First Principles of Technical Analysis (3/?)

2: Trends are more likely to continue than to end

[dc]T[/dc]he previous post in this series considered the first principle of price behavior: that markets tend to alternate between periods of trends and trading ranges. This post will dig a little deeper into the power of an intact trend and the second principle–that trends, once set in motion, are more likely to continue than to end.

Some traders love to pick tops and bottoms. It is a huge ego rush to have sold the high in Gold or to have picked the exact bottom in a pharmaceutical stock that melts down because it was denied an FDA approval. However exciting they are, trades like this are probably not how most traders are going to build a trading career. It is far simpler to trade on the side of the trend, and the easiest money in the market is to be made in alignment with the trend. In fact, a simple, but effective, trading plan could be to identify trending markets and use the more or less predictable elements of trend structure to position yourself on the same side as the trend. Trading with the trend is more forgiving because the power of trend continuation allows you to be a little early or late on your entries and still make profits; if you are aligned with the trend, many mistakes may be forgiven.

Given any chart, your first thought should be do identify the trend and to find ways to position yourself in that trend. Carefully examine your instincts. If you find yourself always wanting to fade the trend, you probably need to make some changes to your thought process or you are likely in for a short and painful career as a trader.

Rather than spending your time examining moving averages or looking for chart patterns, most trader’s mental energy would be best spent trying to understand what the characteristics of price patterns are in both trends and trading ranges. Here are a few generalizations to get you started:

  • In trends, the basic price pattern is an impulse move, a retracement against that impulse move, and then another trend leg in the original direction.
  • One of the best technical trades there is comes from identifying impulse moves, entering on the counter-trend retracement against that move, and holding the trade as the market turns back in the direction of the impulse move. There are many ways to trade this concept, ranging from positioning in the retracement to entering the with-trend momentum when the market turns.
  • Understanding length of swing analysis can give early warnings as to when the balance of buyers and sellers has shifted in any market.
  • Note that the standard definitions of trends should probably be treated as guidelines, rather than hard and fast rules.

In the next post, a look at some of the standard patterns of trend terminations.



Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.

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