The previous article discussed ways to determine trend direction. If the direction of a trend can be determined, and if you agree that you should always trade in the direction of the trend, it seems unimportant to try to pick the spot where the trend will change direction. Of course, if you are a longer term trader or investor, it might make sense to have an idea when there are warning signs that the trend in place could be changing direction. And, if you are a short term trader, it still might be important to have this information if you were to enter a new position in the direction of the perceived trend, right at the point where the trend was getting ready to go the other way.
But I would caution anyone who thinks that they can pick the spot, with any accuracy, of a trend change. I know many gurus and market timers claim to be able to do this. They usually give both scenarios, and then after the fact point to the correct version. It can be quite gratifying to pick the top of a market, especially when all the media and analysis are on one side of the market, and you go the other direction and win. It gives you a very brief sense of superiority. You could see something that nobody else could, and you made a profit with this knowledge. However, after engaging in this activity for any length of time, you should review your account statements to really see if this has been a profitable way to trade. I’ve been able to do it on occasion, but far more times the trend would resume and stop me out with a loss. I finally quit trying to swim upstream and now try to keep my trades in the direction of the perceived trend.
It is remarkable how the eye can pick out major highs and lows on a chart, and to see many reasons why the top or bottom was so obvious. Maybe there was a classic three-drive pattern, or head and shoulders pattern, along with diverging momentum or volume. It makes picking tops and bottoms look so easy. But if you analyze the chart more carefully, you’ll probably find two or three times as many set-ups that fail. The mind somehow glosses over the failed set-ups and goes right to the successful patterns.
The above chart is an intraday chart of the Dow mini-futures. There is a classic three-drives to a high pattern on prices, and a head and shoulders on the CCI indicator below. Point three on the indicator shows a momentum divergence with the same peak on the new high in price at point three. As this was developing it looked like the market had run out of gas and was ready for a trend reversal down. You can see prices started to go in that direction. You can also see the linear regression curve with the standard error bands, which is the best indicator I’ve found yet for estimating the direction of the trend, was solidly up and gaining strength. The move down did take out the interim swing low in between points two and three, so there was some confirmation in the price structure, but the upper error bands held price, and the uptrend resumed. Using this pattern to exit a long position may have been wise, as the long position could always be re-entered, however, going short would have resulting in only a few ticks potential, and most likely a stopped out loss.
Above is a chart is a continuation of the previous chart. (The area marked “uptrend” is overlapped from the right side of the previous chart.) You can see a better indication on this chart that the trend is indeed changing. The regression curve is now rolling over and rounding over the top of the prices. There is an upmove near the rounding over regression curve that is a test of the previous high. The test of the high, or failure to even reach the previous high, and inability of the market to get over the regression curve is a good warning sign of lower prices. The CCI had not give much of a warning until the bars turned red and re-tested the zero line (purple line) and turned back down. This zero line represents the moving average that is adaptive to the perceived cycle. The confirmation that the trend has changed comes when the previous swing point is taken out, where the horizontal blue line is broken. The CCI quickly goes to the bearish –100 line and hovers in that area. While waiting for the confirmation of the swing point to be taken out is the safest approach, it can also be a frustrating wait. The CCI gave a signal that would have been positioned with much better trade location, but with a lower probability of success. There is always trade-off between timeliness and safety.
Above is a daily chart of Starbucks, with the regression curve and standard error bands. As the market was approaching highs in the middle of the chart it was hard to find an analyst saying anything negative about this stock. The regression curve was solidly up until prices crashed through, when the curve and error bands acted as resistance to the rebound rally attempt. Notice how the regression curve bent over the top of prices, even as the stock price tried to rebound. Prices stopped at the curve almost to the tick.
But how can we get some advanced warning that prices will change direction without waiting for such a large adverse move prior to confirmation. You can really never know for sure, but there are indications, or warnings from indicators. But they are only warnings. The Dow futures example above shows how quickly the trend can resume.
Here is the same chart with the scaling widened out a bit and focusing more on the trend change area. You can see three-drives to a high where I drew the blue line on prices. You can also see a momentum divergence on the indicator below illustrated by the blue downtrending line. This indicator happens to be a smoothed stochastic. It could be most any momentum oscillator. This is very similar to the pattern in the Dow futures example that didn’t work out for very long. In this example the market did break down eventually, but even after the momentum divergence there was a period of sideways to slightly up action, and then a retest of the rounding over regression curve before prices finally broke in earnest.
Here is the same chart again, this time scaled out even wider to show more detail. You can see price close at a new high when it poked through the red line, but closed right back under that high on the next day. This is a failure of the test to make a new high. Often the failure of this test will come on the third high in a series of pushes. I’ve seen 8 or 10 tests of new highs before the market finally fails. In this case it came right on schedule on the third try. Also, sometimes the failure will come on the same bar. That is, the market will make a new high, and then turn around and close on the same day under the previous high. Sometimes it can be several days later. Don’t try to be too exact. It is just the concept that is important. A market makes a high, corrects a bit, retests that high, then either succeeds or fails on that test. Exiting a long on this failure can often be a good idea. Entering a short here can often be good for a scalp, or even on rare occasion a perfect place to short the top of the market. This failed test, until confirmed, is just a warning. The safest place to assume the trend has turned down is to wait for the break of the interim low swing point in between the two high swing points. You can see this where I drew the horizontal blue line. The break of that blue line is the confirmation. Now, based solely on price structure, you can assume the trend is now down. There is often a re-test of the breakout, as it did in this example, where you can see prices moving back up to the right side of that blue line many times. The market is always testing and re-testing. It tests a swing point, and if it breaks it successfully, it will most likely re-test that point. You often see this on trend line breaks and head and shoulders neckline breaks. For my trading I also use the regression curve for my confirmation. Many traders use moving averages.
Here is another similar example with a very sharp three-drives to a high pattern. This time the stock is Allegheny Tech. You can see the narrow error bands indicating a very powerful uptrend in place. (More on standard error bands are in the indicators section of this blog.) No reason to think about a down move here as the stock was climbing into point 3. Then the stock suddenly broke to the downside. When price gapped through the error band after point three, a lot of money would have been left on the table waiting for confirmation of a trend change pattern. Also, on this chart you’ll notice that the move after the three-drives pattern resulted in a trend change to a sideways trend, not a downtrend. The market doesn’t always have to be in an uptrend or a downtrend. Another trend is the sideways trend. The rounding over of the regression curve suggested a downtrend, or at least a downward tendency, and that’s the side of the market I would have played had I been trading this.
Again, here’s the same chart with the spacing changed to show more detail of the three-drives pattern. You can see the low swing points between peak 1 and 2 did not get broken, so the uptrend is still intact. However, the low swing point between peak 2 and 3 did get broken. It was not a very timely place to exit a long, however. The impulse up to point 3 was quite steep, so there were no low swing points to test. Usually the swing point is not so far away. I picked this example to show a more difficult situation. (More on swing points in the previous article on Trend Determination) Is there a better solution to get a more timely warning of a possible trend change?
Here is the same chart again. This time a smoothed stochastic is placed under the prices. A clear divergence appears between the second and third peak. Keeping in mind the third peak can be a top, it may be a good idea to protect long positions here. I don’t really trade candle pattern, but when I see a small body in the candle with a thrust up to new highs that doesn’t hold, it becomes a warning. And both these things are just that: warnings. The trend is still up at this point, with a high probability the uptrend will resume, at least until that low swing point is taken out as in the previous example. However, in a blow-off type of move as in this example, a momentum divergence can warn that at least stops on long positions should be tightened up. Most momentum indicators will give a similar divergence. The stochastic is usually a little more timely for divergence analysis, due to the way it treats the closing price of the bar in relation to the range. However, too much smoothing can create lag. There are many more false divergences than successful examples. Be very careful in using this approach for entering positions.
Here is a continuation of the same stock, with the bars tighter again to show more of the data. You can see that after the sideways trend ends, the uptrend resumes. Notice how prices tightened up when it was trying to get over the regression curve, re-testing it. Soon prices moved out of the error bands and made a nice impulse move up as the curve rounded up under the advancing prices.
Here is a chart of Google that I captured on the same day as this is written. There was a huge break in prices. The regression curve was solidly up. But there were some clues to protect long position. Brave souls could have gone short against the trend. The volume bars are on the chart under prices. I rarely use volume. In the days before EFTs and options, volume had more relevance. Today the volume patterns are not as clear and helpful. Sometimes you can still see panic bottoms on high volume, indicating a blow-off low. Sometimes you can see declining volume on the three-drives to a high pattern. Here is one example where volume is declining as prices are making the triple top. I don’t see this often, but when it does occur it is worth noting.
Here is the same chart in more detail. There was some warning from the CCI as prices made a divergence and fell back under the bullish +100 line. It was timely. The red arrow shows that the warning occurred two days prior to the break. Keep in mind, had the news that caused the drop gone the other way, the stock could have gapped up as much as it gapped down, therefore the CCI warning would have been worthless. The indicator does not drive the security’s price; it is the other way around, although at times it might seem like the indicator is leading the way, as in the above example.
Here is the same chart, but this time with the double stochastic. Here the indicator makes a very clear head and shoulders pattern with divergence on the third drive to a high. It breaks the neckline, as well as upper reference line, a bar earlier than the CCI. Either indicator gave a warning in plenty of time to take action. The gap down was severe, but the regression curve is still solidly up. There were no relevant swing points without going back a ways on the chart. The swing point loses effectiveness, in my opinion, if they are too far back.
When thinking about trend change there are some things to keep in mind. First, trends tend to persist; often longer than you think is logical. When trends are up they often climb that wall of worry. Worry that the market will collapse without warning and take away your profit. Worry that the fundamentals don’t justify the prices being traded. Logic might dictate taking profits, but there is worry of leaving money on the table. Uptrends tend to end more leisurely, at least in the stock market. For the public, it is easier to decide to enter a market or take profits in the calm of rising prices, where only greed is the factor. In down markets traders often panic, with margin calls and fear of losing your home often a motivator resulting in more urgency. Therefore, bottoms can form quickly and sharply. Futures markets seem to be a bit more even regarding uptrends and downtrends, due to the nature of the mix of traders involved. A sideways trending market, or a market with a perceived lack of trend, can lull traders into complacency. With attention elsewhere, breakouts into a trend can easily be missed.
To summarize, I find the best strategy is to find the main, confirmed trend, whatever indicator or method used to determine that trend. Then trade only in the direction of that confirmed trend. Trading pullbacks, such as flag patterns, will usually offer the safest entry points. Trends have smaller cycles within the larger cycle. There are usually pullbacks within the longer term trend. I will accept kicking myself for the few times I see tops or bottoms that I will miss. This is a small price to pay for missing many losing trades resulting from trying to buck the trend. There are always trends somewhere and in some timeframe. Going against the trend is like jumping into a river flowing rapidly in one direction, and trying to swim in the opposite direction. It is difficult and exhausting to do. It’s much easier to float down the river in the direction of the current. The ego is more gratified in going the opposite way. The ego is also one of the most difficult aspects of trading to overcome.