From Charles Dow, Robert Rhea, and Richard Schabacker – all early pioneers of stock market technical analysis – four driving principles of market dynamics have endured the test of time and still guide technical trading decisions across all time frames.
Each of the following principles can be quantified mathematically and most (if not all) mechanical trading systems are based on at least one principle.
Principle 1: A Trend is More Likely to Continue its Direction than to Reverse
With price established in a clearly defined trend of higher highs and higher lows, certain key strategies and probabilities begin to take shape. Once a trend is established, it takes considerable force and capitalization to turn the tide.
Fading a trend is generally a low-probability endeavor, and the greatest profits can be made by entering reactions or retracements following a counter trend move – and playing for either the most recent swing high or a certain target just beyond the most recent swing high.
An absence of chart patterns or swings implies trend continuation until both a higher high and a higher low (opposite for uptrend changes) form and price takes out the most recent higher high.
Principle 2: Trends End in Climax (Euphoria/Capitulation)
Trends continue in 'push/pull' fashion until some external force exerts convincing pressure on the system, be it in the form of sharply increased volume or volatility. This typically occurs when we experience extreme 'continuity of thought' and euphoria of the mass public (that price will continue upwards forever).
However, price action – because of extreme emotions – tends to carry further than most traders anticipate, and anticipating reversals still can be financially dangerous.
In fact, some price action becomes so parabolic in the end stage that up to 70% of the gains come in the final 20% of the move. Markets also rarely change trends overnight; rather, a sideways trend or consolidation is more likely to occur before rolling over into a new downtrend.
Principle 3: Momentum Precedes Price
Momentum – force of buying/selling pressure – leads price, in that new momentum highs have higher probability of resulting in a new price high following the next reaction against that momentum high. Stated differently, expect a new price high following a new momentum high reading on momentum indicators (including MACD, momentum, rate of change, etc).
A gap may also serve as a momentum indicator. Some of the highest probability trades occur after the first reaction following a new momentum high in a freshly confirmed trend. Also, be aware that 'momentum high' following a trend exhaustion point are invalidated by principle #2. Never establish a position in the direction of the original trend following a clear exhaustion point.
Principle 4: Price Alternates Between Range Expansion and Range Contraction
Price tends to consolidate (trend sideways) much more frequently than it expands (breakouts). Consolidation indicates equilibrium points where buyers and sellers are satisfied (efficiency) and expansion indicates disequilibrium and imbalance (inefficiency) between buyers and sellers.
It is often easier to predict volatility changes than price, as price-directional prediction (breakout) following a low-volatility environment is almost impossible. Though low volatility environments are difficult to predict, they provide some of the best risk/reward trades possible, one of the set ups that offers this type of opportunity is the 2x inside day set up.
Various strategies can be developed that take advantages of these principles. In fact, normally the best trades base their origin in at least one of these market principles: breakout strategies, retracement strategies, trend trading, momentum trading, swing trading, etc. across all timeframes.
The next time you make a trade, ponder which rule your trade is based on, and if it violates one of these principles, take time to rethink your trade.