Trading & Investing Lessons for Traders and
Investors
Trading Lesson will carry a series of articles, tips,
trading strategies and advice to help the Indian
investor or trader get a better insight to trading and
investing in stocks, futures and options.
You can register for our
free newsletter service to receive email
notifications as soon as anything new is added to this
page.
Trends and Corrections
It is said that "the trend is your friend" in
numerous articles and books on the subject of trading.
For the most part, this is absolutely correct. However,
even the trend can fail to be your friend if you do not
realize when it has likely come to an end.
Although most traders realize that catching a strong
trend can mean a great deal of profits, many still try
to trade against it. Why is that? I believe that it is
safe to say that most feel that once they try to enter
that trend, it WILL end. They try to trade against the
trend because they feel that it has run its course, and
they want to get a jump on the new opposing trend (sell
the very top, buy the very bottom). And of course, most
are unable to determine when it has actually ended,
finding themselves just another victim of the forces of
the trend at hand.
In an attempt to minimize the hazard of entering a new
trend as it may be ending, some have turned to Elliott
Wave analysis. EW analysis is based on counting the
waves that form within a trend. For instance, the basic
teaching of Elliott is that a trend will have at least 5
waves. Three of these waves will be with the trend, and
two of them will be counter-trend, or a 'correction' of
the trend. Each correction is expected not to exceed
100% of the original thrust or wave leading to the
beginning of that correction wave.
For example, if price starts a trend up by making 100
points (wave 1), when it starts to drop again
(correction wave 2), it is expected to drop less than
100 points if the up trend is indeed valid. When it does
end, the original trend resumes what is called Wave 3,
which must exceed the end of Wave 1 (beginning of Wave
2) and move higher before it too corrects into Wave 4,
and so on.
With EW, some figure that if they do not count 5 waves,
then the trend must not be over yet. However, it has
been found that EW can be quite subjective. Getting
every EW Analyst to agree on the count is futile.
Examining thousands of price charts over the years, I
have noted that price tends to trend at certain angles.
A strong bull trend will usually start at some angle of
ascent, and either increases its angle as it nears its
end (a rush to buy from those just realizing the
bullishness of the market), or simply maintains the
original angle.
Trend lines have proven to be an indispensable time
tested tool when it comes to highlighting a trend and
its angle of support. Though it may be said that drawing
a trend line is also subjective, I have found that with
experience the trader/analyst can become quite
consistent in its proper application.
When a new trend begins, it may not be so readily
apparent for many. Yet, a new bull trend may appear at
first to simply be a bear trend correction, but then
exceeds a prior bear trend correction's bottom and top.
Alone this would not be enough to suggest the bear trend
is over, but when that new bull trend corrects for the
first time and fails to take out the very bottom of that
trend, but rather starts up again, this higher swing
bottom is yet another clue that a bottom is in and the
bull has arrived. Further rise in price that then
exceeds the last swing top formed (the start of the last
correction down) continues to suggest that the bull is
in force.
Suppose we number the beginning of each wave for
discussion sake. The new bull move starts from the very
bottom that we call (1). When price tops, and then
corrects (moves down), we call this top (2). When price
stops dropping, and if this is a bull trend we expect it
to do so before reaching the low of (1), it will start
up again. The beginning of this move up we'll call (3).
A simple way to draw a trend line is to place the line
below bottoms (1) and (3) out into the future. This
gives us our first angle of ascent to watch for. It is
advisable that the move from (2) to (3) be at least 38%
of the move from (1) to (2) before you consider that
correction low of (3) for your trend line reference.
Less than 38% suggests that you may not have seen the
(2) to (3) correction just yet.
A good bull trend will usually operate above this
trend line. As a matter of fact, that trend line will
often serve as a good support reference line, where
price that corrects later on may start to resume the
trend once again. Always be mindful to note whether
price starts to become parabolic (starts moving more
vertical at a sharper angle). If it does, you may not
see price correct again to your trend line, and a new
one may need to be put into place once price corrects
again to give you a reference bottom to do so.
The standard definition of a Bull Trend is that price
will make higher swing bottoms (the end of each
correction). At some point, a correction bottom may drop
below a previous correction bottom. This may suggest the
bull is weakening, though not necessarily over, though
it could be. If price were to drop below two prior swing
bottoms, the bull trend is considered over. This is one
way to note that a bull trend is coming to an end. The
best time to consider trading short the end of a bull
trend is not necessarily the very top. Rather, it is
when price fails to move price above the prior swing top
(the current bull top) and starts correcting down again.
This is because the standard definition of a Bear Trend
is that price will make lower swing bottoms and lower
swing tops. So when you see a bull trend make a lower
swing bottom rather than a higher one, be on the lookout
for the possibility of a lower swing top following.
The trend line again can be quite useful here. When the
bull trend is correcting and you note that it just made
a lower swing bottom rather than a higher one (it went
lower than the last swing or correction bottom), see if
it also did so below the trend line you have established
as valid on your chart. If it did not, then be careful
to assume the bull is over. However, if it also moved
below the trend line, the bull may be over.
Understanding the relationship of trends and corrections
can go a long way in helping the trader/analyst trade
with the trend rather than trying to guess its end and
trading against it. It can help the trader stay in the
trade longer while the trend is still intact. In
addition, noting when a correction is greater than
expected can help the trader make plans to be more
aggressive with the stop-loss management, preparing for
the end of the trend likely due shortly.
When you start to become intimate with chart patterns
and how they appear when trending, this will open new
doors to you when it comes to timing those correction
(swing) tops and bottoms.
|
