[dc]W[/dc]hen trying to master any complex subject, it can be helpful to reduce things, as much as possible, to basic elements. Price movements in markets are very complex; so many competing influences and timeframes, combined with a good dose of randomness, conspire to hide any simple tendency that might be present. I want to present an extremely simplified model of price movement today by considering one simple question: A market has made a large move in one direction and then has paused. What do you do? Do you expect the move to continue or to be reversed in the future? Consider this diagram that shows a market that has just made a large move and then gone flat (black line) with two possible future price paths:
So, in this simplified model we only assumed two options. In reality, there are a few others if you include the possible fakeouts or that the market may simply go sideways. Even then, at some point the market will make another move, and that move can only either be in the same direction, continuing the previous movement, or it can reverse it. Over a large number of trades, we would find that about half of them resolve in either direction, showing no edge in such a simplified model, but this, in many ways, the key question of technical trading. Should we be looking for continuation or reversal?
Fortunately, there are some conditions that can sometimes give us an edge, that can sometimes let us know that one resolution is more likely than another. Range expansion is characteristic of trend, and it makes most sense to play for range expansion in markets that are not overextended and show strong market structure to support further trend legs. (Reading that market structure is as much art as it is quantitative.) Mean reversion is more common in overextended markets, and there are other cues that can set up and support these trades. Another thing, that not many developing traders realize, is that the balance of mean reversion and range expansion is different in different asset classes. In many ways, the single most important task of technical analysis is to try to understand whether the environment is setting up to favor range expansion or trend reversal–trades that are correct in one environment are exactly wrong in the other.
So, how do we do this? How do we know whether to be positioning with the trend or looking to trade against the trend, to play for continuation or reversal? There are a few different ways to do this: looking at price patterns, market structure, related markets, etc., but they all depend on one thing–the nature of volatility itself. We’ll dig into that a little bit deeper tomorrow.