online trading
Online Stock Trading - Exploring Market Physics
A Master Swing Trader Explores Similarities Between Stock Market Price Action and The Classic Rules of Physics
By Alan Farley, author of "The Master Swing Trader"

The swing trader faces a considerable challenge mastering the puzzle of market movement. While most of us recognize conflict and resolution within the price chart, we fail to utilize these dependable mechanics in our trading strategies. Fortunately, repeating elements of the charting landscape offer a powerful context to understand and manage these vital aspects of trend development. Through repeating dynamics of crowd behavior, price action tends to mimic classic rules that modern scientists apply to our physical universe.

online stock trading - bullbear
Discover the Physics of Swing Trading

This is probably no accident of nature. Emotion and mathematics interact continuously while they draw the Fibonacci retracements that we see every day through our chart analysis. This fascinating relationship offers a glimpse into the profound order beneath common price movement. At its core, convergence-divergence between these two forces helps us to understand and trade the market swing. For example, we may search the chart for a reversal or breakout pattern that spells opportunity, but we also watch the ticker tape to gauge the crowd's emotional intensity, and to predict where it will burn out or shift gears.

Successful traders draw intuitively upon these bilateral market mechanics as they master the art of speculation. Their advanced skills correspond with the peculiar logic required to unify left and right brain functions into a focused trading methodology. Perhaps future technicians will quantify these profound interactions between herd behavior and physical law, and even open up a new branch of technical price prediction. In the meantime, let's explore some primary characteristics of these underlying market physics.

1. AN OBJECT IN MOTION TENDS TO REMAIN IN MOTION

New trends awaken within the low volatility of a rangebound market and are characterized by directional price momentum. During the early phases of new trends, volatility rises but inertia tends to slow down price rate of change. This often generates a series of tests or congestion mini-patterns while price tries to escape the influence of the old range. Eventually, momentum overcomes inertia and price movement takes on a more vertical appearance. This freedom of motion actually lowers volatility as friction eases and a one-sided market assumes control.

New trends can be very difficult to stop once they are underway. As with other objects in motion, trends feed on themselves because they draw in fresh energy (from cash and emotions on the sidelines). This induces price movement to travel well beyond arbitrary barriers, such as targets set by outside forces. But no trend can last forever or travel to infinity. Just like its physical counterpart, intervening market force will eventually stop or reverse directional price movement.

Simple friction slows down a rolling ball. Active trends experience friction in the form of market gravity. Classic trading wisdom notes that rallies take buyers, but that markets will "fall from their own weight" under the right circumstances. Unfortunately, the dynamics of this well-understood mechanism don't quite match those of Mother Earth. If they did, all markets would fall to zero as soon as buying and selling dried up. The fact that markets retain value suggests that each one has a hidden center of gravity that price development will reach if all participants step aside at the same time. This "central tendency" gently pulls market movement toward a hidden mean during quiet times, but can act with shocking intensity when price action generates strong imbalances during extreme market conditions.

The distance from the current price bar to this elusive value quantifies a level of market inefficiency at each point in time. It also defines most opportunity for the swing trader. Bollinger Bands present a common tool to measure tension on this hidden spring. But other indicators that rely upon deviation from the mean perform an adequate job as well. And don't overlook simple chart patterns. Certain formations can reveal major inefficiency through a simple set of price bars. For example, a Shooting Star candle after a strong rally signals an invisible wall to the observant speculator.

The Pull of Central Tendency

Combine candlestick patterns and Bollinger Band extremes to uncover hidden friction that will stop or reverse a strong market trend. Note how Immunex pierces the top band on July 19th, but closes back within its boundaries in a tall Shooting Star candle.

IMNX

2. FOR EVERY ACTION, THERE IS AN EQUAL AND OPPOSITE REACTION

Traders at all levels must deal with the wavelike motion on price charts. These define underlying cycles that strategies must align with, or risk failure. At their core, these waves reflect constant battles between bulls and bears, and the underlying trend-range axis. Price thrusts forward in a surge of participation but then pauses to test prior boundaries and dissipate volatility. Price bars contract, volume drops significantly, and the trend pulls against its primary direction. But just as that market returns to a stable state, the action-reaction cycle suddenly regenerates and volatility surges. Fresh momentum carries the reawakened trend toward a new price level, or reverses it back toward its origins.

But why aren't markets stuck between two horizontal extremes if trend and countertrend act with equal force, and are polar opposites? The answer lies in how active markets dissipate directional force. Every buyer must eventually sell and every short seller must eventually cover. This induces layers of cycles that equalize price action and reaction over time. Swing traders observe this dynamic process in the trend relativity of different length charts for the same trading instrument. In other words, a single market may print a strong rally on the daily chart, a bear market on the 60-minute chart, and sideways congestion on the 5-minute chart, all at the same time. While this phasing process may seem chaotic, it actually reflects the dissipation of underlying action-reaction polarity. This 3-D trend-range axis also carries an added benefit: its alignment generates many of the setups in the swing trader's playbook.

Locate these important opportunities in the convergence of specific action-reaction imbalances through several layers of price activity. This logical analysis also supports the contrary attitude that leads to successful swing trading. For example, while the crowd sees a buying opportunity when price surges on heavy participation, the swing trader sees selling power increasing in that market due to the entrance of a new crowd of buyers. Fortunes are made through this type of counterintuitive logic, generated by recognition of the underlying power in market physics.

Time Frame Divergence

Price action in 3 time frames generates different support-resistance considerations while Qualcomm tries to halt a sharp decline. The daily chart prints a hammer reversal near a 6-month low. The 60-minute chart shows a bearish pullback into an ugly down gap, while the 5-minute chart offers short-term traders excellent profits through a midday bounce near whole number 50.

QCOM

3. THE STAR THAT BURNS BRIGHTEST BURNS OUT FASTER THAN THE STAR THAT EMITS A COOLER, DARKER LIGHT

We measure the health of a rally or weakness of a selloff by the angle of its rise or fall. Common sense dictates that more vertical price bars reflect more powerful price moves. But how does the intensity of price change interact with the persistence of the trend itself? To answer this question, we can rely upon the characteristics of central tendency discussed earlier. If each market carries an underlying fair value at each point in time, a dynamic move should reach that price in less time (fewer bars) than a slow hike in the same direction. In other words, vertical trend bars should burn out and end their movement much sooner than slower trend bars.

Unfortunately these angles of inclination and declination are relative to the observer. Low price distorts movement on arithmetic charts. A spectrum of growth rates distorts movement on log charts. So before we can objectively measure how bright our market star burns, we need to adopt a common system of viewing price change. Unfortunately this is more difficult than it first appears. Diverse charting types and methods force us to apply measurements that are often dependent upon the software or service that we use. The most fruitful analysis adopts a common view across an entire database, so that visual comparison of trend intensity has a point of reference. Then we can use our eyes and simple standard deviation to examine the duration and stability of price change.

Apply this charting method to locate parabolas that are ripe for strong reversals. In the contrary view of the swing trader, vertical price movement is seen as a prelude to a reaction of the same intensity in the opposite direction. Just as a supernova signals the imminent demise of an aging star, the parabola informs the market that its trend fuel is about to run out, and likely cause a violent reaction. First set a fixed log chart percentage between 15% and 20%. Then scan the entire database for issues with the steepest angles of short-term price change. Isolate those markets with the tallest price bars and visible trends in excess of 45 degrees. Then reset the log scale to automatic for these filtered issues, so that recent price action fills the screen. Apply a standard Bollinger Band and look for bars that print well outside the upper or lower band. Find your fade entry level by dropping down to a lower time frame and locating a small-scale reversal pattern that aligns well with broader landscape features.

A trend that moves at a very shallow angle also predicts its own demise, but for different reasons. This reversal follows the mechanics of the rising or falling wedge patterns seen on many price charts. Both traders and investors want excitement in their lives. They buy or sell so they can watch price ramp to new levels. Shallow trends never fulfill this need for gratification. For example, participants watch price rise in an uptrend to a marginal new high over and over again, but never gather enough momentum to accelerate the rate of ascent. Shareholders eventually lose interest in this type of price action and jump ship in search of a more exciting trading vehicle. The market loses broad sponsorship and finally drops off a cliff.

Locating Blowoffs

Skilled eyes uncover the most dynamic parabolic trends and then execute fading strategies at natural reversal levels. Start with a fixed log chart setting, such as the 15% in figure A. Scan your database quickly and locate the most vertical price movement that you can find, up or down. Return to a more comfortable chart scale (figure B) and apply 3-D charting landscape techniques to identify low-risk entry.

EMC

4. ENERGY SOURCES LEAVE TELLTALE SIGNATURES IN THE FORM OF EXHAUST OR RADIATION

This classic principle of physics requires little translation for the financial markets. Real trading opportunities look like opportunities because they emit characteristics of impending directional price movement. This reveals itself in crowd participation, price action at known boundaries, the creation of recurring price patterns, and the convergence of technical indicators. Interpret these diverse market signatures correctly and book consistent profits as a swing trader.

Engineers build machinery to investigate exhaust emissions and measure their internal characteristics. For example, a hose attached to a vehicle's exhaust pipe tells the auto mechanic the current condition of the internal machinery. Swing traders build similar measurement tools to evaluate the state of internal market activity. But just as the engineer designs instruments to examine a very narrow range of physical information, swing traders must limit data intake to specific market characteristics and filter out many noise levels that can defeat profits.

Chart patterns with true predictive power emit evidence that these market engineers can detect and measure. The radiation of opportunity builds through convergence of diverse elements at narrow intersections of price and time. Each independent signal drawn into this small space raises the odds that a trade setup will produce a valid result. Heat builds strongly at these important levels and tells the swing trader to get on board quickly.

Reading the Charting Landscape

Highly predictive charts print well-organized patterns at expected price levels. AMCC starts with an Island Reversal (1) that ends a clear Elliott 5-Wave (2) rally. Price drops under the intermediate high at 48 and the 62% retracement (3) of the prior move. Weak congestion (4) forms under the retracement level. The bottom Bollinger Band (5) expands downward, opening the door to falling price. All signs points to an impending first failure event (6), in which price will retrace 100% or more of a prior trend leg. The swing trader measures this evidence, sells short into the congestion, and waits for the pattern to work out the expected result.

AMCC

CONCLUSION

Modern traders have great difficulty organizing market movement into a manageable feedback and execution system. Too often, they ignore important chart data because it doesn't fit into a convenient system of horizontal price boundaries. This obsession with simple-minded pattern recognition exposes a trader's inability to grasp the more powerful mechanics of price prediction. Unfortunately, concentrating on a narrow execution strategy is like trying to play music with a single note. It works only when a fleeting moment of opportunity demands a single, flat tone.

Expand your trading knowledge through the application of market physics. Each new aspect expands your ability to profit from subtle aspects of crowd behavior. Keep in mind that these natural forces rely upon mechanics that many speculators will overlook. This lets you gain an important edge on the path to successful trading. It might take a lifetime to explore these complex interactions between evolving price and the emotional crowd. But each piece of this fascinating puzzle adds new levels of empowerment to trading performance.

Comments: trader@hardrightedge.com
© 2001 Brooke Publishers, Inc.
Courtesy of Alan Farley, author of "The Master Swing Trader"
Visit his website at www.hardrightedge.com