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Chapter 6: Principles of Price Behaviour
In this chapter,Tom Hougaard outlines what price trends are and how to apply these patterns in your Forex or stock trading strategies, whether you are an active trader or long term investor.
Transcript:
Introduction:
Have you ever heard the saying "the trend is your friend until it ends"? -well very few people know exactly when a trend is going to end.
However in this chapter we will be discussing what exactly a trend is, and we'll be looking at what signs there are that a trend is about to end.
Scene 1: The Principles of Price Behaviour
Before we get stuck into the principles of price behaviour, I’d like to take a moment talking about why technical analysis is so important for the private trader. Not only is it relatively easy to understand and apply in the market – but the patterns that you’re learning about they are applicable whether you are an exceptionally short term trader trading off a 1 minute or a 5 minute chart, as well as when you are trading the longer term timeframes using an hourly chart or even a daily chart. The fact of the matter is that technical analysis is applicable on all timeframes
These principles are the driving force of the markets, and they should be understood and mastered. It is unlikely you will EVER find a winning strategy that doesn’t have one of these principles as its main driver behind the rules of the strategy.
The principles behind price behavior
- A Trend has a Higher Probability of Continuation than Reversal
- Momentum precedes Price
- Trends end in a Climax
- Markets alternate between expanding its range and contracting
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A Trend has a Higher Probability of Continuation than Reversal
Newton’s first law of motion states that once an object sets in motion, it tends to stay in motion. The financial markets trend and the trend tend to last a lot longer than most traders expect, even the so-called experts.
One of the strongest performing segments of technical trading in terms of returns on investments, if not the strongest, is the trend follower. They believe that trends develop and persist, and no one truly knows when a trend will seize. A trend follower will never get in at the low and never get out at the top.
The trend continues to test out as the strongest component in any winning strategy when it comes to gaining an edge or advantage in the markets.
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Take a look at the chart in front of you. This is a chart of reckin benchizer over a 5 year period. But if i haven’t told you that the stocks name was recckit wopuld it have made any difference to you? Is this not a chart going up or trending higher? Exactly.
What is so profound about technical analysis is that it doesn’t make a fundamental judgement of price earn or any other fundamental indicator that you may think of. It simply just makes an objective judgement of is this instrument trending up or is it trending down.
And as you can see on this chart, it is trending up so therefore you want to be a buyer. And at no point dutring this 5 year period was there any danger of this trend reversing.
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Momentum calculations measure the rate of change in a market. When momentum makes a new high or low, it is likely that price has yet to make a new high or low. In this respect momentum is a leading indicator, as opposed to a lagging indicator, such as a moving average.
In my trading strategy this is a profoundly important technique, and I will endeavour to make sure that you are fully explained how momentum works in your day to day trading.
We will discuss techniques that endeavour to place the trader in the market after the first reaction following a momentum high or low. While it will not work every time, the techniques work on the thesis that once a trend is in motion, it tends to stay in motion, and the job of the trader is to establish positions in the direction of the trend.
We will use other techniques such as range expansion and volume to confirm that momentum is confirming higher or lower prices. New momentum highs or lows confirmed by a “range expansion” is indicative of higher or lower prices to come.
We will also learn to read divergences between price and momentum. The chart that you are seeing now, you can clearly see how a price is making a new high, but momentum is making what is known as a lower high. Thereby indicating that the price chart has almost come to a standstill and a reversal is more likely than a continuation of the trend.
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Trends tend to end in a climax. It doesn’t necessarily mean that they will end in a climax, but they often do.
A trend will continue until it reaches a buying or selling climax. This is often associated with hitting old highs or lows, commonly known as support and resistance, as a surge in volume, as those on the wrong side of the market are scrambling to cover their positions.
A trend culmination tends to be associated with increased volatility and a surge in volumes. Usually there is also an increase in the length of the bars that you are seeing and that’s called a range expansion.
Don’t mistake a culmination with a trend reversal. Just because a trend is culminating doesn’t mean that the market will reverse the other direction. The market often begins a process of “backing and filling”, testing the old highs and the most recent range lows.
Even in long-term up trends spanning years, you will have examples of assets going into a sideways dormant state for a while.
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You should also know that markets tend to move much further than people expect, and often the price “overshoots” to the point where even the experts are surprised. The market will then enter a phase where the market participants are getting used to the new prices, although in rare cases it may reverse back down again.
A recent case was when oil hit a peak of $174, but rather than staying put at this price it declined all the way down again to the $60 range.
It is rare though that after a big up-trend the market will revert immediately into a downtrend, but it happens.
When it happens it’s called a V-Reversal. There are times when the market makes a V reversal. It is signified by a spike higher to new highs or a spike lower to new lows, and the market immediately begins to travel in the opposite direction. It is often associated with news items causing a mixed response in the market or when bull markets and bear markets end. In particular you will actually often see V reversals or spike reversals during the trading day.
The hallmark of a V reversal is that the market reverses direction without any form of consolidation. There is no hesitation there is simply just a shift in power from a bullish force to a bearish force or vice versa.
Trading V reversals can be very profitable, and we will teach you techniques for identifying where potential shock reversals may set in.
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I’m going to let you into a little secret. As a trader I don’t have one strategy that fits all markets. I wish this was the case, but it isn’t because the markets character changes from one moment to the next moment
Sometimes it pays off to the a trend follower and sometimes being a trend follower means that you carry on loosing on your positions and getting chopped out of positions because the market enters into a range.
The first condition is when a market is trading within a range. The second condition is when the market is expanding or trending.
And on the charts that I have provided for you, you will see examples of both.
There are a host of tools that traders use to take positions in the two conditions. But they still require that you as a trader have the ability to change between two sets of circumstances.
A trader needs to be alert when trading a range bound market, because it is impossible to forecast when a market once again will be expanding.
In this course we will be looking at techniques designed to trade both kind of markets.
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Take a look at the chart on the screen. This is a chart of the gold silver index. For months it paid off selling the old highs and buying the new lows as the market was in a range.
But towards the end of the year it began to trade above the old highs. So this market went from being range bound to being a trending market.
One of the hallmarks of a good trader is behaviour modification, which is the ability to change your mind in the face of changing circumstances. A chart is a chart, a chart will be range bound or it will be trending
But how fast are you at changing your mind in the face of changing circumstances, the better you are the faster you will be able to adapt to a new set of circumstances.
11:02 minutes
Tags: forex, stock trading, technical analysis, tom hougaard