4 Timeless Guidelines for

Momentum & Trend

Trading
Timeless Guidelines for Momentum & Trend Trading
Four Guiding Principles of Market Behavior
[BigTrends.com note:  An article below from 2007 which includes analysis from 2000 (and
before), yet is still very insightful today -- that is a sign of a well-written piece that has some
timeless trading knowledge and wisdom, in this case for momentum and trend trading using
technical analysis.]

From Charles Dow, Robert Rhea, and Richard Schabacker (and others) - 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 (vice versa for
uptrend changes) form and price takes out the most recent higher high.

Be aware that some statistical analysis of market action (from intraday to 20 day periods) that
mean reversion, rather than trend continuation is more probable in many equities/indices (as
shown by more up days followed by down days than continuation upwards).  For the current
market environment, until volatility returns (as it may be doing now), this rule may be
restated, "Trends with strong momentum show favorable odds for continuation."
Trading psychologist Dr. Brett Steenbarger contributed to this observation.

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 (when you play for a very large target
when your initial stop is very small - think a 'NR-7 Bars').

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.
(Concept Credit for arranging the four principles: Linda Bradford Raschke (published in New
Thinking in Technical Analysis - 2000)

Courtesy of AfraidToTrade