Since the market is in a distribution/consolidation at these highs, I want to talk about trends. The market will find a direction based on an outside influence that changes what price is seen as the best value and will trend again to this newly perceived value.
A trend is a series of higher highs and higher lows or a series of lower lows and lower highs. The market moves in a zig-zag pattern either up, down, or sideways. Trades can have an entry strategy based on these small retraces that occur along the way.
Trends will typical gain momentum off of something that changed the view of value then will slowly lose that momentum until either there is renewed momentum in the direction of the trend or some period of consolidation sideways. A trend rarely reverses without some capitulation.
Some trends can go parabolic. These trends tend to have a large retrace after momentum wanes. Silver in 2011 and 2012 is a good example.
Good trends have decreasing volatility and appear to be methodical in nature. The grind up from the 2009 lows through the summer of 2010 is an example of a methodical trend cause by the stimulus measures following the financial crisis.
The integral part of the trend is price action. Price action alternates between a range that tries to establish an equilibrium level and an expansion of price to a new level at which point price tries to establish an equilibrium again.
Traders call this building value. Support and resistance areas are examples of areas price has found value. This process happens on all time frames and can either establish an agreement on value or fail and test a previous equilibrium level higher or lower.
Many people also call these price action tendencies ‘swings’. When you hear someone talk about swing highs and swing lows; what they are talking about is price action.
Elliot Wave popularized the use of ‘waves’ that can be measured or counted. Again its price action, but with specific parameters to label them corrective or impulsive.
Chart patterns are just price action that forms specific looking patterns. LBR Group (Linda Bradford Raschke ) has some considerable research on using ATR to help define the the points for defining waves. This research suggest that 2.5 times the ATR can define a suitable wave size.
Interestingly enough before I learned of LBR Group’s studies, I built an ATR based stop system to experiment with how to apply the best stops in a trend while maintaining a reasonable amount of risk. I also found that most times the best volatility filter to use was 2-3 times the ATR.
Trend and Multiple Time Frames
You can also apply this price action when you trade using multiple time frames. I like to use a 15 minute chart during the day to give me a heads up for the longer term trend. I then trade off a volume based chart that builds price bars based on the number of contracts traded.
If you apply the price action to determine trend on both charts, then you are more likely to make good trade in the direction of the prevailing trend.
However, any trade on any time frame should be within what the trader is willing to risk. So that means if a trade is a good trade; but you have to potentially risk more than 1-2% of your account then it’s not a trade for you.
While trading a trend you should be continually analyzing the trend for those swing highs and lows that confirm the trend. If an uptrend is making higher highs and higher lows in a zig-zag pattern then starts to make a lower high and then a lower low; you might be looking at a trend change. The opposite is true if you are in a downtrend, and the market makes a higher low.
One thing about chart patterns is that the longer time frame patters typically take precedence.
Some recent examples of chart patterns I see a lot are bull and bear flags, wedges, and V-spike reversals.
We see V-spike reversals quite often during the day while trading futures. They can happen after news, when stops get hit, or the market gets ahead of itself. These reversals are marked by a candle(s) with large wicks in the opposite direction of the spike.
Price rejection can also signal the end of a prevailing trend.
So lets look at some examples of the last few days.
This Russel 2000 emini (TF) chart is from 10/10/2012 shortly after the open. Notice the large wicks showing price rejection on each side of the range.
The day ended up lower after breaking out of this price rejection, but not before the market tested higher and was rejected again. You can see the rest of the day on the next chart; just look the the left of the chart.
The next TF chart is from 10/11/2012. This is interesting because the first 5 minute candle is showing a large upper wick indicating that the market rejected higher prices shortly after the open.
The market was in an throughout the overnight session. Notice the ‘wave’ motion of higher highs and higher lows through out the night.
Wicks are marked with blue circles. I also marked the Globex high with a yellow horizontal line. Remember the previous posts I did on the 5 minute break out and how the I look at previous high, low, open, and close as well as globex highs and lows. I am always aware of these levels.
When we talked about trend in this article we said that a trend is defined by a series of swings, which are simply highs and lows in a zig-zag. If we had broken down past the previous swing high then I would have targeted that previous low just above @ 827. As soon as there was no price action below this level and we started showing price rejection, the trade was over and it was time to exit. Eventually, after hours of chart time, you can feel the market start to slow as trading sometime diminishes at these levels.
What is price rejection? It’s a potential reversal of the trend. So the trend at this time frame (short) was a retrace in a larger uptrend.
On your own bring up a 5 minute chart, play out the rest of the day without using hindsight. Can you see the trends and price rejections?
In a future article I will show you how to use the Guppy Multiple Moving Averages to judge trends and help you get a feel for market structure.
Let me know if this helps by sending me an email using the contact form on the site. Ask some questions or comment.