WHY WAITING FOR AN UPTREND IS IMPORTANT

Thursday, February 14, 2008

WHY WAITING FOR AN UPTREND IS IMPORTANT

Now may be a good time for technical traders to reinforce their thinking about why trading in the direction of the prevailing trend is considered the major underpinning of technical analysis in the pursuit of consistent, long run, aggregate, net trading profits. Following are some issues raised by John Murphy. Let's see what he says.

"The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends."

"The entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing."

"In a general sense, the trend is simply the direction of the market, which way it's moving."

"The fact of the matter is that markets actually move in three directions-up, down, and sideways. It is important to be aware of this distinction because for at least a third of the time, by a conservative estimate, prices move in a flat, horizontal pattern that is referred to as a trading range. (So in a market like ours, where short selling is not allowed by the local stock exchange-contrary to the unfounded claims of a few who insist that it is-long trades are bound to be unprofitable two-thirds of the time.)"

"There are three decisions confronting the trader-whether to buy a market(go long), sell a market(go short) (again, not allowed by the local exchange), or do nothing(stand aside). When a market is rising, the buying strategy is preferable. When it is falling, the second approach would be correct (ditto-not in our market). However, when the market is moving sideways, the third choice-to stay out of the market-is usually the best."

"Most technical tools and systems are trend following in nature which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter these lateral or "trendless" phases. It is during these periods of sideways market movement that the technical traders experience their greatest frustration, and systems traders their greatest equity losses. A trend following system, by its very definition, needs a trend in order to do its stuff. The failure here lies with the trader who is attempting to apply a system designed for (following) trending markets into a nontrending market environment (or trading against the prevailing direction of the trend)."

(*Annotation in italics and bold emphasis supplied by Whipsaw.)

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Whipsaw's Library

* CYCLES: A TRIBUTE TO J.M.HURST by Brian Millard

* ELLIOT WAVE PRINCIPLE: KEY TO MARKET BEHAVIOR by Frost and Prechter

* FIBONACCI APPLICATIONS & STRATEGIES FOR TRADERS by Robert Fischer

* FORECASTING FINANCIAL MARKETS: THE PSYCHOLOGY OF SUCCESSFUL INVESTING by Tony Plummer

* JAPANESE CANDLESTICK CHARTING TECHNIQUES by Steve Nison

* POINT & FIGURE COMMODITY & STOCK TRADING TECHNIQUES by Kermit Zieg Jr.

* PROFIT MAGIC OF STOCK TRANSACTION TIMING by J.M.Hurst

* TECHNICAL ANALYSIS EXPLAINED by Martin Pring

* TECHNICAL ANALYSIS OF STOCK TRENDS by Edwards and Magee

* TECHNICAL ANALYSIS OF THE FINANCIAL MARKETS by John Murphy

* TECHNICAL ANALYSIS: THE COMPLETE RESOURCE FOR FINANCIAL MARKET TECHNICIANS by Kirkpatrick and Dahlquist

TECHNICAL ANALYSIS EDUCATION

(Excerpts from J.Murphy)

BASIC PREMISE OF TECHNICAL ANALYSIS
1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself.

"The technician believes that anything that can possibly affect the price - fundamentally, politically, psychologically, or otherwise - is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. All the technician is actually claiming is that price action should reflect shifts in supply and demand. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. This action is the basis of all economic and fundamental forecasting."

"The concept of trend is absolutely essential to the technical approach. The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. There is a corollary to the premise that prices move in trends - a trend is more likely to continue than to reverse. Another way to state this corollary is that a trend in motion will continue in the same direction until it reverses. " (p.3)

"Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns, for example, which have been identified and categorized over the past one hundred years, reflect certain pictures that appear on price charts. These pictures reveal the bullish or bearish psychology of the market. Since these patterns have worked well in the past, it is assumed that they will continue to work well in the future. They are based on the study of human psychology, which tends not to change."

BASIC TENETS OF THE DOW THEORY
1. Averages discount everything.
2. The market has 3 trends.
3. Major trends have 3 phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.

TREND FOLLOWING
"The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends."

SPOTTING REVERSALS
"The most difficult task for a Dow theorist, or any trend follower for that matter, is being able to distinguish between a normal secondary correction in an existing trend and the first leg of a new trend in the opposite direction." (p.29)

REVERSAL SCENARIOS (p.29)
1. Failure swing
2. Non-failure swing

CLASSIFICATION OF TRENDS
1. Major (or primary)
2. Intermediate (or secondary)
3. Near term (short term or minor)

TRADING TIME HORIZON
"As a general statement, most trend following approaches focus on the intermediate trend, which may last for several months. The near term trend is used primarily for timing purposes. In an intermediate uptrend, short term setbacks would be used to initiate long positions." (p.54)

THE ELEMENTS OF SUCCESSFUL TRADING
1. Price forecasting
2. Trading tactics
3. Money management

TRADING TACTICS
1. Tactics on breakouts
2. The breaking of trendlines
3. The use of support and resistance
4. The use of % retracements
5. The use of gaps

MONEY MANAGEMENT
1. Maximum loss limit per trade
2. Risk reward ratio
3. Fund allocation

PROTECTIVE STOPS
"For purposes of placing protective stops, support and resistance levels are most valuable." (p.401)

BUILDING BLOCKS OF TECHNICAL ANALYSIS
1. Support and resistance
2. Trendlines and channels
3. Percentage retracements
4. Speed resistance lines
5. Gaps
6. Reversal days

(Excerpts from M.Pring)

ONE AND TWO-BAR PRICE PATTERNS
One and two-bar patterns reflect changes in psychology that have very short term influence on prices.

1. Outside bars
2. Inside bars
3. Two bar reversal
4. Key reversal bars
5. Exhaustion bars
6. Pinocchio bars

Thursday, February 14, 2008