Tag: Traders Toolbox

Traders Toolbox: Bottoming behavior

Posted on by The INO.com Team

Markets which have been in a persistent downtrend often exhibit a common pattern as the end of the decline is approached. The pattern is to post a sharp rally followed by one final decline to new lows.

Sharp rallies formed recently in both pork bellies and gold. Following the rallies, both markets plummeted to new lows. However, once new lows were made, the declines stalled. The failure to sustain the break on the move to new lows indicated the selling was effectively exhausted and potential bottoms had formed. A similar pattern marked the low in soybeans prior to the 1983 bull market.

The logic behind this type of bottoming action is that the persistence of the downtrend has finally forced the bulls out of the market. As the last longs are liquidated, the burden of keeping the down-move going falls totally on the shoulders of the bears to keep pressure on. Any faltering of the bears to keep the pressure on can lead to a sharp short-covering rally as the sellers "all" turn buyers.

Any hint of bullish news accompanying the short covering rally will tend to entice the emotional bulls back into the market. Then, as the bullishness diminishes, the sellers try to reassert themselves. Often a push to new lows occurs and the stops of the early bulls are triggered. The stops provide additional short-term selling pressure. When this subsides and the bears find no more selling entering the market, they head for cover in a more orderly fashion.

A relatively gentle up-move starts as the market searches for the levels which will entice sellers back into the market. From there, the burden of proof falls on the market to determine if the bulls are now the strong hands or if the bears can regain their control.

Traders Toolbox: Psychology of a bottom

Posted on by The INO.com Team

As bull markets roar to a top, it is relatively easy to see the emotional or psychological signs of an impending top. Virtually every source of news will provide coverage of the seemingly endless climb towards higher levels. Greed infests the public as the inexperienced flock to get a piece of the action. Finally, when it is "impossible" for a market to decline and everyone who wants to buy is in, the top will be struck. Buyers become sellers and a downmove ensues.

To an extent, the same sort of pattern unfolds at major bottoms. However, since the events surrounding the decline are not as exciting or newsworthy as those in a bull market, the signs are harder to see. Instead of greed permeating the atmosphere, fear becomes the emotion of significance. As the news becomes per- ceived as increasingly bearish, traders who had been bullish give up. The emotional stress of margin calls and "bad" news finally forces long liquidation.

Despair, disgust and disillusionment abound among the public traders. Producers resign themselves to selling their production near current levels and, in fact, often sell future production as well. They become convinced the market is destined to move even lower. As the bearish attitude spreads, an important sign of a nearing bottom is declining open interest. This is especially true if this long liquidation of futures positions drops the open interest below recent low levels. In markets where individuals are the original holders of production, an additional sign is liquidation of cash positions.

Traders and marketers take any rally as a "gift" to sell on. Bullish fundamental conditions which may exist are discounted as the memory of the persistent downtrend remains entrenched. As a market starts up from the lows, the rallies are viewed with suspicion. Even the few who remained bullish don't trust the rebounds and often take advantage of early rallies to liquidate long positions. Setbacks from the early rallies are often sold as the participants don't want to miss the next washout to new lows. And, if enough gain this attitude, the break will not continue and traders then have to wonder why the markets won't go down on "bad" news. Eventually, their short covering triggers additional gains.

A final important component of an approaching bottom is the inability of a market to sustain a downmove on bearish news. The most common form of this action is seen when government reports are released. The bulls no longer rationalize a bearish report into a bullish one. Instead, the bulls resign themselves to additional declines. Bears move towards overconfidence and start selling the breaks as well as the rallies. Bearish reports often trigger downmovement, initially, but then additional declines fail to materialize. Moves to new lows are rejected as everyone who wants to be short already is and the longs have been liquidated, thereby leaving the markets with no one to initiate new selling. And, as at the top, but in reversed roles, the sellers become buyers.

Traders Toolbox: Reactions within a downtrend

Posted on by The INO.com Team

Many traders, especially those who have not traded very long, find trending declines very difficult to trade. Many trad- ing and analytical tools which perform well in uptrends, or even in sideways pat- terns, often perform differently in down- trends. This is not to say such tools will not work well in a downtrend, but, real- istically, many perform differently.

Many traders (once again, especially those with little experience) tend to be biased to the long, or buy, side of the market. Such traders often have difficulty adapting to the changes which may occur in the performance of their favorite tools in declining markets. Thus, many tend to shy away from the short side of markets. This is unfortunate as markets often fall more quickly than they go up. As a result, profits can be potentially harvested faster in a down move than in an uptrend.

While some traders tend to avoid the short side of markets altogether, others would be interested in selling short if only they could find a way to get on board trending declines. As mentioned earlier, while many tools don't appear to work as well in a down- trend, there is a pattern which occurs often enough to be helpful in analyzing and trading.

The reliable pattern which often develops within down trending moves is a consistency of the upward reactions. The consistency within upward reactions can be in terms of time or price or both. However, most patterns tend to involve time, either alone or in combination with price.

Generally speaking, upward reactions in true downtrends tend to last from 1 to 3 days. The reactions are not limited to 3 days; however, many declines will follow this pattern.

To be more specific, individual markets often mark the maximum time span of most upward reactions with the first rebound in a downtrending pattern. For example, if the first upward reaction lasts two days, many of the subsequent rebounds within the downtrend will last two days or less. A good example of this phenomenon occurred in the February/March, 1991 collapse in the currency markets.

The first rebound in the Swiss franc, following the posting of the February high, lasted for about a day and a half. From that point forward until the primary downtrend came to an end in late March, no upward reaction (arrows) lasted much more than a day and a half. And, when the Swiss franc rebounded for more than a day and a half, (circle) it proved to be a signal the clean portion of the downtrend had come to an end.

The trading strategy is quite simple. In general, traders may look to sell 1- to 3-day rebounds in downtrending markets. If a reaction lasts longer than the longest previous reaction, the strategy then moves to either being stopped out or to look for a gracious way to move to the sidelines on the next break. This is done because, even if the market eventually moves lower, what remain, compared to the previous trending portion or "meat" of the move, often prove to be the "crumbs." Obviously, the strategy is adjusted when a specific market has marked its reaction time.

The spring, 1991 situation in the new-crop corn market pres- ents an example of a time span longer than three days being marked as the primary reaction time. After collapsing from the March high, December corn marked its key reaction time with the sharp rebound into early April. This 4-day bounce set the stage for subsequent reactions to last from 1 day to 4 days. In addition, December corn has marked the likely size, in terms of price, of most subsequent reactions.

The rebound posted in December corn into early April was 13.25(E. This is likely to be the approximate size of the largest subsequent rebound which occurs within the downtrending move. A rebound which is substantially larger than 13.25 cents is likely to signal an end of the primary decline. However, on a daily degree, it is rather obvious that a 13.25C rebound in corn is a large reaction. While a 4-day reaction time is realistic, most reactions in price are likely to be smaller than 13.25 cents.

Notice the 4-day rebound which followed the posting of the April high. This upward reaction was 5cents. From this point on, it was/is reasonable to expect most reactions to be in the neighborhood of 5(t or Go; and to last from 1 to 4 days. However, it would be wise to allow for at least one larger-degree rebound of about 13 cents.

In the spring, 1991 situation in the December corn market, a possible trading approach would be to sell rebounds from a new low of 5cents to 6cents. Risk could be limited to a point which is 14cents or 15cents above a new low. Thus, the effective risk should be about 8cents to l0cents. Once a new low is posted, if one were using "tight" stops, the risk could be limited to about 7cents to 8cents above each new low. Otherwise, a 14cent or 15cent trailing stop above each new low should keep one in position for the bulk of a move. While this is a possible approach, it is not necessarily a specific or the only approach to trading a short position.

As always, knowing the personality of a market can prove beneficial. In the spring, 1991 corn market, it was wise to allow for one rebound in time of up to ten days. This is due to the presence of such rebounds in time in potentially similar previous downtrends in the corn market.

The tendency for consistent reactions in a downtrend should be an attractive addition to one's technical "toolbox". This pattern offers a low-risk method to reap potentially substantial rewards.

Traders Toolbox: Support and resistance

Posted on by The INO.com Team

Although many of you will find this lesson in one of the most basic concepts of market behavior "old hat", it never hurts to review. One of the first things a new trader is told (I hesitate to say learns as many never do) is to buy a breakout above resistance and sell a fall through support.

Resistance is the level which holds a market down, while support is an area which props up a market much like a ceiling and a floor. The key is to identify the critical levels. There are a number of methods to determine support and resistance: trendlines, moving averages, retracements, Gann angles, etc. However, simple observation can be an effective means of locating the important areas. A quick glance at the October cotton chart reveals the most basic levels of support and resistance (broken lines).

A previous high often provides resistance, while an earlier low tends to offer support. Support or resistance levels are not necessarily flat. For example, trendlines reveal areas of rising support or falling resistance. Also, when broken, uptrend lines offer a new level of rising resistance, while the opposite is true for downtrend lines. In fact, virtually any broken area of support will become resistance and vice versa. After breaking a level of support (or resistance), the market commonly comes back to test that level before resuming the downmove (upmove). This may be the single most effective method of locating low-risk entry points for trading purposes. This lesson may seem like wasted space to the experienced. However, it is amazing how often traders simply forget (or ignore) the power of basic support and resistance levels. This concept can be very profitable, but it may be just too "easy".

Traders Toolbox: The Elliott Wave Principle

Posted on by The INO.com Team

As with any tool, the Elliott Wave Principle is not the answer to most analysts' problems. It is only a tool, but used properly with other analytical aids, it can greatly enhance the understanding of the overall direction of a market.

The following discussion will be very basic. The primary goal is to give you an understanding of the basic structure or skeleton of a market.

With all due respect to Robert Prechter, I have seen very few other analysts survive almost solely on the Elliott Wave theory. However, having a working knowledge of the principle can prove invaluable when analyzing markets. While I do not purport to be an Elliott Wave expert, I have had success applying many of the basic elements of the principle. In fact, I like to think of myself as an Elliott Wave realist instead of a theorist.

I like to compare the Elliott Wave theory to an outline one might use to present a speech; it provides a general format to follow without having the text etched in stone. The primary pattern for a market consists of a 5-wave rally, as illustrated, followed by a 3- wave downmove, commonly referred to as an a-b-c correction. The 5-wave pattern is referred to as an impulse wave which means a wave in the direction of the prevailing trend.

The primary 5-wave structure may be subdivided into smaller 5-wave patterns, creating smaller impulse waves followed by a-b- c corrections. Note after these waves combine to create a 5-wave move, a larger a-b-c correction forms. The a-wave is shown in this example as a 5-count pattern, indicating this is the direction of the near-term trend and only the first part of a larger degree corrective move. Be aware that an a-wave may or may not be a 5- count wave but that a c-wave invariably will contain 5 swings.

Also take note that the a-b-c corrections ideally return to the area of the previous fourth wave. This may be followed by a new impusle wave or by a congestion or sideways pattern.

For an in-depth discussion of the Elliott Wave theory, I suggest you get the book Elliott Wave Principle, by Frost and Prechter. This book should be part of any serious technician's library.
<h2>Basic wave extension</h2>
As with any theory, reality proves variations of the ideal pattern will occur. The primary variation of an impulse is an extension.

An extended wave generally is an elongated or protracted wave within the 5-count basic wave. Extra swings develop which commonly appear to be individual primary waves but actually form a single impulse wave. The wave extensions are generally larger than the minor degree swings within a primary wave but often are not as large or clearly denned as the primary waves.

At times, the extended waves are difficult to distinguish from the primary waves, giving the appearance of a 9-wave structure. The extension is undefined, which is not critical since a 9-wave structure is an extended 5-wave pattern and holds the same level of importance. When dealing with an undefined extension, I have found the subsequent a-b-c correction often terminates in the area of wave 6 (see arrow) instead of the normal area of wave 4.

While the extra swings or extensions may occur within the first or fifth wave, the most common location is within a third wave. Extensions are common, especially in bull markets; generally an extension should be expected to occur in one of the three primary impulse waves. However, extensions normally occur in only one primary wave.

Once an extension has occurred, you can expect the subsequent wave(s) to be easy to identify 5-wave patterns. If the first two impulse waves form without exhibiting an extension, the final wave can be expected to contain an extension; if the first two impulse waves are of similar length as well, the last has the potential to be explosive. Explosive fifth waves may contain extensions within extensions.

For an in-depth discus sion of extended waves, lmpulae read Chapter 1 of Elliott Wave Principle by Frost and Prechter.