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March 17, 2000

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Charts courtesy of BigCharts.com

IT'S ABOUT TIME 

A trading strategy needs to work in all types of markets, including bull and bear ones. The current stock market environment offers a perfect real world test for methods developed during the great bull run of the mid- to late 1990s.

To complete the research and proof of a trading strategy, you must verify that it works on past, present and future data. Furthermore, it must work on bull, bear and chicken markets. (In case you have forgotten what a chicken market is, read Trading 102: Getting Down to Business.)

In the past, we have not encountered any decent bear markets, ones that were sustained over any length of time. The current market action provides a lovely environment of a classic bear market action against which you can test your theories.

In a bear market, the surprises are to the upside, as the unsuspecting public will see upside moves, not as corrections, but as a clue that the downdraft is over. The uninitiated will participate in "bottom-fishing," looking for good deals where they can buy shares at a cheap price. The conundrum, of course, is that low is only low when it's over. Any attempt to buy stocks while they are going down could result in a losing money management strategy. Unless you have a direct line to God, these are times to be careful when attempting to pick a bottom.

Over the long-term, my research has shown that you should buy only when the market tells you it is going up. How does the market talk to you? Through price action! This strategy will, by its nature, get you in late and have the apparent affect of leaving money on the table.

How do you know the market is going up? Are there any classical patterns or indicators that show you in advance that a downdraft is over? Techniques such as Elliott Wave and Gann analysis purport to give you advance warning, but fall short of ideal as new market data continues to reveal itself. Elliotticians regularly hedge their bets with verbiage like "If it stops here, then it's clearly a 5-wave. But if price continues in this direction, then it could be a...". Other techniques and indicators based on price are lagging indicators because they take past prices into each calculation. Again, this brings me to conclude that it is better (read: more profitable) to get in late, after the market has shown its hand.

There are two tools that I find give consistent alerts as the market changes direction: trendlines and ADX. Most traders understand how to use trendlines. By definition the market trend is up when we have higher highs and higher lows. A support trendline is drawn by connecting consecutive lows as the market is rising.

Watching for decisive penetration of support gives you clues as to what the market is saying. Downtrends are viewed by lower highs and lower lows. Trendlines drawn on top of downtrends provide a measure of resistance as the market turns and attempts to change its direction. You draw these trendlines by connecting consecutive highs to form the line.

When this line is penetrated decisively, the market is changing direction. Confirmation of the trend change often is provided when you observe two successive tests opposite to the newly forming direction, so that you can draw a new trendline of support.

The other tool I find invaluable in detecting market trends is ADX. Invented in the early 1970s by Welles Wilder, the ADX indicator is one of the standard available indicators in most popular trading software. Many traders are reluctant to use ADX, because they do not understand how to read it. Simply put, ADX is either rising or falling. If it is rising, the market is trending. If it is falling, the market is not trending, in other words, its sideways.

ADX alone does not tell you which direction the market is trending, only that it is trending. ADX is like an on/off switch: trending/not trending. Often, as you enter a period when ADX is falling, a market transition is taking place. The rising ADX could indicate either a new direction (trend) or a continuation of the present trend. If you wait and let the market tell you what it is doing, then you watch for penetration of prior support or resistance before entering a trade.

These techniques apply to charts of any time frame. A chart, is a chart, is a chart. Whether it is a two-minute chart used by speed-traders, or a daily or weekly chart used by investors, the market is fractal. This means that the market is like those little Russian dolls, when you open one you find another just like it, only smaller. In the markets, there are patterns within patterns, within patterns as you expand and contract the time frame. Markets, such as the current one, give you a great opportunity to re-evaluate your assumptions. However, be careful what you presume because the market is a master of surprises.

Copyright © 2001 Futures Magazine Inc.

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