I

Market Structure

A Practical Guide for the Short-Term Trader

I

Copyright © 2008-2011 Nigel Bahadur

ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the publisher and the authors.

This publication is designed to provide accurate and authoritative information in regard to the subject

matter covered. It is sold with the understanding that the authors and the publisher are not engaged in rendering legal, accounting, or other processional service.

The charts used in this book were created with Tradestation, copyright © of Tradestation Technologies.

ISBN 978-0-9828183-9-8

Printed in the United States of America

II

III

The trend is your friend

Trends end in a climax

IV

V

Disclaimer

It should not be assumed that the methods, techniques, or indicators presented in this book will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples in this book are for educational purposes only. The author, publishing firm, and any affiliates assume no responsibility for your trading results.

Further, this is not a solicitation of any order to buy or to sell.

The NFA requires us to say that:

“HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ASO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE

UNDER- OR OVERCOMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.”

1

Contents

Disclaimer .......................................................................................................................................................... V Contents................................................................................................................................................................... 1

SECTION 1 .................................................................................................................... 1

The Basics ....................................................................................................................................................................... 1 Chapter One ................................................................................................................................................................. 2

Laying the Groundwork ......................................................................................................................................... 2 What Does the Active Trader Really Want? ..................................................................................................... 3 What You Should Get from This Book ............................................................................................................ 3 What This Book Is Not....................................................................................................................................... 4 Market Structure Theory – Basic Requirements............................................................................................... 4

Chapter Two .............................................................................................................................................................. 10 Trend Components: Legs and Swings ................................................................................................................. 10

Defining Leg or Swing ..................................................................................................................................... 16 Examples of ATR Swings/Legs ...................................................................................................................... 19 Try It! ................................................................................................................................................................ 22

Chapter Three ............................................................................................................................................................ 23 Defining the Trend ................................................................................................................................................ 23

Uptrend ............................................................................................................................................................. 25 Examples of Trend and Trend Reversals (Down to Up) ................................................................................ 26 Examples of Trend and Trend Reversals (Up to Down) ................................................................................ 30 Some Final Words about Trend ....................................................................................................................... 32 Summary ........................................................................................................................................................... 34

Chapter Four .............................................................................................................................................................. 36 Basic Retracements: Small Scalps ....................................................................................................................... 36

Long Trade Example #1 .................................................................................................................................. 38 Short Trade Example #1 .................................................................................................................................. 39 Long Trade Example #2 .................................................................................................................................. 40 A ‘Failed’ Long Trade ..................................................................................................................................... 41 Early Entries ..................................................................................................................................................... 43 Summary ........................................................................................................................................................... 43

Chapter Five .............................................................................................................................................................. 45 Complex Retracements: Power Trades ............................................................................................................... 45

Power Buys and Power Sells ........................................................................................................................... 45 Examples of Power Trades .............................................................................................................................. 46 Trading Power Buys and Power Sells ............................................................................................................. 50 Trailing Stops on Power Trades ...................................................................................................................... 54 Final Notes on Power Trades ........................................................................................................................... 55 Additional Chart Examples .............................................................................................................................. 57

Chapter Six ................................................................................................................................................................ 60 More Trend Reversals .......................................................................................................................................... 60

Example #1 – Bonds, 500 Tick Chart ............................................................................................................. 60

2

Example #2 – Natural Gas, 500-Tick Chart .................................................................................................... 62 Example #3 – A Trend-Reversal Trade that Didn’t Work ............................................................................. 63 Example #4 – An Almost-Perfect Trend-Reversal Trade .............................................................................. 64 The Trailing Stop .............................................................................................................................................. 65 Power Trades and Trend Reversals ................................................................................................................. 66 Handling Whip-Saws ....................................................................................................................................... 66 Maximizing Trading Opportunities in a Trend ............................................................................................... 66

Chapter Seven ........................................................................................................................................................... 67 Advanced Trend Recognition .............................................................................................................................. 67

Example #1 ....................................................................................................................................................... 67 Example #2 ....................................................................................................................................................... 69 Example #3 ....................................................................................................................................................... 71 Summary ........................................................................................................................................................... 74

Chapter Eight ............................................................................................................................................................. 75 Coils, Consolidation & Classic Trading Patterns ................................................................................................ 75

Triangles and Converging Trend Lines ........................................................................................................... 75 Boxes ................................................................................................................................................................ 76 Setting Stops ..................................................................................................................................................... 78 Setting Targets .................................................................................................................................................. 80 More Chart Examples ...................................................................................................................................... 81 Summary ........................................................................................................................................................... 85

Chapter Nine ............................................................................................................................................................. 86 Multiple Timeframes ............................................................................................................................................ 86

Example #1: Gold ............................................................................................................................................ 87 Example #2: Australian Dollar ........................................................................................................................ 90 Example #3: Wheat ......................................................................................................................................... 92 Example #4: Natural Gas ................................................................................................................................ 94

SECTION 2 .................................................................................................................. 98

Wave Structure and Classical Technical Analysis ................................................................................................. 98 Chapter Ten ............................................................................................................................................................... 99

Wave Structure with Support and Resistance ..................................................................................................... 99 Example #1 ....................................................................................................................................................... 99 Example 2 ....................................................................................................................................................... 101 Example #3 ..................................................................................................................................................... 103

Chapter Eleven ........................................................................................................................................................ 108 Using Wave Structure with Technical Indicators ............................................................................................. 108

Example #1 ..................................................................................................................................................... 108 Example #2 ..................................................................................................................................................... 111 Example #3 ..................................................................................................................................................... 113 Summary ......................................................................................................................................................... 116

SECTION 3 ............................................................................................................... 118

Other Topics ............................................................................................................................................................... 118 Chapter Twelve ....................................................................................................................................................... 119

Impulse and Retracements ................................................................................................................................. 119 Our Definition of Impulse .............................................................................................................................. 119 Trading the Impulse - Retracements.............................................................................................................. 121 Trading the Impulse – Aggressive ‘Go with the Flow’ Trade ..................................................................... 121 Other Examples ............................................................................................................................................. 122 The Few Trades Dilemma ............................................................................................................................. 124 Multiple Timeframes ...................................................................................................................................... 126

3

Chapter Thirteen ...................................................................................................................................................... 127 Stop Placement ................................................................................................................................................... 127

Review Stop Placement at Swing Highs / Lows .......................................................................................... 127 New Idea #1: The High / Low of the First Bar that Changes Color ............................................................ 128 New Idea #2 : Set the Stop to the Size of the First Retracement in a New Trend ....................................... 134 Time Stops and Combination Stops .............................................................................................................. 139

Chapter Fourteen ..................................................................................................................................................... 141 Wrapping It Up ................................................................................................................................................... 141

Summary ......................................................................................................................................................... 141 The Charts ....................................................................................................................................................... 142 Contact ............................................................................................................................................................ 143

SECTION 4 ............................................................................................................... 144

Appendices ................................................................................................................................................................. 144 Appendix A ............................................................................................................................................................. 145

Tradestation Code for Coloring Bars ................................................................................................................. 145

1

Section 1

The Basics

2

Chapter One

Laying the Groundwork

This book stands on the shoulders of luminaries in the field of technical analysis. We often say that everything there is to know about price behavior and technical analysis was published a hundred years ago. But that does not mean that the published body of work on any particular concept or topic is suitable for today’s traders. In fact, it seems that more often than not, the published work of a century ago is dense to the point of being indecipherable to all but the most tenacious

students of technical analysis.

So much of what has been written in the past is impractical for the modern short-term trader and, for that matter, impractical for most traders. The published work is either highly theoretical or highly subjective and is often hard to use. Further, any practical information is scattered among various published books and articles.

Our book attempts to respond to this problem by simplifying and codifying basic principles of price behavior so they become useful for the average active trader.

3

What Does the Active Trader Really Want?

… other than the proverbial Holy Grail that prints money while they’re sitting on a beach sipping drinks with pretty umbrellas in them? Kidding aside, this is the question we asked ourselves when approaching the content of this book. The truth is that after a little experience, all traders soon find that they need a way to impose a bit of structure on price action. They need a way of determining where to put stops, what price targets to shoot for, when to play for a small or large

target, and how to trail a stop. They also need to know when to bet small and when to increase size.

Without a way of adding structure to the price action, traders flounder around getting whipped out of perfectly good trades by vicious price movements that are no more than corrective to the primary trend. Tiny movements in price take on greater meaning than they should. Without structure, it is harder to define risk and harder to optimize the use of leverage. The

lack of a structured way of looking at the price action makes it harder to approach the markets in a consistent fashion. That, in turn, makes it almost impossible to be successful at trading in it.

What You Should Get from This Book

After reading this book you should be able to:

Impose a general structure on any market

Filter out “noise” to see the bigger picture

Evaluate with certainty whether a market is in an uptrend, downtrend, or range/noise environment

4

Identify whether or not a particular trading

opportunity is to be played for a scalp or held for a bigger win

Objectively identify risk points

Objectively trail a stop when playing for a larger win

Effectively use multiple timeframe analysis

Discard almost all indicators that are simply derivatives of price, and use pure price movement for trading

Make better use of common price or indicator patterns when initiating or exiting trades

What This Book Is Not

This is not a book about technical analysis or a manual

that will teach you the basics of trading. While the concepts discussed here are purely technical, we are not going to discuss basic technical analysis. We assume that readers have some basic experience in the market and are reading this book in order to hone their current trading skills.

With these caveats in place, let’s get rolling!

Market Structure Theory – Basic Requirements

In order to impose any kind of order on price data, we need to create a requirements list. The list should derive from the problems the average trader encounters when attempting to interpret price action

5

and to use it for trading. Let us look at some of the

issues the average trader has to deal with:

Issue #1: The Fractal Nature of Price Action

Price is fractal in nature. By this we mean that no matter how tightly you zoom in or how wide you zoom out, the same patterns will appear. For example, the same double-bottom patterns appear on 10-tick charts, 1-minute charts, 5-minute charts, 15-minute charts, and hourly charts. They appear on daily, weekly, monthly, quarterly, and yearly charts. A trader attempting to "trade in the direction of the higher timeframe" is frequently stymied by multiple conflicting signals – patterns that say sell on an hourly chart but buy on a 15-minute chart. How can a trader reconcile such conflicts?

Issue #2: Noise

To the untrained eye, price is also random. In the real world, this is mostly the case but not always. Market

prices have fat tails, not a condition seen in data that is purely random. In fact, many market practitioners attempt to capture these fat tails. But the appearance of significant amounts of “random” action makes it hard for the average person to impose a meaningful structure on the market and to thereby capture any edge that is present in the non-random portion of price action.

In other words, there is a lot of noise in the market. Frankly, noise kills. Many markets go through

extended periods of above-average noise – it is these in periods that most traders get chopped to pieces, wishing they had a model that would keep them out of the market or warn them to switch timeframes in order to find better tradable opportunities.

6

Issue #3: Volatility Contraction and Expansion

One reason it is hard to impose structure on the market is the volatility cycle. Volatility expands and contracts on a regular basis. In fact, some technicians believe such fluctuations are far more predictable than raw price movement.

Volatility expansion and contraction contributes to the noise environment, and any theory of market structure needs to directly address this basic issue. After all, what’s a trader to do when a market paints a nice tall green bar one day and then follows that up with three days of endless chop? How can a trader determine the true trend of the market? How can he decide on a risk level when one day the bars are big and the next day the bars are small?

Issue #4: Market Indicators

Most traders use indicators in an attempt to impose order in an unstructured environment. The more

experienced traders use them to more easily identify patterns in raw price data. For example, sometimes it’s easier to see a loss of momentum first in the form of a divergence in an indicator, at which point the eye can turn toward the raw chart for confirmation.

The basic problem with indicators, especially for the beginning trader, is this: they lag price. They are derivatives of price and therefore will always be behind price. Waiting for a line to turn up or down will always make you late to the party, especially in the types of

urgent markets that are present these days.

Then there is this issue: no indicator in the public domain has been shown to have an edge. In fact, no matter how you twist and turn it, all indicators test out

7

no better than a random entry- and random-exit

system.

Inexperienced traders use indicators upon indicators, and then more indicators. Their screens are filled with fancy colored lines, blinking lights, arrows, dots, and shapes. They feel that more is better. Of course, nothing could be further from the truth. Therefore, we are going to throw out all but one indicator. And the indicator we’re going to keep is simply a way of measuring how far and how forcefully price has moved

in a particular period of time. This indicator is not a derivative of price but a direct result of price action.

This indicator is a version of the "zig-zag" that is very popular in some areas of technical analysis. However, most versions of this indicator uses a percentage of price or absolute dollar value to filter price movements. This is undesirable simply because you cannot take the same "settings" and have it apply to a different chart/instrument. So we have modified this

classic indicator to fulfill our requirements.

The Requirements List

This brings us to the following list of requirements that we would require from any method that would attempt to impose an objective structure on price:

First and foremost, the structure should assist the trader in eliminating noise as much as possible. And it should do this without losing important structural information.

As a consequence of that structure, the true trend of a market on any timeframe should become obvious.

Once the true trend of the market is obvious, the structure should provide objective risk levels.

8

It is not a requirement that the structure provide

price forecasts or price objective/target levels. No market structure can forecast the future! Instead, the requirement is that the structure provide a method of staying with the true trend for a long as possible; in the absence of a trend or in a trend that is getting “long in the tooth,” the structure should provide the market participant with a suggestion that it’s better to play for a smaller win.

The tools used in the method should not significantly lag price.

The tools used in the method should be flexible – complementary to a trader’s existing methods. At the same time, the method should be able to stand on its own as the only tool used for trading, if that is the wish of the trader.

With this list in hand, we will delve into price action in the next chapter and develop the structure that will

drive the contents of the rest of this book.

9

Acknowledgements

Before jumping in, we wish to acknowledge the work of our predecessors - work the authors of this book relied on and adapted to modern market behavior.

First is Arthur Merrill and the concept of Filtered Waves. While he was not the first to use the idea of waves, he was the first to attempt to quantify it, imposing a semblance of order on seemingly random market movements. His book, Filtered Waves, Basic Theory: A Tool for Stock Market Analysis, was published in the 1970s. In it he defined the beginning or end of a wave as a five-percent move.

Prior to Arthur Merrill there was a Wall Street legend name Jesse Livermore. A lot is written about this individual, much of it questionable. It is rumored that he used a swing trading system that filtered market movements using two-percent to four-percent movements, depending on the direction of the move (up or down).

Finally we must credit the inventor of the concept of Average True Range: Welles Wilder. He introduced it in his book New Concepts in Technical Trading Systems. The ATR is a way of measuring volatility in price. Using it in defining wave filters is a great way to have price waves adjust to current market volatility.

10

Chapter Two

Trend Components: Legs and Swings

The foundation of technical analysis starts with the trend. Most traders and technical analysts are lost without a determination of the current prevailing trend.

The classical definition of trend is a series of higher highs and higher lows (uptrend) or a series of lower highs and lower lows (downtrend) that chart the price direction of a security or of the market. Idealized

uptrends and downtrends are shown in Figure 1 below.

11

Figure 1: Idealized uptrends and downtrends

Of course, in the real world, the patterns are not as clear-cut as the idealized versions shown above. The

issue becomes the definition of a leg or a swing. (“Leg” and “swing” are synonymous).

Figure 2 below is a daily electronic wheat chart. We have drawn in a single line that shows what could be a down leg (downswing).

Idealized Uptrend Idealized Downtrend

A single leg in the trend.

12

Figure 2: A single down leg/downswing

The figure below shows how the same leg can be divided into two legs. Obviously, the question becomes which is the correct leg representation? Recognition of the noise that creates the two tiny up legs is just as valid as if we ignored it completely and created a single down leg, as in Figure 2 above.

13

Figure 3: Single leg (black line) split into multiple legs (red and green lines).

The following three figures show how a leg can be broken up into different smaller legs. These examples show how impossible it is to truly define a leg, which means it’s also impossible to create a true definition of a trend! Therefore, our first order of business is to rigorously define a leg or swing.

14

Figure 4: A single down leg followed by a single up leg.

15

Figure 5: The up leg from Figure 4 becomes multiple legs! The original legs are the black lines, and the new legs are in red and green lines.

16

Figure 6: The legs from the Figure 5 can be broken up into even more legs! So how is a trader to determine the true leg composition? How do you define leg? How do you define the legs in this chart? Are they as shown in Figure 4 or as shown in Figure 5? Or are the legs defined as shown in this chart?

Defining Leg or Swing

As you can see, different traders can look at the same chart and see different legs. This means different traders will see different trends evolving from the same chart! Obviously, there needs to be an objective method for defining a leg or swing.

Over the years, many methods have been used to mark off a swing. Some traders use an absolute value off of a swing low/high in order to determine whether a new swing is warranted. Others used a percentage function. Arthur Merrill published a book in the 1970s called Filtered Waves. In it he used a minimum

17

percentage movement in price in order to create legs

within his waves.

The issue with using an absolute value is one of portability. That value will have to be different for each market and each timeframe. The use of a percent of price function works for multiple markets but not for multiple timeframes. Both methods also ignore the effects of volatility in the market. An upswing could start prematurely in a market that has suddenly become more volatile while not starting at all in a

market that has reduced volatility for an extended period of time. Ideally we would like a single definition of a leg/swing to be applicable across all markets, all timeframes, and all volatility environments.

To accomplish this, we are going to use something called ATR – Average True Range.

Computing Average True Range

The concept of Average True Range was introduced by J. Welles Wilder, Jr. in his book New Concepts in Technical Trading Systems. We have found no better concept that incorporates market volatility without straying far away from the raw price action in the markets.

Before you can compute an Average True Range, you need to compute the value of the True Range for the day.

The True Range is the greatest of the following:

The price difference from today's high to today's low.

18

The price difference from yesterday’s close to

today's high.

The price difference from yesterday’s close to today's low.

With the True Range for each bar in hand, you can compute the Average True Range, which is simply a moving average of the True Range for the last so many bars.

With this concept of Average True Range, we can

define upswings and downswings that vary in length based on current market volatility – in other words, an ATR automatically adapts the length of a swing to the current intensity of the market's action.

Definition of an Upswing

A market changes from a downswing to an upswing when price has moved 2.5 ATRs (that is, 2 1/2 times the Average True Range) from the lowest low of the

past 16 bars. The ATR is computed using 9 bars. It remains in an upswing until the definition of a downswing has been met.

Definition of a Downswing

A market changes from an upswing to a downswing when price has moved 2.5 ATRs from the highest high of the past 16 bars. The ATR is computed using 9 bars. It remains in a downswing until the definition of an upswing has been met.

Obvious Questions

The most obvious question is why 9, 16, and 2.5? Why not 10, 20, and 3.0? Or 5, 15, and 2.0? The answer is this: in our experience, these parameters strike a nice balance between being too early and too

19

late when turning the swing leg from up to down or

vice versa. Frankly, using 10, 20 and 2.5 really will not make that much difference. You can experiment with the values, but you must pick one set and use it across all timeframes and all markets.

Examples of ATR Swings/Legs

Now that we have an objective definition for a leg or swing, let us look at some examples. In Figure 7, point B is where the price has moved 2.5 ATRs from the

lowest low of the last 16 bars. It is at this point that we can say the swing or leg has turned up. At point A and at every data point between A and B, the swing/leg is still down. Only when the price has moved far enough does the swing turn up – this occurs at point B.

The swing will stay up until price moves 2.5 ATRs from the highest high of the last 16 bars. This occurs at point D. At this time the swing/leg is considered to have turned down. Even though the price action

between C and D is down, the swing or leg is still considered to be up until point D is hit.

20

Figure 7: Turning points in a swing

In Figure 8 we have drawn in the zigzag lines that make it easier to visually see the individual legs. It is important to note that the line from A to C is not drawn until price has reached point B. This is because the definition of point A is based on price trading through point B. Remember, the swing does not turn up until price has traded 2.5 ATRs up off the lowest low of the last 16 bars, which does not occur until point B.

Similarly, the line that starts from C and moves down

through D and toward the last bar on the chart is not drawn in until price has reached D. This is because the definition of point C is based on price trading through point D. In other words, Point C is defined because price has traded 2.5 ATRs off the highest high of the last 16 bars, which occurs at point D.

21

Have you noticed how the difference in price between

points C and D is greater than the difference in price between points A and B? This is because of volatility. Prices at A are a lot less volatile than prices at B. Therefore it takes less actual price movement to turn the swing up around point A than it does to turn the swing back down around point C.

Figure 8: Turning points in a swing with zigzag lines

Figure 9 is a daily chart of another commodity, the Euro-Currency (EC). Notice that the last leg is an upswing. Notice also that although price has moved down from the highest high of the last 16 bars, it has not moved far enough from that point to draw in a downswing. Therefore price is still considered to be in an upswing.

22

Figure 9: Zigzag lines showing legs on EC

Try It!

Before reading the rest of this chapter, pull out your charts and see if you can draw zigzag lines according to the definitions we have provided here. Most charting software products such as Tradestation, CQG, Aspen Graphics, and eSignal can color bars based on these definitions. By coloring your bars red when they meet our down-leg rules and green when they meet our up-leg rules, you can visually see where the swings turn up or down. Some products can even draw in the zigzag lines for you. Tradestation and e-Signal can do this. (The code for a Tradestation paint-bar indicator is included in this book’s Appendix.)

23

Chapter Three

Defining the Trend

Many traders have heard the terms higher low, lower high, lower low, and higher high. Intuitively we know what is meant here, but for our purposes, we need firm definitions. Once these are in place, we will have objective criteria for defining trends and trend reversals.

Higher Low

A higher low is formed when price enters a downswing and then creates an upswing before price takes out the origin of the previous upswing.

Figure 10, point C is the first higher low shown on the chart. However, point C was not created until the swing turned back up at point D – when the bars changed color from red to green. Remember, that occurs when price has moved 2.5 ATRs up off the low of the last 16 bars.

Also notice that point C is higher than point A. It is this fact that creates the term “higher low,” because even though point C is a swing low, it is higher than point A.

As an exercise, can you identify the point on the swing line between H and J where point J was initially drawn on the chart?

24

Figure 10: Points C and F are higher lows. Point C is above point A (which was the prior swing low), and point F is above point C which was the previous low. The swing line at the end of the chart that goes below point H is a lower low because it is lower than point H.

Lower High

A lower high is formed when price enters an upswing and then creates a downswing before price takes out the origin of the prior downswing.

In Figure 11, point D is the first lower high shown on the chart. However, point D was not created until the swing turned back down at point E – when the bars changed color from green to red. Remember, that

occurs when price has moved 2.5 ATRs down off the high of the last 16 bars.

Also notice that point D is lower than point B. It is this fact that creates the term “lower high,” because even though point D is a swing high, it is lower than point B.

25

As an exercise, can you identify at what point (on the

swing line between G and H) point G was initially drawn?

Figure 11: Points D, G, and I are all lower highs.

Uptrend

An uptrend is started when a market makes both a higher high and a higher low and continues up from there.

From this definition we see that an uptrend can be

started in one of two ways:

Price makes a higher low, a higher high, another higher low, and turns up from there to make a higher high.

26

Price makes a higher high, a higher low, and

turns up from there to make another higher high.

Downtrend

A downtrend is started when a market makes both a lower low and a lower high and continues down from there.

From this definition we see that a downtrend can be started in one of two ways:

Price makes a lower high, a lower low, another lower high and turns down from there to make another lower low.

Price makes a lower low, a lower high, and turns down from there to make another lower low.

Examples of Trend and Trend Reversals (Down to Up)

Figure 12 is an example of a trend-reversal process from an established trend down to a new uptrend. At point A, price is still officially in a downtrend. Point C is the first higher low, and point D is the first higher high.

Point E is the second higher low, and at point F we have a warning that a trend reversal up could occur. When price continues to move higher than point D, the

new trend up is confirmed.

In other words, we have a higher low and a higher high, and then price continues upwards.

Note that point E isn’t drawn on the chart until point F is reached. Remember from our earlier discussions

27

that point E cannot be identified until price has moved

2.5 ATRs from the lowest low of the preceding 16 bars.

Once that has occurred, the swing low can be identified and drawn on the chart. In our example, you can see that the bar colors change from red to green at point F. This color change makes it easier to visually identify the swing low at point E.

A few other items to note:

At points B, C, D, E and F, price is still technically

in a downtrend. It is not until point D is taken out (that is, exceeded by subsequent price action) that the trend officially turns from down to up on the timeframe shown (1000 ticks).

If at some point price had turned down and made a lower low than point E – after point F was hit but before price moved higher than point D – then the trend change would have been invalidated.

28

Figure 12: The trend-reversal process, from down to up – a trend-reversal warning to the upside is given at point F and is confirmed when price moves higher than point D.

Figure 13 shows another trend reversal from a downtrend to an uptrend. Price is in a downtrend at point A. Point B is the first higher high, and point C is the first higher low. At point D we have the warning that a trend reversal could take place – a warning which is confirmed when price continues higher than point B.

Note that point C isn’t drawn on the chart until point D is reached. Remember from our earlier discussions

that point C cannot be identified until price has moved 2.5 ATRs from the lowest low of the previous 16 bars.

Once that has occurred, the swing low can be identified and drawn on the chart. In our example you can see that the bar colors have changed from red to

29

green at point D. This color change makes it easier to

visually identify the swing low at point C.

In this chart, the higher high was created first. In the previous example, the higher low was created first. In this chart it takes fewer legs/swings for the trend reversal to occur because the first leg was strong enough to make a higher high. In the previous chart, there were more legs because the higher low was created first, and then the higher high formed.

Another item to note is that at points B, C, and D, price is still technically in a downtrend on the timeframe shown in the chart (1000 ticks). So even though price is moving up until point B is taken out, we are still in a corrective phase in the overall downtrend. However, if you were to look at a lower timeframe, such as a 15-minute chart, you would see the trend reversal occurred on that timeframe first.

30

Figure 13: The trend-reversal process from down to up – a trend-reversal warning is given at point D and is confirmed when price moves higher than point B.

Examples of Trend and Trend Reversals (Up to Down)

Figure 14 is an example of a trend reversal process from an established trend up to a new downtrend. At point A, price is still officially in an uptrend. Point C is the first lower high, and point D is the first lower low. Point E is the second lower high, and at point F we

have a warning that a trend reversal from up to down could occur. When price continues to move lower than point D, the new trend down is confirmed.

Note that point E isn’t drawn on the chart until point F is reached. Remember from our earlier discussions that point E cannot be identified until price has moved

31

2.5 ATRs from the highest high of the previous 16

bars.

Once that has occurred, the swing high can be identified and drawn on the chart. In our example you can see that the bar colors have changed from green to red at point F. This color change makes it easier to visually identify the swing high at point E.

Figure 14: The trend-reversal process from up to down – a trend-reversal warning is given at point F and is confirmed when price moves lower than point D.

Figure 15 shows another trend reversal from an uptrend to a downtrend. Price is in an uptrend in point A. Point B is the first lower low, and point C is the first lower high. At point D we have the warning that a trend reversal could take place – a warning which is confirmed when price continues lower than point B.

32

Note that point C isn’t drawn on the chart until point D

is reached. Remember from our earlier discussions that point C cannot be identified until price has moved 2.5 ATRs from the highest high of the previous 16 bars. Once that has occurred, the swing high can be identified and drawn on the chart. In our example, you can see that the bar colors have changed from green to red at point D. This color change makes it easier to visually identify the swing high at point C.

Figure 15: The trend-reversal process from up to down – a trend-reversal warning is given at point D and is confirmed when price moves lower than point B.

Some Final Words about Trend

There are two characteristics about trends that you should keep in mind:

33

First, a trend has a higher probability of

continuation than of reversal.

Second, trends usually end in a climax. (A Climax is a sharp price movement on heavy volume. Price is usually extended far away from all the moving averages. In many instances the price chart looks like a parabolic curve because price moved so rapidly.)

The corollary to these two points is that once a trend

has changed from one direction to another, it remains in that new direction until the rules for a trend change have been met or until the end is signified by a climax. Thus, once an uptrend has formed, price technically remains in that uptrend until a downtrend forms (and vice versa).

In Figure 16 you can see that the e-mini S&P chart is in an uptrend. But despite all the chop and the myriad of swings on the right-hand side of the chart, no trend-reversal pattern has occurred. Therefore, even though

we are forming a range, the official trend is still up.

34

Figure 16: Lots of chop but no trend reversal yet

Trend reversals are a process and can take a long time. You can usually see these on the chart by the formation of a sideways line or a “head and shoulders” type of formation. And price can move quite a distance before getting an official trend-reversal signal.

Trend reversals will naturally take place on the shortest timeframes first, which makes it important to keep an eye on your lower and higher timeframes. We will discuss multiple timeframe techniques in Chapter 9.

Summary

We have covered a lot of ground in this chapter. Now you have the basic techniques by which to overlay a

35

structure onto the seemingly random price movements

in the market. At this point you should understand:

The rigid definition of a leg or swing

The identification of higher lows and lower highs

The rigid definition of a trend change

You should also instinctively understand that our definition of a leg/swing is something that allows us to filter out most smaller and inconsequential price movements on the chart.

Before proceeding to the next chapters, take the time to look at as many charts as possible and try to identify the points at which clean trend reversals were made. Identifying the current trend and the points where a trend reversal could occur are probably the most important techniques you can learn as a technical analyst/trader.

In the next few chapters, we will outline some concrete trading techniques and patterns based on the concepts discussed in this chapter. It is important that you understand these basics thoroughly before proceeding, since they form the foundation of everything else that follows.

36

Chapter Four

Basic Retracements: Small Scalps

The most fundamental pattern for a trader is a small pullback within a trend. The best pullback will be the first one after a trend change. As the trend matures, each pullback becomes a lower probability trade. The first and second pullbacks will usually be simple ones consisting of a single leg. About every third one will be a more complex pattern with multiple legs.

The simple retracement trade is usually a scalp trade.

Our definition of a scalp trade is a trade made with an objective of a single swing only. With such trades, the greatest objective is usually a retest of the previous swing high or low.

There are specific rules that can be used to trade these retracements within a trend. Most important is that the structure of the trend and the retracement leg provide a defined risk point for the trade.

Rules for a Long Trade

1) Within the context of an uptrend, wait for a downswing to occur.

2) Once the downswing is complete, go long on the close of the bar at which the swing turns back up.

37

3) Your risk point will be the swing low that is established when

the swing turns back up.

4) Usually you are playing for a small target – at most a retest

of the previous swing high. However, if there is a pattern on a higher timeframe that has a larger target, you can trail a

stop. (We will cover multiple-timeframe analysis in a later chapter.)

Rules for a Short Trade

1) Within the context of a downtrend, wait for an upswing to

occur.

2) Once the upswing is complete, go short on the close of the

bar at which the swing turns back down.

3) Your risk point will be the swing high that is established when the swing turns back down.

4) Usually you are playing for a small target – at most a retest of the previous swing low. However, if there is a pattern on a

higher timeframe that has a larger target, you can trail a stop.

Generally speaking, the best long retracement trade is the first pullback after a trend change from down to up. The opposite is true for short trades: the best short retracement trade is the first pullback after a trend changes from up to down.

The choicest trades occur when you have a clean trend change on a higher timeframe followed by a pullback on that timeframe. This usually leads to a trend

change on the lower timeframe. The entry comes when the lower timeframe changes its trend again so that both the higher timeframe and the lower timeframe are trending in the same direction. We will cover multiple-timeframe trading in Chapter 9. For now, let's look at some examples of the basic retracement trade.

38

Long Trade Example #1

Figure 17 is a daily chart of gold. Point B is the first higher high, and point C is the first higher low. When point B is exceeded (after point C has formed), the new uptrend is confirmed. Point E is the next higher low that forms (when point F is created). Remember that point E is not identified until price trades at point F.

The entire downswing from points D to E is considered a simple retracement. The trader goes long on the close of the bar at point F and sets a stop at point E. (Point F can be more precisely identified in the image by realizing that it is the first green bar after point E.)

Ideally, the target would be a full retest of point D. This does not happen 100 percent of the time. Some traders will trail a stop on a lower timeframe – maybe a 60-minute chart, since this is a daily chart. Others

will set a target, get 50 percent of the way there, and take off half a position when that is reached. Still others will use complete discretion and decide how to handle the trade each day.

Obviously this commodity went on to make new highs. It is more likely than not there was a pattern on the higher timeframe (weeklies) that would have alerted us to attempt to trail a stop instead of playing for a fixed target.

39

Figure 17: A basic long retracement trade in gold: the entry is at point F; the stop is at point E.

Short Trade Example #1

Figure 18 is a 60-minute chart of gold. Point A is the first lower high, and point B is the first lower low. When point B is exceeded (after point C has formed), the new downtrend is confirmed. Point E is the next lower high that forms – it forms when point F is created.

Remember that E is not identified until price trades at

point F, thereby creating the first red bar. The entire upswing from points D to E is considered a simple retracement. The trader goes short on the close of the bar at point F and sets a stop at point E. (Point F can be more precisely identified in the image by realizing that it is the first red bar after point E.)

40

Ideally the target would be a full retest of point D. This

does not happen 100 percent of the time, although it occurred in this instance. In fact, in this example the commodity went on to make substantial new lows, as shown.

Figure 18: A basic short retracement trade in gold: the entry is at point F; the stop is at point E.

Long Trade Example #2

Figure 19 is a 500-tick chart of the Euro Currency (EC). Point B is the first higher high, and point C is the first higher low. When point B is exceeded (after point C has formed), the new uptrend is confirmed. Swing D-E is the first downswing that is formed after the new uptrend is confirmed.

41

As usual, you should remember that that point E is not

identified until price trades at point F. The trader goes long on the close of the bar at point F and sets a stop at point E. (Point F can be more precisely identified in the image by realizing that it is the first green bar after point E.) Again, the objective was for a retest of point D, but this example continued to make new highs beyond that.

Figure 19: Another basic long retracement trade: entry is at point F; the stop is at point E.

A ‘Failed’ Long Trade

Figure 20 is a 500-tick chart of the EC. Point B is the first higher high, and point C is the first higher low. Leg D-E is the first pullback. Point F is the entry for the first long trade after that first pullback (that is, the first retracement after a trend change from down to up.)

42

The ideal target would have been a retest of point D.

Instead, price turned back down before point D was reached and made new lows below the prior low (Point E). A quick trader or someone trailing a tight stop would have been stopped out for breakeven, or possibly have gotten out with a small profit, since the trade was profitable for a period of time. This market eventually continued lower and made a trend change from up to down. So the uptrend only lasted for a brief period, and the trader would have been stopped out at point E.

Please note that, according to the rules, you are absolutely stopped out at point E under normal market conditions.

Figure 20: Failed long trade in EC: point F is the entry for the long after a trend change to the upside. The official target would have been a retest of point D.

43

Early Entries

Aggressive traders can easily use any number of tactics for an early entry. In the examples shown in Figure 18 early entry would be achieved by not waiting for point E to be confirmed. Remember that point E is officially identified only when price trades through point F.

In Figure 18, an example of early entry would be to

enter as soon as point D is confirmed. Point D is confirmed when price closes 2.5 ATRs above the lowest low of the last 16 bars. In this example, that happens at the first green bar in the D-E swing. An aggressive trader could enter there and set a random stop of 2 ATRs or above point C. Once point E is confirmed, the stop would then be pulled down to that point.

Another idea for early entry would be to use classical three-bar swing lows and highs. On any of the long

examples shown, the trader would wait for the first red bar to be painted that creates the downswing. Then they would wait for a three-bar pattern where the low of the center bar is lower than the bar to the left and the bar to the right (a classic swing low point). Entry would be taken either on the close of the third bar or above the high of that third bar, and the stop would be placed on the swing low that formed.

Summary

The simple retracement trade is the most commonly used trade and sets up quite often. It is a trade that should be in every trader’s arsenal of tactics. It is a low-risk, high-probability trade because it is taken in the direction of the prevailing trend. If a higher

44

timeframe filter is used, the probability of a successful

trade is even higher. Should one need it, there is no better trade to use to dig oneself out of a deep drawdown.

144

Section 4

Appendices

145

Appendix A

Tradestation Code for Coloring Bars

The following is the code used to create a Tradestation paint-bar study. This paint-bar automatically colors the bars on a bar chart to illustrate whether price is in an upswing or downswing. The charts in this book use black and gray to differentiate between upswings and downswings, but the paint-bar should probably be set to use green and red, since those colors are more aesthetically pleasing.

The Tradestation Easy Language code for this function is:

Input: BarLength(16),

ATRLength(9),

ATRMultiple(2.5),

pPlotWidth(1);

Variables: SwingDirection(0), LowestLow(0), HighestHigh(0);

LowestLow = Lowest (low, BarLength);

HighestHigh = Highest (High, BarLength);

If Close > LowestLow + AverageFC(AvgTrueRange(ATRLength), ATRLength) * ATRMultiple

AND

Close > HighestHigh - AverageFC( AvgTrueRange(ATRLength), ATRLength) *

ATRMultiple then begin

SwingDirection = 1 ;

End;

If Close < HighestHigh - AverageFC( AvgTrueRange(ATRLength), ATRLength) *

ATRMultiple AND

146

Close < LowestLow + AverageFC(AvgTrueRange(ATRLength), ATRLength) * ATRMultiple

then begin

SwingDirection = -1;

End;

If CurrentBar > 1 Then Begin

If SwingDirection = 1 then

PlotPaintBar(High, Low, Open, Close, "LongShort", Green, Default,

pPlotWidth);

If SwingDirection = -1 then

PlotPaintBar (High, Low, Open, Close, "LongShort", Red, Default,

pPlotWidth);

End;

{***Copyright 2002-2010 Nigel Bahadur and Linda B. Raschke - All rights

reserved***}

The End.