Trend Continuation
Trend continuation plays are not simply trend plays or with-trend plays. The name implies that we find a market with a trend, whether a nascent trend or an already well established trend, and then we seek to put on plays in the direction of that trend.
Perhaps the most common trend continuation play is to use the pullbacks in a trend to position for further trend legs. It is also possible to structure breakout trades that would be with trend plays, and there is at least one other category of trend continuation plays—trying to get involved in the very early structure of a new trend.
In the context of our simplified stage model, trend continuation trades are most appropriate in markup or markdown, but these early trend trades may be attempted where accumulation breaks into the uptrend or where distribution breaks down into the new downtrend.
If you are trading in these areas of uncertainty, it is important to not be stubborn. An aborted breakout of accumulation into an uptrend may well be an upthrust, which is a sign of potential distribution. Listen to the message of the market and adjust accordingly.
Trend continuation plays tend to be high-probability plays because there is a verifiable, statistical edge for trend continuation; these plays are aligned with one of the fundamental principles of price behavior.
It is important to have both the risk and the expectation of the trade defined before entry; this is an absolute requirement of any specific trade setup, but it can be difficult with trend continuation trades.
The key to defining risk is to define the points at which the trend trade is conclusively wrong, at which the trend is violated. Sometimes it is not possible to define nonarbitrary points at which the trend will be violated that are close enough to the entry point to still offer attractive reward/risk characteristics.
On the upside, the best examples of these trades break into multileg trends that continue much further than anyone expected, but the most reliable profits are taken consistently at or just beyond the previous highs. There are several common failure patterns associated with these types of trades.
First, there may simply not be enough with-trend pressure to push the market into another trend leg, so previous resistance holds (in the case of an uptrend) and the market rolls over into a trading range (or distribution).
Traders trading simple pullbacks need to be aware that many pullbacks in strong trends are complex, two-legged consolidations (see Chapter 3), so a good trading plan will plan for that possibility. Dramatic failures of these trades are somewhat uncommon, but they do happen.
Most failed trend continuation trades tend to be rather polite affairs, usually giving the trader a chance to get out for a small loss. However, there is always danger when everyone is leaning the same way in a market, and, especially in well-established trends, there are places where many market participants have piled into a very obvious trend continuation play.
In these situations, especially in extremely overextended markets, reversals can be dramatic as everyone scrambles for the exit at the same time.
Trend Termination
More than any other category, precise terminology is important here. If we were less careful, we might apply a label like “trend reversal” to most of the trades in this category, but this is counterproductive because it fails to precisely define the trader’s expectations. If you think you are trading trend reversal trades, then you expect that a winning trade should roll over into a trend in the opposite direction.
This is a true trend reversal, and these spots offer exceptional reward/risk profiles and near-perfect trade location. How many traders would like to sell the high tick or buy the very low at a reversal? However, true trend reversals are rare, and it is much more common to sell somewhere near the high and to then see the market stop trending.
Be clear on this: This is a win for a trend termination trade—the trend stopped. Anything else is a bonus, so it is important to adjust your expectations accordingly. The obvious spots in the cycle for trend termination trades are where the uptrend stops and moves into distribution, and vice versa on the downside, but there are other possibilities.
Some traders specialize in finding overextended spots in established trends, and fading (going against the trend) these for a very quick and short reversal. For instance, a trader might find spots where the rallies in the uptrend have run up too far too fast, and take short positions against those rallies, planning to cover one to three bars later.
These are trades for only the fastest and most nimble traders; developing traders are well advised to avoid these countertrend scalps because they remove focus from the big picture.
Staying in a consistent time frame is important for these definitions; a trader might look for spots where the short-term downtrends (pullbacks) in the uptrend have overextended themselves, and then take long positions against those lower time frame downtrends.
In this case, the trader is actually positioning countertrend on the lower time frame but with the trend on the trading time frame. Is this a trend continuation or trend termination trade? The answer depends on your perspective and your time frame, and it is only important to be consistent.
Understand what you are trying to accomplish with the trade and how this best fits in the evolving market structure. Trend termination plays are not usually high-probability plays, but the compensation is that winning trades tend to offer potential rewards much larger than the initial risk.
If your patterns allow you to position short near the absolute high point of a trend leg with some degree of confidence, then you have a well-defined risk point and the potential for outsized profits on some subset of these trades.
Over a large enough sample size, the risk/reward profile may be very good, leading to a solid positive expectancy even if most of these trades are losers. Trend termination trades are countertrend (counter to the existing trend) trades, and trade management is an important issue.
Most really dramatic trading losses, the kind that blow traders out of the water (and that don’t involve options) come from traders fading trends and adding to those positions as the trend continues to move against them.
If this is one of the situations where the trend turns into a manic, parabolic blow-off, there is a real possibility for a career-ending loss on a single trade. For swing traders, there will sometimes be dramatic gaps against positions held countertrend overnight, so this needs to be considered in the risk management and position sizing scheme.
More than any other category of trade, iron discipline is required to trade these with any degree of consistency.
Support or Resistance Holding
There is some overlap between these categories, and it is possible to apply trades from these categories in more than one spot in the market structure.
We might expect that most support/resistance trades will take place in accumulation or distribution areas while the market chops sideways, but a trader trading with-trend trades could initiate those trades by buying support in the trend.
Are these trend continuation trades or support holding trades? The answer is both, so traders must build a well-thought-out classification system that reflects their approach to the market.
Your trading patterns and rules are the tools through which you structure price action and market structure, and they must make sense to you. Take the time to define them clearly.
It is easy to find examples of well-defined trading ranges on historical charts where you could buy and risk a very small amount as the market bounces off the magic price at the bottom of the range. These trades do exist, but they are a small subset of support holding trades. Support, even when it holds, usually does not hold cleanly.
The dropouts below support actually contribute to the strength of that support, as buyers are shaken out of their positions and are forced to reposition when it becomes obvious that the drop was a fake-out. For the shorter-term trader trading these patterns, there are some important issues to consider.
If you know that support levels are not clean, how will you trade around them? Will you sell your position when the level drops, book many small losses, and reestablish when it holds again? Will you simply position small in the range, plan to buy more if it drops, and accept that you will occasionally take very large losses on your maximum size when the market does drop?
If you are scaling in, how will you deal with the fact that your easy wins will not be on your full size, as you did not have the opportunity to buy your full line near the bottom of the range? By the time you see the support level is holding, the market will already be far from the level, increasing the size of the stop loss needed.
Because of these issues, support/resistance holding trades, as a group, tend to have the lowest reward/risk ratios. By definition, at support, there is an imbalance of buying pressure that creates the support, but the market is usually in relative equilibrium just above that support.
Most traders will try to avoid trading in these equilibrium areas, so many support holding trades set up in suboptimal trading environments. It is worth mentioning that there is a special subset of support/resistance holding trades that actually are very high-probability trades: failed breakouts.
Remember, when everyone is leaning the wrong way, the potential for dramatic moves increases greatly, and nowhere is that more true than in a failed breakout.
Support or Resistance Breaking or Failing
Support/resistance breaking trades are the classic breakout or breakout from channel trades and, ideally, would be located at the end of accumulation or distribution phases. In fact, these trades actually define the end of accumulation or distribution, as the support or resistance fails and the market breaks into a trend phase.
Another place for support/resistance breaking trades is in trends, but many of these are lower time frame breakout entries into the trading time frame trending pattern. Many traders, especially day-traders, find themselves drawn to these patterns because of the many examples where they work dramatically well.
Many trading books show example after example of dramatic breakouts, but there is one small problem with breakout trades—most breakouts fail. In addition, the actual breakout areas tend to be high-volatility and low-liquidity areas, which can increase the risk in these trades. They occur at very visible chart points, and so they are often very crowded trades.
The presence of unusual volume and volatility can create opportunities, but it also creates dangers. Execution skills probably matter more here than in any other category of trade, as slippage and thin markets can significantly erode a trader’s edge.
These trades can offer outstanding reward/risk profiles, but, especially in short-term trades, it is important to remember that realized losses can sometimes be many multiples of the intended risk, significantly complicating the position sizing problem.
This is not a fatal flaw, but it must be considered in your risk management scheme. Depending on the time frame and intended holding period for the trade, it may be possible to find that there are patterns that precede and set up the best examples of these trades.
The best resistance breaking trades will be driven by large-scale buying imbalances, and these imbalances usually show, for instance, as the market holds higher lows into the resistance level before the actual breakout.
Breakouts driven by small traders who are simply trying to scalp small profits in the increased volatility are less reliable and are usually not set up by these larger-scale patterns.
In the very best examples of these trades, buyers who are trapped out of the market by the suddenness of the breakout will be compelled to buy into the market over coming days or weeks, and this buying pressure will provide favorable tailwinds for the trade.
Traders specializing in breakout trades usually spend a lot of time studying the patterns that set up the best trades, and maintain a watch list of potential candidates for trades at any time. Executing unplanned breakout trades in a reactive mode is unlikely to be a formula for long-term success.
SUMMARY
These four categories of trades provide an excellent framework for thinking about technical trades. This is a simple, valid, and consistent labeling scheme, and it is nearly impossible to find a technical trade that does not fit within these categories.
Many trades may fit into more than one, especially when the complexities of multiple time frames are considered, but this does not compromise the utility of the system. This is not intended to be a rigid, artificial classification system,
but rather a dynamic framework that can grow and evolve with your trading style and your understanding of market behavior. Not to wax too philosophical, but there is another way to think about this cycle.
Some branches of Eastern philosophy believe that every manifest thing we see, feel, or experience in any way comes from the interaction of two opposing, primordial forces. These philosophies tell us that one force can never fully overcome the other, and, when one seems to predominate, it contains within itself the seed of the other.
In the market, buying and selling pressure are these twin opposing forces. When buying pressure seems to be strongest, the end of the uptrend trend is often near. When the sellers seem to be decisively winning the battle, the stage is set for a reversal into an uptrend.
This is why it is so important for traders to learn to stand apart from the crowd, and the only way to do this is to understand the actions and the emotions of that market crowd.