Richard Wyckoff was one of the founding fathers of technical analysis, and one of his most useful concepts was to divide the market into an idealized cycle of accumulation, mark-up, distribution, and markdown. Though it can be difficult to apply this model in actual trading, it has many important lessons and can shape the way we think about market action. From a practical perspective it lays the foundation for a simple categorization of technical trades into four trading categories. There are two trend trades: trend continuation and trend termination, and two support and resistance trades: holding and failing.
Though this may seem like an arbitrary classification system, it is not. Every technical trade imaginable falls into one of these categories. Trades from certain categories are more appropriate at certain points in the market structure, so it is worthwhile to carefully consider your trades in this context.
The first question to consider is: are all of your trade setups in one category? If so, this may not be a bad thing—a successful trading methodology must fit the trader’s personality—but most traders will have the best results when they have at least two counterbalancing setups…. There is an old saying: “If the only tool you have is a hammer, every problem you encounter will look like a nail.” … There is certainly room for the specialist who does one trade and does it very well, but many traders find success with a broader approach.
Some market environments favor certain kinds of plays over others. If you trade within each of these trading categories, then you need to ask yourself: Are you applying the right kind of plays to the right market environments? If you are a specialist who focuses on only one setup or pattern (and, be clear, this is not a criticism if you are successful this way), then you need to realize that only a few specific market environments favor your play and wait for those environments. You can redefine your job description to include not trading. Wait on the sidelines, and wait for the environments in which you can excel. Clarify your setups. Categorize them into trading categories, and then simplify, simplify, simplify.
Let’s look briefly at each of the four broad trading categories and ask the following questions from a general, high-level perspective:
- Which trade setups fall into this category?
- What are the associated probabilities, reward/risk profiles, and overall expectancies of these trades?
- How do these trades fail?
Trend Continuation
Trend continuation plays are not simply trend plays or with-trend plays. The name implies that we find a market with a trend, whether a nascent trend or an already well-established trend, and then we seek to put on plays in the direction of that trend. Perhaps the most common trend continuation play is to use the pullbacks in a trend to position for further trend legs. It is also possible to structure breakout trades that would be with-trend plays, and there is at least one other category of trend continuation plays—those trades that try to get involved in the very early structure of a new trend, before the trend has emerged with certainty. Trend continuation plays tend to be high-probability plays because there is a verifiable, statistical edge for trend continuation; these plays are aligned with one of the fundamental principles of price behavior.
There is a problem, though: It is important to have both the risk and the expectation of the trade defined before entry; this is an absolute requirement of any specific trade setup, but it can be difficult with trend continuation trades. The key to defining risk is to define the points at which the trend trade is conclusively wrong, at which the trend is violated. Sometimes it is not possible to define points at which the trend will be violated that are close enough to the entry point to still offer attractive reward/risk characteristics. On the upside, the best examples of these trades break into multileg trends that continue much further than anyone expected, but the most reliable profits are taken consistently at or just beyond the previous highs.
Trend Termination
More than any other category, precise terminology is important here. If we were less careful, we might apply a label like “trend reversal” to most of the trades in this category, but this is a mistake. That label fails to precisely define the trader’s expectations. If you think you are trading trend reversal trades, then you expect that a winning trade should roll over into a trend in the opposite direction. This is a true trend reversal, and these spots offer exceptional reward/risk profiles and near-perfect trade location. How many traders would like to sell the high tick or buy the very low at a reversal? However, true trend reversals are exceedingly rare, and it is much more common to sell somewhere near the high and to then see the market simply stop trending. Be clear on this: This is a win for a trend termination trade—the trend stopped. Anything else is a bonus; so it is important to adjust your expectations accordingly.
Trend termination plays are not usually extremely high-probability plays, but the compensation is that good examples tend to offer potential rewards much larger than the initial risk of the trade. If your patterns allow you to position short near the absolute high point of a trend leg with some degree of confidence, then you have a well-defined risk point and the potential for outsized profits on some subset of these trades. Over a large enough sample size, the risk/reward profile may be very good, leading to a solid positive expectancy even if most of these trades are losers.
Trend termination trades are countertrend (counter to the existing trend) trades, and trade management is an important issue. Most really dramatic trading losses, the kind that blow traders out of the water (and that don’t involve options) come from traders fading trends and adding to those positions as the trend continues to move against them. If this is one of the situations where the trend turns into a manic, parabolic blow-off, there is a real possibility for a career-ending loss on a single trade. For swing traders, there will sometimes be dramatic gaps against positions held countertrend overnight, so this needs to be considered in the risk management and position sizing scheme. More than any other category of trade, iron discipline is required to trade these with any degree of consistency.
Support or Resistance Holding
There is some overlap between these trading categories, and it is possible to apply trades from these categories in more than one spot in the market structure. We might expect that most support/resistance trades will take place in accumulation or distribution areas while the market chops sideways, but a trader trading with-trend trades could initiate those trades by buying support in the trend. Are these trend continuation trades or support holding trades? The answer is both, so traders must build a well-thought-out classification system that reflects their approach to the market. Your trading patterns and rules are the tools through which you structure price action and market structure, and they must make sense to you. Take the time to define them clearly.
Many trading books will show you examples of well-defined trading ranges, where you could buy and risk a very small amount as the market bounces off the magic price at the bottom of the range. These trades do exist, but they are a small subset of support holding trades. Support, even when it holds, usually does not hold cleanly. The dropouts below support actually contribute to the strength of that support, as buyers are shaken out of their positions and are forced to reposition when it becomes obvious that the drop was a fake-out.
For the shorter-term trader trading these patterns, there are some important issues to consider. If you know that support levels are not clean, how will you trade around them? Will you sell your position when the level drops, book many small losses, and reestablish when it holds again? Will you simply position small in the range, plan to buy more if it drops, and accept that you will occasionally take very large losses on your maximum size when the market does drop? Every decision is a tradeoff, and you must understand the consequences of these decisions.
Because of these issues, support/resistance holding trades, as a group, tend to have the lowest reward/risk ratios. By definition, at support, there is an imbalance of buying pressure that creates the support, but the market is usually in relative equilibrium just above that support. Most traders will try to avoid trading in these equilibrium areas, so many support holding trades set up in suboptimal trading environments. It is worth mentioning that there is a special subset of support/resistance holding trades that actually are very high-probability trades: failed breakouts. Remember, when everyone is leaning the wrong way, the potential for dramatic moves increases greatly, and nowhere is that more true than in a failed breakout.
Support or Resistance Breaking or Failing
Support/resistance breaking trades are the classic breakout or breakout from channel trades and, ideally, would be located at the end of accumulation or distribution phases. In fact, these trades actually define the end of accumulation or distribution, as the support or resistance fails and the market breaks into a trend phase. Another place for support/resistance breaking trades is in trends, but many of these are lower time frame breakout entries into the trading time frame trending pattern. Many traders, especially daytraders, find themselves drawn to these patterns because of the many examples where they work dramatically well. Many trading books show example after example of dramatic breakouts, but there is one small problem with breakout trades—most breakouts fail.
In addition, the actual breakout areas tend to be high-volatility and low-liquidity areas, which can increase the risk in these trades. They occur at very visible chart points, and so they are often very crowded trades. The presence of unusual volume and volatility can create opportunities, but it also creates dangers. Execution skills probably matter more here than in any other category of trade, as slippage and thin markets can significantly erode a trader’s edge. These trades can offer outstanding reward/risk profiles, but, especially in short-term trades, it is important to remember that realized losses can sometimes be many multiples of the intended risk, significantly complicating the position sizing problem. This is not a fatal flaw, but it must be considered in your risk management scheme.
Depending on the time frame and intended holding period for the trade, it may be possible to find that there are patterns that precede and set up the best examples of these trades. The best resistance breaking trades will be driven by large-scale buying imbalances, and these imbalances usually show, for instance, as the market holds higher lows into the resistance level before the actual breakout. Breakouts driven by small traders who are simply trying to scalp small profits in the increased volatility are less reliable and are usually not set up by these larger-scale patterns. In the very best examples of these trades, buyers who are trapped out of the market by the suddenness of the breakout will be compelled to buy into the market over coming days or weeks, and this buying pressure will provide favorable tailwinds for the trade. Traders specializing in breakout trades usually spend a lot of time studying the patterns that set up the best trades, and maintain a watch list of potential candidates for trades at any time. Executing unplanned breakout trades in a reactive mode is unlikely to be a formula for long-term success.
(This post first appeared on See It Market, and also was adapted from my book, The Art and Science of Technical Analysis.)
