How to Correctly Identify the Trend - Part I

If there is one piece of the trading puzzle that remains a bit unclear for traders it is that of the 'trend'. Depending on whom you speak to, each will have a different answer. Regardless, of their answer however, it is critical that you arrive at the correct answer in the context of how that person trades. Failure to correctly identify the trend will greatly reduce the odds of success.

The first place to start is by identifying which time frame you plan to make your trade off of. For me, I only have three choices, 60-minute, 240-minute or the daily chart, as these are the only three time frames I follow for trade set-ups. The vast majority of the trades are based on the 60-minute chart however. So, for the time being, let's keep it simple, I will not factor in the other time frames as it can get a bit confusing.

What is the trend on the following chart?

In all fairness, it is a bit of a trick question. The answer, based on my approach, is that there is simply not enough information to make that call. Sure, the last several bars have been moving up, but overall prices are still trending lower.

Let's add one more piece of information to the chart.

By adding a moving average, one can much better analyze the 'current' trend. Remember, I am not terribly interested about what happened several hours ago, but I am interested in what has happened in the last 4-6 hours.

Without the moving average, it is nearly impossible to correctly identify what the current trend is.

Let's look at another example.

I suspect there were some readers who said; "The trend is up, I will look to buy into this pull-back." But again, there is simply not enough information to draw that conclusion presently. Let's add in the moving average.

If you did not correctly identify the trend, many will succumb to buying the pullback into support, or in this case fib support – this losing trade could easily have been avoided if you correctly identified the trend.

Needless to say, this trade would have flamed out badly.

Later this week I will go into more detail about correct trend definition as well as factoring in other time frames in order to refine your definition of the trend.

The Elliott Wave Theory Demystified

I've had many readers ask me whether purchasing a trading system for several hundred or even a few thousand dollars is worth the investment. When I say "trading system," I mean some type of mechanical trading system that usually requires one to be "in the market" (either long or short) all or much of the time--or, some specific trading method a trader has devised and deems profitable. My answer to these readers is: While some trading systems or specific methods may (or may not) be useful or profitable, why not spend that kind of money, or less, and attend a quality trading seminar or workshop.

Attending a trading seminar or trading workshop allows you to hear some of the best traders and trading educators in the world share their knowledge. Furthermore, the smaller trading workshops allow you to not only learn from the trading instructor, but also likely learn something from your peers who are also attending the workshop.

I've attended many trading seminars and workshops over the years. My favorite seminars were the Technical Analysis Group (TAG) seminars. I've heard these TAG seminars are no longer conducted--or at least were not conducted this year. These were annual seminars held each fall at some major city in the U.S. The cost of the TAG seminars was around $700 per person. From 15 to 20 of the most respected traders and trading educators in the world gave lectures at the conference. And, attendees got a big fat notebook filled with all the featured speakers' presentations, in case an attendee could not make it to all of them.

One should never stop striving to learn more about markets and trading. The more knowledge a trader can attain, the better his or her chances for trading success. Last year, my good friend Glen Ring asked me to attend one of his intensive three-day trading workshops. Glen is a trading and trader education master. Glen has taught me much about markets, trading and the psychology of trading. I want to share with you some of the topics the workshop touched upon--without giving away any of the specific trading methods Glen discussed at his workshop.

Here are a couple "nuggets" we discussed at the workshop that I think will be beneficial to you:

---There are several components involved with successful trading. They include spotting the trading opportunity, proper entry and exit strategies and money management. Glen says (and I concur) that the most important of the components I mentioned above are money management and exit strategies. "Anybody can get into the market, but it's the real pros who know when to get out," says Ring. He, too, advocates using fairly tight protective stops when trading futures. He pointed out statistics in our industry that underscore why "survival" in futures trading is so important during a trader's first few months or first couple years of trading. Glen said studies in the futures industry show the average length of time a person stays in the business of trading futures is nine months to one year. What this very likely means is that the vast majority of beginning futures traders start out in this business not using effective money management or protective stops--and end up losing most or all of their trading capital in a few short months. I can't stress enough the survival mentality that all traders--especially those with less experience-­need to employ.

---At the workshop we also discussed how Elliott Wave Theory can be a valuable trading tool. However, it is complicated and many traders do not master the theory well enough to ever use it effectively. I'll briefly discuss Elliott Wave Theory, but if you want to learn more I'd suggest reading books dedicated to this theory.

R.N. Elliott discovered the wave theory in the 1930s. Elliott waves describe the basic movement of stock or futures market prices. The principle states that in general there will be five waves in a given direction followed by usually what is termed and A-B-C correction, or three waves in the opposite direction.

In Wave One, the market makes its initial move upward. This is usually caused by a relatively small number of traders that all of a sudden feel the previous price of the market was cheap and therefore worth buying, causing the price to go up. This is where bottom-pickers come into the market.

In Wave Two, the market is considered overvalued. At this point enough people who were in the original wave consider the market overvalued and take profits. This causes the market to go down. However, in general the market will not make it to its previous lows before it is considered cheap again and buyers will re-enter the market.

Wave Three is usually the longest and strongest wave. More traders have found out about the market; more traders want to be long the market and they buy it for a higher and higher price. This wave usually exceeds the tops created at the end of Wave One.

In Wave Four, traders again take profits because the market is again considered expensive. This wave tends to be weak because there are usually more traders that are still bullish the market, and after some profit taking comes Wave Five.

Wave Five is the point most traders get long the market, and the market is now mostly driven by emotion. Traders will come up with lots of reasons to buy the market and won't listen to reasons not to buy it. At this point, contrarian thinkers will probably notice the market has very little negative news and start shorting the market. At this point the market becomes the most overpriced.

At this point in time, the market will move into one of two patterns, either an A-B-C correction or starting over with Wave One. An A-B-C correction is when the market will go down/up/down in preparing for another five-wave cycle.

I am not an Elliott Wave expert, but I do believe there is merit to the tenets of the theory. Importantly, the tenets of the wave show us how much human psychology plays a part in the way traders trade and the way markets move.

How Richard Lees Incorporates Physics Into His Technical Analysis

Stock market and options trader Richard Lees has combined physics, pattern recognition and technical analysis to form several new "pH-Indicators" to guide him in trading.

Lees is a money manager and president of Richard Lees Capital Management in the Studio City area of Los Angeles. He is a featured speaker at the Telerate Seminars 20th annual Technical Analysis Group (TAG 20) conference here this weekend.

"I began to trade the markets in 1982 when, after my father died, managing family money arose literally from a life-and-death situation as my responsibility in the family. So the enterprise has, from day one, left me with little patience for hypothetical market methods," said Lees.

He has studied technicals, fundamentals and systems trading that combined them both. "Eventually, I felt my own way to what worked in real time and with real money," he said.

After some valuable additional encouragement from one of the "wizards" in Jack Schwager's book, "Market Wizards," Lees developed an entirely new set of indicators.

"The indicator set, which is what I'm introducing for the first time in public at TAG 20 in Las Vegas, is called The pH-Indicators. And they are elastic, or what I like to call liquid oscillators. They do not reach, what conventional oscillators call ‘overbought' and ‘oversold,' but rather establish trend points which give signals, although in all timeframes. I use them on everything from intermediate signals on the stock market to day trading."

"One is pH-F, my fundamental indicator, and keys off the S&P earnings yield rather than its price-earnings ratio. This has kept me on the right side of the bull market of the 1990s.

"Second is pH-L, my Liquidity Indicator, which sits at the heart on my work. It is a simple, but I think elegant, way I've found to connect what the Federal Reserve is doing in the real economy with how the stock market is valuing that real economy.

"Last is pH-I, my Market Internals indicator, which gives me everything technical I need to know about market action in one indicator. It's kind of an updated version of TRIN, and it was formed at least in part because of my simultaneous admiration for and disappointment in TRIN. I would emphasize that I consider Richard Arms one of the true brilliant men in technical analysis, and I've long admired his work. It's just that I found what I consider a more immediate and fast­changing indicator which I believe is more suited to the electronic markets of today and tomorrow."

Lees said he then combines what these indicators are telling him about the market to produce an Overall Market-pH number, which is also the percentage he will be invested at any given time in the market. (i.e., if the Overall Market-pH is 9.3, he wants to be 93% in the market with his stock picks.)

Then he uses a 21-point Screen he developed for picking stocks, which essentially identifies "a key data signature that I've found over the years selects value just before it's about to become growth."

"I'm effectively always in the market then, but at different levels of commitment. I believe in stock picking, not mutual fund investing, as I believe money managers should be paid for picking stocks, not other money managers."