How to 'Trade What You See' in Today's Market

Editor's note: DailyWealth readers know we love to use history as a guide for potential investments. And our colleague Greg Diamond couldn't agree more. In this piece – from a recent Ten Stock Trader Weekly Market Outlook issue – Greg explains how identifying certain market patterns can lead to unique buying opportunities... but only if you understand what you're looking at.

Geometry, harmonics, and "trend days"...

These are just a few of the concepts that technical traders Larry Pesavento and Leslie Jouflas cover in their book Trade What You See: How to Profit From Pattern Recognition.

The idea is that markets follow geometric patterns, which repeat over time. "Harmonics" take those patterns to the next level by defining inflection points. (And "trend days" are the days in which a stock price moves in a certain direction for most of a trading day.)

Together, these concepts help us interpret chart patterns – the simple line movements that many of us see from week to week. And ultimately, we can use them to help predict future price action.

Now, "trading what you see" might sound simple. But to do it well, you need to understand what to look for on a chart.

I believe traders should focus on the patterns that tend to catch their eye. That usually leads to a more positive trading experience... and better investing outcomes.

Of course, there's a lot of debate about what works and what doesn't in the field of technical analysis. But if you focus on the patterns you feel comfortable with, you can embrace your strategy and continuously improve your trading approach.

Today, I'll outline what I see in the Russell 2000 Index. The technical pattern at work here is incredibly useful... And right now, it could set up a buying opportunity for contrarian investors.

It's especially important to consider patterns as you sift through the many financial-media headlines...

For example, Bloomberg recently reported that hedge funds have "one of their biggest net short positions in Russell 2000 futures on record," according to data from Ned Davis Research.

This record net-short position is a catalyst that could send this sector – that is, small-cap stocks – much higher.

But I can't just take Bloomberg's word for it and immediately start buying the iShares Russell 2000 Fund (IWM).

I have to see the pattern in order to trade it successfully. With that in mind, here's the IWM chart I'll be tracking over the next week or two...

As you can "see," I've outlined a potential setup for bulls (in red). This pattern is based on the principles of Elliott Wave Theory... which comes from the work of R.N. Elliott. It uses Fibonacci retracements and projections to make sense of market moves.

This pattern is a more complex topic on its own than we can cover in detail today. But simply put, prices tend to move in "waves."

Specifically, Elliott discovered that prices move in a combination of five waves and three waves that have unique characteristics. When a stock is moving up, it will track five waves into a top... And when a stock is moving down, it will track five waves into a bottom.

This is a pattern I watch for regularly. And if we look at the Russell 2000, it shows that a correction may unfold over the next week or so. (It may wind up being a bit steeper than what I've shown above.)

What's more, though, this setup will likely lead to more upside into the summer months...

It would be a "pain trade" for any hedge fund that has record short trades in this sector. As the saying goes, the market often tends to inflict the most pain on the most possible people.

If the majority of hedge funds are short (which Bloomberg and Ned Davis Research say they are), the "pain" would be much higher prices. They would lose money and be forced to buy back their short positions.

This would fuel a big rally... And it would also line up with the technical framework I outlined above. It's a powerful combination.

This way of thinking is what being a contrarian trader is all about...

When certain patterns develop (like the one I've outlined today), we can prepare a game plan while others second-guess themselves.

As contrarian investors, that's how we can profit from what we "see" in the market.

Good trading,

Greg Diamond, CMT

Editor's note: Greg says we're headed for one of the biggest market shake-ups of 2024... a "May Surprise" that could begin as early as today. But one strategy – which Greg has been perfecting for the past 20 years – could help you profit from this chaotic event.

It's a technique he has used to book big, quick gains during every market surprise of the past five years. And now, it's time to put it to work again – before this window of opportunity disappears... Find out more right here.

Further Reading

History is a great guide to the future. If you can identify specific patterns over time, you can learn to spot the most likely outcomes. For example, understanding how market tops and bottoms "behave" can tell you a lot about where stocks could go next... Learn more here.

Folks often get distracted by why a stock moves... when they should be asking when a stock will move, and what prices will do. This mindset can reveal problems that most folks miss – including a warning sign that flashed before the global financial crisis... Read more here.