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If there were ever a tougher concept to assimilate than this little tidbit, I’d like to know what it would be. Common sense is a fine thing to possess, but it is of very little use when learning to trade ES Emini futures contracts. And here is the rub, the market does not always move in a logical manner.

You tell yourself, “But earnings are up, the market has to go up, too.”

Nope.

The market often moves in a manner that is contrary to common sense. Recently, the market has taken a particular liking to rising unemployment numbers. Of course, the traditional logic explains this phenomena by quoting the inverse relationship between unemployment and inflation. Common sense tells us that higher unemployment means less money to spend and lower earnings, and hence, lower stock prices. This has not been the case, though.

In some of my previous articles you may have heard me harp on the adage, “trade the market, not the economy or the news.” Since we are regularly inundated with all sorts of news this feat is easier said than done. My solution is simple, when I trade I do not listen to the radio, watch television or check any of the financial websites. I only trade the chart in front of me and draw my own conclusions from the information I glean from that particular chart.

It is difficult, at best, to “turn you brain off to the world” when you trade, but you must trade only what the market is actually doing. Time and time again the market has befuddled the experts by moving in a manner that is inexplicable. I have heard thousands of traders say they were in the perfect fundamental setup and the market had to do this or that, and it didn’t. Their conclusion is that the market isn’t a reflection of reality, which may or may not be true. But this is true, when trading with actual dollars all that matters is whether you trade is profitable or a loser.

No matter the reason, if you are on the losing side of the trade, “the market was right, and you were wrong.” If you don’t believe me, take a look at your account balance in this situation…it will have less money. What better proof is there?

So, you ask, “you are asking me to through common sense out the window?” And the answer is…kind of. Often times, the market moves in a very orderly and logical manner. Things that ought to happen occur right on cue. On the other hand, there are countless times the market misbehaves and moves in a direction that is contrary to common sense logic and you will have to learn to watch your indicators and price action to pick up on these illogical moves before they become a disaster. As I have said, it is easier said than done, yet it is one of the most important concepts to understanding trading.

The Market is always right.

A General Rule of Thumb is that a Market will persist in a Trend typically 3 to 5 Rotations.  After 3 to 5 Rotations the Pattern typically changes.  Take a look at the Daily Bar Chart of the E-Mini S&P 500 (Figure 1). From early July 2009 the market has been in an Up Trend continuously making New Highs (NH) and Higher Lows (ALs).  Notice this last New High put in on December 4, 2009.  This New High was put in with “Little Conviction.”  The previous New High was only taken out by just under 7 points.  The Market is working on it’s Sixth (6^th) rotation.  Unless the Market can take out the Highs at 1114.00 plus or minus with some type of “Move with Conviction” we are due for a Larger Retracement to somewhere around the 1025.00 area (Re-test of AL4 and AL3).

Figure 1.  Daily Bar Chart of the E-Mini S&P 500

The 30 Minute Chart of the E-Mini S&P 500 (Figure 2) is in a Sideways Trend and possibility in STAGE 3 of the Market Cycle (see my article posted on Dec 7, 2009 at http://blog.tradingconceptsinc.com/technical-analysis/the-market-cycle/) further indicating that the Market may pullback further than it has the last few days.  In any case, continue to trade the Intra-Day Trends per the Trading Concepts Methodology and be aware of the potential that the Market may be topping out here… and may require a larger pullback or retracement to continue with the current Daily Up Trend.

Figure 2.  30 Minute Chart of the E-Mini S&P 500

Economic Calendar

 No significant Economic News today!

 FYI…

Wednesday, December 16, 2009 at 2:15pm ET is the FOMC (Federal Open Market Committee) Rate Decision.  This is the primary tool the FOMC uses to communicate with investors about monetary policy.  It contains the outcome of their vote on interest rates and other policy measures, along with commentary about the economic conditions that influenced their votes.  Most importantly, it discusses the economic outlook and offers clues on the outcome of future votes.  It has a Very High Impact on the Market.  The Market typical becomes very volatile immediately following the announcement and may remain volatile for about 45 to 60 minutes.

High Probability Trading, in my opinion, is defined as those Trades that are Low Risk with a Very Good Chance of working out. In other words, making Trades with the Odds in your Favor.

For the most part, High Probability Trading is trading in the direction of the major Trend. There are numerous ways to define a Trend. For example, Moving Average crossovers, MACD, ADX/DMI, and other Indicators. One of the most simple ways to define a trend, yet often overlooked, is by using Price Action itself. The Market does not go straight up and/or straight down, it moves in a series of Waves, Higher Lows and Higher Highs or Lower Highs and Lower Lows. When a pattern of Higher Lows and Higher Highs or Lower Highs and Lower Lows changes, the Market may be providing a warning sign that a potential Trend Reversal is imminent.

A Technical Approach to define an Up Trend, Down Trend, and Sideways Trend by using Price Action itself is to apply the Market Cycle Model. The Market Cycle Model suggests that a Market has to be in one of four Market Stages.

The Four Stages of the Market Cycle, as illustrated in Figure 1, are a Basing Sideways Trend (Stage 1) with predominantly equal Lows and equal Highs, an Up Trend (Stage 2) with Higher Lows and Higher Highs, a Topping Sideways Trend (Stage 3) with predominantly equal Highs and equal Lows, and a Down Trend (Stage 4) with Lower Highs and Lower Lows.

Figure 1. The Four Stages of the Market Cycle.

Stage 1 (or Basing Sideways Trend) is where the Market is in a state of Equilibrium. During this stage, there will usually be several swings between Support at the bottom of the Sideways Trading Range and Resistance at the top of the Sideways Trading Range. This is the point where many Traders try to Enter LONG into the Market and catch the bottom price, however, it doesn’t do much good to initiate LONG positions yet until the beginning of Stage 2.

Stage 2 (or Up Trend) is where the Market is Advancing. This is the ideal time to initiate LONG positions, ideally on a Correction or when the Market pulls back to re-test the breakout from Stage 1. Initiating a LONG position here is a Low Risk, High Probability, and potentially High Return Trade. See Figure 2. This situation is Optimal for a LONG Entry as each successive High becomes Higher than the previous. The less the Market pulls back, the stronger the Market.

Stage 3 (or Topping Sideways Trend) is where the Market is in another state of Equilibrium. The Up Trend loses momentum and starts to Trend Sideways. During this stage, there will usually be several swings between Resistance at the top of the Sideways Trading Range and Support at the bottom of the Sideways Trading Range. This is the point where many Traders try to Enter SHORT into the Market and catch the top price, however, it doesn’t do much good to initiate SHORT positions yet until the beginning of Stage 4.

Stage 4 (or Down Trend) is where the Market is Declining. This is the ideal time to initiate SHORT positions, ideally on a Correction or when the Market rallies to re-test the breakout from Stage 3. Initiating a SHORT position here is a Low Risk, High Probability, and potentially High Return Trade. See Figure 2. This situation is Optimal for a SHORT Entry as each successive Low becomes Lower than the previous. The less the Market rallies, the weaker the Market.

Figure 2. Low Risk, High Probability, and potentially High Return Trade.

The key to successfully trading a Market is to:
(1) know how to Identify what Stage of the Market Cycle the Market is in,
(2) know what Direction you need to be Focusing your Trades on (determined by (1) above),
(3) know when a Favorable Opportunity presents itself to Enter the Market, and
(4) know how to Manage your Trades.

Figure 3.  A 15 Minute Chart of the E-Mini S&P500 Futures Contract (Oct through Nov 2008) clearly showing the Market Cycle.

In the Trading Concepts E-Mini Trading Course you will learn the Market Flow Analysis Method that will change the way you analyze charts altogether. This will help eliminate any confusion that you may have about the Markets and make your analysis more objective. Once you grasp this approach, trading the Market will become much easier for you… and more Profitable!