Using Simple Box Formations for Big Trading Profits (Part 1)

One of the simple visual techniques I teach my newer and younger students (and one I use in my own trading) is the power of simple box formations. These “boxy” formations (ranges, congestion, energy coils) become very easy to spot once you start marking them and observing their behavior.

But too many traders don't pay attention to boxes or ranges and end up entering a trade because they are following a lagging indicator that gave them an entry signal or because they were following a line, had their mind set on a trade idea, and never recognized the box or congestion forming. I have a term I use with more experienced traders (generally a bit more mature in age) to describe entering a trade in the middle of a box or range: “Trading in the killing fields.” These traders may have the right idea, but the range usually ends up running their stops and they usually end up on the sidelines watching price move without them.

Here's one of my charts that I'll use to show you how I use boxes, but the idea for these particular boxes and the eventual trade entry came from my son, Sean. These are daily bars, and I'll tell you the instrument at the end of the article, so you can look at price action and try to read what it is going to do without opening a current chart.

Note the box formation I drew in the upper-left-hand portion of the chart. This is price trading within a range, restoring spent potential energy, much like a car's gas tank getting filled while it sits still at a gas station.

There is one excellent clue to the likely direction price is going to break out of this box formation. I purposely did not mark it on the chart.

Can you spot it?

After trying to retest the prior major swing high, price failed and turned lower, a sure sign that there were large limit entry sell orders at or near the prior swing high. These are orders left by the largest traders, the “whales.” You can see that every time price attempts to test that prior high, it fails. Price is running into the limit sell orders left by the whales. After a feeble third attempt, price trades a little lower and then the significant event takes place.

Do you see it now?

Price gaps significantly lower and eventually trades down to test the multi-pivot line, filling in a simple formation I call a “mountain.” Even though it climbs quickly out of the hole and fills the gap, after three higher highs, it leaves double tops and then turns lower again and heads straight to a test of the multi-pivot line.

The first time lower, after price gapped lower and filled the mountain formation, there were limit buy orders at the multi-pivot line—again, left by large traders (the whales) because traders likes to fill gaps. The whales were already short near the highs of this formation, so it would not be unusual for them to lock in profits as price re-tested prior lows.

But if you look at the quality of the rally that followed the first retest, you can see it never made it anywhere near the prior swing high. If you were a whale, or large trader, you might be less inclined to take profits on your short position or to establish new long positions at the multi-pivot line until you watch the price action in that area.

Now look carefully as price heads lower again towards the baseline of the prior mountain formation, which also serves as a multi-pivot line. Price has no difficulty breaking through to the downside. The whales pulled their limit buy orders! See, you really can trade with the whales if you just know how to look for their “tracks.” (And by the way, I know this because in some markets, I am one of the largest traders—making me, by definition, a “whale.”)

Note that once price breaks below the multi-pivot line, which had acted as support, the line now acts as resistance. Price tries to get above it and close above it several times, but fails.

Can you guess why?

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Yes, the whales don't have limit buy orders at the multi-pivot line now. They have lowered their limit sell entry orders from the area of the major swing high down to the multi-pivot line area. It always sounds so simple, but it works so often: What was support has now become resistance. This is part of the inner workings that make ranges form. And it's another reason why price often doubles the prior range. And if you look at the current chart, price doubles the range just about to the penny and then turns back higher.

This shouldn't surprise anyone. Sir Isaac Newton, the famous mathematician and physicist, was also an alchemist and devoted a great deal of time translating books written literally thousands of years before he was born; books written by the Egyptians, the Greeks, and the Phoenicians. His translation of the Emerald Tablet is still the favored translation of that important text today. Many feel he was inspired by the Emerald Tablet when he wrote his three laws of motion, as evidenced by this often-quoted phrase, “As above, so below.” Many see this simple, four-word phrase as the precursor to Newton's famous, “For every action, there is an equal and opposite reaction.”

And of course, price indeed makes an equal and opposite reaction if you look at the multi-pivot Line in the center of the chart as the center line, the major swing high and a line drawn horizontally from it as the action line, and then project the distance from the center line to the action line back underneath the center line, you get a near-perfect reaction line. “As above, so below.”

When price comes back to fill the mountain formation, retesting the lower multi-pivot Line (which is also the reaction line), you can see that once it filled the mountain by retesting the baseline, it gapped lower through the lower multi-pivot line and continued lower. You can assume the whales who were short waited to enter limit buy orders to see just how many smaller traders were caught long—and how much lower their stop loss orders would push this market.

But at some point, the selling dried up and a 'V' bottom formed, with price turning back higher and rallying just as fast as it sold off. What would smaller traders find when price approached the lower multi-pivot line from below as price rallied? Would prior support now be resistance?

More tomorrow in Part 2…