There are patterns in market prices that can point to trading opportunities and potential profits. This is one of the fundamental assumptions of technical/tactical trading (and can be verified by quantitative and statistical analysis.) Most people are familiar with the idea of finding patterns to set up trades, but we can do much more if we use those patterns in different ways. In fact, a simple pattern can give us good insight into trend integrity and a very high level perspective on sentiment and market structure.
Some of the most useful trading patterns are variations of the pullback theme: trending markets move in alternating rounds of with-trend strength, interspersed with pullbacks or pauses against the trend, that then break into further trend legs. The simple schematic pattern looks something like this:
That’s the theory, and it works like that often enough that you can build a complete trading program around this simple concept. We can take it a bit further by considering the strength and character of the move out of the pullback. Yes, here we cross a line from what is clear and objective to something more subjective, but it’s an assessment that can be made with a little experience–weeks instead of months to learn the concept and months, not years, to have a very good grasp on it.
Take a look at the chart of the US Dollar index below. The Dollar index was in an uptrend for at least part of this chart, and I have marked points where the Dollar broke out of bullish consolidations with arrows. Consider the difference in character between spots marked with green and red arrows:
With one exception (marked “?”) the moves marked with green arrows had conviction; they quickly went to new highs, didn’t pause very much, and made new trend legs that consolidated at higher levels. When we get to the right of the chart (red arrows), the attempted moves up failed pretty quickly. This alerts us that something has changed in the market–character has changed, and maybe the market is entering a new regime.
Now, you might argue that this isn’t useful because it is only history; of course the market was going up on the right side, so consolidations broke to the upside, and then it stopped going up, so consolidations had trouble breaking out. This is obvious and is to be expected. You would be right to make that argument, but there is one more thing to consider: this is not only history because we can also make these assessments in real time. We can judge the character of these breakouts and compare them against our mental map of what “should be” happening if the trend is intact. It’s a subtle thing, but it’s also real and is an element of market analysis that can easily be learned.
So, give this a try. Pick a market you follow closely, and start watching the right edge of the chart. (Don’t bother to go back and look at history because that is easy. This is an exercise that must be done as it unfolds.) When the market makes a pause or consolidation against the trend, watch the character of the move out of the consolidation. Compare it to previous moves, and think about what you should see if the trend is strong and intact. Spend a few weeks watching the market with this idea in mind–the subtle shift in attention to assessing the character of the extension out of the pullback is what will make the difference. In a few weeks, you may see the market with new eyes.
Hi Adam,
how do we know that a consolidation is an accumulation or a distribution of trend? For example the USDCAD daily was in a consolidation from end of january 2015 until 15 april 2015. Which technical sign was in that range until 14 april(on 15april the range was broken)that we have to do with an distribution and not with an accumulation?
Thanks and regards Daniel
Character, Strength, Shifts in Trends / Regimes can help learn & improve our estimates of probabilities of Various Set-ups…. Thank You !
I have a related question to timing these pullbacks. Let’s consider a simple ABCD structure with AB = impulse, BC = retracement, CD = 2nd impulse. Conceptually, we can try to build a system that times an entry into C, given the length / duration of AB.
From an ex-post analysis of market structure, we can estimate a probability distribution of the length/duration of BC (given AB) – and use some sort of confidence level to design stop / targets. So if we’re looking to go long, we could draw a box (time vs distance) on the chart where probability of making a low is the highest. Then we buy either failure tests at the bottom edge or breakouts from the top edge of this box.
My question has to do with the effect of delay on such a system. In other words, our pivot high (or low) on a weekly chart isn’t known until a week after it’s made. If we are lucky (relatively long retracement) , we will know AB with certainty at the point of trying to predict C. It’s also possible that we have to make an assumption about AB (think of a situation where B and C happen in successive candles – we don’t know B with certainty until after C has also been tested, and probably passed, so we have to take a leap of faith on both).
In either case , this opens up the possibility of Type 1 / 2 errors both w.r.t. determining the previous swing high (and low). Have you done any work around how much this can hurt such a system? Alternatively where do we draw the line to take those leaps of faith? (This assumes we can make do with first order pivots…second order pivots would worsen the delay. I haven’t gotten around to conceptualizing / statistically analyzing my system beyond this!)