Principle 1: Trend is More Likely to Continue its Direction than to Reverse
With price established in a clearly defined trend of higher highs and higher lows, certain key strategies and probabilities begin to take shape. Once a trend is established, it takes considerable force and capitalization to turn the tide. Fading a trend is generally a low-probability endeavor and the greatest profits can be made by entering reactions or retracements following a counter trend move and playing for either the most recent swing high or a certain target just beyond the most recent swing high. An absence of chart patterns or swings implies trend continuation until both a higher high and a higher low (vice versa for uptrend changes) form and price takes out the most recent higher high.
Be aware that recent statistical analysis of market action (from intraday to 20 day periods) over the last five years shows that mean reversion, rather than trend continuation is more probable in many equities/indices (as shown by more up days followed by down days than continuation upwards). For the current market environment, until volatility returns (as it may be doing now), this rule may be restated, “Trends with strong momentum show favorable odds for continuation.”
Principle 2: Trends End in Climax (Euphoria/Capitulation)
Trends continue in push/pull fashion until some external force exerts convincing pressure on the system, be it in the form of sharply increased volume or volatility. This typically occurs when we experience extreme continuity of thought and euphoria of the mass public (that price will continue upwards forever). However, price action – because of extreme emotions – tends to carry further than most traders anticipate, and anticipating reversals still can be financially dangerous. In fact, some price action becomes so parabolic in the end stage that up to 70% of the gains come in the final 20% of the move. Markets also rarely change trends overnight; rather, a sideways trend or consolidation is more likely to occur before rolling over into a new downtrend.
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Three Things Markets do:
1. Breakout and Trend.
2. Breakout and Reverse (False Breakout).
3. Trading Range (High and Low). | |
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Principle 3: Momentum Precedes Price
Momentum
– force of buying/selling pressure – leads price in that new momentum
highs have higher probability of resulting in a new price high following
the next reaction against that momentum high. Stated differently,
expect a new price high following a new momentum high reading on
momentum indicators (including MACD, momentum, rate of change). A gap
may also serve as a momentum indicator. Some of the highest probability
trades occur after the first reaction following a new momentum high in a
freshly confirmed trend. Also, be aware that momentum highs following a
trend exhaustion point are invalidated by principle #2. Never establish
a position in the direction of the original trend following a clear
exhaustion point.
Principle 4: Price Alternates Between Range Expansion and Range Contraction
Price
tends to consolidate (trend sideways) much more frequently than it
expands (breakouts). Consolidation indicates equilibrium points where
buyers and sellers are satisfied (efficiency) and expansion indicates
disequilibrium and imbalance (inefficiency) between buyers and sellers.
It is much easier to predict volatility changes than price, as
price-directional prediction (breakout) following a low-volatility
environment is almost impossible. Though low volatility environments are
difficult to predict, they provide some of the best risk/reward trades
possible (when you play for a very large target when your initial stop
is very small – think NR-7 Bars).
Various
strategies can be developed that take advantages of these principles.
In fact, almost all sensible trades base their origin in at least one of
these market principles: breakout strategies, retracement strategies,
trend trading, momentum trading, swing trading, etc. across all
timeframes.
Concept Credit for arranging the four principles:
See also:
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