How to identify price trend reversals

From the January 01, 2012 issue of Futures Magazine Subscribe! By Billy Williams January 1, 2012 e!rints Share on t"itter Share on faceboo# Share on lin#e$in Share on email Share on !rint More Sharing Ser%ices Successful he$ge fun$ managers, such as Bruce &o%ner, '$ Sey#ota an$ John (enry ha%e been stal"arts of tren$ tra$ing for years) *his a!!roach has been one of the most reliable tra$ing metho$s $e%ise$ for those see#ing outsize$ returns) +t has a !ro%en history of !ro$ucing large !rofits in e%erything from stoc# in$e,es to orange -uice) +t also "as, !erha!s most famously, the metho$ use$ by a relati%ely "ell.#no"n grou! of a%erage !eo!le "ho ichar$ /ennis turne$ into !rofitable tra$ers, #no"n as the 0*urtle *ra$ers)0 ichar$ /ennis "as a famously "ealthy tren$.tra$er himself) But, at some !oint, all goo$ things must en$, inclu$ing a tren$) When this occurs, a !rice re%ersal ha!!ens, an$ if you are unable to ma#e the $istinction bet"een a !rice !ullbac# an$ a !rice re%ersal, it can cost you $early) 1rice re%ersals can be brutal an$ su$$en because "hen an e,isting mature tren$ is in !lace, it can catch com!lacent tra$ers off guar$, as if they are hit by a suc#er !unch) *he reason is any tren$, no matter ho" strong or ho" long it has been in !lace, can outrun its un$erlying fun$amentals or e%ol%ing technical criteria) 2i#e a rubber ban$ that has been stretche$ to its limit, at some !oint it "ill sna! bac# 3uic#ly in the o!!osite $irection) *ren$ tra$ers must #ee! this scenario in min$) +n a fast.mo%ing mar#et, not #no"ing "hen a !rice re%ersal "ill a!!ear is li#e !laying ussian roulette) '%en if you get luc#y fi%e times, "hen the hammer falls you are finishe$) Trend physics 4e"ton5s First 2a" of 1hysics $etails that, 06n ob-ect in motion stays in motion "ith the same s!ee$ an$ in the same $irection unless acte$ u!on by an unbalance$ force)0 *his a!!lies to tren$ tra$ing) *ren$s ha%e a natural bias to continue, "hich is "hy they are so !re$ictable in nature as "ell as a reliable frame"or# for tra$ing) (o"e%er, the har$ truth of tren$ tra$ing is that at some !oint it en$s) Worse, $uring its mo%e it can lea$ to com!lacency on the !art of the tra$er because it can lull you into belie%ing that it "ill

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continue on its current !ath fore%er) *he tra$er sim!ly o%erloo#s the consi$eration that the tren$ coul$ en$ su$$enly an$ abru!tly) (er$s of tra$ers fall %ictim to !rice re%ersals sim!ly by the inability to rea$ "arning signs an$ ma#e a$-ustments because they are not rea$ing !rice accurately) *his lac# of s#ill can cause unnecessary losses, but, more than that, it can cause missing o!!ortunities if a ne" tren$ begins to materialize) Laying the foundation 6 tren$ is !rice mo%ement, !lain an$ sim!le) 6s long as grou!s of !eo!le ha%e gathere$ together to tra$e stoc#s, cattle, horses, real estate or any goo$, !rice tren$s "ill emerge) 1rice "ill then go u!, $o"n or consoli$ate bet"een t"o !rice le%els until an outsi$e force enters the mar#et to force one of those $ynamic actions to change) *o analyze !rice mo%ement, you must be able to classify it in one of three time !erio$s7 Short. term, interme$iate.term an$ long.term) Short.term tren$s last from a fe" minutes to a fe" $ays8 interme$iate.term tren$s last from a "ee# to se%eral months8 long.term tren$s last from se%eral months to years) +n a$$ition, tren$s "ill begin to form $e!en$ing on "hether the un$erlying security is un$er acti%e accumulation or $istribution 9see 0Mar#et mo$es,0 belo":) 6ccumulation occurs "hen a stoc# or commo$ity is being ac3uire$ by a sufficient number of in%estors an$ the mar#et reflects a gra$ual increase in !rice because of rising $eman$) *his is in$icate$ by a stea$y series of higher.highs an$ higher.lo"s)

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;on%ersely, $istribution occurs "hen a stoc# or commo$ity is being sol$ as a sufficient number of in%estors li3ui$ate their hol$ings) *hat results in a gra$ual !rice $ecline as $eman$ for it falls, lea$ing to a stea$y succession of lo"er.highs an$ lo"er.lo"s) +f !rice is not e,hibiting either of these beha%iors < u!"ar$ mo%ement or $o"n"ar$ mo%ement < then it is consoli$ating in a tra$ing range until an imbalance is create$ in either su!!ly or $eman$, an$ "ill remain in consoli$ation until either the bulls or bears gain control an$ force a tren$ to emerge) *he game changer then is "here an e,ternal force, or catalyst, enters the mar#et an$ changes the $ynamic of the $irection of the tren$ that "ill be re%eale$ in the tren$5s !rice action) Defining the rules
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*he follo"ing rules act as a gui$eline to frame the terms or con$itions in "hich a !rice re%ersal is li#ely to a!!ear7 1) Select the time !erio$ that you are tra$ing in its res!ecti%e time frame) 2) =uantify the $irection of that tren$ by $ra"ing a tren$line from #ey !rice le%els) >) +$entify brea#s in tren$lines an$ ho" !rice reacts) First, $efine the time !erio$ that you are tra$ing an$ i$entify the time frame that the tren$ is mo%ing "ithin) For e,am!le, if you are hol$ing !ositions o%er a !erio$ of $ays to "ee#s, then you are tra$ing an interme$iate.term tren$ an$ "oul$n5t nee$ to trac# the !rice mo%ement on the short.term or long.term time frames) Secon$, $ra" a tren$line on that time frame to 3uantify the tren$ in !lace) For bullish tren$s, you "ant to $ra" a tren$line from the lo"est lo" !oint in its !rice action to the highest lo" !oint) For bearish tren$s, $ra" a tren$line from the highest lo" !oint in its !rice action to its lo"est high !oint) Finally, if !rice brea#s through the tren$line an$ the tren$ resumes but then fails to ma#e a ne" high 9if it5s a bullish tren$: or a ne" lo" 9if it5s a bearish tren$:, then the re%ersal has occurre$ an$ gets confirme$ "hen the recalibrate$ tren$line is breache$ after the failure) 1rice consoli$ation $oes not "arrant any ty!e of $efensi%e action unless !rice begins to ma#e contrary high or lo" !oints in !rice5s o!!osite $irection) *his ty!e of !rice action "ill tra$e bac# an$ forth bet"een t"o relati%ely easy to i$entify !rice !oints "here you can $ra" t"o horizontal lines until one si$e < bulls or bears < gains the u!!er han$ an$ ta#es control of the tren$ 9see 0Brea#ing the tren$,0 belo":)

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4F2? fell belo" the first tren$line in mi$.June but "ithout forming a lo"er lo" an$ "ent on to ma#e a ne" high) @n July 2A, 2011, !rice again bro#e belo" the secon$ tren$line 9forme$ by the !re%ious breach: but forme$ a lo"er lo" on 6ug) B an$ lo"er high on 6ug) 12) *his brea#ing of the tren$line "ith a failure on the !art of !rice to go on an$ ma#e a higher high confirme$ a !rice re%ersal an$ signale$ that a !ossible ne" tren$ may be emerging) +f you ha$ hel$ on to your entire !osition from the secon$ entry of C12B to this signal to e,it at aroun$ C221, your !rofit !otential "oul$ ha%e been D> !oints a share, or -ust un$er E>F return) (o"e%er, -ust as 4F2?5s !rice action signale$ an e,it, it also in$icate$ the !otential for a ne" tren$ to emerge "hen lo"er highs an$ lo"er lo"s "ere forme$) 1rice then offere$ t"o relati%ely easy entries as it bro#e through its 200.$ay sim!le mo%ing a%erage an$ !ulle$ bac# on 6ug) >1 an$ Se!t) E) +n either case, you coul$ ha%e shorte$ the stoc# itself or bought !ut o!tions for a $irectional mo%e to the $o"nsi$e) Static defense, dynamic offense
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@nce bullish !rice action brea#s its tren$line an$ fails to follo" through, the corres!on$ing !rice mo%ement "ill re%eal "hether a ne" tren$ is emerging or "hether it sim!ly is a correction) 2i#e"ise, if bearish !rice action fails to follo" through after a brea# of its $o"n"ar$ tren$line an$ begins a series of higher.highs an$ higher.lo"s, then a re%ersal to the u!si$e is in !lay) Gour tren$line acts as a static $efense !oint that signals your ne,t course of action in the e%ent that a re%ersal is ta#ing !lace) 1rice $ictates your ne,t mo%e in the form of $ynamic offense to tra$e the other $irection) @nce a tren$line is breache$, it signals you to !re!are for $efensi%e measures in the li#elihoo$ that the current tren$ "ill en$) Where a re%ersal is $eeme$ !ossible, you coul$ ta#e !artial !rofits, tighten your sto!s or he$ge your !osition using o!tions) But the initial breach is only a "arning flag) 6s much money has been left on the table by early e,its as by hanging on too long) *a#e $efensi%e measures, but "ait for confirmation of a tren$ change before e,iting com!letely, an$ for confirmation of a re%ersal before -um!ing on the other en$) The wrap-up *ren$s are easy to s!ot, but money is ma$e by your ability to catch them early an$ to #no" "hen they en$) *hose t"o things are only i$entifiable in hin$sight) *he ability to inter!ret "hat !rice action is in$icating can hel! you to better un$erstan$ tren$s an$ their $uration as "ell as $istinguishing bet"een corrections an$ re%ersals) *he #ey lesson is to let !rice $ictate "hat you $o ne,t by being an inter!reter of !rice in the !resent moment, not a !re$ictor of "hat "ill come to !ass) Hn$erstan$ing mar#et $ynamics that lea$ to tren$ re%ersals "ill !re%ent you from being caught flat.foote$ by an une,!ecte$ mar#et mo%e or by bailing at the first sign of trouble) Gour un$erstan$ing of !rice mo%ement is your $efense against the une,!ecte$ that occurs in tra$ing, "hile your ability to translate these three rules of !rice re%ersal into action ser%es as your offense to seize a tren$ that still is in its infancy) Billy Williams is a 20-year veteran trader specializing in momentum trading of both stocks and options. Read his market commentary at www. tock!ption ystem.com.

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