In this lesson, we will discuss some additional tools we use with Price Charts.
A trendline is a drawing technique whereby users draw a straight line connecting important lows in a uptrend, or highs in a downtrend. Theory goes that price will then find support at the uptrend line or resistance at the downtrend line.
Subjectivity rules yet again, as opinions differ on how to draw the line. Some chartists insist that the line cannot cross through any price bars or candles - only connecting the lows. Others feel that 1 or 2 lows may be anomalies, so they draw an "internal" trend line trying to connect as many lows and highs as possible, arguing this is more of a concrete support level.
No matter which way you draw them, make sure you have a eraser handy, because in the real world the trend lines you draw will be constantly broken, and hence will need to be redrawn. This only follows logic, because price will not follow any pre-ordained path. Sometimes it will, which is simply the random nature of price movement. So price breaking a trendline in and of itself is not telling us much information; but when we look a little deeper it can tell us a great deal.
Trader Vic's 1-2-3 Reversal
In his masterpiece, "Method's of a Wall St Master" trader Vic explains his method for identifying a trend reversal. This method can be used on any price timeframe.
1 - There is a existing trend in place with a drawn trendline connecting lows (or highs). Price then violates the trendline, This triggers step 1.
2 - Price then rallies back towards the initial high - but stalls out at or below that level, and reverses lower. This triggers step 2.
3- When price then breaks through the low that was set at the end of step 1 you have a confirmed reversal.
So the trend-line violation in and of itself is not meaningful. However, when you see that price rallies back in a attempt to continue the prior trend, but then fails - This is very valuable information. Further when we see confirmation of this failure by price making a new "lower low", now we can see that the trend has reversed, or at minimum has ceased being a trend.
The 2B Variation
If we look at the above example, the Step 2 high is around $57. If we wait for the final confirmation of step 3, we must wait for price to fall below the Step 1 low which is around $53.
While waiting for confirmation has it's benefits, the drawback is that a logical exit of the preceding high is now $4 away. Further to this, we missed out on $4 of profit if you were bearishly inclined.
To deal with this issue he has added the 2B signal, which simply means acting once you believe step 2 is in place. This benefits us because we are much closer to a logical exit, although you will be more prone to whipsaws without trend change confirmation.
We do want to beat other traders to the punch and provided our signals are showing Unity, we believe it is prudent to take the 2B signal. To mitigate potential false starts you can enter 1 unit at the 2B, and then add 1-2 units after the 1-2-3 confirmation is in place.
As we mentioned in prior lessons, in our early days we were trading soley off chart signals, including acting on "breaking of trend lines", erroneously believing this gave us an edge to our trading operation.
Experience taught us that as a stand alone signal, trend-line breaks don't reveal much information - but when we observe other aspects in respect to trendlines, they can be very useful.
We have been discussing quite a bit in this Chapter the concept of mean reversion after a extreme move, or said another way, a statistically significant move. What we have observed is that as price moves become more extreme or stretched, like a rubber band, they will snap back or regress back towards the mean. These opportunities can provide us with a High reward Low risk setup that we are looking for
When we draw a trendline connecting lows - by looking at how price "walks that line" it gives you information as to the current psychology of the traders and their activity in that market. If prices are moving steadily in a Impulsive movement, you will see prices making higher lows as well as higher highs (or vice versa) in a steady fashion. If price behavior changes, and suddenly begins accelerating away from the trend-line, this is signaling that traders are getting very excited or fearful, i.e. increasing volatility and now climbing or falling at a accelerated rate.
This is akin to a runner running up hill for a long distance - Then they begin running up a even steeper incline. Then after that leg of the race, they begin running up a even steeper incline - This will then continue until eventually the athlete runs out of gas - They can no longer continue accelerating at this rate and will eventually fall back to a more sustainable slope.
To further illustrate this point, step on a treadmill running at the same steady speed, and then every 5 minutes into your run, increase the incline. The longer you have been running, and the more times you have increased the incline, the more the burning you will feel in your legs and lungs until you no longer can continue that pace of acceleration - Your only choice is to completely stop, or slow down and decrease the incline in order to continue.
You cannot sprint and run up ever increasing hills forever - you simply run out of fuel. And Futures prices operate exactly the same way.
So when we draw our trendlines, once we start observing this price acceleration we add a second trendline accounting for the new trajectory. As this acceleration continues we will add a third, and fourth if necessary. This gives us the visual appearance of "Fan". Lets take a look at a weekly chart of the Nasdaq100 Futures contract from 2009 - 2016.
Characteristics you tend to see are:
- The initial trendline is the longest in duration and at the lowest slope. In the above example the Nasdaq100 begins marching higher at a angle of approx. 70degrees. This steady march lasts for 4 years from 2009-2013.
- We then see the trend accelerate at point 2 - We are now at a 60 degree angle which lasts for 18 months.
- The trend then kicks it to an even higher gear - We are now at a 45degree angle which lasts for about 9 months, until eventually prices give way and start mean-reverting back towards trendline number 1.
In conclusion Prices cannot run in one direction at ever accelerating speeds forever. When you start to see this behavior via ever increasing trendline slopes it is a warning signal that this run is approaching it's end. Use this valuable intel in conjunction with your other indicators and be ready to profit from the inevitable reversion back to the mean.
Oscillators are technical tools that measure the rate of change of the trend. Examples of them included in standard charting tools include: 1) Stochastics 2) Momentum 3) Relative Strength Index.
They typically have a baseline oversold/ overbought level which acts as a signal line - The daily or weekly momentum data will then be calculated on a score of 1-100, and plotted on this graph.
If the indicator goes above 70 or below 30, it is signaling a extreme move.
The key point to note here however, is that these extreme signals are not necessarily trade triggers. In strongly trending markets, oscillators can stay overbought/oversold for weeks and even months. They tend to work better in a sideways/choppy market as traders are then selling rallies and buying dips as "Lines" are being drawn.
A second way to use them is as a confirming indicator. For example if price continues to accelerate making new highs or lows, but however your oscillator is not - It is signaling that there is a deceleration in the rate of change, or loss of momentum.
Just as when you toss a ball in the sky, before Gravity wins the battle and pulls the ball back to earth, the first thing you will see is a slowing of acceleration...then it stops accelerating... then it begins it's decent, picking up momentum as it goes. This is the same concept with price movement, and what the oscillator is measuring.