Week 25: Horizontal Lines
Simplicity is the ultimate sophistication
Hi. Welcome back to Fifty Trades in Fifty Weeks!
This is Week 25: Horizontal Lines
50in50 uses the case study method to go through one real-time trade in detail, about once per week. This Substack is targeted at traders with 0 to 5 years of experience, but I hope that pros will find it valuable too. For a full description of what this is (and who I am), see here.
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Not too much news on the open trades, other than SPY ripping to 430 now and putting the 436.60 stop loss in some jeopardy. The sentiment survey was interesting last week. Here are the results:
Two takeaways: People were mega bearish stocks, gold, and EURUSD last week. People don’t feel confident predicting copper. The sample size was 217 respondents. Thanks to all those who filled it out.
Here’s this week’s survey. Please take 2 minutes to fill it out! Thanks.
Now, let’s talk about simplicity.
“Simplicity is the ultimate sophistication.” — Leonardo da Vinci.
The idea for this Substack was to teach new traders how to trade. I feel like the last few notes have been pretty complicated, with advanced concepts like bet sizing, options, the fourth dimension of time, and so on. Let’s get back to basics this week and talk about the simplest, but arguably most effective tool in technical analysis: Horizontal lines.
I have always preferred horizontal lines and simple support and resistance to trendlines, channels, arcs, Gann fans, and so on. The reason is simple. There’s very often a reason horizontal lines work… They are reflecting the reality of large bids and offers in the market.
I like approaches that reveal an underlying reality in the market
Most of the technical approaches that I use reflect something about the underlying structure of the market in a particular area. For example, the beauty of simple horizontal lines is that they very often reflect the presence of large orders. Let’s say a Japanese auto exporter needs to sell 5 billion USDJPY, and they leave an order with a bank to sell at 116.33. They are patient and don’t mind waiting. You might get a chart that looks like this:
USDJPY double touch of horizontal resistance at 116.33
Remember that because support and resistance are simple and not subject to much interpretation, most people in the market will be monitoring roughly the same support and resistance levels. This is the self-fulfilling prophecy aspect of technical analysis.
Because horizontal lines are obvious and easy to understand, you need to think about the metagame and leave your stops far enough below support (or above resistance) that you are not dinged by a weak stop loss run that takes out an obvious level. It is often best to place your stop loss about a half-day’s range above or below a major horizontal level to avoid any noisy whipsaws around that point.
An example in EURUSD
Last week, an interesting thing happened as I was writing my global macro daily (am/FX). I was sick of trading EURUSD from the short side for most of this year and wanted to open my mind to the alternate hypothesis.
This is what I do when I feel I have been stuck in one mode for too long and worry that confirmation bias might be creeping in. I consciously try to write a piece going the other way, or at least honestly explore the other direction. Here is the piece I wrote last Thursday:
am/FX, August 11, 2022
As someone who has the word “nimble” in his daily closing salute, I have not been particularly nimble of late as I have been either flat or bullish USD and either flat or bearish stocks for ages. This worked well in Q1 and Q2 but is leading to a lot of red P&L this quarter and so I’m going to try to keep an open mind.
The EURUSD chart still looks rather bearish, with the only real bullish angle being that the huge gamma pocket and round number at 1.00 held right at the peak of EUR bearishness. Here is the daily:
EURUSD daily since April 2021 with 60-day and 120-day moving average
A close above 1.04 would take out the 60-day moving average and would exceed the pivot marked by the last thin red line. The thin red lines show that each broken support has held as strong resistance with just one tiny exception in early April. Good trends find resistance at prior support, and this has been a good trend.
Selling at the red line and the 60-day has been a good expression of the trend most of the way down. 1.0613 is the big daddy but that moving average was only tested once (in February 2022), and the 60-day has been way more actionable.
Rate differentials show nothing bullish for EURUSD (still near the lows), and relative equity performance has been in line with the currency. On the bullish side, BTPs are back to 200bps over Germany after twice testing 250bps… So you could argue the much-hated TPI (the ECB antifragmentation tool) has worked, to some extent. Then again, BTPs are mostly just a risky asset and they have performed worse than SPX on the massive recovery in risky asset sentiment since mid-June. SPX is making new 3-month highs while BTP spreads are nowhere near the tights printed in May.
It’s not like lower crude prices have helped the idiosyncratic EU energy story. Here’s Dutch Natural Gas:
Dutch Natural Gas
And the UK still has plenty to worry about:
To me, everything still points to EUR softness. Yesterday, I wanted to avoid the USD side, so I went short EURAUD because anything long AUD, or long carry makes sense as I expect we enter a two-week period of low vol, out of office emails, early departures, and family tripping.
I promised myself I would go into today’s am/FX with an open mind and now my view is back to bearish EURUSD. That’s fine! I believe my analysis and process were unbiased. I actually started writing this piece with the intent of outlining a bullish case for EURUSD in the spirit of examining the alternative hypothesis. And I found very little that was bullish.
The chart looks particularly nice, location-wise as you only have to risk 120 pips from here. Short EURUSD here at 1.0346 with a stop loss at 1.0463 and take profit at 1.0166. Risk 120 to make 180. The 1.0466 stop is above the 60-day moving average, the thin red line, and the 05JUL22 high.
I think there are two takeaways here:
If you go in with an open mind, trust your conclusion, even if it’s not what you were expecting! You need to be able to trust yourself to have an open mind and when you are questioning that ability, go hard towards the alternate hypothesis and see what happens. If you end up back at the original hypothesis, you followed the process and can feel more confident in your original view.
Horizontal lines are useful!
Here’s what happened after I published that on August 11.
EURUSD hourly showing last two instances where support became resistance
EURUSD held the old support perfectly, failed at the horizontal line, and dumped 200 points in a straight line in three days. The take profit (1.0166) hit today.
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The beauty of horizontal lines is:
Horizontal lines are objective and simple, not arbitrary. If the old low was 1.0550, the line goes straight across to 1.0550. You are not fudging around with angles and determining whether a trendline touched based on the width of the crayon you’re using. When a method is objective and simple, there is less chance that confirmation bias will pollute your analysis. When someone uses Elliott Wave, for example, there are so many subjective interpretations and wave counts possible that if they started out bullish, they will probably find a bullish wave count!
Horizontal lines reflect market reality. When a market keeps bouncing off the same level, it’s often because there is a huge order there. Central bank orders, barrier defense, corporate orders, M&A transactions, institutional demand, and other types of non-urgent limit orders from large patient participants create horizontal support and resistance. When the horizontal level breaks, the order is probably gone and the underlying supply/demand dynamic has changed. This isn’t hocus pocus tech stuff, it’s the reality of transaction level activity being directly reflected back at you in a chart.
Horizontal lines are easy to use. No protractor required! If the line breaks, you know it broke, and you can act accordingly.
Peter Brandt is one of the best-known technicians out there. Here is a quote from Jack Schwager’s interview with Brandt in Unknown Market Wizards:
I used to trade any pattern I could see. I would trade 30 to 35 patterns a month. Now, I am much more selective. I used to trade patterns like symmetrical triangles and trendlines, which I no longer do. I only trade patterns where the breakout is through a horizontal boundary.
Why is that?
With horizontal boundaries, you can find out much more quickly whether you are right or wrong.
Was there a catalyst for that change?
No, it was just a gradual process of realizing that I was getting my best results trading rectangles, ascending triangles, and descending triangles. Give me a 10-week rectangle with a well-defined boundary that ends with a wide daily bar breakout out of that pattern, and now we’re cooking.
Let me reiterate an important concept that is critical to understanding something simple like how to use horizontal lines.
I never do a trade purely on technicals. Technicals are a good risk management tool but not a great forecasting tool. My ideas come from my read on changing narratives, from cross-market correlation, pattern recognition, backtesting, positioning, and other fundamental or microstructure analysis. Then, I use technical analysis to hone my tactics, maximize leverage, put up risk management guard rails, and determine the stop loss and take profit. Sometimes, I’ll find a trade I love, but the techs don’t line up, so I’ll wait. This is about strategy vs. tactics. Macro, cross-market, and behavioral stuff is for strategy, technical analysis is for tactics.
The most useful way to use horizontal lines is to find setups that maximize leverage. Let’s look at a simple trade using horizontal lines.
Short MSTR with a tight stop
In my crypto piece last week (MTC 29), I showed how the price of MicroStrategy stock varies according to two main drivers. 1) the price of bitcoin and 2) the momentum in meme stocks. Here’s a comparison of MSTR “fair value” (or, estimated intrinsic value) vs. its stock price.
The gray line is MSTR stock, the blue line is “fair value” and the purple line is the MSTR premium over fair value. If you know when past meme stock rallies happened, you can see that the premium on MSTR goes up and down with meme stock fever.
MSTR stock (gray) vs. “fair value” (blue), with premium over fair value in purple below
Let’s say I’m getting bearish bitcoin here because I think risky assets are stretched, the dollar is strong, real interest rates are high and rising, and short MSTR looks nice because you are selling it at an inflated premium level. 2.5X fair value is where MSTR is trading now and that’s where it peaked in the past.
When selling a raging mutant beast like this, there are two main approaches. Small position with wide stop (like in 50in50, Week 23) or take a big position with a tight stop. In the second instance, you wait for what looks like a perfect entry, then take your shot with a fairly tight stop loss. If you time it perfectly, the asymmetrical payout is yours. If you time it wrong, you get stopped out and life goes on. Your mental theta is minimal because you are either going to time it right, or lose right away.
That “I’ll know right away if I’m wrong” aspect has value, as discussed in Week 22. It’s especially useful on an expensive short like MSTR where you could be paying 10%-15% / year for the borrow.
You’ve been waiting patiently as MSTR rallied… Now ETH has failed at 2000 (round number, and market is raging bullish), BTC has looked soggy the whole time (options open interest in the toilet), and we are back to a major level in MSTR. You draw a couple of horizontal lines and get this:
MSTR with two horizontal lines off March low support, May low bounce, and May triple top resistance
One line is off the March support, and one is off the last bottom in early May (and it also covers the triple top before the LUNA-driven collapse). Pre-LUNA, MSTR had a hard time getting below 363. Once it broke down, it never got back above 369. As such, you could do worse than selling here ($345) with a stop above both lines at $381. That’s a tight stop loss on a stock that’s trading an average daily range of $27 in 2022, but it’s not ridiculous. “Tight but not ridiculous” is a good way of thinking about the right stop loss for a max leverage trade.
The current MSTR rally started at $240, so we will look for a full round trip and put the take profit at $251 (just ahead of $240 support). Risking $36 plus slippage to make about $98. There is always going to be gap risk with MSTR because it trades like a meme stock and tracks bitcoin (which moves over the weekend, when MSTR is closed). Also the short interest is large (37% of float). Size accordingly!
I will rate this trade 7 out of 10 conviction on the sheet, though someone pointed out to me that my conviction could be high on a trade like this as it pertains to expected value, but still less than 50% on the probability of being correct since the trade pays 3:1.
That is an inherent issue with any conviction vs. accuracy assessment of bets that are not 50/50. Are you describing your conviction as it pertains to the expected value of the trade or the probability of winning? Here, I’m saying as a trade (taking into account the probability of a win, and size of potential win) I rate this a 7 out of 10.
Horizontal lines are simple. When it comes to technical analysis… Simple is good.
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