By Ray Barros
In “Anatomy of a Trade”, I said that identifying the trend of the timeframe you are trading is important because it sets up the strategy for your trade. In other words, in an uptrend, you buy dips or upside breakouts, in a downtrend, you sell rallies and downside breakouts and in a sideways trend, sell the top end of the range and buy the bottom end.
It is almost a cliche that “trends are where traders make their money”. However, I believe that you need to go beyond merely identifying a trending market. To maximise my profits, I would rank the type of trending market I am in.
For the purposes of these notes, I am assuming a monthly uptrend. The monthly is therefore the “trader’s timeframe trend”.
Moves in the direction of the trend (ie up moves), I shall be calling “impulse moves” or “impulsive” and moves in a direction opposite to the trend (ie down moves), I shall be calling “corrective moves” or “corrections”.
This article will suggest four categories. They are ranked from “0” to “3”, with “0” being the most difficult to make money and “3” being the easiest provided you can identify it.
The key to the categories is the relationship between the impulse and corrective waves by the amount that one overlaps the other.
Ranking “0”
Characteristics
1 Corrections of the impulse move tend to be between > 67% to < 87.5%.
2 Breakouts are followed by a correction between > 67% to < 87.5% and a deep re-entry (ie greater than 50%) into the previous correction. eg After the breakout at “3”, the market retraces between > 67% to < 87.5% of “2” to
“3” and greater than 50% of “1” to “2”.
3 At either Point 5 or point 7, the trend or trend type will change. In other words, the market will either change from an uptrend to a downtrend or at Point 5 or point 7 change to a Ranking of 1 or 2 or 3
Profit Potential
Unless you identify it, it is difficult to make money in this type of trend.
Breakout traders have to wear the pain of the retracement. Most will place their stops below the 50% or 67% retracement areas and will continually get stopped out.
Responsive buyers
ie buyers on dips will probably not get set.
Responsive sellers at the top end of the ranges will make some money if they take partial stops or use some form of trade management. Otherwise, they also will be stopped out continually.
Ranking “1”
Characteristics
1 Corrections of the impulse move tend to be between > 33% to < 67%.
2 Breakouts are followed by a correction between > 33% to < 67.% and a shallow re-entry (ie 50% or less) into the previous correction. eg After the breakout at “3”, the market retraces between > 33% to < 67.% of “2” to “3” and 50% or less of “1” to “2”.
Profit Potential
Profit potential is reasonable.
The danger points are the correction following the breakout when re-entry occurs below the point of breakout. Good trade management is necessary.
Ranking “2”
Characteristics
1 Corrections of the impulse move tend to be between > 33% to 50%.
2 Breakouts are followed by a correction between > 33% to 50% and no re-entry into the previous correction. eg After the breakout at “3”, the market retraces between > 33% to 50% of “2” to “3”
and above “1”.
Profit Potential
Profit potential is excellent as this is the most orderly of all the trends. When the market retraces into the previous correction’s range, you will KNOW that a CIT is imminent.
Ranking “3”
Characteristics
1 Strong (in terms or price and time) directional move after a confirmed CIT on breakout above “1”.
2 No corrective moves.
Profit Potential
Profit potential is poor unless identified early or you have developed special rules to deal with it. This type of trend can prove very frustrating for the responsive trader as the market steams ahead without any corrections.
Breakout traders can make excellent money as the market quickly turns poor trade location into fine ones.
Novice traders learn extremely dangerous habits as they “learn” that the market will get them out of trouble as long as they trade with the trend and “isn’t easy to identify a trend that will go on forever” (??!!)