How to Make Money While the Train is Refueling! (Part 1)
06/02/2008 12:00 am EST
Trends are like rivers and streams: They move fast and furious for a time, then hit a snag and slow down and meander for a bit and then finally, they take off again. Many traders are pretty good at identifying and trading a trending market. But most traders are not very good at identifying the market congestion that is the equivalent of a river or stream that is meandering. And even fewer traders are able to make money in these consolidation areas. Let me show you how I make money in a market that is 'taking a breather' after a vertical move.
Let's look at a chart of a beautiful down trend in the e-mini S&P futures:
Price fell in a near vertical fashion from 1421 to 1388 with few pullbacks to give you any high probability trade entries unless you managed to get short near the beginning of the move. The reality of the markets is that there are times when you miss that one easy, early entry and then you are forced to watch it make a large move in one direction-without you! Every trader experiences this and most traders find it near impossible to watch the 'train leave the station' without them; that generally means that they force an entry or chase the market and those types of entries are not quality entries. It's always better to wait for high probability trade entries that you have seen over and over and then enter the market. It's better to miss a trade entry, even one that might have led to catching a large trending move, than to chase the market when it is moving fast, because when you chase the market, you generally end up with an entry that has poor trade location and you generally get stopped out of the market, even though you are trading 'with the trend'.
So how do you make money if you missed 'getting on the train' when it first pulled away from the station? My mother taught me that 'trees don't grow to the sky' and if you think about it, even trains have to stop and refuel. Let's see what a refueling stop in a trending market might look like and how you can make money while the train is refueling.
Let's take a look at the same e-mini S&P Futures chart, further down the tracks:
The first sign that price is re-storing energy is a change in the market's behavior. In this case the market has been making lower lows and lower highs, without any interruptions. When price begins to slow down and makes a series of higher highs and higher lows, it's a sign the market's behavior has changed. Is it a sign that the major down trend is over? It might be. Or it might be that the trend has simply run out energy and needs to refuel before continuing on.
How can you tell if the trend has ended or if the market is just taking on new fuel? If you look at the chart above, I'll point out some of my favorite sign posts. Price had been a very strong down trend and it had no problem staying within the boundaries of the green steep down-sloping Median Line and its Parallels. Price began to 'drift' out of the green median line parallel to the right; that was my first sign that the trend was running out of energy. Then it made a higher high as it traded through the right green parallel. Finally, although it had traded out of the green down-sloping median line and its parallels, it began trading in an energy coil [or trading range]: It was unable to make a new significant high and it was unable to make a new significant low.
Note that I added a blue up-sloping median line and a set of parallels that does a good job catching the highs and lows of this consolidation phase or energy coil. The trend may or may not have ended-we don't know yet-but this new blue median line set clearly shows me the probable path of price; IF price continues to follow it, we are seeing a change in trend. If price changes character again and stops following the path suggested by this new up-sloping blue median line and its parallels, we may be seeing a return to the down trend.
Now note that I added the 38.2% geometric retracement drawn from the 1421 high to the 1388 low. Price has pulled back from the lows, but it hasn't tested the 38.2% geometric retracement. A market that cannot break above the 38.2% geometric retracement is a very weak market-so when I am watching a market restoring its energy, I always want to know where that 38.2% geometric retracement is at. If price breaks and holds above it, I have a strong sign that the down trend may have ended. But in this case, price hasn't broken above the 38.2% geometric retracement-in fact, it hasn't even tested that area yet. At this point, even though this market has stalled and is restoring energy, it is showing every sign that it is still very weak. Until it shows me signs of strength, I am looking for a high probability trade entry to enter a short position.
More in Part 2 tomorrow.