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can be placed. Having these factors in place prior to the actual trading session makes trading almost automatic. It is not necessary for the successful trader to question and rethink each strategy as it appears on the screen. Experienced traders, confident of their strategies, can simply place the proper orders with the expectation of a favorable result.
1. Technical indicators work as they do because so many people use them to predict repetitive human behavior that eventually determines prices.
2. Each stock issue or commodity contract exhibits its own personality traits with respect to its response to technical trading strategies.
3. The response of each issue or contract can be measured and quantified as a probability percentage.
4. Probability factors can be significant in increasing the confidence level of individual traders.
THE CONCEPT OF TREND EXHAUSTION
One thing is common to all markets-they go up and they go down. Before you snicker "Hey, no kidding!" stop and consider how useful it would be if one knew when a market was tired of moving higher and was about to turn and go lower for a while.
In many respects, markets are no different than people in their basic actions. After all, markets are created by people making buying and selling decisions. Markets, or people for that matter, rarely, if ever, move in the same direction for an extended period of time. After a bit they all become tired, or exhausted, of moving in the same direction so they turn and go the other way.
Think in terms of a basketball that is thrown into the air. Obviously, like a rising market, the ball cannot be expected to rise indefinitely. There will be a point at which the rise of both our basketball and our market will slow their respective ascents and begin to fall back in the other direction. When the turning point of the ascent nears, the upward momentum will begin to diminish and then cease altogether as the maximum point of the ascent is reached. At the time during this process when the market and the basketball begin to slow and therefore exhibit signs of exhaustion, the ball and the market are
still rising and the uptrend is still intact. However, both the rise of the ball and the trend are beginning, however imperceptibly, to show signs of exhaustion. The market and the ball have used most of their internal energy, and their trip higher is about to end. It is obvious to the casual observer that our basketball is slowing its ascent and will soon begin moving in the opposite direction. However, at this point the same casual observer would have a difficult time visually determining the approach of exhaustion in our rising market situation. The dynamics of our two hypothetical situations are obviously much different at this point.
Even though it may be difficult for the casual chart observer to note the market exhibiting signs of exhaustion, there are multiple methods by which trend exhaustion can be identified and measured.
Markets that are approaching these described exhausted conditions can also be referred to as being in an overbought or oversold condition. It is this overbought/oversold/exhaustion parameter that is measured by many of the popular oscillator-type indicators such as stochastic, RSI (Relative Strength Index), and Percent R, which are widely used by market traders. These tools are all designed specifically to identify market exhaustion and thus the short-term trend of the market. In Chapters 9, 11, and 12 a unique application of these popular tools will be described that will enable the trader to trade effectively in the direction of the major trend of the day.
The identification of the short-term trend of the market is arguably the most difficult task for the day trader. It is necessary to keep the long-term picture in mind, but it is also critical that the "noise," or random movement, of the market be filtered out of the decision process.
As mentioned, this is not a simple task. For this reason we use multiple approaches to pinpoint exhaustion. The key to using these indicators for this purpose is to use all three of these tools in combination with each other as the charts are forming.
THE APPLICATION OF THE EXHAUSTION THEORY TO DAY TRADING
As is the case with our utilization of oscillator-type indicators, I will be describing a use of a commonly observed market phenomenon-in
this case, exhaustion-in a manner that is a bit different than normally seen.
As with oscillator indicators, many traders attempt to use exhaustion principles as a tool to identify the top or bottom of a market. After the top is defined, they will attempt to establish a short position, preparing to profit from the decline they expect to materialize. Conversely, a long position is established when they are convinced that a progressing downtrend has become exhausted. If you are working in the environment of a sideways, directionless day, this strategy can be helpful. However, when attempting to apply this trading method to a trending market, be it either up or down, traders often find themselves once again swimming upstream against the major trend of the day.
Our four-step method of developing high-probability trades consists of:
1. Defining the major trend of the day.
2. Defining the minor trend within the dominant trend.
3. Defining the exact entry point for a highly accurate trade.
4. Defining a logical exit sequence.
It is in step number two of the process where the concept of trend exhaustion becomes a major player. After defining the dominant trend, we begin looking for corrections against the trend that we can use for entry in the direction of the major trend. We attempt to identify buying or selling windows on the charts by identifying the exhaustion phase of these corrective movements.
Logic tells us that when more than one method is used to identify the same situation, the likelihood is higher that a turning point has been identified. For this reason I recommend that you not rely solely upon a single exhaustion mode tool for the determination of the short-term trend. My research has shown that, the concurrent use of multiple indicators dramatically increases the accuracy of this critical determination. In Chapter 6, devoted to the use of multiple settings of oscillator indicators, I will describe the use of several combinations of stochastic, Percent R, and RSI that can be used to identify accurately exhaustion points of these important market corrections in later chapters.
THE CONCEPT OF TREND EXHAUSTION
1. Trend exhaustion is a common element of all markets, preceding the actual turn in market trends.
2. The identification of exhaustion is a vital concept that must be mastered.
3. Trend exhaustion information, as used by most traders, can lead to selling strong rallies and buying severe downtrends.
4. Later chapters will cover alternate methods of exhaustion identification that allow trading in the direction of the major trend of the day.
CONVENTIONAL USE OF ONLINE INDICATORS
Many trading systems and indicators have been fabricated over the years using some of the popular, readily available, traditional technical trading tools. There have been volumes published on a myriad of methods by which these basic indicators can be used in various trading strategies. Most of these theories revolve around the conventional use of these items. Later on we will detail a more nonconventional approach to the effective use of these indicators in conjunction with the Directional Day Filter and simple support and resistance calculations. First, to form a foundation on which we will build later, lets quickly examine the more traditional uses of stochastic, Percent R, and Relative Strength Index.
All of these indicators are part of a family of trading tools collectively referred to as oscillators. They have received this designation due to the fact that their formulas do not allow their values to rise above a certain number, usually 100, or fall below another number, usually zero. Since the plots of these equations move back and forth between these extremes, or oscillate, they are collectively known as oscillator indicators.
When the value of any oscillator-type indicator approaches the
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