Friday, December 31, 2010

Trend breaks and trend births

The first thing a price action trader learns is that the market is either trending or in a trading range. If its in a trend, take only with trend trades. If its in a trading range, fade breakouts, i.e., take counter-trend trades.

Of course, many traders find themselves in trouble when they find they are trying to trade with trend but the trend has already ended or they are trying to fade a breakout into a new trend. Therefore, its vital to know when a trend has ended and when a trend is erupting from a trading range.

Many trend terminations are fairly obvious because they end in Wedges or overshoots and then reverse. However, often trends end in a consolidation. The definitive sign a trend has ended is if the trend line is broken. A broken trendline is clear and obvious if the price moves below the previous swing low in a one legged move as it did today from b37 to b40. The fact that it did so after a failed breakout from a horizontal final flag adds credibility to the end of trend. At this point the market is in a trading range bounded by the recent swing high of b37 and the swing low of b40. Any move to the edges of this range may be faded. If the range size is small as it was today, there could be insufficient room to give a scalp profit using price action entries. Limit traders can fade the first approach with confidence knowing that the first attempt is likely to fail and they have a reasonable stop a tick or two above the recent swing points.

Trends usually birth after a breakout failure of one of the bounds of the range. Today, we got two attempts to break above the range at b51 and b65 and this gave a DP (double top/bottom and pullback) at b75. DPs are often trend generators and work best in the direction of the previous trend.

Today's move had a breakout below the range but it failed at a measured move of half the trading range. The failure resulted in a breakout attempt on the opposite side of the range and gave a breakout pullback long entry (essentially a pause bar on b80). A failed breakout on one end of the trading range usually gives a breakout pullback on the other side of the range esp if the test on the second end is a one legged move. These are also very strong trend generators.

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