The First Piece of the Jigsaw Puzzle
Editor’s note: Murray Dawes is the editor of Alpha Wave Trader, a short-term trading service that trades stocks and indices from the long and short side. He is filling in for Harje while he is away overseas.
In yesterday’s essay I set out a few insights I have gained after observing and trading markets for 25 years. My plan over the next few weeks is to slowly build your understanding of my way of analysing markets so I can communicate with you effectively. I’d like to add some value to your day rather than just helping you pass time while you eat a sandwich at lunch.
But it is a tall order. I need to outline the key concepts behind my trading philosophy, explain the logic of the technical patterns that I focus on and give you live examples. All while keeping you awake!
I won’t be able to give you my trading secrets of course, so in the end I will have to show you the shadow of what I work on with the members of my trading service. But hopefully the shadow will be enough to get you thinking.
I started my career on the floor of the Sydney Futures Exchange full of romantic notions of being a gun trader yelling ‘buy, buy, buy, sell, sell, sell!’ But those days are long gone. Now I analyse risk/reward scenarios and read a hundred reports looking to enter one trade.
I have a few technical set-ups based on concepts that I have been working on for decades. I also have a couple of entry and exit methods based on being either aggressive or conservative.
And that’s it.
But to get there I had to go up so many blind alleys that my head is sore from butting brick walls. I’ve got little interest in selling you the dream that you click a button and mountains of money flood in. Trading is hard work. It takes immense dedication and focus.
There are certainly rewards for perseverance. And the rewards aren’t just monetary. You learn an immense amount about yourself as a trader. If you aren’t humble, you’re dead in the water. The market loves to lead a big ego up a garden path before it disappears over a cliff.
Everything I am going to discuss with you is based on probabilities, not certainties. As I said in my article yesterday, no one knows the future, including me.
A lot of what I discuss will possibly sound quite complex at first if you aren’t used to thinking about markets and price action in the way I will describe. But if you take the time to read what I write carefully, it will soon make sense. If you have access to charts you should play around with some of the concepts I divulge to come to your own understanding.
Now, let’s move on to the second insight which I revealed to you yesterday…
Prices constantly revisit old ground, shaking out weak hands
How can we use this knowledge to our advantage? If prices are constantly shaking traders out won’t we just be one of them? Not necessarily.
Now don’t let your eyes glaze over reading the next paragraph. I am going to spend a lot of time explaining everything that I say.
Whether markets are range-bound or trending, there are certain areas where reversals often occur and there are various ‘Points of Control’ around which the market oscillates. There are ratios based on the size of ranges that inform future price action both internally and externally from the range. The same calculations used on ranges can be used on waves within a trend.
Combine the above with a concrete set of rules for when price momentum has shifted, plus some secret sauce, and you are on the way to a viable trading strategy.
Let me show you what I mean at a very basic level to get the ball rolling.
The first universal technical pattern that I am going to discuss is the widening distribution. It is caused by a series of false break-outs.
Rather than prices ‘breaking-out’ after periods of consolidation, you often see false break-outs which stop short-term traders out of positions and tempt new traders to enter, looking for a break-out. Once all the stop-losses have gone off and new traders have entered their positions, the price will often reverse course and go straight back to where it came from, almost like it was oscillating around a central gravitational point (The Point of Control or POC), and the attempt to leave the gravitation of that point had failed.
Widening distribution due to false breakouts
Port Phillip Publishing
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Current monthly chart of US Dollar Index
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In time traders become fatigued after a series of false breaks create what I call the ‘widening distribution’. And then in the blink of an eye the market will rocket either up or down from the ‘Point of Control’ and a trend develops again.
Whether the market is trending or range-bound you see these distributions forming repeatedly across all time scales. I started to notice that trends could be seen as a series of these distributions stacked on top of each other with periods of strong trends when the markets were very out of balance.
If you were aware of how these patterns form and began to expect them, could you see the benefit of waiting for a false break in direction of the current trend?
For example, when looking at the monthly chart of the US Dollar Index above, you can see prices fell sharply below the bottom of the range, I have indicated that on the chart in early 2018 (the fourth ‘FBO’). If you understood the theory behind widening distributions, you would have seen that sell-off as an opportunity to get long the US dollar.
There are a few more pieces of the jigsaw that I need to reveal to you so you can see just how compelling that opportunity was, and I will do that in tomorrow’s article. But for now, all I want you to think about are the ideas behind why these structures form, and imagine trading at the edges of the distribution expecting a move back to the point of control at least.
Editor, Alpha Wave Trader
Editor’s note: This is just a quick note to let you know that due to a technical issue, we have had to re-upload Murray Dawes’ market update video from Monday’s Money Morning. That means if you’re trying to view it again today, you’ll find that link is broken. Instead, the video can now be found here. If you haven’t caught Murray’s update on Australia’s coming east coast gas shortage, and some of the companies that could benefit and why, be sure to check it out.