Therefore, you can condense science in the markets down to problem-solving. Whereby, using critical thinking and evidence to create solutions and make decisions. Problem-solving and critical thinking are two of the most important skills we learn. They are essential to making good decisions that lead to achievement and success in not only our trading journey but also life.
For this reason, this month I will take a scientific approach and focus on a scientific pattern that seems to always find its way into very explosive trading moves. We will use a combination of time and price to evaluate the set up in the article, but let’s first understand the reasoning behind why the markets have explosive moves.
Prolonged compression is often the result of an explosive move. Compression in the market is often referred to as a Pennant Flag. The technical analysis world often refers to this as a Pennant Flag because the pattern resembles a flag on a pole. The pole is the result of a vertical rise in a market and the flag results from a period of consolidation. While there might be logic behind the name, the explanation seems rather amateurish. Let’s take a more scientific approach to its meaning.
Technically, a market is under a state of compression, at some specific point based on supply and demand. Compression is the function of balanced inward or pushing forces from two different points, the bulls and the bears. It forces with no net sum directed so as to reduce its size in one direction – making an explosive move.
If we look at the monthly chart of AMP (ASX: AMP) below you will see that the function of balanced inward or pushing forces from both the bulls and the bears resulted in an explosive move to the down side – proving that the bulls finally gave in and the bears dominated the move.
The more time within a compression the greater the force will be once time is up. You can see from the chart below; the market action has been compressing since 2008. While other markets within the Australia Financial sector broke their pre-2008 highs, AMP struggled to get back to 50% on the Highs Resistance Card. Also note that from 2015 the market moved in a sideways period, until it finally broke out in the early part of 2018.
However, volume showed a different picture. After ten years of compressing, the market broke to the upside with a weekly volume of 30 million, when the average turnover for a week is 36 million. This rings alarms. While the market was able to close above the trend line, there were no ‘revs’ to fuel the breakout. Volume is a key indication as to whether a breakout is going to fail.
If you visualize this chart yourself for a minute; ask yourself ‘if you were a bull buying on the break and after 5 weeks the market hadn’t moved anywhere, would you question the future strength of this move?’
If you refer to similar compression patterns in other markets, often when the market breaks out it moves very quickly. I liken this to the compression of a spring. If you think about compressing a spring between your fingers, followed by letting it go, the spring explosively ‘moves’ away.
If however, the move fails to breakout, the market is more likely to run twice as hard the other way. As you can see in the chart below, the market spent a couple of weeks trying to break higher, followed by a couple of weeks that moved nearly four times the distance to the downside.
Remember that science has us asking questions such as ‘what is the problem? and further constructing a hypothesis (How do I solve it?). You want to test it with evidence and evaluate the result (Did the solution work?). This is often how trading plans evolve; making future decisions based on that result.
It’s Your Perception