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Trade Patterns With The Trend

12/07/10 08:55:04 AM
by Billy Williams

Chart patterns are both a reflection of volatility and market psychology, which can offer easy entry points in the direction of the market.

Security:   SPX, KMX
Position:   Hold

Chart patterns form with regularity in the stock market and smart traders know how to both spot them and trade them intelligently within the context of the market, but opportunities exist within chart patterns that don't work out as first planned. To trade the market effectively, you can use chart patterns as entry points but, more important, you must enter them in the direction of the primary trend.

These points of contraction where the opportunities for ease of entry can be found if you have both the skill and will to trade it when it appears. Within these periods of price activity, chart patterns can form as volatility diminishes, providing you with the opportunity to trade in the direction of the dominant trend.

According to Larry Connors, author of How The Stock Market Really Works, volatility will revert to its mean so when it is at an extreme level, it will statistically "revert" back in the other direction. Volatility when low is likely to revert to its mean indicates that low volatility is followed by periods of high volatility, and vice versa. See Figure 1.

FIGURE 1: S&P 500. After pulling back in price, the SPX trades along the upper trendline before breaking higher on December 1, 2010, forming a bullish flag pattern at the same time.
Graphic provided by:
So when price is trading within a contracted range after experiencing a period of expansion where price surges in a given direction, then it is likely to revert to a level where its range narrows. These ranges can be unpredictable because the market is made of human beings prone to act irrationally; otherwise, the market would be predictable and trades could be made with 100% accuracy. Instead, behavioral study of the market shows something entirely different.

When the market is climbing, traders will be attracted to the market and look to take part in what appears to be easy money. This is the first phase of a runaway market where sophisticated players who have been on the sidelines begin to come in slowly at first, then move en masse, making the market move more and more noticeable.

Then, the unsophisticated players such as retired couples or young participants who have never experienced a bear market begin to enter the market on what appears to be a sure thing. This is the second phase of an irrational market where the uninitiated enter the market without ever considering that the market can just as easily wipe away everything they have invested. See Figure 2.

FIGURE 2: CARMAX. KMX led the larger market, forming a bullish flag pattern, then trading higher up through the trendline before breaking out to new highs.
Graphic provided by:
This lack of sophistication when dealing with stocks and the market as a whole is the staging ground for a runaway market where the net buyers far outweigh the sellers, taking the market to incalculable heights without a sound basis to do so.

For trend-followers in particular, this is a dream where by just following the trend, fortunes can be made, but the dream can soon become a nightmare when it soon becomes evident that fortunes are harder to make than previously imagined. It soon becomes evident that a reliable trading system is necessary. In this case, reliability is not a matter of being right on every trade, but a proven system that has been validated over a series of trades as a solid means to making money in a variety of market conditions. The amateurs who come into the market in search of easy money are ill-equipped to deal with the realities of the market.

As Warren Buffett once remarked, if you enter a poker game and within five minutes can't tell who the sucker is, then it's you.

When the market surges higher, inevitably, it will stall.

Trade trends, not opinions.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 12/07/10Rank: 4Comment: 
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