The more involved you get with the financial markets the more you notice that science is everywhere. Essentially every decision we make is based on scientific processes. The Gann methodology is renowned for scientific exploration as our human instincts become alive. It is natural human curiosity and necessity that leads to asking questions (What is the problem?), constructing a hypothesis (How do I solve it?), testing it with evidence and evaluating the result (Did the solution work?), and making future decisions based on that result.

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.

It is often volume that leads the way when the compression phase is up. The week starting, 2 February 2018, the market was able to break to the upside, finally shedding some light on the fact that the compression phase was over.

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.

As history goes, the week proceeding, 9 February, the market made a retest of the breakout with bigger volume. Over the space of a month the volume never intensified nor did the market move away ‘explosively’. Automatically, this pattern would have triggered the fact that it is more of a “false break”. A false break, therefore, is more likely to provide twice the force in the opposite direction.

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.

The bulls realised that they better start covering long positions. Ultimately, when the trend broke out the week of 13 April, the volume was 78 million, which was well over two multiples of the average 200 weekly volume. The following week, 20 April, the market moved very strongly, with large volume showing the true signs of a compression break out.
We have only focused on compression patterns in this article, but science in the markets does not stop there. I encourage you to take a more scientific approach to movements in the market. Be a data researcher with a scientific outlook on set ups. Simple science terminology, such as gravity, can be molded to bigger picture set ups. The 50% level for example is a gravitational pivotal point. Gann writes about the 50% rule in How to Make Profits in Commodities. The 50% rule has a scientific meaning which is worth further investigation.

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

Robert Steer