false breakout instead; and rather than sell an intraday breakout below a TD Demand Line which is not qualified, one would actually buy the false breakout. Whether a trader should take the breakout signal or fade that signal is determined by four qualifiers. Meeting any one of the following four qualifiers validates the TD Line and enables a trader to enter intrabar price breakouts in a trending market. If none of the qualifiers are met, however, then any intrabar price breakout is invalid and indicates that one should trade against the trend. The latter situation provides an ideal time to enter the option market in anticipation of a trend reversal. The first three qualifiers presented subsequently have been applied to markets successfully for many years while the fourth qualifier is of fairly recent vintage.

Qualifiers for an Upside Breakout of a TD Supply Line

The existence of any one of the following four qualifiers validates an intrabar upside breakout above a TD Supply Line:

Qualifier no. 1. The price bar prior to an upside breakout must be a down close. If the closing price one price bar before an upside breakout is a down close versus the prior price bar’s close, then an intrabar upside breakout is qualified for purchase. In other words, if the close one price bar ago is less than the close two price bars ago, then qualifier no. 1 is met. Upon reflection, this makes sense, since if the previous bar’s closing price is down, then traders’ likely expectations are for the down trend to continue and therefore they will probably be initially skeptical of any intrabar breakout upside. As we have mentioned repeatedly throughout this book, most traders are trend followers and are not likely to acknowledge a change in trend until after it has occurred. Once a conventional trendline is broken, most traders typically defer to the closing price for confirmation that the breakout is legitimate, thereby forfeiting a good portion of the breakout move. By qualifying an intrabar breakout and then entering at the breakout price, as opposed to awaiting a market’s close for confirmation, a trend-following trader is afforded an edge over trading peers who await the close of trading for confirmation of a breakout.

Qualifier no. 2. The current price bar’s open must be greater than both the current TD Supply Line and the previous price bar’s close and must then trade at least one tick higher. If qualifier no. 1 is not met and the price bar one prior to an upside breakout is an up close versus the previous price bar’s close, then one can refer to qualifier no. 2 to validate an intrabar price breakout. Qualifier no. 2 states that if the current price bar’s open is above both the declining TD Supply Line and the prior price bar’s close, and the current price bar’s high exceeds the current price bar’s open upside by at least one price tick (smallest increment of trading in that market), then the trade is qualified and intrabar entry is justified. The price gap upside from the prior price bar’s close above the TD Supply Line indicates that the balance between supply and demand has dramatically shifted in favor of demand since the close of the previous price bar. This is usually the result of an unexpected news announcement or development, the implications of which were not previously discounted in the price of the security.

Qualifier no. 3. The previous price bar’s buying pressure must be less than the current price bar’s TD Supply Line price level If neither qualifier no. 1 nor qualifier no. 2 are fulfilled, then qualifier no. 3 can be applied. Qualifier no. 3 states that if the previous price bar’s measure of demand—the difference between the previous price bar’s close and its true low (that price bar’s low or the previous price bar’s close, whichever is less)—-when added to that price bar’s close is less than the current TD Supply Line, then a breakout above the TD Supply Line is qualified. An easy way to learn this qualifier is to first subtract the previous price bar’s true low (either the previous bar’s low or the close two bars earlier, whichever is lower) from the previous price bar’s close. This will give the trader a numerical value that represents the previous bar’s buying pressure. This value is then added to the previous price bar’s close to obtain a measure of demand. This demand value is applied to the current price bar and compared to the TD Supply Line. If the demand value is less than the TD Supply Line, then any upside breakout above the TD Supply Line is qualified because price has not only exhibited more demand than the previous price bar’s expression of demand but it has also exceeded the resistance upside offered by the TD Supply Line itself, thereby demonstrating market strength.

Qualifier no. 4. (This qualifier is new and optional.) The current price bar’s open must be greater than both the previous two price bars ’closes, and the current price bar’s TD Supply Line must be greater than the previous price bar’s high. If qualifiers 1,2, and 3 are not fulfilled, one can look to qualifier no. 4. If the current price bar’s open is above both the previous two price bar closes, and the current price bar’s TD Supply Line value is greater than the previous price bar’s high and the current price bar’s high is above the current price bar’s open, then a high above the TD Supply Line is qualified.

Qualifiers for a Downside Breakout of a TD Demand Line

The existence of any one of the following four qualifiers validates an intrabar downside breakout below a TD Demand Line.

Qualifier no. 1. The price bar prior to a downside breakout must be an up close. If the closing price one price bar before a downside breakout is an up close versus the prior price bar’s close, then an intrabar downside breakout is qualified for sale. In other words, if the close one price bar ago is greater than the close two price bars ago, then qualifier no. 1 is met. Upon reflection, this makes sense since if the previous bar’s closing price is up, then traders’ likely expectations are for the up trend to continue and therefore they will probably be initially skeptical of any intrabar breakout downside. Again, as we have mentioned, most traders are trend followers and are not likely to acknowledge a change in trend until after it has occurred. Once a conventional trendline is broken, most traders typically defer to the closing price for confirmation that the breakout is legitimate, thereby forfeiting a good portion of the breakout move. By qualifying an intrabar breakout and then entering at the breakout price, as opposed to awaiting a market’s close for confirmation, a trend-following trader is afforded an edge over trading peers who await the close of trading for confirmation of a breakout.

Qualifier no. 2. The current price bar’s open must be less than both the current TD Demand Line and the previous price bar’s close and must then trade at least one tick lower. If qualifier no. 1 is not met and the price bar one prior to an intrabar downside breakout is a down close versus the previous price bar’s close, then one can refer to qualifier no. 2 to validate an intrabar breakout. Qualifier no. 2 states that if the current price bar’s open is below both the ascending TD Demand Line and the prior price bar’s close, and the current bar’s low exceeds the current price bar’s open downside by at least one price tick (smallest increment of trading in that market), then the trade is qualified and intraday entry is justified. The price gap downside from the prior price bar’s close below the TD Demand Line indicates that the balance between supply and demand has dramatically shifted in favor of supply since the close of the previous price bar. This is usually the result of an unexpected news announcement or development, the implications of which were not previously discounted in the price of the security.

Qualifier no. 3. The previous price bar’s selling pressure must be greater than the current price bar’s TD Demand Line price level. If neither qualifier no. 1 nor qualifier no. 2 are fulfilled, then qualifier no. 3 can be applied. Qualifier no. 3 states that if the previous price bar’s measure of supply—the difference between the previous price bar’s true high (that price bar’s high or the previous price bar’s close, whichever is greater) and its close—when subtracted from that price bar’s close is greater than the current TD Demand Line, then a breakout below the TD Demand Line is qualified. An easy way to learn this qualifier is to first subtract the previous price bar’s close from its true high (either the previous bar’s high or the close two bars earlier, whichever is greater). This will give the trader a numerical value that represents the previous bar’s selling pressure. This value is then subtracted from the previous price bar’s close to obtain a measure of supply. This supply value is applied to the current price bar and compared to the TD Demand Line. If this supply value is greater than the TD Line, then any downside breakout of the TD Demand Line is qualified because price has not only exhibited more supply than the previous price bar’s expression of supply but it has also exceeded downside the support offered by the TD Demand Line itself, thereby demonstrating market weakness.

Qualifier no. 4. (This qualifier is new and optional.) The current price bar’s open must be less than both the previous two price bar’s closes and the current price bar’s TD Demand Line must be less than the previous price bar’s low. If qualifiers 1,2, and 3 are not fulfilled, one can look to qualifier no. 4. If the current price bar’s open is below both the previous two price bar closes, and the current price bar’s entry price is less than the previous price bar’s low, and the current price bar’s low is below the current price bar’s open, then any intrabar breakout below the TD Demand Line is qualified.

The series of qualifiers for both TD Supply and TD Demand Line breakouts legitimize an intrabar breakout entry. These qualifiers allow traders to gain an edge over those who await a breakout confirmation on the close. However, for the purpose of option trading our recommended usage is to apply them to the underlying securities and to scenarios where none of the qualifiers are met. In these instances, trendlines no longer act as trend-following indicators. Since disqualified price breakouts are very likely to fail, one could sell an upside TD Line disqualified breakout (buy puts) or buy a downside TD Line disqualified breakout (buy calls). This reverse trading strategy is an effective method to day trade options, especially if the disqualified breakout occurs during the early trading hours. While a call option can be purchased by a trend follower once an underlying security records a qualified TD Line upside breakout, purchasing a put option in response to a disqualified TD Line upside breakout of an underlying security provides more potential. The primary reason is that a trader will be bucking the current trend; this implies that put premiums should contract as price advances and the put’s price at that time will likely be down versus the prior price period’s close. Conversely, while a put option can be purchased by a trend follower once an underlying security records a qualified TD Line downside breakout, purchasing a call option in reaction to a disqualified TD Line downside breakout of an underlying security provides more potential. The primary reason is because a trader will be bucking the current trend; this implies that call premiums should contract as price declines and the call’s price at that time will likely be down versus the prior price period’s close.

Although they can be applied to a chart of practically any time frame, the five examples selected to illustrate disqualified TD Lines are all of a daily nature. On the charts, disqualified TD Lines are represented by dotted lines, while qualified TD Lines are represented by solid lines. Price is expected to be repelled or reverse once the dotted lines are penetrated. Since these price levels are defined before trading begins, it is possible to place orders in anticipation of price reaching these levels. Since the charts and the TD Lines within apply to the underlying securities and not the options, the information provided on the charts must be reapplied to the options. The first chart of the S&P 500 September 1998 contract, Fig. 7.5, identifies two instances in which price intersects disqualified TD Lines; in each case, price reversed its trend for at least that trading day. Figure 7.6 illustrates the same type of response to penetrations of the Dow Jones December 1998 contract, and in each case the market reversed its movement at least by the close of trading that day. The chart of Merck (MRK) identifies two instances in which disqualified TD Line breakouts coincided with market price reversals (see Fig. 7.7). In the first example, the market declined after exceeding the disqualified TD Supply Line breakout level. In the next example, the market penetrated the disqualified TD Demand Line downside intraday and then proceeded to reverse its price movement, rallying over five points. Since none of the four TD Line qualifiers were met, both breakouts proved to be false, providing an excellent low-risk put-buying opportunity above the disqualified TD Supply Line breakout and an excellent call-buying opportunity following the downside breakout of the disqualified TD Demand Line. Figures 7.8 of Cisco, 7.9 of Com, and 7.10 of Intel provide further examples of disqualified TD Lines and how they would apply to option trading.

Having so few disqualified TD Line trades is not unusual, but with the vast selection of stocks with related options available, many trading opportunities appear daily. If a trader chooses to trade more often, lower-level charts, such as hourly or 30-minute charts, can be surveyed as well for additional low-risk trading opportunities. However, we do not necessarily recommend trading disqualified TD Lines on any level other than a daily basis since the profit potential for these trades intraday is limited.

Calculating TD Line Breakout Price Objectives

Once a qualified TD Line breakout occurs either upside or downside, then trend following traders can calculate price objectives. These price objectives are irrelevant when trading disqualified breakouts; they only apply when trading qualified TD Line breakouts. To arrive at an upside price objective after recording a qualified upside breakout of a TD Supply Line, one must first identify the lowest price beneath the TD Supply Line. Next, one must calculate the difference between that lowest price beneath the TD Supply Line and the TD Supply Line value immediately above that lowest price—in other words, on the same price bar (same date) as that lowest price. This difference is then added to the upside breakout price level (on the price bar that the TD Supply Line is exceeded) to arrive at an approximate upside price objective. Conversely, to arrive at a downside price objective after recording a qualified downside breakout of a TD Demand Line, the highest price value above die TD Demand Line must be identified. One must then calculate the

Figure 7.5. Within a trading range market, it is not uncommon to record both false breakouts upside and false breakouts downside. TD Line Qualifiers are often effective in distinguishing between real and bogus price breakouts. This chart of the daily S&P September 1998 futures contract displays two instances in which disqualified TD Lines identified false breakouts which developed into trend reversals for that trading day.

Figure 7.6. This chart of the daily Dow Jones Future December 1998 has two dotted (disqualified) TD Lines-the upper, a TD Supply Line, and the lower, a TD December Lines. In both cases, false breakouts presented ideal trading opportunities for the trader prepared to operate against the trend.

Figure 7.7. Two disqualified TD Lines for Merck (MRK) are presented in this example. In both instances, the market reversed trend coincident with the false (disqualified) breakouts.

Figure 7.8. It is not uncommon to see a stock in a up trend or a down trend or a down trend break trend break a disqualified TD Lines intraday, only to witness the trend resume. CSCO broke out downside through disqualified up-sloping TD Lines in early and mid-December, only to have price rally off of those price levels.

Figure 7.9. This chart is somewhat deceptive in that what appears to be one disqualified TD Supply Line is in fact two TD Supply Lines that happen to be superimposed upon one another. These disqualified lines are dotted to differentiate them from any solid, qualified TD Lines which may appear on the chart.

Figure 7.10. The daily chart of Intel (INTC) displays two TD Demand Lines which are qualified and one which was disqualified.

difference between the highest price above the TD Demand Line and the TD Demand Line value immediately below that highest price—in other words, on the same price bar (same date) as that highest price. This difference is then subtracted from the downside breakout price level (on the price bar that the TD Demand Line is exceeded) to arrive at an approximate downside price objective. Once these primary price objectives are reached, additional price objective levels can be calculated by multiplying the difference between the TD Supply Line and the low price or TD Demand Line and the high price by different percentages. A good selection is multiples of 100 percent, since the market has a tendency to advance or decline in incremental price bursts.