Median Lines

YOURTRADINGedGe JUL/aUG 201038

Timothy Morge on how to draw and use median lines, a leading indicator.

Median Lines

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Median Lines

JUL/aUG 2010 YOURTRADINGedGe 39

edian lines, or pitchforks, are one of the few true leading indicators in technical analysis today. They are an offshoot of action and reaction lines, which were developed by Dr Alan Andrews in the mid-1920s. It is said that Dr Andrews made more than $450 million for Joseph P. Kennedy, Sr. during the market crash beginning in 1929. These simple yet powerful drawing tools have changed little over the years,

and when Dr Andrews died around 25 years ago, these techniques nearly disappeared from the trading world.

In the early 1980s, when personal computers and real-time data were becoming regularly available, I had these tools professionally coded for my own use on several charting packages. In 1995 I began the web page 'MedianLine.com' in an effort to bring the tools alive and put them in the hands of chartists around the world. It has been quite a journey since then, but pitchforks are now becoming popular and are available on almost every real-time and delayed charting program. I continue my efforts to bring traders to an understanding of the correct way to use these powerful leading indicators.

Median lines, or pitchforks, always begin with alternating pivots: a high, low, high or a low, high, low. The interplay between these alternating pivots, specifically the relationship between the midpoint of the line drawn between Pivot B and Pivot C and the

beginning Pivot, A, gives rise to a mathematical relationship that can be statistically proven to be valid, even when the pitchfork is first drawn. As Dr Andrews often stated, price makes it to the median line from its upper or lower median line parallel 80 per cent of the time. This mathematical relationship makes pitchforks true leading indicators; the areas where price should run out of directional energy on the upside and downside can be projected forward in price and time as soon as the three alternating pivots are identified and the pitchfork drawn. Let's take a look at a normal median line set up (figure 1).

In figure 1 it is easy to see that I chose a major high as my A pivot, and a major low as my B pivot. The question is whether my choice of a C pivot is valid. Note that I drew in two horizontal black lines. The higher of the two horizontal lines simply marks the major swing high at Pivot A. The lower of the two horizontal lines is drawn through price action. If you look carefully, you'll see that it touches numerous high and low pivots; I call this line a multi-pivot line.

Price stretched itself higher, pulled back, and then made a slightly higher high before heading back lower and breaking below the second horizontal line, the multi-pivot line. You can see that price formed numerous small range bars before trying to move higher but was unable to travel very far to the upside. When price broke below the multi-pivot line and the smaller range bars bunched, we were given the first clue that price might be running out of upside directional energy.

There's one line on this chart that I haven't spoken about yet: I connected the low from the B pivot to the next major swing low

with a solid line and projected that line forward in time. This is a line I will watch, because although it slopes upwards, it connects two major swing lows. This line is an early warning system so I don't have to wait until the low at Pivot B is broken to the downside to confirm that the uptrend has ended. If the price stays near the upper parallel as it moves to the right, it's possible price could swing down and test this line much as a pendulum swings down in its normal arc and then continues higher; much will depend on how and when this line is tested.

So now I have constructed a red median line and its parallels, or a pitchfork, but it's important to note that although I have shown you the reasons I was willing to draw a down-sloping pitchfork, it's not clear that the uptrend has ended. It's important to stay one step ahead of the market in terms of thinking about the possibilities. At the moment, the red

FiGURe 1: Canadian dOLLaR FUtURes: a standaRd Median Line set Up

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Median Lines

YOURTRADINGedGe JUL/aUG 201040

down-sloping pitchfork is a thought exercise, drawn as I ponder whether price has indeed run out of upside directional energy. Price is always right. Only market structure can confirm that an uptrend has ended.

Figure 2 shows that price climbed back higher and tested the red down-sloping upper parallel. Note that the bar that tested the upper parallel closed on its lows; I call that 'closing with good downside separation'. Separation is a measure of the distance between where price tests support or resistance and where a bar closes. It is usually a good indication of whether buyers are in control or sellers are in control at the close of the bar that tested the support or resistance. I don't pay much attention to the separation indicated by each bar until price approaches an area of either support or resistance. In this case, price tested an area where it should run out of upside directional energy, commonly thought of as resistance, and the bar closed on its lows – indicating sellers were in control of this bar.

When price tests either the median line or the upper or lower parallels, it is an indication that this median line set might project the probable path of price. Figure 1 was a thought exercise; it was not yet clear that price had run out of upside directional energy and that the C pivot I had chosen was a meaningful swing high. But when price traded lower, breaking below the prior swing low, the high at Pivot C was confirmed as a major swing high. The confirmation of the C pivot and the test of the upper parallel by the bar that closed with good downside separation turned this median line set from a thought exercise into a median line set that should project the probable path of price. Now I have much more information and an opinion based upon the median line's projection of the probable path of price. I am ready to place orders in the market.

Once price traded lower, breaking below the prior swing low, I began working a limit order to sell a retest of the red down-sloping upper parallel. My initial stop loss order would be above the major swing high that I used as the C pivot. I always place my stop loss orders in the market at the same time I place my limit entry orders, so that I am always protected in case news comes out or unforeseen volatility hits the market. I never change my stop loss orders lower, but I try to move to a breakeven stop loss order when doing so

makes sense. If I have an open position and price begins to leave a market structure that I can hide my orders above or below, I will move from a breakeven stop to a profit stop order.

While planning my trade, I need to know three things:1. Where I will place my initial limit entry order.2. Where I will place my initial stop loss order.3. Where is the area, or areas, in which I think price can realistically

trade if I'm correct in my projection of the probable path of price. This is the area or areas where I leave my limit buy orders to take profits.Once I know these three things, I can calculate how much I am

risking on the trade, using my initial stop loss order. I almost always place my stop loss orders beyond swing highs or lows because there should be limit market entry orders at these areas. These orders should provide protection for my stop loss orders; I rarely use a fixed amount of cash to determine my stop loss level. I do, however, have a maximum intraday and longer-term trading stop loss limit – in other words, a maximum amount of my capital that I will risk on any one trade. If I cannot find an initial stop loss level using market structure to help protect my stop within the maximum amount of capital I'm comfortable risking on any one trade, I simply pass on the trade. For this particular trade, I'm willing to risk a maximum of 20 ticks, which is $200 per contract plus brokerage.

Now that I know my maximum risk, I can look at potential profit targets. By combining the two, I come up with potential risk-reward ratios. I never take a trade with a risk-reward ratio less than 2 to 1. For this particular trade, I'm willing to risk a maximum of 20 ticks or $200 and the first logical profit target comes at a test at the change-in-behaviour line as well as near the prior swing low at 9937, which would net me 94 ticks. I am risking 20 ticks to make 94 ticks, giving me a potential risk-reward ratio of 4.7 to 1. There are two logical profit targets below this area, so if I choose to use one of them when taking profits, my profits will be significantly higher, as will my risk-reward ratio.

Take a close look at the last bar on the chart in figure 2. You will see that price did climb higher, retesting the red down-sloping upper parallel, and my limit sell order at 1.0031 was filled. But pay attention

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Median Lines

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to where price closed on this last bar! Once again, price closed with great downside separation, a sign that the sellers were in control at the close of this bar.

Now that the market has let me into this short trade, let's see how

price unfolds from here (figure 3).Once my limit sell order was filled, price began a near vertical fall

that tested the change-in-behaviour line; price recovered a bit after testing this simple trend line and then began to sell off again. For the type of trader who scales out of positions or takes partial profits, leaving a limit buy order just above the change-in-behaviour line for a portion of the position would be a good strategy, because this same price area coincides with a prior swing low.

Price left double tops and then headed back lower to test the change-in-behaviour line the second time. The closes of the bars were near the low of the bars, meaning the bars were closing with good downside separation, and that indicated to me the sellers

were in control. Rather than take profits the second time price tested the change-in-behaviour line, I entered a stop profit order above the double tops and then decided to 'buy a bar', which means I watched the price action as another bar unfolded. If price rocketed higher, I would have boxed in a profit; if price broke below the change-in-behaviour line and the prior swing low, I felt price was likely to head quite a bit lower.

You can see that buying a bar turned out to be an excellent strategy, especially since I had a stop profit order in place if the market turned back higher. The next bar zoomed lower, in a free fall, closing well below the red down-sloping median line. After such a wide-range lower bar, you can generally expect some consolidation, as price restores its energy, and that's what happened. Seven bars later, price left a 'pseudo' double top bar (it missed being a double top by a tick or two) that turned out to be a swing high when price made a new low; I then moved my stop profit order down above these 'pseudo' double tops. Note that I am always

paying attention to market structure and hiding my stop profits above swing highs and market structure, in this case double tops. These areas generally attract limit sell entry orders in a downtrend – and price is in a strong downtrend.

There was no real opportunity to move my stop profit order lower and after a handful of bars, my limit buy order at 9783 was filled, giving me a profit of 248 ticks on this trade before commissions. I check that I am flat and working no further orders, then I calculate

FiGURe 2: Canadian dOLLaR FUtURes: pRiCe CLiMbs baCk hiGheR

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my profit to make sure it is close to what my trading platform states I made: I risked $200 to make $2,480 per contract, less around $5 per contract in commissions on this trade, for a realised risk-reward ratio of better than 12 to 1.

The keys to this trade were simple: 1. Wait patiently for market structure to form and then confirm a

topping formation, which can then be used as Pivot C when drawing a red down-sloping median line set.

2. Wait patiently for price to come back and test the red down-sloping upper parallel. This does two things: a) if the upper parallel acts as resistance and stops price, I am much more confident the median

line will project the probable path of price; and b) if price stops at or near the upper parallel and then heads lower, it will be making lower swing highs, a sign of weakness, and further confirmation that a new trend may be under way.

3. Once the upper parallel is tested, I leave limit sell orders to enter a short position there. This assumes I am comfortable with the amount of money I have to risk to place my initial stop loss order above important market structure, the major swing that formed the C pivot. This area should have a large amount of resting limit sell entry orders that will help protect my initial stop loss order.

4. Once short, I pay close attention to the unfolding market structure. I generally do not scale out of my positions and this trade is no different. I do however leave a stop profit order above the double tops once price breaks below the change-in-behaviour line, taking advantage of the possible resting limit entry sell orders.

5. As price heads lower in a vertical fashion, I take any opportunity to 'box in' profits, in case price runs out of downside directional energy and heads higher.

6. I leave my limit buy order just above where Dr Andrews' median line theory tells me price is headed: the lower parallel.

Timothy Morge has been a professional trader, author, educator and mentor for more than 39 years. For more information visit: www.marketgeometry.com and www.medianline.com or email Timothy at timothymorge@marketgeometry.com

Median Lines

FiGURe 3: Canadian dOLLaR FUtURes: ChanGe in behaviOUR Line

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