Fractal Energy Trading: Four Simple Rules to Profit In Any Market & Any Timeframe [Print Replica] Kindle Edition 9781079277944

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FRACTAL ENERGY TRADING Four Simple Rules to Profit in Any Market & Any Timeframe Authored by Doc Severson

Fractal Energy Trading: Four Simple Rules to Profit in Any Market & Any Timeframe Copyright ©2020 by Doc Severson. All Rights reserved, including the right to reproduce this book, or portions thereof, in any form. No part of this text may be reproduced, transmitted, downloaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any form or by any means, whether electronic or mechanical, without the express written permission of the author. The scanning, uploading, and distribution of this book via the Internet or any other means without the permission of the publisher is illegal and punishable by law. Please purchase only authorized electronic editions and do not participate in or encourage electronic piracy of copyrighted materials. The material in this book is for educational purposes only. Doc Severson and Hampshire & Holloway LLC or any other agents or employees are to be held harmless against any civil actions are we are not acting as brokers, advisers, or registered agents. Any material or contact with the firm or its agents is not to be construed as investment advice or solicitation for funds. Trading involves risk. Trading in stocks, options, commodities, cryptocurrencies, and other derivatives is risky and subjects you to risk of losses that can be potentially greater than your initial investment. The material written by Doc Severson is not a substitution for obtaining professional advice. None of the employees or agents are acting as agents, mental health care professionals, accountants, or lawyers. Doc Severson recommends that you obtain advice from professionals in their respective fields before making any trading decisions. Any past results mentioned are not indicative of future performance, and the material is for illustration and informational purposes only. To make all of the attorneys really happy, we should state that no one involved with the production of this book has a clue as to what is going on. Doc Severson, Hampshire & Holloway LLC, and everyone else involved with this project are raving lunatics and listening to us would be the least intelligent thing that one could do. That should just about cover everything. Cover stock image via Adobe: Image ID: 284049466 And ID: 295125777 Cover Design by: Zizi Iryaspraha S, www.pagatana.com ISBN-9781079277944

Dedication This book is dedicated to my father Allan for taking the ultimate risk as a young man so that the rest of us had the freedom to pursue opportunity. Liberty is a very powerful concept and one that he fought for with his life. This book is also dedicated to my mother Charmaine who understood at an early age that opportunity cost was defined by “staying put,” that not having the freedom to express one’s talents was akin to imprisonment, and that tea must only be brewed whilst boiling.

TABLE OF CONTENTS Section One: Getting Ready to Get Ready

1

Preface 3 How to Use This Book

Section Two: What is the Problem We Need to Solve?

5

7

Chapter One: The Retail Trader Struggle

9

Chapter Two: Why Does Price Move?

27

Chapter Three: Markets Mimic Nature

35

Section Three: Price Action and Trends

47

Chapter Four: Introduction to Price-Based Analysis

49

Chapter Five: The Tides of the Market

59

Chapter Six: Single Timeframe Price Trends

79

Chapter Seven: Fractals and Financial Markets

93

Chapter Eight: Trading Price Fractals in Five Steps

111

Chapter Nine: Fractal Price Action Setup Examples

121

Section Four: Market Energy

133

Chapter Ten: Introduction to Market Energy

135

Chapter Eleven: Market Energy and Trends

149

Chapter Twelve: Fractal Energy Trading

167

Section Five: The Four Major Rules of Fractal Energy

179

Chapter Thirteen: Building a Fractal Energy Trading System

181

Chapter Fourteen: Rule Number One

187

Chapter Fifteen: Rule Number Two

193

Chapter Sixteen: Rule Number Three

199

Chapter Seventeen: Rule Number Four

203

Chapter Eighteen: Using the Four Major Rules with Your Trading

209

Section Six: Fractal Energy Trading Applications

215

Chapter Nineteen: Directional Trading Applications

217

Chapter Twenty: Non-Directional Trading Applications

229

Chapter Twenty-One: Fractal Energy Trading Scans

239

Chapter Twenty-Two: Final Thoughts/Next Steps

245

Section Seven: Appendix

249

Appendix I: Trading Maxims

251

Appendix II: Indicator Code

253

Appendix III: Charting/Photo Credits

257

Appendix IV: Disclaimer

259

Appendix V: About the Author

260

Section One

Getting Ready to Get Ready

PREFACE W

ith a tip of the hat to Simon Sinek, I need to give you my “WHY?” for writing this book:

“Is the price going to go up or down from here on this stock/cryptocurrency/ asset?” I cannot count how many times I’ve heard this question. And to be fair, this is a question that I sought the answer to on everything that I traded when I began my retail trading career. Knowing what’s “supposed to happen in the future” carries a certain amount of comfort and certainty, yes? It implies that you’d enjoy better performance if you just “knew” what was about to happen. There’s a certain irrationality that comes with thinking that someone can predict the future. It’s often not until several years (and several thousand dollars of “lessons”) that one finally accepts the truth that anything can and often does happen on day +1…or in the next minute. No one can accurately predict the future, nor the forward/future pricing of any financial asset. That doesn’t stop the retail trader from seeking this answer; in the back of their mind, they feel that someone has the answer. And it usually starts with

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a pundit flipping a coin and picking a direction, accidentally getting the prediction correct, and then trumpeting on social media for all to hear that “they called the crash/rally/consolidation/whatever.” That sort of public chutzpah makes an impression on an inexperienced investor, and it might cost them a good part of their risk capital before they uncover the folly. Once a retail investor latches onto “their” guru, the confirmation bias kicks in which creates a polarizing filter that prevents any disparate information from hitting their consciousness other than the prediction that the guru has provided. That leaves at least a 50% probability that they will be wrong, triggering the usual cries of betrayal and outrage. We really make it so difficult on ourselves due to our human tendencies. In this book, therefore, I hope to show you a way to put those “tendencies” in your favor by giving you a logical and systematic method for analyzing any financial market and discovering the structure that lies within. This structure is there regardless of whether we’re looking at Stocks, Bonds, Futures, Cryptocurrencies, or anything else that offers price discovery through a public market. That’s my “why.” Let me show you how. Doc Severson Greenville, SC February 2020

.

4

How To Use This Book I

sometimes work in weird ways and it’s probably not a stretch to imagine that some of you do as well. For instance, the percentage of readers who actually finish reading a book that they start is somewhere between 28 to 50%. Unless it’s a real page-turner, a book on chart analysis techniques will rarely see the last pages read. Sometimes the very act of buying the book ticks that “to-do” checkbox from someone’s mental list and they never actually pick it up after that. I have done that, so if you’re actually reading this, congratulations! You’re in the top fifty percentile! Some of you might have strange reading habits, like me. I tend to pick up magazines and read them from back-to-front. Maybe this is an ingrained habit due to all the ads being front-loaded into magazines, or perhaps it’s an undiscovered deeper-seated issue that I’ll find out later. With these points in mind, this book does build from one chapter to the next in a linear fashion, with the latter chapters augmenting the early ones…but I have written this book in a manner which encourages you to pick it up and just start reading it wherever you open it. So go ahead, jump to the back and look at some of the trade examples.

Bounce forward and look at some of the energy analogies. Do what you have to do to convince yourself that this work is well worth your time, and then maybe start from the beginning again and commit yourself. Since repetition is the mother of skill, I hope you find this book worth reading a couple of times, and maybe using it as a reference down the road. We all suffer from that internal resistance to getting started on something that doesn’t offer immediate benefits, so enjoy the journey in any way that you can. If this book leaves you wanting more, I’ve included some references and additional resources in the Appendix at the end of this book. If you catch any typos or spot an egregious mistake, please bring it to my attention at: [email protected] Enjoy the journey

Section TWO

What is the Problem That We Need to Solve?

Chapter 1:

The Retail Trader’s Struggle

It all starts innocently enough. You’re new to investing, or perhaps you’ve been around this business for a while yet are not enjoying the performance that you desire. You attend some type of seminar or webinar, usually for free. An “instructor” leads you through an engaging presentation on how they made money through a few simple setups. Incredibly, they walk you through every detail of the setup. (How can they just give this away, you wonder?) It looks very simple. All of a sudden, your brain starts to explode with the possibilities, mentally adding up how many trades you’d have to make per day to hand in your two-week notice to your boss and quit your day job. As soon as the presenter finishes, usually with a “wait…there’s MORE!” conclusion, you can’t wait to plunk down your credit card for yet ANOTHER program. (Just one good trade will pay for this program!) Your spouse is skeptical, asking you “what’s different with THIS program, and what was wrong with the OLD one?”

Fractal Energy Trading

Now you not only do you have to battle with the markets, you also have to deal with the added pressure of proving yourself to friends and family, that this is not just some boondoggle. Here you are, holding another “trading education” book in your hands. What is wrong with us as humans that requires us to go through this seemingly endless cycle of education necessary to learn to trade the market consistently? Why can’t we learn one thing and be done with it, living on that beach like we imagined? There are many answers to that question…such as how markets move in a contrarian fashion to the “conventional wisdom” of the day, and how markets move in such a manner as to cause the greatest amount of pain to the largest population of position holders. Those are concepts that trading students must master at some point before they find themselves on the correct side of the tape. (We’ll talk about those concepts in a bit) The majority of the time, understanding “trading” is as simple as 1) making sure that we’re in “long” positions when the Market is moving higher, and 2) either trimming risk from our portfolio and/or taking “short” positions when the Market is going lower. And when I say “the Market,” I mean ANY financial market that is publicly traded and has adequate liquidity. It doesn’t matter whether that asset is a stock, a bond, a cryptocurrency, a precious metal futures contract, or a forex pair. At the core, that’s a pretty simple concept, and it sure seemed ridiculously simple to you when you signed up for that five-figure course fee at that seminar all those years ago. And yet, here you are, still searching. What is wrong with us? The usual reaction to under-performance (or negative performance) by retail traders is...more analysis. Technical indicators fascinate us because they look so predictive in the past. You can add just about any indicator from your charting program and look at previous charts, and it seems like they all work 10

The Retail Trader’s Struggle

out great...until YOU try it on the next signal. You figure that it’s the indicator’s problem, and you try another one...or perhaps ADD another indicator to your chart. Pretty soon, you’ve got a mess of tangled indicators on your workspace, and the price chart is occupying a very small piece of real estate in the upper right section of your chart: Figure 1.1

Figure 1.1

You’ve obscured the very thing that you want to focus on - (PRICE!) but no one told you that. Everyone’s been so focused on putting MORE tools into your hands in the hunt for the Holy Grail of chart analysis, that few of these students will stop to ask whether they should have added all of those indicators in the first place. Let’s talk about the elephant in the room, the study of Technical Analysis…

The Problem with Traditional Technical Analysis The main problem with most of the technical analysis indicators that have been taught for years - and are still being taught today - is that they are 11

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trailing indicators. Just about every indicator is derived from Price and Volume, which means that there have to be enough samples of Price and Volume before the indicator develops a signal, usually based on a sample of “n” bars where “n” is typically sampling the past 7-14 price bars. This means that your technical analysis signals are lagging behind the price, not leading it, and definitely not reflecting what is happening right now.

Using Indicators In Figure 1.2, we have a typical oscillator tool, or “Slow Stochastics.” This tool attempts to show when the chart is “oversold” vs. “overbought.” Figure 1.2

Values above 80 are “overbought,” and values below 20 are “oversold.” The typical timing signal is when the %K line (light grey) crosses over/under the %D line (darker grey). Sure, there are some good signals especially on the oversold side, but few pullbacks go deep enough to produce valid oversold signals. And on the overbought side, most of the signals above the “80” level are false, as the oscillator begins to “saturate” and produce irrelevant signals. 12

The Retail Trader’s Struggle

Frankly, this tool isn’t producing any usable signals in this market. The next approach that most people take is to slap more indicators on their chart. Let’s add a MACD Histogram tool onto the chart, as shown in Figure 1.3. Figure 1.3

We can watch for signals that cross up through the “zero line” from lower values as confirmation that we can take a long trade, or a cross down through that zero line from above for a short entry. This does improve our accuracy somewhat; however, we start to notice that the confirmed signals are WAY behind the actual turning points. We’re missing a good chunk of the move already, (all in the name of “confirmation”) and in some cases getting into the price “chop” that follows a big move off the bottom. We really don’t have any edge. This is where traders figure that “more equals more” and turn their charts into spaghetti by increasing the number of indicators on their chart, as we saw in Figure 1.1 above. The problem here is that we’ve turned ourselves into discretionary computers, trying to evaluate a nested “If-Then” statement about 13 levels deep (IF 13

Fractal Energy Trading

the Stochastics cross up AND IF the MACD turns positive AND IF the price is above the moving averages…etc.). Note how we’ve almost obscured the most important variable, which is PRICE.

Using Divergences Once the aspiring trader gets tired of going cross-eyed trying to interpret all of these different signals, then the first “black art” that they are then introduced to are Divergences. They are a little confusing at first, as you’re spotting a “lower high” in the indicator while watching the price make a “higher high,” or vice-versa for a downside move. After you spend enough time staring at charts, you’ll see them everywhere. In Figure 1.4, we can see some classic negative divergences as the price makes a “higher high” while the indicator shows a “lower high.” None other than Alexander Elder proclaimed the MACD Histogram divergence signal as “the strongest signal in technical analysis.”1 Figure 1.4

1 Trading For a Living, Alexander Elder, page 134. 14

The Retail Trader’s Struggle

How well did these signals do for us? Not really all that well, either. Sure, the divergence shows us that something is about to happen since the trend is losing momentum, but haven’t we seen this type of trend over and over again during the past few years? Divergence signals lose their predictive power when we try to use them against the major trend.

Character Changes The root issue here is that we’re seeing actual character changes in how markets operate and trend. When we’re seeing a trend, it goes on and on for much longer than we’d ever expect. You don’t have to take my word for it, a quick look at the S&P500 Monthly chart in Figure 1.5 will tell you everything that you need to know: Figure 1.5

Notice that as we got into the late 90’s, the character of the US Stock Market changed. And apart from some brief consolidations, we have seen historic magnitudes of volatility that are just swamping all of our oscillators and relegating much of what’s been taught about classical indicator-based Technical Analysis to the dust bin. 15

Fractal Energy Trading

For the most part, individual investors won’t give up on the old “tried and true” axioms of Wall Street, such as “the market returns 10%/year” or “Sell in May and Go Away.” Old habits die hard, and so do our techniques for analyzing the Market. Perhaps it’s time that we looked at the market from a different perspective, much like we talked about at the beginning of this chapter - as a living “thing.”

While I’m no psychology expert, I do find the study of human behavior and personal performance fascinating. While no two people are the same, I’m absolutely stunned by how similar everyone’s experience is when it comes to trading performance, and how many people have similar problems mastering this “trading” thing. I think it comes down to some very basic things:

We Come From the “Factory” Incorrectly Programmed to Trade I would maintain that literally NO ONE is born and bred to be a successful trader. We have to overcome ourselves and learn this skill, sometimes at great cost. Most give up rather than violate their basic “programming,“ and fewer still are able to grasp the root issue. Think about it; from the day that we are born, we hear statements like: • BE CAREFUL! DON’T HURT YOURSELF! • Don’t take risks! • You might get hurt doing that! • I just don’t want to see you suffer. And on and on. Look, our parents love us and don’t want to see any harm come to us. This is why they pushed you towards getting the “safe” degree that was employable, why they taught you to look both ways before crossing the street, to drive at the speed limit, to use your turn signals, and to check the 16

The Retail Trader’s Struggle

expiration date before eating that cheese. This is why the majority of people are risk-averse, favoring safe careers in safe occupations where the risk of ruin is very low, yet the opportunity for reward is low as well. I’m no different than anyone else, I followed the same path. And then…we get into trading and are asked to suddenly violate EVERY principle that we’ve learned through our entire life to that point! We get turned on to the idea of unlimited rewards…but no, we don’t want to RISK anything to get there! (Impossible!) After playing it safe with your life for the past 20…30…40…maybe even 70 years, all of a sudden you want to be paid for TAKING ON risk? This is where your accumulated genetic programming and life experience will come together to make things really tough for you. I get this question all the time, “Doc, what’s the safest strategy out there that will allow me to safely accumulate profits every month?” The answer? CERTIFICATES OF DEPOSIT. MONEY MARKET ACCOUNTS paying a fixed interest rate not much above 0%. You see, you cannot earn rewards without taking on risk. You’ve been taught your entire life that RISK IS A BAD THING and only NOW do you hope to entertain it as a friend? Let’s say it again: You cannot seek reward without taking on risk. If there is little risk with a trade, then there is likely little reward. This is what financial markets do so well, they are incredibly efficient at matching the reward with the risk taken. The usual way that we try to “transition” into this strange world of taking on risk is to wait until everything “feels” perfect with a trade. I mean, EVERYTHING is lined up! Everyone on Twitter is on board with the idea, all of the technical studies line up, news is good, all of the talking heads on TV are fully on-board…everything that you could want. You are so confident that you double down on the trade. 17

Fractal Energy Trading

You are shocked and betrayed when the price goes in the opposite direction. In fact, it almost appears as if the market is “out to get you.” Almost like it waited for you to enter before moving. After a while this becomes commonplace with your trades, so you say to your friends, “If I go long, that’s a signal to go short!” The usual response to this is to assume that your analysis of the markets is faulty, meaning that you need to add “just one more study” to the chart. However, the actual root cause is something quite different. You’re not trading to win; you’re trading not to lose. You know where this is going. If you’re reading this, it’s highly likely that you’re already on this path and trying desperately to get out of this rut. Usually our first step is to turn to the analysis of others, with our thinking being “the more, the better!”

Humans are Pack Animals Unless you’re an avowed loner, then the majority of us feel better when we’re in the safety of a crowd. For me, there’s no better feeling than sitting with 100,000 of my closest friends, watching College Football and yelling at every play as if the referees could actually hear me. Others find belonging and sanctuary in bars, dance halls, raves, churches, or any other of the countless ways humans get together. Many people say that the strongest correlation to happiness appears to be “belonging,” whether it’s a significant other, an alliance, or a group. It’s only natural for a struggling trader to seek out inclusion and “safety” through a community. Most of these trading communities are online today; one confirmation email later, and you’ve instantly got hundreds of friends! Next thing you know, you’ve got welcome messages in your inbox and all kinds of folks with cool avatars saying “Hi N00b!” 18

The Retail Trader’s Struggle

It feels great, I get it. Everyone likes to be part of something bigger than themselves, it’s in our DNA. But this can also be one of the most dangerous things that we can do to our trading capital.

The Lure of Confirmation Bias See if this sounds familiar: you join a group, spend some time “learning the ropes” there, perhaps post a couple of times, and in general keep your head below the radar since you’re a “newbie” - even your avatar says as much with a post count of “2.” There’s a certain decorum that’s expected of new members in forums, subreddits, Facebook groups, or any other online gathering. (These “Rules of Order” have been in place since the early bulletin board services of the 1970’s!) Then one of the “Alpha Dogs” posts, and everyone pays attention. These individuals convey the weight and purpose of experience, so everyone drops what they’re doing to monitor their contributions. And it’s usually a market opinion, such as “XYZ will rise from here!” which is exactly what the rabble wants to hear. It feels good to hear someone else with experience submit an opinion or prediction as to what will happen in the future, especially if this information “aligns” with our Subconscious Mind’s “belief system.” It’s like your mind is saying, “oh yeah, I can TOTALLY buy into that concept!” And this is where the Reticular Activating System (RAS) of your brain kicks in. It serves as the “filter” to the outside world for your Subconscious Mind. Since you are so receptive to the Guru’s opinion, your RAS will filter out EVERYTHING else but those ideas posed by said Guru. In this manner, we “see” what we want to see, and “hear” what we want to hear. This is “Confirmation Bias.” This is why two people involved in a car accident will invariably have different stories; they saw what they WANTED to see. It’s also why you can have a conversation with someone, and they COMPLETELY miss what you said; 19

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they heard what they wanted (or expected) to hear. Back to the Market and our Guru’s opinion; you’re now committed to their opinion as you’ve totally bought into their point of view. Your RAS will not allow you to see nor perceive of any other market opinion than theirs. This is precisely what happens to so many traders when the price moves OPPOSITE to what they “felt” would happen, they invariably become like deer in the headlights of life, paralyzed and unsure what to do. They had only accounted for the ONE opinion of “the Guru.” How does that poor newbie trader feel now? Confused and feeling betrayed by the Guru, who now posts “I changed my mind last night and posted that reasoning in the private advisory section. Join our Inner Circle today.” What is the usual course of action that the newbie trader takes at this point? Rather than correctly identifying the root issue - Confirmation Bias leading to myopia - they conclude that the error was following the wrong guy, so the solution must be to find a different guru to follow. Latching onto a guru and creating errors in analysis through Confirmation Bias is a very real issue that many retail traders struggle with, until they learn to independently analyze the markets. Another issue that makes this difficult is the “Herd Effect.”

The Herd Effect I mentioned earlier that humans are “Pack Animals.” Not only are we susceptible to latching onto a Guru and getting Confirmation Bias, but we can also fall under the sway of The Herd. This is really a much more recent phenomenon since the advent of Social Media, where we can quickly and easily see what the “majority opinion” is just by logging into any of the popular social platforms. Unfortunately, if you put any weight into what you read via social media then you’ll automatically become part of what is called the “Investing Herd.” 20

The Retail Trader’s Struggle

Being part of The Herd is a notoriously dangerous place to be, because it’s a given that Retail investors will “chase” market tops and “puke out” during market sell-offs/bottoms. It’s been happening since before the Tulip craze of 1634, and it’s still happening today. Trading with The Herd feels like the safest place to be due to our social nature, but ultimately it ALWAYS ends up being the most dangerous place to live if you’re a Retail Investor. Accepting the advice to “ignore social media” is easier said than done in today’s world, where we implicitly TRUST social reviews about products on Amazon, Uber driver ratings, or restaurant ratings on Yelp. Many of you have literally grown up trusting social reviews as a way of life. While there is always a certain amount of manipulation of these reviews, or “gaming the system,” overall, they are very valuable if your goal is to save time and hassle with a purchase. Buying a dog bowl is a lot different from seeking investment advice on Twitter or TikTok, however. Sooner or later, after being burned enough times, Retail investors will eventually learn to avoid the advice of those that wallow in the gutters of social media…but the majority are still not ready to fully “let go” and become independent thinkers. Still seeking guidance, their next stop is to look to the pundits of the Financial Press.

You Can’t Trust the Financial Press The first thing that I did when I quit my job to “trade for a living” was to set up a monitor so that I could watch “stock TV” during the day. I felt that this would give me an edge over all of those poor saps who were still working on salary and would give me several hours of head-start on an entry. I won’t bore you with the details, let’s just say that that didn’t meet my expectations, and actually had a detrimental effect. I had to learn just how “efficient” markets truly were, with all expectations already priced in long ago.

21

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There are some major issues with the financial press as it exists today: • Misinformation - the financial press is desperate for new information and will give anyone a “free pass” if they agree to contribute content to their platform. This can be very dangerous if larger players “talk their book” with a secondary agenda. They can stimulate Retail into buying if their comments are particularly bullish, where their secondary (and disguised) agenda is to distribute inventory (sell) to the very listeners that they’re whipping into a bullish frenzy. • Clickbait - because financial news is a commodity these days, the only way that most financial news organizations can create revenue is by selling ad space. And a “clickbait” title is necessary to get people to view the page. There’s really very little of value to these articles; do we really put any weight into the forecasts of “experts” like the clickbait headline below? Figure 1.6

Yet the Retail Herd will inhale articles like this, inheriting a raging case of Confirmation Bias, and then wonder why their performance is poor. Newer investors LOVE IT when a pundit makes a loud, click-bait forecast that aligns 22

The Retail Trader’s Struggle

with their own bias. How can you expect to create exceptional returns vs. the rest of the market if you are trading with the rest of the market? You can’t. With all of these potential land mines outlined, let’s see what we have to do to stand out from the crowd…

What Retail Traders Have to Change You might get to this part of the chapter and agree with everything that I’m saying, and suddenly it dawns on you what a tall task that I’m outlining for you. We’re all human, we all come to the party with roughly the same human traits, but here I am saying “don’t do that!” In a nutshell, you have to STOP acting like everyone else and START thinking and acting like a professional if you want to stop funding others’ accounts. Giving you the structure to accept this, is what the rest of this book is about. Here’s a quick summary of what we have to change about how we handle things in a live financial market: • Risk: Your results will not change for you until you become good friends with your former adversary, “risk.” You need to harness “risk” and seek it out when others shy from it. That’s not to say that you’re suddenly going to start free-climbing Yosemite like Alex Honnold, but that you must start looking at financial risk as a “tool” and not something to avoid. Without risk there is no reward. Look, gasoline/petrol is an extremely flammable and explosive substance but harnessed in the proper manner can provide massive utility and joy. • Stop Lagging: While I think it’s possible to be successful with any of the innumerable technical analysis “systems,” I have found it to be infinitely more beneficial to understand WHAT THE PRICE IS 23

Fractal Energy Trading

ACTUALLY DOING vs. trying to trade based on lagging “signals.” Traders get very religious and protective of their technical signals, (especially if they paid someone else for them). In my mind these signals are subordinate to what the actual PRICE is doing. Technically derived signals will always be “lagging” versus actual price. Imagine listening to a speech at the United Nations; everyone has headphones on, listening to an interpreter trying to real-time translate the speaker. No matter how good they are, they will always be a sentence behind and might miss a word or two along the way. Now, compare this to listening to the speaker and understanding their native language. You will be a step ahead and be able to detect and interpret all of the second-order nuances that give expression and more meaning to a speech, such as pauses, inflections, and other forms of emphasis. You will get MUCH more meaning out of the speech if you understand the native language. I believe the same thing about learning to read what the PRICE is trying to tell you. Analyzing based on Price will always “adapt” to the character of the current market, vs so many “one and done” systems that fail when market character changes. • Simplify: In practice, most professional traders use very crude pricebased systems, and very few use complicated technical systems employing several indicators. The choice is always yours. Imagine that you are a sculptor with a big lump of clay; your job is to remove everything that does not belong. • Be Independent: Using a community to accelerate your learning and exposure to techniques and tools is a great idea…but using a community as a source of OPINION is a very dangerous thing. The most successful investors/traders are always looking in places where others are not, and are willing to back their own ideas, usually going AGAINST the crowd. Before we get into creating a system that is based on PRICE, it will be helpful to understand what makes price move in the first place. 24

The Retail Trader’s Struggle

Chapter Summary • Most Retail traders are influenced from the same sources which is why the majority create the same results. • There is a natural progression that most Retail traders go through, which appears to be logical at the time, but usually does not improve their results. • We are not properly taught how to process “risk” in a financial market; we usually process it by reacting to “fear” and making the same irrational mistakes as others. • Cognitive biases are a huge source of error for most Retail traders. And these biases come from the same sources, such as Social Media, the Financial Press, etc. • The same natural instincts that help protect us in “daily life” are massively detrimental when it comes to trading financial markets. • In order to gain edge in the financial markets, we have to learn to think differently than just about any other profession.

25

Chapter 2:

Why Does Price Move? Why does price move in financial markets? Look at the chart below; why does the price first move up, then violently down, then sideways, then back up again? - And then the pattern repeats! Figure 2.1

Fractal Energy Trading

I know that some of you will puff out your chest and proclaim, “Why, SUPPLY AND DEMAND is what moves markets!” Yes, with a tip of the hat to Adam Smith, supply and demand does move price OVER TIME. Although most of the moves that we’ll concern ourselves with, particularly the “violent ones,” occur because of the irrationality and emotion of the humans that participate in that market. Before we start to analyze the movement of financial markets in this book, it’s helpful to understand that they react like any other living organism; financial markets are ALIVE and as a result they exhibit behaviors that can be predictable or completely irrational at any point in time.

Linear Logic vs. Irrationality We humans like to think of ourselves as pragmatic, logical thinkers. It’s a prized skill in the business world to be a calculating, unemotional business manager who makes difficult decisions in the heat of the moment, displaying an ice-cold demeanor while always making the right decision. Some examples of this are: • The football quarterback waiting in the “pocket” until the very last second to hurl a 50-yard bomb to his open receiver down the field, knowing that he’s about to get trucked by the defensive end. • The sales professional presenting his product to a hostile crowd, coolly ducking the volleys and deflecting the “trap” questions back to his audience until one by one, they have been converted. • The operations manager calmly surveying the facts in front of them during a full-scale service outage, encouraging root-cause analysis to find the culprit and restore the service again. In fact, most of these problem cases in the business world reward the ability to survey the problem in front of you, pull out your skills of applying linear logic and analysis towards a problem, and slay the dragon. In fact, most of us get 28

Why Does Price Move?

so good at this after a decade or two of experience that we think we can apply this same level of logical analysis to financial markets as well. Quite frankly, this is where so many retail traders get their asses kicked. We try to bring these same skills of linear analysis from our successful careers to the world of financial markets, and suddenly find that none of it matters! The market essentially thumbs its collective nose at us and laughs at our logical attempts to rationalize the behavior. Need some examples? See if these sound familiar: • Your analysis tells you to buy; you just bought the short-term highs and are forced into a stop-out. • A nasty geopolitical event unfolds; bad news is everywhere. As soon as the markets open, you open up short positions. The market goes lower for a few minutes after the opening bell, then finishes the day much higher. All of your positions are seriously underwater. • Your fundamental analysis tells you that this asset is undervalued and is a good “buy.” As soon as you buy it, it descends into a dreary, longterm downtrend. • Good news comes out on an asset and the potential appears limitless; as soon as you buy it, it drops in price violently. I could go on, but you probably get it and are reminded of similar failures. Why does the Market seemingly have it “in for you?” Why are markets so damned vindictive? Why does your application of logical analysis appear to be SO USELESS? It’s because humans in the context of a crowd are incredibly irrational. And financial price charts display a to-the-minute response of crowd behavior.

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Crowds and Irrational Behavior We all want to belong to something bigger than ourselves. And this impulse to “belong” can have positive and negative consequences. While humans alone are somewhat irrational, blending them together in a group can create a monster. Think about how a “mob” gets started. A bunch of individuals collect in a confined space, each mildly interested in what’s happening. Then a catalyst appears, usually someone willing to be the lightning rod for the collective. And that individual’s actions become attractive to more and more people, until a “tipping point” is hit when people become desperate to be included, when it becomes emotionally painful to be left out. (All those instances of NOT being picked in the schoolyard come back to haunt them!) At this point, a loose collection of people become a mob. Occasionally, it can be a thing of wonder when a “flash-mob” begins to sing or dance or do something fun. Unfortunately, more often than not it becomes an instrument to express ones’ dissatisfaction with an earlier “pain point” in their life. Got beat up by a bully in 6th grade? Join the mob and smash some windows! I could point out some “mob” examples of how things go from a loose collection of people to an angry, electrified, dangerous group...but we’ve all seen enough examples of this lately. How does this relate to financial markets? Think of the price discovery of any chart as a “mob.” Some decades ago, this was true with many trading pits in Chicago and New York, as well as in other global markets. Pit traders would literally punch and kick each other while trying to get that bid or offer. Now the mob is almost universally electronic, and the medium of price discovery is usually a price chart on your screen. What really drives a crowd? I would contend that it’s the “fear of being left out.” We all want to be part of something larger than ourselves…and it’s a very deep fear, for most, of being left out of something big happening. And as we’ll see, this “fear” can have negative and positive triggers. 30

Why Does Price Move?

How Fear Drives Market Pricing Most of the time you hear that “Fear and Greed” rule markets and thus the pricing of them. I think that’s about half-right. I think that it’s mostly FEAR that rules markets, balanced with the absence of fear which is more accurately classified “complacency.” Let’s throw out a maxim about price movement, which I want you to remember: Price moves because someone’s in pain. Yep, price moves because someone’s getting spanked. Perhaps it’s the bears who are holding a net short position, and a positive catalyst just came into the market; they fear being run over thus are punching out as fast as they can by buying back their net short positions, further adding to the demand as the “short squeeze” plays out. If you’ve ever been on the wrong side of price movement in a fast-moving market, and you’re watching your position value erode by the second, you’ll recognize that feeling of abject panic. Notice how this exact scenario is playing out for the Bears in this chart: Figure 2.2

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In the midst of a downtrend, there was a consolidation of about a month in duration between late September and early October; normally these patterns break in the direction of the former trend, which in this case was a downtrend. Bears were enjoying the new downtrend break from this pattern and had gotten complacent, when a new catalyst hit the market which caused the massive bullish candlesticks that broke to new pivot highs. This is a great example of how FEAR moves the price; the bears were getting thoroughly spanked by the large bullish price movement and being forced to cover their net short positions in haste. At the same time, Bulls were sensing a new opportunity to go long so the FEAR OF MISSING OUT (FOMO) started to strike the other side of the ledger. “Here it goes, this might be the start of the new trend and I don’t want to be left behind!” FEAR rules the movement of price in financial markets. FEAR causes individual traders to mash the “Market Exit” button on their broker’s interface, not knowing that thousands of other individual traders were taking the exact same action at the same time, creating a huge vacuum in the order book and FORCING the price to move violently. The first time anyone learns about Economics 101 and the Laws of Supply and Demand, they are taught: “Price rises because demand is greater than supply for that asset.” And while there is truth to that statement in the larger sense, especially over an extended period of time, the REAL price movement occurs due to the collective emotional characteristics of individual traders and firms. It all goes back to that childhood fear of not being picked in a playground game. Markets move because someone’s in pain. As we progress through this book, we’ll examine WHO is most likely to create movement by putting themselves in position to get hurt. It’s a fascinating and rewarding process to finally give up this sense of linear logic - thinking 32

Why Does Price Move?

that 1+1 = 2 in the financial markets - and to depend instead on analyzing the tendencies and vulnerabilities of the collective “herd” of millions of traders. In this chapter we showed why price moves - mostly due to fear and pain. Perhaps you could feel those emotions kick in again as I brought up the examples. If you haven’t felt them, you haven’t traded. Now I’m going to kick things up a notch and go into straight anthropomorphism. In the next chapter I’m going to make the case that financial markets are really just “organisms” in the way that they move and behave. Markets mimic nature.

Chapter Summary • Price moves in financial markets because a large collection of the participants are in pain, and are operating out of fear. • The logical skills that were so valuable to us in our “day job” will absolutely work against us while trading financial markets. • Fear is the main emotion that drives markets, through “Fear of Missing Out” and “Fear of Loss.” • Crowd behavior is irrational and almost never correct.

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Chapter 3:

Markets Mimic Nature

I

n the last chapter we saw that markets move because of the raw emotion of fear, and ultimately through the pain that’s caused by being on the wrong side of price action. Let me ask you a question - have you seen any technical studies that are called the “pain study” or the “fear oscillator?” Last time I looked; I didn’t see them in the list of studies on any of my charting platforms. Question: If price moves in financial markets due to fear/pain, why aren’t we trying to measure it with a technical study/indicator? Quite honestly, because it’s too subjective and too difficult to accurately measure across the span of market participants. Recent attempts have been made to measure this “fear sentiment” by aggregating social media data. The jury’s still out on these techniques. Artificial Intelligence still has a difficult time weeding out things like sarcasm.

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What am I asking for, another technical study or indicator? Every charting program available today has literally dozens of different indicators that we can apply to our charts - aren’t those good enough? Well, I’m not going to disparage the last hundred years of Technical Analysis, but it’s obvious that methods seem to come and go over the years. An analysis method that might be hot one year...seems to completely fail us the next year as the character of the market changes. Just looking at the monthly charts of the major stock indices over the last couple of decades should convince us that character of the market has certainly changed from what we saw prior to the late 20th century. Figure 3.1

The point is that “outsmarting the market” by adapting a new study or indicator rarely works for long, because markets change their stripes.

For as long as Mankind has existed on this planet, we have been trying to “figure it out” on our own. Yet if you go back over some of the most significant innovations of the past few centuries, you’ll notice that when inventors took the time to learn from and copy nature, they found dramatic efficiencies and shortcuts in development time. Let’s look at a couple: 36

Markets Mimic Nature

The Winglet I think that it’s a huge understatement to say that we’ve seen dramatic advances in aviation technology over the past century. One hundred years ago, Man was lumbering over Europe in canvas and wooden biplanes...and fifty years later, we were flying three times faster than the speed of sound. Yet, even after all of that immense advancement, we still had problems to solve. Aircraft wings were very inefficient; yes, they provided great lift, but much of the efficiency of the wing was spoiled by a vortex of air that would “spill” over the end of the wing, wasting all that potential lift. How could we fix that problem? Engineers worked at it for decades before one of them noticed a bird in flight: Birds had been using these “winglets” at the end of their wings since they began to fly...notice how the wingtips curl up. These winglets made their wings more efficient and allowed them to stay aloft with very little expended energy. Figure 3.2

Once engineers applied this concept to airplanes, dramatic increases in efficiency were seen, and today you can see these winglets on most aircraft that require efficiency over performance:

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Fractal Energy Trading Figure 3.3

The point of this story, and really the point of this chapter, is that if we just stop to look at what is already occurring with nature....and in our case, the financial markets....then we can see elements of nature at work in everything that we do. If you study markets long enough, you’ll realize that they are just a very large organism with billions of individual cells (traders) that tend to move collectively, as a herd does, for the reasons that we talked about in Chapter Two. So my intent with this book is to show how we can bring our intuitive sense of how Nature and Humanity operates....and bring this knowledge to bear on how we can interact with markets. And maybe a methodology that is more closely aligned with the cells that comprise this organism...will be a more effective tool for us. Before we get to that, however, I think we have to first take a step back and continue on this path of seeing how we’re doing it wrong...first we have to identify and agree on what’s broken before we can fix it.

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Markets Mimic Nature

The Market as a Living Organism When we think about markets, we mostly think of them as numbers or prices or a chart. We attach an identity to a stock symbol, and a mention of “Apple” brings to mind the shape of the chart more than the company behind it. If you’re in this game long enough, you’ll speak in code to friends by using the company ticker symbols, such as “Hey, let’s meet at SBUX if PNRA is too crowded.” What we lose sight of is that markets are made for stocks or commodities or cryptocurrencies…and even individual options....by people like you and me.....and traders in an open outcry pit....and institutional traders in an office.... and traders overseas as markets open and follow the sun. It’s not just a price chart; the chart is just a reflection of the collective influence of all of these humans, their collective emotions, and ultimately their decisions. So you can really think of the market for a particular asset…as a living, breathing organism that has emotions and is comprised of millions (maybe even billions) of individual cells. Recall my story about the winglets on a jet aircraft. It wasn’t until we studied nature a little more did we put together how birds automatically employ “winglets” to prevent the loss of lift at the end of their wings. Maybe we’ve been looking at markets from too much of a “mechanical” perspective; we’re trying to get the movement of the chart to fit into our ideas of how it should move. Why don’t we take the opposite approach, and treat it as a living organism, and see what we can learn from the chart so that we can better understand it? And no, I’m not suggesting that we all become botanists. To understand how markets move like Organisms, we’ll first have to understand how Markets “move” in the next section. Following that we’ll cover how Markets “rest” and then “tire” in another section. My hope is that like how those Aeronautical Engineers figured out how to use nature to improve a wing’s efficiency, we can also use facts that you already know in order to become a more effective, profitable trader. Now it’s time to get into Fractals! 39

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Nature Is Fractal What is this “Fractal” term that I’ve brought up and included in the title? Well, let’s get that out of the way right from the top. A quick search of the term gives us this result: “A fractal is a natural phenomenon or a mathematical set that exhibits a repeating pattern that displays at every scale. If the replication is exactly the same at every scale, it is called a self-similar pattern. Fractals can also be nearly the same at different levels……..Fractals also includes the idea of a detailed pattern that repeats itself…….The feature of “self-similarity,” for instance, is easily understood by analogy to zooming in with a lens or other device that zooms in on digital images to uncover finer, previously invisible, new structure. If this is done on fractals, however, no new detail appears; nothing changes and the same pattern repeats over and over, or for some fractals, nearly the same pattern reappears over and over.”1 I really didn’t gravitate towards theory in school, instead preferring the applied world…so let me “apply” this mathematical verbiage to a couple of principles that we’ll be using for the rest of this book: • Larger things are created from smaller, identical things. • Change to these larger things starts with the smaller things first. These are two principles that most of us can immediately recognize from our daily travels and experiences. Let’s dive into these for a moment, because I want you to understand how much you already know about these concepts… Then I’ll show how this whole “Fractal” concept applies to Financial Markets. Once we accomplish that, then we’ll show some concepts for how to make money with Fractals. But first, a little background on Fractals:

1

https://www.fortinet.com/blog/industry-trends/fractalizing-security.html

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Markets Mimic Nature

Larger Things are Made Up from a Collection of Identical Smaller Things Let’s start off with an illustration of the Sierpinski Triangle; note how the larger overall triangle is composed of an almost endless series of progressively smaller triangles: Figure 3.4

This concept of “self-similarity” can be seen in this illustration of a triangle; if you blur your focus of this diagram, you’ll just see a larger triangle. Zoom in, and you’ll start to see an almost infinite series of triangles, which replicate themselves in the fractal nature to build the “larger” triangle. Now let’s look at a picture of some Romanesco broccoli:

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Fractal Energy Trading Figure 3.5

Notice how one of the “major” cones is comprised of dozens of the smaller cones, and each of the smaller cones has its own set of “child” cones. It’s a fascinating image that shows that “larger things” are built from a collection of identical “smaller things.” The further we zoom in, the more the pattern replicates. Even you and I, when looked at from a distance with the human eye, appear as a human body. If we zoom in, we’ll see that we’re a collection of cells, mostly identical cells in groups. Zooming in further would show the molecular structure based on the function of that cell. What I’d like to encourage you to do, starting today, is to really open your eyes to all of the Fractal relationships that are around you in everyday life. Perhaps you have a theoretical mathematical background, in which case this is old news for you. For the rest of us, myself included, this was somewhat of a startling revelation as I started to piece together how much financial markets resembled all of the fractal structure that I was surrounded by in nature. 42

Markets Mimic Nature

Change to larger things starts with the smaller things first I think that most of us have heard the expression “change comes from within.” Most of the time that phrase is meant to allude to our outlook on life, or our awareness and beliefs. You cannot change your mind in an instant. Changing a belief is a process that the mind works on and turns over, comparing it to your current belief system…before change can occur. But many other changes come “from within.” Think about your health for a minute…The last time you got the flu, it might have seemed like it occurred instantly, but it did not. There was literally a war going on inside your body for some length of time against a replicating virus before your immune system waved the white flag and croaked out a terse “help!” Change started one cell at a time until the tipping point was reached, and you felt like you’d been beat up by a 2-by-4. A more extreme example is cancer; abnormal cell replication occurs on a small, almost undetectable level for a long time, possibly years. You’re none the wiser, until it begins to metastasize elsewhere in your body and affect organ function. Only then do you begin to be aware of the changes in how you feel, and you’re in trouble. We’ve all had fun “zooming in” on world landmarks with programs like Google Earth. You could, for example, start to zoom in on a medieval castle, which looks perfect from a distance of a thousand meters. Only when you zoom in on the individual bricks & stones would you know the condition of that structure. A single disintegrating stone can shift the loads and cause massive stress in ways that the rest of the stones were not expected to carry. A pothole in the road starts as a very small pit in the road surface, which is enlarged over time through daily wear and expansion/contraction forces, especially through the effects of water & ice. What started as a very small hole soon becomes a tire-wrecking chasm as the cumulative effects of lots of small changes leads to something much larger. 43

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Change starts at the smallest levels first and propagates upwards in scale through this chain-reaction effect. Look around you with new eyes today; all around you, you’ll notice that “larger things are made from identical smaller things,” and “change begins from the inside-out.” Nature is FRACTAL.

How Does This Apply to Financial Markets? Hopefully, you can see where I’ve been going with this line of thinking. I would like you to start thinking of financial markets as a “structure” or an “organism.” I’d like you to envision financial markets as living, breathing entities…after all, they are comprised of millions of active traders, no different than “cells.” As you go through this book, you’ll see how the laws of physics appear suited to financial markets as well. What I’m asking you to do is to start looking at financial markets through the same lens that you look at everything in your daily life. One of the first things that we learn about analyzing markets is to turn off our intuition and to hand over responsibility to unknown “indicators.” We learn to disconnect everything that we know about how things “work,” thinking that we cannot use our life experiences to evaluate markets. What we’ll find is that markets are Fractal in timeframe or transaction…larger timeframe chart moves are built up from many smaller-timeframe chart movements. The concept of self-similarity is evident, as larger timeframe charts look like larger replications of smaller timeframe charts. Most traders don’t really know why they are looking at a particular timeframe of chart…is a 120-minute chart better than a 60-minute chart, or should you use a 30 minute chart? What we’ll show is that there is a relationship amongst the different charts, whether “timeframe” or “tick.” And we’ll also find that financial markets change “from within.” Changes occur very infrequently on larger timeframe charts, almost imperceptibly. 44

Markets Mimic Nature

Most traders lose perspective on any change, panicking on the first daily candle to the downside, not seeing how that move fits into a larger pattern or rhythm. Most of us don’t see changes in trend occurring until it’s almost too late, and the move is “over.” Look, trading on the “hard right edge” of the chart is difficult. I’m not saying that it’s easy. What I am saying is that there are relationships that we’ve been ignoring because most of us really don’t know what to look for on charts, instead assigning heavy responsibility to trailing indicators (like moving averages or other studies that look good on charts) - looking in the rear-view mirror. If you really apply what I’m talking about in these first three chapters, you’ll start to see the underlying STRUCTURE that works in any timeframe, laws of the universe that work regardless of what organism that we’re evaluating. You’ll start to see the reason behind the move, instead of just emotionally reacting to the move like everyone else. There’s no doubt that this will require a little work to get there, but I need to lay the groundwork first to show you how much you already know. Nature is Fractal, and so are Markets. Now that we’ve discussed the back story, it’s time to dive into Financial markets starting with Section Three and “Price Action and Trends.”

Chapter Summary • We can think of a financial market as a “living organism” because it’s created from millions of individuals operating in the context of a crowd. • Nature is Fractal; that is, larger things are created from a collection of identical, smaller things. • Change to an object begins from the inside-out, and eventually this “change” propagates to the “larger” object.

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• Financial markets are Fractal as well. Larger timeframe moves are created from many smaller timeframe moves. Change (i.e. Trend reversal) to a larger timeframe chart starts from the inside-out, from much smaller timeframes reversing trend first. • Humans tend to perform better when we align with natural principles.

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Section THREE

Price Action and Trends

Chapter 4:

Introduction to Price-Based Analysis

T

he foundation for everything that we’ll discuss throughout this book depends on our assimilation of some simple theories for determining price movement and trends. And to understand these concepts, the logical place to start is with Charles Dow and what later became “Dow Theory.”

Charles Dow and the Creation of Dow Theory Chances are good that if you’ve been around the field of trading and used any form of technical analysis, then you’ve heard of Charles Dow and “Dow Theory.” Figure 4.1

Fractal Energy Trading

Were Mr. Dow alive today, not only would he be mistaken for a craft brewery owner, but he himself would also be amazed at how a few basic suggestions that he made early on grew to become much more than that; indeed, they have become the bedrock of technical analysis. Charles Dow helped found the Dow Jones company, as well as the Wall Street Journal1. He was a journalist covering the financial markets in the latter part of the 19th century, into the early 1900s. In his precursor to the Wall Street Journal, he wrote on January 31, 1901: “A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned. This method holds good in watching and determining the flood tide of the stock market.”2 Not long after that note was written, Charles Dow died in December 1902. He never created a “theory,” however he was the first to publish his observations about the cyclical nature of price movement in financial markets. It was not Dow himself, but rather a succession of efforts from others to translate Dow’s editorial observations into what is now known as “Dow Theory.” Dow’s successor, William Peter Hamilton, began the effort in 1922 with his book The Stock Market Barometer, followed by Robert Rhea, an analyst who finally aggregated Dow’s observations into a full “theory” by 1932 with his book The Dow Theory. (As of this writing, both books were available to purchase on Amazon through the miracle of on-demand printing!) Stop for a minute and realize what this means; the study of Technical Analysis did not really get its foundation until the 1930’s! And it really did not become popular as an investment tool for selected institutions until the 1970’s. Retail traders had no other option for understanding Price Discovery (not being on the trading floor) so the field of Technical Analysis has really exploded with the adoption of Retail trading. 1 2

https://en.wikipedia.org/wiki/Charles_Dow AAI Journal, September 2012, “Charles Dow’s Theory Still Valid for the 21st Century,” Jack Schannep

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And it all started by Charles Dow’s observations.

Dow Theory - What Is It? My intent here is not to cover the entirety of Dow Theory, because quite a lot of it concerns itself with the interrelationship between the Dow Industrials and the Dow Transports. Think about the entirety of the economy in 1932; Industrials would build products, and the Transports would ship them, and that represented the majority of the GDP. The modern economy is much more diverse with so many more Services and Technology sectors that did not exist in the 1930’s, however you will find those that follow the original Dow Theory to the letter. Let’s visit the six main components3 to Dow Theory: 1.

The Market Discounts All Available Information

This is the “efficient market hypothesis” which means all markets are priced to perfection at any given second. This means that tomorrow’s expected news is already priced into the chart. 2.

Three Kinds of Primary Trends

Primary trends last a year or more, during which they will experience secondary trends which work against the primary trend. (Pullbacks or consolidations) Lastly, there are minor trends which last three weeks or less, which are typically considered to be “noise” in the larger perspective. 3.

Primary Trends Have Three Phases

In a Bull Market, these are the Accumulation phase, the Public Participation phase, and the Excess Phase. In a Bear Market, these are called the Distribution phase, the Public Participation phase, and the Panic phase. 4.

Major Indices Must Confirm Each Other

This rule was based on there being two main indices; the Dow Jones Industrial Average, and the Dow Jones Transportation Average. If business con3

https://www.investopedia.com/terms/d/dowtheory.asp 51

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ditions were strong, then both averages would move in the same upward direction. This is certainly dated in its application today, as this rule of the theory was based on the overall market being a predominantly industrial economy that built products and then shipped them to their destination. Today’s economy is much more diverse. 5.

Volume Confirms the Trend

This rule states that volume should be increasing in the direction of the primary trend, with low volume signaling a weakness in the trend. I do not think that this rule applies as prominently as it used to, as I’ve seen year after year of low-volume trends that just keep climbing the “wall of worry” driven by those that insist that low-volume trends are about to fail. 6.

Trends Will Persist Until a Clear Reversal

This rule is an attempt to communicate that traders should not be shaken out of the Primary trend by a Secondary or Minor trend.

Dow Theory - How Do We Use It? My intent of bringing Dow Theory to your attention is how it defines and provides structure to the measurement of trends. We’ll spend the rest of this section providing a new, clear look on how we should analyze price movement. And yes, we’ll “borrow” some of the elements of Dow Theory, notably: • Trends - we’ll show how to use multi-timeframe analysis to help define and qualify the difference between Primary, Secondary, and Minor trends. • Phases - we won’t really get into the nomenclature that the Elliott Wave Theory folks use, but the “three-phase” definition of Dow Theory works nicely to provide structure for the different primary trends. • Reversals - everyone’s “holy grail” is to spot price reversals, as this creates the ideal reward-to-risk environment. We’ll also provide more structure to Dow Theory in this regard. 52

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Quite honestly, the rest of Dow Theory is somewhat irrelevant in its application to today’s market structure. We have so many other sectors besides “Industrials” and “Transports,” and while volume can signify that someone’s getting “spanked” and covering/closing positions in great pain, there’s also another great saying which is much more appropriate to today’s markets: “Never short a dull market.”

Why Shouldn’t We Use Technical Studies? At this point, you might be saying “I don’t need no stinking price action! I have my favorite set of technical studies to help me!” Well, if you’ve learned chart reading from 99% of the available “market education” vendors over the last couple of decades, chances are really good that the first thing they did with your price charts was to decorate them with all kinds of fun-sounding technical studies. What new trader wouldn’t want to add “Andrew’s Pitchfork,” the “Vortex Indicator,” or the “Parabolic SAR” to their charts? Nearly all retail traders start their careers by immediately adding too many technical studies to their charts. I can think of several reasons why this happens: • Confidence - there is a certain sense of confidence that comes with looking at previous price action, and the studies showed a signal that one might have taken. We love to mentally curve-fit signals to the past, even though we would not have taken the entry. • Marketing - many times these educational firms will market a proprietary study that promises to create profits where no other system will. A compelling marketing campaign will create the illusion that you would have had 100% profitable trades if you’d have just plunked down the $300 to buy the license for that study. The panic and pull created by these campaigns is very real.

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• Education - reading price action by itself is not difficult but can appear to be so to the newer trader. It’s easier to fall back and let a “study” do the work vs doing your own price analysis. • Visuals - chart studies are very “visual” and appealing to the eye. In fact, there is a very common cycle that traders go through with regards to their charts. I have seen this cycle occur 100% of the time with traders who earn their living from the markets: • Phase 1 - newer trader starts out with the basic sets of studies. • Phase 2 - newer trader is losing money, blames it on studies, looks for “holy grail” indicator. • Phase 3 - trader now has more experience but no better results. Continues adding more studies to create an impossibly complex entry condition. Reaches the peak of frustration when they continue to lose trades no matter how many studies they add. • Phase 4 - trader with more experience finally finds one or two core principles that they will focus on. Starts shedding studies from chart. • Phase 5 - trader is now consistently profitable and has narrowed down signals to looking for “one thing.” • Phase 6 - trader is professional that lets trades “come to them,” no longer needs lagging studies to tell them what price is doing. If you were to plot the number of studies that the typical retail trader uses on their charts over time, it would most likely represent the shape of a normal distribution curve:

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In t roduc t ion t o P rice-B a sed A n a lysis Figure 4.2

The majority of professional traders use very crude systems that require very little interpretation. I think that this occurs for many different reasons, but mostly it’s because the professional has learned to “listen” to the price and not insert their own narrative to what’s happening. For many of us, success in the markets is simply a matter of stepping out of the way of our own cognitive biases that we collect like clutter in a home. A true professional reads a chart for what it is showing, and not to justify their own inherited bias. I can’t tell you how many times I’ve been challenged by the “keyboard cowboys” on the Internet when I show them a simple price-based decision system: “Your system isn’t valid! How can you possibly trade without an RSI?!” My response is usually that anyone with a profitable system over time should continue what they’re doing, even if it’s using a pile of studies on their chart. But if they aren’t trading profitably, then the definition of insanity is to continue doing the same thing and expect different results. If the majority of profitable professionals are making decisions based on price alone, then we should probably spend our time learning their methods, yes? 55

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Myself, I prefer using a minimal dose of technical studies, not only because an economy of signals provides fewer distractions and more clarity, but also because the vast majority of technical studies provide “lagging” signals.

The Lagging Signal Problem Let’s say that we wanted to look for breakouts to new relative “highs” as a long trade entry signal. On a price chart this is relatively simple to calculate; when the price moves to a new “high-water mark” then your entry is a “go.” You can see a couple of these potential entry points in the upper chart of Figure 4.3. Compare those entries vs those in the lower chart where we waited for the MACD Histogram to show us “positive momentum” as the histogram values started to print above the “signal line.” In general, those signals showed anywhere from one to two days later. Figure 4.3

It’s impossible to expect the MACD to be as responsive as the price itself, because the MACD is measuring convergence/divergence from multiple moving averages, which are themselves a “trailing” indication of trend. 56

In t roduc t ion t o P rice-B a sed A n a lysis

Don’t get me wrong; I’m not disparaging the MACD study itself (nor any other time-tested analytical study). It’s perfectly valid to use, and it provides a nice “visual” of the transition to positive momentum, right? But I know I would rather be in on the first available signal, because sometimes this is all the “edge” that you’re given, and in theory gives you a better reward-to-risk entry.

Chapter Summary What can we summarize from Dow Theory and using Price itself to make our decisions? • Markets are extremely efficient and instantly reflect all forward expectations on a given asset. • We’ll expect to see Primary Trends, Secondary Trends, and Minor Trends in any market. • Primary Trends will typically have three phases but we won’t fight the price if the chart decides to create more than three. • Volume shows “confirmation” as well as who’s getting spanked. • We will stay with a primary trend until we identify a clear reversal. • Technical Studies will generally be “lagging” vs. making decisions based on price itself. At this point I hope you’ve bought into the concept that we should be using PRICE as our primary input for making trading decisions, however you are probably confused as to HOW we do that. Before we get stuck in the dogma of actual strategies and entry points, I need to show you some of the larger forces that affect price. Let’s turn back to “nature” for a moment to show how we can relate these concepts to things that we see every day. A financial market is just another natural organism, after all.

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Chapter 5:

The Tides of The Market

I

f you caught the explanation that Charles Dow gave in the last chapter, he equated market action with ocean waves and tides. I think that this is a brilliant analogy for how markets move and is a great reminder for us that larger forces are at work, even though we don’t always see them. Let me give you a couple of examples to help make this clear. • You visit a beach on the ocean and hop in the water to play in the waves, not noticing that you’re near an estuary and there are warning signs all over the beach about “rip tides.” You’re so focused on jumping each wave that you don’t notice that you’re being carried out further from the beach with every bounce due to this unseen rip tide. By the time you notice your predicament, you’re tired and barely make it back to shore, fighting against this underlying force that is more powerful than the waves crashing on the beach.

Fractal Energy Trading

• Beach time again. You visit a different beach, and you take your rental Jeep right down onto the sand. There is plenty of space between your vehicle and the water. Half an hour later, the tires of the Jeep are getting splashed by the waves and you have to hustle to get your vehicle out of there before it’s swamped. Once again, you focused on the individual waves, and did not factor in the rising tide, which is much more powerful than the waves themselves. Financial markets exhibit the same behavior; we focus on the smaller daily (or intraday) price movements (waves) but need to understand that there are larger forces (tides) at work. While we’re not weather forecasters, we operate in the same manner in that we try to classify all of the data in front of us and attempt to project potential forward movement using this data. And many times those who are examining the movements of financial markets can’t see the forest around them for all the trees in their face; we’re zooming into individual candles and trying to analyze markets when we should be expanding our view to see that the “tide” has shifted. There are two different “macro” views that tend to explain these unseen market “tides” very well because they repeat over and over again due to the manner in which crowds process risk and opportunity. And as we’ll see in later chapters, these “tides” can be seen in a fractal nature even in the intraday charts…but we’ll get to that soon enough. First, the “Four Stages of a Market Rally:”

The Four Phases of a Market Rally It’s a fact that Herd behavior is so well-ingrained in our human makeup that experienced market watchers will tune out their own responses and take advantage of the Herd behavior - more on that later.

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Performance guru Tony Robbins has a way of boiling down the human element into a couple of recognizable sound bites. One of the lessons from a program that I bought long ago goes something like this: “People take action based on two things: to avoid pain, or to seek pleasure.” Think about how true that statement is; we procrastinate until the pain of not doing an associated task becomes greater than the effort to actually accomplish it....and if pleasure is involved, don’t stand in front of the door! We’re all over it! Can you see how this principle applies to a financial market? We make trading decisions that help us avoid pain... or to help us seek pleasure! We avoid pain by not taking the “correct but difficult” entries, and we seek pleasure by jumping on board a trend at the very end of the run, when the rest of the Herd is validating our decision. To this end, we have the four phases that the Market cycles through, without end. It has been operating in this same manner since the market began, and it will continue to do the same thing regardless of High Frequency Trading or Robots or anything else that you want to throw at it… so even though we can apply the Four Phases to any financial asset, we’ll illustrate this example with the S&P500 chart. Phase One - Disgust The Market is in a downtrend and participants that were previously holding stocks have, for the most part, washed out their positions and they are feeling the deepest form of resentment - or disgust - with the markets in general. Figure 5.1 shows the S&P500 in the middle of a sell-off, climaxing in the “disgust” phase of the move.

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Fractal Energy Trading Figure 5.1

Most Retail investors wait until the very bottom of the move before selling their stock, convinced that the price will go much lower, as every pundit in the financial media is whipping up tales of doom and gloom (Fear sells!). This event is called “capitulation” and usually marks the very bottom for that move. There’s little doubt why this phase is called Disgust!

Phase Two - Disbelief Once the average Retail investor capitulates during the “Disgust” phase, the Market usually rebounds strongly, even during true Bear Markets. If you haven’t experienced this before, it is a time of supreme confusion to the Retail investor...since they just closed out their positions for a big loss, and now the market’s rallying again! Utter disbelief and shock ensue. Figure 5.2 shows the S&P500 going through the “Disbelief” phase right after the “Disgust” phase:

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The Tides of The Market Figure 5.2

This move catches a lot of investors off guard, and it’s partly fueled by those speculators who had “shorted” the market (took a position to gain value if the price had gone lower) and must now cover their positions at great loss by buying their short positions back, which further drives demand. During this phase, the overall market has a very biased memory, since the recent sell-off was just a couple of weeks ago and everyone is still scared. As a result, the majority of traders are still very skeptical about the ability of the market to rise further from this level, and in fact, many bears begin to short the market AGAIN at these higher prices, only to cover later at even higher prices. This sort of move can extend for great distances as a result of this factor alone.

Phase Three - Acceptance The market has no memory, however, and keeps climbing this “wall of worry” higher until its performance wins everyone over; the pundits - and the Herd - all agree that prices are going higher in the short term. By this point all of the “short” positions have been covered, and the prices are being bid up by 63

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“long” Retail and Institution action. Everything feels “normal” again, and the chart looks good as we can see in Figure 5.3: Figure 5.3

The average retail investor is still tending to their wounds from the earlier sell-off, and they are still waiting until things “feel right” before they enter the market. And it won’t take long before they’re ready, in the next phase:

Phase Four - Euphoria Eureka! The market is going higher again! All of the news is good, the financial media is ebullient, and everyone walks around with a bounce to their step. The average retail investor is hearing more and more stories of those that entered positions during the “Acceptance” phase, and it’s starting to really bother them that they’re not in the market. The earlier losses are only distant memories now, as everyone becomes a stock expert...including relatives and barbers. Investors are truly feeling “euphoria” as every position that they enter seems to go higher. Figure 5.4 shows a chart of the S&P500 approaching this level: 64

The Tides of The Market Figure 5.4

Finally, our “average retail investor” cannot stand it any longer, as he runs to catch the train leaving the station and hops on the stock that has caught most of the attention. Unfortunately, what this leads to is a repeat performance of the entire cycle, as we enter the next phase of “disgust:” Figure 5.5

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Once again, the average retail investor has bought in at “the high” and will likely sell his position at great pain and expense at the capitulation point of the swing lows. It’s incredibly unfortunate to watch this cycle occur again and again; your heart goes out to the investors who either 1) choose not to learn about the market cycles, or 2) find themselves incapable of making unemotional decisions regarding the market. Yet this cycle will go on and on; it will repeat as long as free markets exist. The point here is that it’s your choice.....you can either choose to learn how to think like a Contrarian and avoid the bad decisions of the Herd, or you can continue to do what you’ve always been doing. Learning about these unseen “tides” beneath the surface of the market will help you to participate in the right direction.

Financial Markets and Changing Character It might surprise you to learn that any financial market sheds its skin and changes quite frequently, not only in the direction that it moves, but also the “character” of the price action with the overall volatility and the manner in which price changes are made. Not only do we see this with the major stock markets…but we also see these changes in behavior with every financially traded asset. It’s little wonder why so many investors are frustrated, as the strategies and analysis techniques that they just learned…no longer work just months later! The point of this section is to show you: 1) how to “read between the lines” and understand when/how markets are changing, and 2) how to adapt those changes to strategies that we might use. This is why I love using analysis techniques that are based on “price,” because they will ALWAYS work! I see this “herd” cycle over and over again. When the market adopts a certain “character” or style of movement, and smart traders adapt to it quickly and pull profits from it over and over again while the investing “herd” is slow to 66

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adapt and wonders why the OLD system that they bought last year no longer works. Slowly, their consciousness becomes aware of these “smart guys” who are making money with a new system so they find someone that they can learn from and invest the time to learn it. And pretty much as soon as they start to use live capital with this new system, the market shifts character again and this cycle of frustration repeats. It’s not their fault. No one really told them that things change all the time in markets. Most of us live our lives in stasis; traffic laws don’t change, a cheeseburger in 2021 will taste the same as one from 1972, there’s still 90 feet between home plate and first base, and there are 60 minutes in an hour. We also assume that market price movement will remain the same next year as this year. I hate to be the one to break it to you but things will ALWAYS be changing with financial markets, so I’m going to use this material to show you some things that you need to be aware of; how to spot these changes early on in the process….and then show you how we can alter our trading plan to make the best use of these changes.

The Trap of Current Performance It’s not uncommon to see month after month of profitable trading during a bull market. The dips keep being bought, there is a certain “rhythm” to the markets, and you get this feeling that you cannot lose. Sometimes, it almost looks too easy. And if I’ve been on a streak like this for over a year, I start getting cautious. Something’s about to change. Let’s go to the volatile cryptocurrency markets and use Bitcoin as an example. During the last major bull run that ended in 2017, we had a persistent anchor trend, the dips were bought, and we had a persistent series of “higher highs” and “higher lows” as you can see in Figure 5.6:

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Fractal Energy Trading Figure 5.6

Persistent price action like this normally will lead even the most seasoned investor to overconfidence, unless they are aware of how markets change their stripes when they “transition.” And this started as the crypto market went completely parabolic in December of 2017, as we can see in Figure 5.7: Figure 5.7

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That last parabolic run where BTC hit about the 20k level was a classic example of “euphoria” where retail traders start throwing money at anything and everything, as there is no sense of “risk.” And professionals start mumbling under their breath about the risk, but no one listens, until the price starts to transition into a downtrend and the “disgust” phase as the calendar turns to January 2018. This is why I refer to this as the “Trap of Current Performance.” As long as something is working, you should CONTINUE to use that strategy… however the longer that it does work, the more aware you should be that a change is coming around the corner. Learning to spot the signs of change will separate you from the rest of the Herd. What kind of change? How can we tell? Should we just tune into the TV and watch the professional pundits tell us what to do? Let’s learn to read the market’s “character,” not only to understand what is happening now, but also to anticipate what is likely to occur next.

What is “Market Character?” You might have heard me use this term before…talking about “market character,” and perhaps you wondered what on earth I was talking about. That’s how I felt the first time that I heard about it, and it took me a while to absorb and process. Mothers are EXPERTS in the field of noticing little changes in “character” with their children. The way they interact, the way they carry themselves, their tone of voice, their written communications...all carry a huge amount of information to “Mom” that instantly puts them on DEFCON-1 high alert when they see something changing. And men like me are typically oblivious to these changes, rowing headdown day after day until we finally look up from the oars to see that we’ve been rowing upstream. So guys, there’s definitely something that we can learn from women, that is we need to start looking at the market in ways that we haven’t 69

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done before. Step back and detach. And for the women that are reading this, you have that inherent skill that just needs to be tuned to read the same thing in markets that you do with children and people in general. There is a “next level” of analysis that not only looks at what is happening today, but how things are actually changing in front of us. Let’s start out by defining the different types of price character that we’ll see in today’s market…

Defining Market Character - The Four Market Types There might be an almost infinite display of the different “characters” that price movement can take on, but we’ll confine our study to four major types of price movement that we’ll see in the charts. These are the ones that I most frequently find in any market:

Quiet and Trending This is the quintessential Bull Market character, where price movement is very linear and predictable. Trendlines work to show potential areas of support, pullbacks are bought, and the market can stay in this state for a year or more. Figure 5.8

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These “Quiet and Trending” markets are typically spawned from choppy and/or volatile price behavior; as we’ll see in a subsequent chapter, this is what we call “Range Expansion.” A “Quiet and Trending” period is usually followed by a “Volatile and Sideways” period, which is where the market gets a chance to catch its breath and recharge, and it may or may not lead to a full change of polarity to a downtrend. Note that we will almost NEVER see a “Quiet and Trending” market to the downside. Bear Markets are NEVER quiet and are always volatile.

Volatile and Sideways This type of price action is most normally seen as the first act of a larger corrective pattern kicking in. Volatile and Sideways price behavior usually follows “Quiet and Trending” which is a rude shock to those that had become very comfortable with the quiet, predictable bull market. Figure 5.9 shows an excellent example of a Volatile/Sideways market; note that you would not be able to determine this market character until the very end! This is what makes the shift of this character so hard to determine for bulls that hang on until the very end. Figure 5.9

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Notice that these “volatile and sideways” patterns are created from big, linear moves, regardless of whether they are bullish or bearish trends: A Sideways/Volatile market character is a warning sign; it will “resolve” in one of two ways. • It can resolve BACK into the next Quiet/Trending character trend, or: • It can transition into Volatile/Trending price character, also known as a Bear Market.

Volatile and Trending We don’t see this price character as frequently as the previous two; normally it shows up right as a market transitions into a Bear market. Volatile price behavior like this is associated with uncertainty and this is where we get some giant tug-of-wars going on between the bulls and bears. Figure 5.10

Notice that Volatile/Trending character comes AFTER the market has already transitioned into “volatile” behavior; the only difference between Vola72

The Tides of The Market

tile/Sideways and Volatile/Trending characters…is that Volatile/Trending ALWAYS carries a nasty downtrend with it.

Quiet and Sideways We rarely see financial markets set up with a Quiet/Sideways character for any length of time; this has the effect of “winding the spring” to build a tremendous amount of potential energy for the next move. As we’ll see in the next section of this book, this extreme “Range Contraction” almost always leads to violent “Range Expansion,” as you can see in the subsequent move in this chart: Figure 5.11

Section Four of this book is dedicated to identifying these “range expansion/range contraction” modes, which we’ll pair with Price Action to form the “Fractal Energy Trading” methodology.

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Identifying and Anticipating the Type of Market It’s one thing to look at a chart in the rear view mirror and determine what the market “type” is; it’s quite another thing to ANTICIPATE and then correctly READ what the market type is while it’s in the process of changing. What is nearly impossible to ignore is the fact that we’re all human and therefore susceptible to the effects of bias, whatever the source. And one source that is very difficult to overcome is that of “Recency Bias.” This is the tendency to weigh recent data more heavily than other data; this is extremely difficult to overcome near market bottoms and tops, where we have emotional extremes occurring in the market. There’s a saying that “the market never rings a bell at the top.” This is another way of saying that “there are no warnings” when markets transition, and you will only catch a stronger case of “bias” by listening to friends or to the financial media. You’ll need to get GOOD at spotting the clues while a market’s in a “transition” phase. Let’s look at the most likely transitions that you’ll see in financial markets:

Quiet Markets Transitioning to Noisy/Volatile Ones Markets tend to spend most of their time (roughly 80%) in quiet, directional bull markets, especially if they are spawned from noisy, volatile conditions. And these quiet bull markets will continue until we see them start to “crack” and start to become unstable. We will typically see that begin with what I call a “shot over the bow”; this starts with an unexpected, negative event that drives the price quickly down, such as those shown in Figure 5.12:

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The Tides of The Market Figure 5.12

The market was quiet and trending prior to these unexpected negative events; it quickly became much more volatile after that…first “volatile/ sideways,” and then ultimately “volatile and trending” in a bear market. The conclusion to a Quiet and Trending bull market is almost always a transition to a much more unstable, volatile market.

Noisy/Volatile Markets Transitioning to Quiet/Trending Ones The converse situation occurs when a market “coils up” all of that power from volatile price action until it finally chooses a direction to trend in. Most of the time, that energy will be transferred into a strong, quiet, linear bull market:

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Fractal Energy Trading Figure 5.13

On rare occasions, we’ll see the energy from these “noisy” conditions actually transition into a volatile trending environment to the downside, as in Figure 5.12. As we discussed earlier, downside trends are ALWAYS volatile. If you can just apply the understanding of “character transitions” from quiet markets to volatile ones, and then back to quiet markets again…you will be on the opposite side of the Herd who will carry recency bias forward to their detriment.

Trading Guidance for Different Market Characters One of the biggest mistakes that investors/traders make is to trade all different market “characters” in the same manner. For example, those investors that have been indoctrinated into the “buy the dip” mentality from Twitter or Reddit will come into a Volatile/Trending bear market buying the dip left and right, and absolutely get their head handed to them by the larger overall downtrend. Let’s break this down by Market Character type: 76

The Tides of The Market

Quiet/Trending This should be the character that you’ll see the majority of the time. Trading traditional “buy & hold” as well as “swing” trades should be made during this time, biasing the long side. This is a very “linear” market character where market actions will make “sense” to the majority. They say that “everyone’s a genius in a bull market” and it can certainly feel that way as dip after dip gets pushed higher to the upside.

Sideways/Volatile You will see dramatic swings in both directions; this will be where the majority of the gains can be made to the long side, however this should be a warning to lighten up and take profits, or tighten up stop-losses if you are overly “long” in your portfolio. Once again, you cannot assume that the price will just automatically transition back to Quiet/Trending and resume the upside advance. Those that trade very short-term or intraday can really clean up on both directions in this price character.

Volatile/Trending The only viable “long” trades during this time will be the short, strong swings back to the upside, known as “bear market rallies.” Those that adhere to “Dollar Cost Averaging” or “buy the dip” strategies will do so at the peril of trying to catch the falling knife; what goes “low” can go even “lower.” Short trades can be made by the more experienced traders, but the setups will be very rapid and easily missed. Compared to the Quiet/Trending bull market, the Bear Market is very NON-linear and price action will make very little “sense” to most who trade based on identifying linear structure. This is a very difficult time to trade for most, and the majority would be better off just moving their capital to another market which is in Quiet/Trending character. Professional Bearish traders will absolutely clean up during this type of price character, but 77

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they have to do it quickly, since this type of character does not linger.

Quiet/Sideways Not a character that we see very often. Just understand that the price will break hard in one direction or another, and you will not know with any certainty which direction that might be. Range Contraction always leads to Range Expansion. Chapter Summary • We saw that there were four phases to a market rally: disgust, disbelief, acceptance, and euphoria…and then the cycle repeats. • Markets change “character” all the time in a manner unseen to most, like the shifting tides of the ocean. • The Trap of Current Performance means that most Retail traders will be still trying to trade the “last” character of the market and wondering why they can no longer win trades. • There are four main types of “market character:” Quiet/Trending, Volatile/Sideways, Volatile/Trending, and Quiet/Sideways. • Markets normally transition from Quiet markets to Volatile ones, and then back to Quiet character again, and the cycle never stops. Now it’s time to dig into Price-based signals on a single timeframe level.

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Chapter 6:

Single Timeframe Trend Analysis

L

et’s circle back to the measurement of “price.” There is a very systematic way that we’ll apply analysis techniques to the price charts of financial instruments to determine first “trend” and then “signals,” and we’ll start that process by looking at one timeframe only.

Measurement of Price at Discrete Time Periods So far in this book, I’ve made the assumption that you have some experience with individual price bars and/or candlesticks. As a quick review, all candlesticks/bars are based on “OHLC” data points, or “open/high/low/close.” Figure 6.1

Fractal Energy Trading

The Opening price will always be on the left for a price bar, and the closing price on the right, with a bullish price bar having a higher “right side” closing price than the left. A Candlestick will designate “bullish” or “bearish” by the color of the body, or the rectangular portion of the candlestick, and the “open” and “close” price points will define the “real body” of the candlestick. We will use Candlesticks to designate individual periods of price action through the rest of this book. I have nothing against price bars, and many oldschool traders still prefer them, however I believe that Candlesticks do a better job of conveying price information in a book format.

Trend Measurement on a Single Timeframe Let’s dive into the application of “trend measurement” as it applies to Dow Theory. The one that we really care about relates to how a trend is defined. An Uptrend is a series of higher highs and higher lows: Figure 6.2

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Singl e T imef r a me T rend A n a lysis

Each shaded line denotes a price “Swing.” A Swing can go in either direction, irrespective of the primary trend, which is an uptrend in this case. Notice how each “swing” of the price carries it to a new high price, before it pulls back and creates a “higher low” in the price. Each “high” is a “higher high” and each “low” on the pullback creates a “higher low.” Conversely, a downtrend is a series of lower highs and lower lows, as shown below: Figure 6.3

Notice how each “swing” of the price carries it to a new low price, before it bounces up and creates a “lower high” in the price. Each “low” is a “lower low” and each “high” on the pullback creates a “lower high.” I’ve found that some traders can get “stuck” trying to determine exactly which price swings to graph like that. Sometimes chart study tools like a “zigzag” tool can help you identify the important swing highs/lows, however they must be “tuned” to match the chart…or you can use a Weekly chart configured to display as a “Line Chart” to help identify the swings: 81

Fractal Energy Trading Figure 6.4

There is a specific terminology that we’ll use through the rest of this book to help us be more precise and to save time. It involves the definition of how we define and label Swing Highs and Swing Lows.

Terminology Definition - Swing Highs and Lows Something that will be important to us to agree on is the termi-

nology behind these “swing” points. You can see in Figure 6.5 how the swings are marked, with “PSH” standing for “Prior Swing High” and the “PSL” standing for “Prior Swing Low.” It doesn’t matter whether we are in an uptrend or downtrend, there will be swing highs and swing lows.

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Singl e T imef r a me T rend A n a lysis Figure 6.5

In the first half of the chart, the price is in a primary downtrend; notice how the down trend shows the “next” swing highs and swing lows are LOWER than the “previous” swing highs and lows. In the last third of the chart, the trend moves to an uptrend. In an uptrend the swing highs and swing lows will be higher than the previous swing highs and lows, until we get to the “current swing high” and “current swing low.” You’ll hear me refer to “prior swing high” (PSH) and “prior swing low” (PSL) through the rest of this book; make sure that you know what this term means respective to the trend and the timeframe being examined.

The Holy Grail - Identifying the Price Reversal If you recall reading about the six “Dow Theory” rules, rule number six spoke to staying in a trend until there was a “clear reversal.” What exactly IS a “clear reversal” in price? Many newer traders confuse the first “pullback” off of a swing high as a “reversal” …not so.

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Let’s list a couple of trend-reversal definitions, and then show some examples on the chart. • Uptrend Reversal - the most common example of an uptrend reversing into a downtrend happens when the price prints a swing high BELOW the PSH, and then follows that up with the price falling below (taking out) the PSL. • Downtrend Reversal - the most common example of a downtrend reversing into an uptrend happens when the price prints a swing low ABOVE the PSL, and then follows that up with the price rising above (taking out) the PSH. Here is an example of a chart in an uptrend, until it prints a “lower high” below the PSH, and then drops to “takes out” the PSL to print a new, lower PSL…which marks the beginning of the lower high/lower low downtrend: Figure 6.6

Here is the opposite example, with a chart in a clear downtrend, until it prints a “higher low” above the PSL, and then rises to “take out” the PSH to create the beginning of the higher low/higher high uptrend: 84

Singl e T imef r a me T rend A n a lysis Figure 6.7

Occasionally we will see a reversal that does not follow this script, and it’s usually when we see very “emotional” price action. This can be a case where the price completely drops like a falling rock off of the PSH, and immediately “takes out” the PSL to begin the reversal process, which is followed by a “lower high” to confirm the reversal. Figure 6.8

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These types of reversals can occur from very quiet conditions where the PSL is very close to the PSH, with the price action being low and “compressed,” or they can come from a parabolic rise to new highs (like the chart above) which are generally unstable/unsustainable.

Terminology Definition: “Taking Out” the Swing High or Low As we move forward in this book, I will constantly refer to the action of the price “taking out” a Prior Swing High or Prior Swing Low. Figure 6.9 shows an example of how the price “takes out” the level at the Prior Swing High at the dotted line to create a “higher high” in price; this is significant. Figure 6.9

This means that a new “high” has been made in the price, and the uptrend is confirmed again after printing a new “higher high.” Where many Retail traders get “faked out” is when the price confirms the uptrend by taking out the PSH and establishing a new high in price, it then sells-off...yet notice that in each case, the subsequent “low” is still a “higher low,” thus the primary uptrend is still intact. 86

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Conversely, “taking out the prior swing low” means the opposite thing, as we can see in Figure 6.10: Figure 6.10

When the price “takes out” the prior swing low by making a “new low,” then the downtrend is confirmed, or actually established if we see a reversal from a recent high. Note that once the price makes a new low to confirm the downtrend, then it’s common to see the price rise dramatically, once again faking out the majority of Retail traders that a new uptrend is afoot. This only serves to establish a new “lower high” before rolling over again into the next downswing.

Terminology Definition: “Change of Polarity” This is a more concise phrase which indicates that the trend at a particular timeframe has “flipped” from a downtrend to an uptrend…or an uptrend to a downtrend; its “polarity” has changed. This is one of the most important changes that any trader will want to be able to identify, because depending on the signal that we get…we’ll either have a full confirmation that the trend has 87

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changed at that timeframe, or we’ll get an early warning that we have a very high probability that it’s about to change. Both of these events create potentially massive trading opportunities that we’re always on the hunt for. In Figure 6.11, we can see how an uptrend…with a series of higher highs and higher lows….fails to make a new high at the PSH near the beginning of October, instead putting in a “lower high and then confirming the trend change, or “change of polarity” as the price “takes out” the PSL dotted line and creates a “lower low” by doing so. This is a change of polarity to a downtrend at that timeframe. Figure 6.11

Pay attention to how the price reacts from the “disappointment” at the lower high; the price literally DIVES lower, more than likely due to the number of new “longs” that were expecting to buy the “dip” one more time yet had to pull the ripcord and bail out of the position at a loss. Price moves because someone’s in pain. Note also that when that downside swing plays out to form the new PSL, that a very strong rebound begins, but the new PSH that forms in early Decem88

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ber is only a “lower high” compared to the PSH that preceded it. Many retail traders do not understand that price moves in “waves” like this, and you can see very strong countertrend moves which just serves to set up the next lower high in a downtrend. In Figure 6.12, we see the opposite type of “change of polarity” occur: Figure 6.12

The price is in the middle of a downtrend, with lower lows and lower highs. That starts to change in mid-December as the price prints a “lower high” and then “takes out” the PSH to the upside in late December, creating a “higher high.” The change in polarity is now complete, even though the price drifts lower to form another PSL right after printing the new high. The price has just completed a change in polarity to the upside…from a primary downtrend to a primary uptrend on the daily chart.

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Processing Trend Changes with Dow Theory Here is the process that we’re going to use with every timeframe to determine the trend and potential reversal levels: • Mark the “swing highs” and “swing lows.” In time it will become obvious when a PSH or PSL can be marked on the chart, and you’ll see that doing this with multiple timeframes will help us sort out the real moves from the false ones. • As we mark the swing highs and lows, we’ll know what price level must be “taken out” in order to perpetuate that trend, or give us a warning that it’s about to fail and perhaps head in the other direction - a change in polarity. Admittedly it will take some time to build your “eye” to determine these swings. Some steps that you can potentially take to help speed up this process might be: • Do “Hard Right Edge” training; scroll back to some past price action on a chart where you do not know what will happen next, and “bump” the price forward by a day at a time. Mark the charts as to where you think that the next PSL and PSH are and note what would have to occur for the polarity of the current trend to change. • Add a crutch like a “swing tool” or even the Donchian Channels, which marks a channel with the last significant “highs” and “lows” over “n” bars. You can see how this would look in Figure 6.13:

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Singl e T imef r a me T rend A n a lysis Figure 6.13

What Are the Problems with Single-Timeframe Price Analysis? So far everything might be making all the sense in the world, and it might make you want to jump into your chosen market and plunk down some capital. And as soon as you do, you’ll notice that things don’t exactly work out like you thought they would. “I understood the examples in the book, but the price in front of me looks... different.” There are two reasons for that: • There is no context to the price movement; is the price acting inside of a specific “character?” • We haven’t discussed the influence of larger and smaller timeframes on the price. Your single-engine Cessna plane might have its nose pointed directly at magnetic north, but if you don’t account for that 40 knot wind from the west 91

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(that is infinitely more powerful than your 150hp Lycoming engine) then you will end up miles off-course. In the next chapter we’ll start our journey to using multiple timeframes, with “price fractals.”

Chapter Summary • Candlesticks or price bars are a way to look at a single unit of time. • We need to use combinations of candlesticks which are strung together to determine the price “swing.” • We will then use these price swings to determine the flow of the “swing highs” and “swing lows.” • From these swing highs and swing lows we can determine the price “trend.” • The price trend will be determined by the direction of the combination of swing highs and swing lows. • The reversal process begins when the price “takes out” the PSL in an uptrend, or when the price “takes out” the PSH in a downtrend. • A Change of Polarity occurs when a former uptrend turns into a downtrend, and vice versa. • If you have difficulty marking the PSH and PSL swing markers, you can use technical chart tools like Swing Tools or Donchian Channels.

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Chapter 7:

Fractals and Financial Markets

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n chapter three, I discussed Fractals and used different examples and analogs to make my point, specifically that “larger things are made up of a collection of identical smaller things” and “change starts from the inside with smaller things and propagates upward.” Now it’s time to graduate to financial markets and start to apply these concepts to things that we really care about, which ultimately is making money by having a better “edge” in the market! And understanding how reversals come about can help us secure better edge.

Walking the Dog I want you to imagine that you’re walking your dog from your home to a specific destination. If you’re like me, the walk itself is a task to complete and your mind is already thinking about what you will do when you arrive at your destination. You will take the shortest path between points “A” and “B.” To your dog, however…the walk presents the most incredible opportunity to sniff new smells, see new things, and pursue an aggressive expansionary

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policy by “marking” new territory. Your dog will conduct “discovery” to explore the limits of their leash from you. Let’s also assume that we’re dealing with a 150-pound person and a 30-pound dog. You are five times the mass of your dog; in theory, your dog will “orbit” you like a planet to a nearby star. Let’s follow the path of both you and your dog as you walk from point A to point B: Figure 7.1

What do we notice with this diagram? You, the larger object of the two, will set the overall path of the combination marked by the straight dark line. The dog, representing the smaller object of the two, is free to explore the limits of its boundary as long as it stays within the “orbit” of the larger object. And both you and your dog arrive at your destination at the same time, at the same exact location. In this manner, the smaller “thing” operates under the influence of the larger “thing,” tracing out its own path, yet still operating in congruence with 94

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the larger object. This is an important concept to keep in mind as we transition from something we know - dogs and walking - to price charts with a fractal relationship. Larger things set the overall direction.

Introduction to Markets and Fractals The first thing that we’re going to discard from our previous analogy is the concept of “things” ...we’re generally going to focus on TIME from this point forward. Most of the charts that we use are based on charting the actual price as time goes by on the horizontal axis of the chart. (There are other relationships that work for this Fractal concept which we’ll discuss in the “Trading Applications” section of this book) We previously said that when it came to fractals, “larger things are made up of a collection of identical smaller things,” we are now going to say that: • Larger Timeframe price movements are made up of a collection of identical smaller timeframe chart movements. And when we previously said that “change starts from smaller things and propagates upward” we are going to modify that for financial markets by saying that: • Trend change starts from smaller-timeframe trend reversals and this change in trend propagates upward to larger timeframe trend reversals. By the end of this section you’ll see how this all fits neatly together, like a jigsaw puzzle that starts with random pieces yet ultimately all of them fit together perfectly. There is an amazing amount of clarity that you can derive from understanding the “structure” of the price chart when it’s broken-down into fractal timeframes. Rather than looking at a price chart as a meaningless collection of candlesticks, you will begin to see the “moves within the moves” and the underlying structure to trending price movement.

Which Timeframes? When I first started my own journey to learning technical analysis, there 95

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didn’t seem to be any rhyme or reason about what timeframe charts that traders would use. Most would use the daily chart for swing trading, but would also look at the Weekly chart, a 60-minute chart, a 15-minute chart, and so on. I was beyond confused…they all looked somewhat different and gave different information. Which one was in charge? Which one to trade from? Nothing made sense. All that changes now with the introduction to the Factor of Five.

The Factor of Five Series What solved this riddle of “what timeframes should I use” was learning about the “Factor of Five” from one of my early mentors. Once you start to apply it, you’ll start to see these Fractal patterns literally pop out of the charts… you’ll start to see how larger timeframe swings are made up of a collection of identical smaller timeframe trends and swings. Let’s start by focusing on the shaded swing higher on the Weekly chart in Figure 7.2: Figure 7.2

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Notice how this shaded swing on the Weekly chart is actually built out of several distinct swings…and an entire uptrend series…on the Daily chart in Figure 7.3: Figure 7.3

Isn’t this EXACTLY what we saw with the “walking the dog” example? The daily chart moved all over the place, faking out traders left and right with the sharp primary trend and secondary countertrend moves…yet the Weekly chart was essentially a straight-line swing higher. The Weekly chart in this case was the larger “human,” and the daily chart played the example of the curious “dog.” Sharper readers will also note that there are five distinct swings on the Daily chart (three “up” and two “countertrend”) to the one price swing on the Weekly chart. As I noted in chapter four, there is a tie-in to the basic five-wave Elliott Wave structure, which I’ve found to be useful to a degree as long as I don’t neglect the rules of price action which is our main focus here….and not to get tied into the dogma of how price “should” move. If there’s one thing that we’ve learned over and over again with today’s Market, it’s that price can 97

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do WHATEVER it wants to without regard to what you and I consider to be “normal” behavior. This is why the rules that we’ll cover for Price Action in the next chapter will work for any market, at any time, regardless of what meddling and artificial stimulation that we feed that financial market. Back to the Factor of Five. If we consider the Equity markets for a minute, this means that a Daily chart and a Weekly chart are separated by this factor, since there are five trading days in one week. Some other relationships that we can explore are: • The Monthly Chart has approximately five weeks in one bar/candle. • The Weekly chart has exactly five days in one candle/bar. • The Daily Chart (which has 6.5 hours or 390 minutes of trading action on stocks and options) contains five 78-minute bars/candles. • A sixty-minute chart contains five 12-minute bars/candles, etc. And so on. Now, is there some mathematical basis for this “Factor of Five?” I’m sure that some of you will not be swayed unless there is a Fibonacci number behind a relationship, as this “five” number seems arbitrary. And the answer is… it doesn’t really matter. This Factor of Five works nicely to show an interrelationship between the timeframes, without being so spaced out that you lose detail. You can truly see the “swings within the swing” with the 5x differential. The interrelationships that we’ll see in the Equities markets will be somewhat different when we trade the Cryptocurrency markets, since they never close down. For example, the relationship between the Daily and Weekly charts is “7,” since price will trade seven days a week. Even though the interrelationship is not “factor of five,” we’ll find that the fractal relationships between timeframes do not have to be exactly “five” to work well for us. So, experiment with them, find the multiple that “works” for you depending on the market that you intend to trade. The Factor of Five works for me for Equity or Cryptocurrency markets. 98

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Now, what timeframe do you “anchor” on? Where do you start when defining the timeframe series? Where do you end the timeframe series? To answer these questions, we need to define our “Family of Timeframes” that we’ll trade with, as well as the style of trading that we’ll pursue.

The Family of Timeframes Think about a typical “nuclear” family of four; two parents, two children, and you’ll typically find that they’ll differ in size from larger to smaller members. If we’re talking about a family of four that’s within the middle of the normal distribution curve, then the father will be the largest member of the family, followed by the mother, then the oldest child, with the youngest child being at the end of the train (This model also assumes that the kids never age). Figure 7.4

Think about how they operate as a unit when there is a shared mission, such as going on vacation. There’s nothing more exciting than going to a remote, exotic vacation spot! Everyone is up early getting their stuff together and 99

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packing the car for the long journey ahead. Everyone is well-rested, and they all work well together to get on the road. Laughing, joking, singing and in good spirits, they hit the road and make good time to start the day. And then…stuff happens, doesn’t it? Those of you that have children can relate to this, and perhaps you can even remember back to those days of sitting in the back seat on a long trip. No handheld games nor movies to watch, so it was endless hours of boredom and challenging your sister to spot more blue cars than you could. And this is where the youngest begins to crack. “Are we there yet? I’m hungry. I have to go to the bathroom.” Most fathers behind the wheel would ignore these initial requests for as long as possible before the mother would empathize, “It’s been an hour, can’t we make one little pit stop?” This irks the father to no end, as they are making GOOD TIME with MOMENTUM, and he is on a MISSION. So they stop for a short break, and the father races back onto the road trying to make up the lost time. An hour later, the oldest child pipes up, “I’m not feeling well. Can we pull over?” “More delays!” grumbles the father….” …at this rate we’ ll never get there!” They pull over, for a somewhat longer break now, especially since the mother has found a “cute little gift shop.” Once again, the father pulls all of them together and roars off down the road. He has MOMENTUM and wants to keep going! Well, this scene plays out over and over again during the course of the day and they haltingly make progress towards their destination. But a change comes over the parents by the end of the day, still far from their destination. The mother is completely exhausted from tending to her children’s needs. The children are now up and bouncing in the back seat, as they close in on their destination. Yet all of this pulling along his family has taken its toll on the father; 100

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he is now tired and is having a difficult time keeping his eyes open. He’s pulled for all he’s worth, and now he’s done. They turn off the road into a hotel and the parents collapse on their bed, asleep before their heads hit the pillow, while the kids jump up and down on the second bed. Can’t you just see it? Isn’t this how family trips are? And this same scenario is how major market moves play out over the course of months or sometimes years. Larger timeframe swings/trends define the overall course of the market, and “pull” these markets for swings that sometimes defy belief. Yet during the path of these mammoth swings the smaller “child” timeframes create movement “inside” of those larger “parent” timeframe swings. Financial markets operate just like a family of four on a road trip, with each family member contributing to the trend and the chaos in their own way, with the larger members contributing more to the overall trend, and the smaller members creating more of the “pauses” or volatility. Now it’s time to use more precise notation to these “members:”

Anchor and Signal Charts We will use these “fractal” relationships to help us in our trades. Think about the “dog walking” example …or the Weekly/Daily timeframe chart relationship in Figures 7.2 & 7.3. We are going to use the larger timeframe chart as our “Anchor” chart, and trade in the direction of the Anchor chart swing. And then use the smaller timeframe chart as our “Signal” chart, and use that timeframe to define, or “signal” the entry of the trade. • Anchor Chart - a larger timeframe, at least 5x the size of the Signal chart, used to trade in the direction of the Anchor chart swing. • Signal Chart - a smaller timeframe, at least 5x “faster” than the Anchor chart, used to determine entries in the direction of the Anchor 101

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chart swing. We can place these “anchor” and “signal” charts side-by-side in most charting programs, showing the fractal relationships:

Figure 7.5

Notice the discrete “swings” on the weekly chart on the left side; you can mentally mark those with “PSH” and “PSL” points. You can see the price swing up and down within the uptrends and downtrends on this weekly chart. At the same time, note how the daily chart has MUCH more activity in the same space! There are 5 times the number of candlesticks! We can use this tighter granularity to identify much more accurate, high-probability entry points that give better edge when entering in the direction of the Weekly Anchor chart swing. And we can extend this principle to include three fractal timeframes, as shown in Figure 7.6:

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Fractals and Financial Markets Figure 7.6

In this case the main “Anchor” chart will still be the Weekly chart on the left. I will frequently use the “Nx” designation when we use multiple timeframes like this. For this case, we have the following charts: • 25x (Weekly) chart - this is the main anchor chart that is 25x larger than the smallest. • 5x (Daily) chart - this is the chart that is 5x larger than the smallest timeframe • 1x (78min) chart - this would be the signal chart in this series, and the smallest timeframe. We can also shift the timeframes to longer ones, in this “family” of timeframes:

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For this fractal series, we have • 25x (Monthly) chart - this is the main anchor chart that is 25x larger than the smallest. • 5x (Weekly) chart - this is the chart that is 5x larger than the smallest timeframe • 1x (Daily) chart - this would be the signal chart in this series and the smallest timeframe. (You might be wondering what the purpose of the “5x” timeframe is in the three-chart series; we’ll show that in the next section of this book when we discuss “energy.”) In general, the timeframes that we will select should match the “style” of trading that we’ll pursue. Swing trades with powerful signals behind them might only show every couple of months, in which case we’d use the Monthly/ Weekly/Daily fractal series. Swing trades that show within the span of a week might use the Weekly/Daily/78min series. And those that scalp or “day trade”

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might use something like a 25 min/5min/1 min fractal series.

Lining Up the Trends for Trade Entries Perhaps you’re familiar with the tales of Odysseus and “The Odyssey.” I won’t recount Homer’s entire epic poem here, but Odysseus is a wandering soul and has been gone so long that suitors are lining up to compete for his wife’s hand. (Penelope) She figures that she can stall/avoid them by forcing the suitors into a contest, to first string Odysseus’ massive bow, and then shoot an arrow through the heads of a dozen axes, lined up in a row: Figure 7.8

As the fable goes, none of the suitors can do it. Odysseus, dressed as a beggar and watching the entire affair with amusement, offers to try it. He (of course) strings the bow and shoots an arrow through all of the axe heads. He then rips off his rags and slays the suitors with some help. (If you haven’t seen the movie, Kirk Douglas gives a rousing performance as our hero) I want you to remember this image of the axe handles; for you to shoot an arrow through them successfully, your aim must be true, and everything must be lined up. And this is the same approach that we’ll take for setting up trade entries. So, for us to take a “long” trade on the Weekly/Daily combination of timeframes in Figure 7.5, the following conditions have to be true: 105

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• •

•

The Weekly chart must be in an Upswing (Uptrend preferred but not required) The Daily chart might have pulled back or consolidated during this weekly upswing, which is good…but the Daily chart needs to transition into an Upswing AND Uptrend itself. When both Weekly Upswing and Daily Upswing/Uptrend are in place, we have Trend Alignment and we have improved our probabilities that this trade will play out to our favor.

Let’s look at one little slice of the fractal relationship between the Weekly and Daily charts shown earlier on Figure 7.5. We see in the late January/early February time period that the Weekly chart is DEFINITELY not only in a swing higher, but also an uptrend, as shown by the large black arrow on the Weekly chart on the left side of Figure 7.9: Figure 7.9

So, what do we know at this point? The ANCHOR (Weekly) chart is in an uptrend, and it’s swinging higher from the PSL, which means that we should be looking to take a Long (bullish) trade. Our attention now shifts to 106

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the SIGNAL (Daily) chart for an opportunity to get long. Can we just enter ANYWHERE on the Daily chart, now that we’ve decided to take a long position? It really depends on how precise you want to be. I think that entries on the Signal chart tend to work out better when they are not arbitrary, but instead contain an element of edge. And this is what a pullback or consolidation gives us, as we will see in Section Four. But for now, waiting until the Daily chart re-establishes an uptrend is a good start, and you can see this entry point on the right side of Figure 7.9 as the price “takes out” the PSH and re-establishes the Daily chart uptrend. At that exact point, both Anchor (Weekly) and Signal (Daily) charts are in trend alignment. You can get some powerful moves when all of the “family” of timeframes decides to move in alignment! One of the hidden benefits of this method is that you will be able to decode the “structure” of the market, systematically. You will be able to tell the trend at any particular timeframe and understand what would have to happen in order for the price to achieve that desired “alignment.”

The Holy Grail of Trading - Price Reversals There’s no doubt that the Holy Grail of Trading - the most sought-after signal - is the trend reversal. Actual reversals in trend carry the maximum edge, since you’re on the other side of the boat from everyone that’s being tossed off… and these trade entries also carry the maximum reward-to-risk if you catch them at the right point. There’s no doubt that these reversals are at the maximum end of the “contrarian” scale. Confused? This will make sense in a minute. In chapter three we discussed how physical objects typically change from the inside-out. A virus might start to replicate inside of you and you’d never know it until your immune system finally is overwhelmed and you can’t lift a finger. Houses begin to fail from the foundation-up as termites eat the structural wood until the loads shift and the house begins to sag. You’d never see that change from 107

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the outside until the damage has already been done. Cars tend to rust out from the subframe-up, and you’d never anticipate it just looking at the exterior. Change starts from within, and it propagates to larger and larger objects as this “state reversal” becomes a contagion. Guess what? The same thing happens in financial markets. The “Great Recession of 2008” didn’t happen all at once; erosion had been occurring in the smaller timeframe trends well before it suddenly “let loose.” Just like everything else that we encounter, change comes “from within.” And we’ll find the same thing as we study price action…that changes in trend actually start from the smallest timeframes going in a counter-trend direction, before those changes actually start to propagate to larger timeframes making a countertrend move as well. Where the “change” actually stops…depends on how deeply the “foundation” of the market was corroded. If conditions are no longer adequate to support growth going forward for the next year or two, a full monthly trend change might be in order. Can you see why we’d want to be in FRONT of that and not BEHIND like the rest of the Herd? Let’s show an example of this “reversal of trend” occurring on the S&P500 through Figure 7.10. Figure 7.10

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Start by looking at the weekly chart in the left pane; note how it was in an uptrend with a HL and HH, peaking out in October. Eventually the weekly chart reversed into a downtrend, first printing a LL followed by a LH, then another LL as panic begins to set in. It looks all so easy in the rear-view mirror, but it was certainly felt unreasonable at the time to assume that a market that just printed great GDP numbers and was setting new all-time highs in price would suddenly collapse and drop 20% of its’ value over the next few weeks. Change comes from within. Now look at the daily chart in the right pane; note how it was printing HH’s and HL’s within the uptrend into October. We know that uptrends that continue will print NEW “higher highs,” and this one suddenly failed to do so in early October. In fact, it printed a LH or “lower high, followed very quickly by “taking out” the PSL at the horizontal dotted line. This is a definition of a trend reversal or “change of polarity” and it happened very quickly and also very close to the all-time highs. This gave the “aware” trader a massive edge, risking very little to pursue a short position, while the weekly chart took much longer to confirm the change in polarity to a downtrend, which it eventually did weeks later (and several hundred points lower) in December. Change starts from within beginning with smaller timeframes, and it propagates to larger and larger timeframes. Think about some of the concepts that we’ve discussed in this chapter of the book…even though it doesn’t seem like we’ve covered much ground, I think that you’ll be surprised at how you’ll find yourself thinking about markets in a completely different manner than you probably did before. In the next chapter we’ll put everything together that we’ve covered to this point into a set of rules and guidance that will allow you to build a pricebased trading system.

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Chapter Summary • Larger Timeframe charts are made up of a collection of identical smaller timeframe charts. The major swings that we see on a larger timeframe chart like the Monthly chart…are built up from several smaller swings and trends from its “child” chart. • We will use a 5x or “Factor of Five” Relationship Between Chart Timeframes. This relationship differential shows excellent detail of smaller timeframe swings within the “parent” timeframe trend. • The larger timeframe chart will be used as an Anchor chart, and we’ll trade in the direction of the Anchor chart swing. • The smaller timeframe chart will be used as a Signal chart, and we’ll look for entries on this chart which align with the Anchor chart swing direction. • Trend change begins with smaller timeframes and propagates upward to larger timeframe charts.

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verything to this point of the book has been very “Fisher-Price” as I’ve tried to paint some well-known analogies with bold, broad colors. I want you to understand how much you already know about the concepts that we’re discussing when it comes to these “Fractal” relationships and price action. And let’s get one thing out of the way right off the bat; this method of price action analysis is not “predicting the future.” This is no “crystal ball” method of forecasting; we are simply evaluating the price action on our “family of timeframes” and letting the trend of each timeframe show us 1) where price is going, and 2) the price level where we’d take action. It’s a very objective, clinical system when done properly, and frankly I doubt that you’ll find anything more accurate. If I were you, I would write this down and stick it on my office wall: “Technical Analysis is not for predicting the future; it creates a framework from which you can make decisions.” The objective of this chapter is to wrap up everything in Section Three into a couple of trading rules that we’ll use which is really going to be the basis for our Fractal Energy Trading system. The skills that you learn from this sec-

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tion can be applied to ANY market being charted in ANY timeframe. Here we go…

Two Trading Rules for Price Fractals We have already brought up these rules through this section as we’ve explained the material, but now we’ll put a stake in the ground and formalize them.

Rule #1: Larger Timeframes Establish and Dominate the Overall Trend Think back to our example in the last chapter with the family going on vacation; the largest “timeframe” in that example set the tone for the trip and established the overall direction and trend, minus some distractions provided by the smaller timeframes along the way. The larger timeframes of a fractal family of timeframes will absolutely dominate the overall trend. This means that we want to align our trades in the direction of the Anchor chart price movement.

Rule #2: Reversals Start with the Smallest Timeframes and Propagate Upwards Monthly charts don’t stop and reverse their trend in the opposite direction any more than an aircraft carrier can reverse its course at full speed in less than a few miles of ocean. Just like we talked about with Fractals and objects, small & imperceptible changes will occur to a larger trend, starting with the smaller timeframes first. One by one they will reverse like dominos, until the major trend finally reverses. In the case of our Monthly chart, it might take up to a full year to truly reverse, but we’ll have an early warning to watch for that reversal since 112

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we’re watching the smaller timeframes. We will want to use our Signal chart to focus on the best possible entry that creates Trend Alignment between the Anchor and Signal charts.

Five Steps to Outline a Trade Entry In conjunction with the two rules outlined above, we’re going to use them in the context of several linear steps that should be used to evaluate every trade setup, whether long or short.

Step One: Determine Your Anchor and Signal Chart Timeframes Your Anchor and Signal chart timeframes will generally be chosen to match the style of trading that you do. I will generally separate the Anchor and Signal timeframes by a 5x multiple, although there are applications where I might separate them by a 25x multiple. Here are some typical applications: • Swing Trade: Trade duration from 1-4 weeks, Weekly Anchor chart, and Daily Signal chart. • Swing Trade: Trade duration = C[1], H, C[1]),Len) Lowest(iff(L