Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
How to "See" the True Message of the Markets (Part 2)
02/03/2009 12:01 am EST
Many traders feel that Fib ratios offer clues about whether a move higher in an established downtrend, for instance, is a pullback in the downtrend, or whether the move higher is a change in trend to the upside. In particular, some traders view the 61.8% Fib ratio as the dividing line. If price has been in a downtrend and manages to rally past the 61.8% Fib ratio, it’s likely that the move higher is a new emerging uptrend, not a rally in an established downtrend. And you can see on the second chart in Part 1 of this article that this trader was pointing to price’s failure to test or break above the 61.8% Fib ratio before turning back lower as a likely sign that the recent up move was merely a countertrend rally.
The new student then added what he considered to be the most probable path of price. After doing his pre-trade analysis, he had decided price was about to resume the downtrend. With this view in hand, he would be looking for price to test the red, down-sloping upper Median Line parallel after a slight rally. Note that he expected the next rally, the one that might test the upper parallel, to be lower than the prior swing high.
When I work on pre-trade analysis with a trader in mentoring, I am examining the trader’s analysis and ability to “read,” or “see” the market structure clearly. In my mind, I am asking, “Can the trader “see” the market structure clearly? Has he considered both the downside and upside scenarios during his pre-trade analysis? Is he projecting a realistic probable path of price? Is he being objective or is he choosing his analysis to support his view on the market?” Often, the only way for me to determine if the analysis is objective is to start from scratch and do my own analysis, in front of the trader. Let’s see what steps I went through with this trader:
The first thing I generally do when analyzing a market is look closely at the market structure. I want to know the major swings, how they formed, and where the market is currently in terms of swing structure.
On the daily gold futures chart above, I removed the red Median Line and its parallels—and that makes it much easier for me to see and mark the major swing highs and lows. Note that I marked higher highs and higher lows in green, indicating price was in an uptrend. I marked lower highs and lower lows in red, indicating price was in a downtrend. And I marked congesting or contracting areas, where price was making higher lows and lower highs, in blue. This simple analysis gives me a feel for the length of swings for this particular market, shows me visually how price generally confirms trend changes in the market, and of course, it shows the current trend of the market.
All other analysis flows from this simple structure analysis. When I do my own pre-trade analysis on a given market, I may or may not have to draw in these swings—my eyes are well trained at this point, and it is easy for me to see market structure. But if it is a market I am not familiar with, or if the structure is not instantly visible to my eyes, I clear off any lines drawn on the chart and do this simple swing analysis—and the market structure instantly becomes recognizable.
More tomorrow in Part 3…
I wish you all good trading.
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