Interactive Investor

Chart of the week: A stunning trade setup

17th October 2016 11:34

John Burford from interactive investor

Rolls Royce presents a textbook trade

I last covered Rolls-Royce on 25 July when the shares were in a move that I believed was a pure counter-trend bear market rally. That means I expected the rally to fizzle out at some point and the shares to resume their slide.

The previous week, the company announced that it had lost a massive £2 billion in adverse currency moves that it called an "accountancy adjustment". But since 2015 revenues were £13 billion, that little "accountancy adjustment" represented a cool 15% of revenues.

I don't know about you, but if my annual income was clipped by 15% because the bank had guessed currency moves wrongly, I would definitely not call it an accountancy adjustment.

So I can only hope for the company's sake that it has a new director of currency hedging strategies and that he or she has access to a chart of GBP/USD and can see that the trend has been down, down, down for well over two years.

That is the first clue that US dollar revenues should not be hedged or converted back to sterling. In fact, in the previous two years, cable has collapsed from $1.72 to last week's low of $1.22 - a very steep decline of 30%.

Back in July, I believed the Rolls-Royce rally might have been ending. This is the chart I presented:

I have a classic A-B-C that would be confirmed if the market turned down from that level. This is what I wrote:

The shares track the FTSE 100 index quite accurately and with that index at a major resistance level around 6,700, odds are good that any further advance in RR will be hard-won. The odds are swinging towards a resumption of the decline.

But the odds were not swinging fast enough, because the market continued its rally to cancel out my A-B-C conjecture. Of course, the market reckoned that with a weaker sterling, dollar earnings would translate into larger profits - provided the company handles its currencies correctly (which it signally failed to do last time around!)

In fact, the market continued its rally right back to the Fibonacci 62% resistance:

Only three days after my Chart of the week article appeared, it hit it.

Remember, the most common retrace of a major wave is the Fibonacci 62% level. This level seems to possess the highest level of resistance to further gains.

Note on the chart that, when the market reached that level at 875p on 28 July, it was spurned in no uncertain terms and produced a "pigtail" spike on the chart. The market certainly did not like trading at these elevated levels!

That kind of action usually indicates the next direction of travel is down.

And the refusal to advance brought the shares down to my lower blue tramline support around 700p and in the past month, the market has rallied back off that tramline to the 800p area again.

But, backing up to the rally continuation in late July, I noted that "RR. tracks the FTSE100 index quite accurately" and in this period, FTSE 100 was in firm rally mode.

Since RR. made its 870p high on 28 July, FTSE 100 has rallied, while RR. has trended down, which has created a divergence. Will RR. catch up with the FTSE, or vice versa?

Here is the daily RR. chart and it shows a stunning trade setup:

The decline off the 28 July spike high is in a clear A-B-C format (counter-trend) and it carried to the 700p level which is a Fibonacci 62% retrace of the previous wave off the June lows. There's that Fibonacci 62% again!

Not only that but, at the C wave lows, momentum was diverging and that indicated a lessening of selling pressure and heralding a rally was approaching.

And that presented a stunning opportunity to go long near the 700p level - and at low risk because a stop loss could be safely placed just under the Fibonacci 62% support.

With a long position at 700p, I have room to give the shares chance to move higherEven if I was wrong and the market headed lower to stop me out, the loss was minor. For traders and investors alike, this is as perfect a setup as can ever be presented.

And lo and behold, the market moved sharply above the upper blue wedge line in a classic breakout. That is very near-term bullish action.

The key to maintaining the bull trend is to clear last week's 795p high soon. Failure to do that would put a little downward pressure on the shares and a test of the gap in the 740p level would be on the cards.

But with a long position at 700p, I have plenty of room to give the shares chance to move higher - and I can now move my protective stop to "break even". So even if the rally fails and takes me out, I will suffer zero loss. And that is a wonderful position to be in, whether a trader or an investor.

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