Character of Trend Legs
One important question for discretionary traders to consider is how to weigh objective and subjective elements in technical analysis. Some things are simple and clear, which is one reason that many traders focus on indicators: Price is above the moving average, or it is not. The MACD histogram is higher than it was yesterday, or it is not. In each of these cases, there could not be much room for debate. However, when we start talking about things like character of moves or judging the conviction behind such moves, we are on shakier ground.
Two analysts could look at the same chart and the same set of data, and come to different conclusions, and the same analyst might even make a different call looking at the same data on a different day. To some critics, this invalidates the discipline of technical analysis, or forces them to focus on only the objective elements. This is a mistake, because some of the most powerful tools of technical analysis are at least partially subjective. The question should be: How can we build, refine, and verify the validity of our subjective analyses?
This is a good question. Part of the answer is to remember that the beginner has not seen enough market data to start to develop this subjective sense. For this reason, beginners are probably better advised to stick with more concrete elements, and to take careful notes of their impressions and subjective judgments as intuition starts to develop. Intuition, the classic “market feel,” is based on a combination of a number of elements, most of which in themselves are fairly objective.
Where the subjective element comes into play is in the synthesis of many individual factors, and it can be difficult to articulate precise rules for this part of the process. This is what good traders do: they are synthesizers, taking many disparate elements and combining them into a whole that is much greater than the sum of the parts. As an example, in considering the character of trend legs, the following elements might be important:
- Length of swing on the trading time frame. Longer swings usually mean more conviction, with the exception of potential exhaustion if a market is overextended. As a rule of thumb, if, after several swings in the same direction, a swing emerges that is two to three times the length of the average swing, this may indicate an overextended market and a possible climax.
- Number of bars in each leg. This is a measure of time, and is usually redundant because we can perceive the same information via the slope of the trend on the chart. There is almost never any need to count bars.
- Height of bars near the beginning and end of the legs. Larger bars (relative to the average bar size) usually indicate increased conviction, but very large bars near the end of a swing can indicate exhaustion or climax, which will usually be obvious on the lower time frame.
- The position of the closes in the trading time frame bars. In general, closes below the midpoint of the bar in an uptrend probably indicate some disagreement on a lower time frame. Conversely, closes right at the extreme high of the bar, especially for multiple bars in a row, can indicate exhaustion. This is counterintuitive, but it is a statistically verifiable principle of price behavior.
- Presence or lack of significant price action around previous resistance levels.
- Presence or absence of lower time frame pullbacks within each trend leg. Trend legs can be clean one-directional moves on the lower time frame, or they can hide ABC structures on the lower time frame. Complex consolidations can work off overextended conditions, setting the market up for another trend thrust.
- Higher time frame considerations. For instance, if a trend on the trading time frame is exhausting into a higher time frame resistance, this might be something to pay attention to. In contrast, if a strong uptrend develops on the trading time frame atthe same point where a higher time frame bull flag breaks out, this is a pattern that is likely to see some continuation.
- Volume and trading activity matter. How easily does the market go up? Are there gaps up that do not fill on a daily chart? Intraday, are price levels skipped because large orders clear many levels in the book?
Many traders focus their trading activity exclusively on trending environments; there is certainly some justification for this because many outstanding trades come in trending environments. Market structure in trends is often driven by a strong imbalance of buying and selling pressure, it is relatively easy to define risk points for trades, and some of the cleanest, easiest trades come from trends. However, markets do not always trend. We do not always know when markets are trending, how long the trend will last, or what potential our trend trades may have. A complete understanding of market structure also includes a good grasp of the trading ranges, and the common patterns by which markets transition between the two.