Four Basic Principles of Market Behavior

05/17/2010 10:28 am EST

Focus: STRATEGIES

We have all seen so many lists of trading rules that we sort of become numb to them. Even if they contain good advice (“Always respect your stops”), they are so omnipresent in the trading literature and on Internet forums that we probably don’t pay as much attention to them as we should. I want to share a very different kind of list today. This is a list of what I believe are the basic principles of market behavior. This list is, in some sense, a list of what makes technical analysis work. We will encounter these ideas in future blogs and discussions, but today, I just want to put them out there for you to start thinking about them.

I also should acknowledge my debt to the people who taught me. Over the years I had several mentors, and I, frankly, owe them a lot. This list is compiled from the teaching of several of these people, and I know they borrowed these ideas from the people who came before them. This really is one of those fields where, if we can see a little farther than everyone else, it is only because we stand on the shoulders of giants. Or, another way I like to think of this is that I have many great ideas, but very few of them are actually my ideas!

Markets Alternate Between Range Expansion and Range Contraction

Markets tend to exist in one of two phases: Either trending or chopping back and forth in ranges. The problem is that trading tools that will work in one environment are exactly wrong in the other. Applying a strategy that is appropriate in a trading range (selling resistance or buying support) will get you killed in a trend. This is why the first step in any real market analysis is to quantify the most likely emerging volatility environment. (Read that last sentence over several times.)

Trend Continuation Is More Likely Than Trend Reversal

Countertrend trading can be seductive. We all love to catch the exact high or low of a move, and while it certainly is possible to make money this way, it is the hard money. Traders who focus on countertrend trading often get an emotional charge from “being right” and from “catching the turn,” but this approach often causes us to miss the really easy money in trends. Given a market in a trend, your best bet is always to bet on continuation of the trend.

Trends End in One of Two Ways: Climax or Rollover

There are predictable patterns to the ways trends end. Either the market just runs out of steam, resistance starts to hold, and the market rolls over. (This is the cause of the “rounding top” formation that some people are so fond of.) The other common way trends end is in a buying climax. The market goes parabolic as the last buyers are willing to pay practically any price to get in. Once that last buyer buys, a vacuum is created on the other side and the market collapses. As a funny aside, one of my very first trades was buying wheat futures in late April 1996 when I was sure they was going to the moon. (Check the charts if you don’t know that little piece of market history—we learn best from our painful mistakes!)

Momentum Precedes Price

This one is maybe the most important of the four. The basic unit of market movement is a move in one direction, a pause and smaller move in the opposite direction, and then another move in the original direction. This pattern repeats over and over in all time frames. This meaning of this rule is that when a market makes a sharp move (an “impulse” or “momentum” move), price is likely to continue further in the same direction. (Note that this does not mean that indicators that measure momentum lead price—there are truly no leading indicators because all standard indicators are derivatives of price.)

Think about these rules and how they apply to the patterns you see and the trades you make. Whether you are establishing positions to hold for many months or scalping a few cents off the order flow in the tape, if you’re making money, then you almost certainly are aligned with these principles. If you are not making money, then it might be helpful to rethink your strategies in light of these basic principles of price behavior.

By Adam Grimes, trader at SMB Capital and director of tactical investments at Waverly Advisors

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