Friday, February 21, 2014
Trend and chop
The most important criteria to optimize your odds is to trade in the direction of the trend, which implies sitting out when there is no trend. This gives rise to the question of how to determine when the market is trending. A related concern would be the strength of the trend, which can help determine targets.
A trend simply defined, is higher highs and higher lows for bull trends and lower highs and lower lows for bear trends. However, this is too simplistic in practice. Technically, a trend is a sustained move in one direction. The opposite of a trend is chop.
For example, today's open was a choppy open and its pretty obvious from the sequence of opposing bars. But then a trend broke from b16. (Identifying the breakout of a trend before it breaks is called the breakout problem and is an active research topic.)
Once the trend breaks, you would need to wait for a setup at the trendline. In general, the setup needs to be a multi-legged and/or deep pullback. The picture above shows several ways to draw trendlines. The purple line is simply an inferred trend line drawn parallel to the TCL from the prior two pushes. The bear trendline from b7-b16 is the shallowest bear trendline that can be drawn from the HOD. Similarly the trendline b37-40 is the shallowest bull TL that can be drawn from the LOD.
The shallowest TL is the safest, highest probability TL and is the only place you can take swing trades (trades with indefinitely large targets). A sustained breakout such as the one below b11 enables the drawing of a steeper TL that sometimes works at least once (this is due to the fact that strong breakouts usually have at least one more leg). Note that the breakout above b33 for example was a strong move but not a sustained breakout since it did not continue for many bars and many ticks.
In most cases, there are at most two trendlines, the shallowest bull and the shallowest bear. In a bear move such as today, every new pullback after a new push down will attempt to create a new shallowest bull TL that could break and give a new move down. The steeper the shallowest TL, the stronger the trend.
The first achievement in trading is predicting the direction of the market correctly. The shallowest TL is the simplest way to learn to guage direction. Waiting for the price to poke beyond the trendline before taking a trade will ensure at least directional correctness. To start with, disregard, breakouts and reversals. Wait for an obvious trend and wait for price to pullback to the shallowest trendline and take every trade. You may use a bar stop in the beginning or even a tight stop and not worry about the win/loss because your goal not really to profit but to learn to read direction.
Once you are comfortable with your sense of direction, you can fine tune your entries to work with a tight stop and later move to optimize exits.