Principles of PRICE BEHAVIOR

There are four basic principles of price behavior that have held up over time. Confidence that
a type of price action is a true principle is what allows a trader to develop a systematic
approach.

The following four principles can be modeled and quantified and hold true for all time frames,
and all markets. The majority of patterns or systems that have a demonstrable edge are based
on one of these four enduring principles of price behavior. Charles Dow was one of the first
to touch on them in his writings.

Principle One: A Trend Has a Higher Probability of Continuation than Reversal

This is one of the basic tenets of Dow's theory. An uptrend is defined as BOTH a higher high
and a higher low, and vice versa for a downtrend. For example, in order to reverse from an
up-trend to a down-trend, the market must make a lower low and a lower high and then turn
DOWN from there. If the market is in a well-defined trend, the largest price swings tend to
occur in the direction of the trend. When the price is moving in a clearly defined trend, there
are numerous strategies for entry based on the small retracements that occur along the way.
These reactions allow the trader to find a tight risk point while still playing for a new leg in
the direction of the trend.

A few notes on trends:

• Once a trend is established, it takes considerable power and time to turn it.
• A major trend seldom reverses without warnings, such as a pronounced loss of
momentum followed by a period of accumulation or distribution, or a buying or selling
climax.
• In strong trends, reactions become shallower as the trend progresses.
• The absence of any pattern or swing in the price implies a continuation of the prevailing
trend. The strongest trending action tends to be accompanied by a decrease in volatility.
This could be described as a methodical eating away of overhead supply or a slow, steady
price deterioration in the case of a downtrend.
• Trends tend to begin after the market has wound down to an equilibrium level. Just as
volatility collapses in the middle part of a trend, price action can become more parabolic
in the later stages of a trend. In some extreme cases, 75% of the gains can come in the
last 20% of the move.

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Principles of PRICE BEHAVIOR

Principle Two: Momentum Precedes Price

If momentum makes a new high or low, the price high or low is most likely yet to come.
Momentum is one of the few “leading” indicators. Elliot used the term “impulse” to refer to
an increase in the market’s momentum. Impulse indicates an imbalance in the supply-
demand equation and most often occurs in the direction of the prevailing trend. A trader
should look to enter in the direction of the market’s initial impulse.

New momentum highs can be made in both a trending environment or on a breakout of a

trading range. New momentum highs or lows should correspond with a new price high or low
as well.

Momentum can be defined using a number of different types of calculations. For example,
new highs or lows with momentum accompanied by range expansion also confirms new
momentum highs or lows as an increase in range is a sign of “impulse”.

A trader should look to establish new positions in the market on the first reaction following a
new momentum high or low. The only exception to this rule is after a market makes a buying
or selling climax. This is not a new momentum high or low, but an exhaustion point that
creates a vacuum in the opposite direction.

A trader can enter a trade “at the market” when new momentum highs or lows are made
following a breakout from a trading range. In an already established trend, a mild pullback or
consolidation will be more likely than new momentum highs or lows following a breakout.

Principle Three: Trends End in a Climax

A trend will continue until it reaches a “buying or selling climax.” This tends to be marked by
an increase in volatility and volume. Ideally, there should also be a marked increase in the
range.

A buying or selling climax indicates that the last buyer or seller has been satisfied. The market
then usually begins a process of backing and filling, testing and retracing, and in some cases,
has a greater reaction in the opposite direction.

Trends tend to go further than we think they will and often, the price “overshoots” on the
extremes. Price is at a new level and nobody has had a chance to get comfortable with the
new levels. The market will tend to begin a testing process in both directions until it reaches
a new equilibrium level.

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It is rare that a market immediately begins a sustained downtrend after it has been in an
uptrend. Thus, a trader should be prepared to trade in both directions for a while after a trend
has ended and not be too eager to set positions in the opposite direction. The process of
consolidating back to a new equilibrium point can be a long and drawn-out process.

There is a smaller percentage of times where a market makes a “V” spike reversal following a
buying or selling climax. This is the most powerful pattern in technical analysis as it creates a
vacuum on the other side. In these situations, the market sharply reverses its direction
without the normal consolidation period. This type of pattern does not happen very often but
has powerful forecasting implications when it does.

Principle Four: The Market Alternates between Range Expansion and Range Contraction!

Price action tends to alternate between two different states. The market is either in a trading
range environment trying to wind back down to an equilibrium level, or it is expanding in
range with impulse, indicating a persistent supply-demand imbalance.

This mark-up or mark-down phase persists until it reaches a new level. Once a new level is
reached; the testing process will begin all over again as the market winds back down to an
equilibrium level.

And, once again, when a market has narrowed in range and found an equilibrium level, it is
difficult to predict the direction of a breakout. On occasion, the market will move first in one
direction and then move sharply in the opposite direction.

Volume is a useful confirmation took that the range expansion is for real.