A market trends, and then consolidates, before either resuming the trend or reversing. Is there any way that a technical trader can get a hint about which outcome, the reversal or the continuation, is more likely? This market analyst offers his method for finding out.
O ne of the first guidelines technical traders learn is The trend is your friend. Then you begin to realize the trend is your friend -- until it reverses. At that point, it becomes someone else's friend and your enemy. So, soon thereafter you find yourself asking, Are there signs that occur before a price trend ends? After all, knowing what usually takes place before a trend ends could be of utmost importance to the trend-follower. Armed with this knowledge, the trend-follower could conceivably determine whether a countertrend move is a correction or not, and make the appropriate decision.
What could the trend-follower use to make this determination?
The most appropriate tool would be price momentum. In Figure 1, the top half of each chart is a proxy for price and the bottom half is momentum, which is the rate of change of price. This simple indicator is calculated by taking the difference between today's price and the price any number of days ago and dividing by the number of days. Any lookback period could be used, depending on a trader's personal preference.
Figure 1: Market bottom and rate of change. These are two distinctly different bottoms with very different momentum signatures. In the example on the left, the descent of the market slows and reverses direction at a gradual rate, and the rate of change of the price nears zero as the trough of the trend approaches. Thus, decreasing price momentum precedes the termination point. With the trend depicted by the example on the right, the rate of change increases as the trough approaches. In this case, increasing momentum precedes the termination point.
We use a 25-day moving average to define reactionary highs and lows. When the price closes above the moving average, we consider the lowest closing price when the market was below the average to be a reactionary low (L). If the market closes below the moving average, we consider the previous highest closing price when the market was above the average to be a reactionary high (H). The identification of successive highs and lows continues this way as the market closes below and above the moving average (Figure 2).
Figure 2: Successive highs and lows. The first step is to identify highs and lows to define and identify price trends. A 25-day moving average is used to define reactionary highs and lows. When the price closes above the moving average, the lowest closing price when the market was below the average is considered to be a reactionary low (L). Next, if the market closes below the moving average, the previous highest closing price when the market was above the average is considered to be a reactionary high (H). The identification of successive highs and lows continues this way as the market closes below and above the moving average.
