Forex Journal

Defining the Trend and Market Cycles for Effective Swing Trading

Monday, 04 January 2010 00:00 Raghee Horner Technical Analysis 2

The basis of using any trading strategy must be determining the market direction, which can also be referred to as market phases or cycles. I was first introduced to market cycles as I was reading about Dow theory. A basic tenet of Dow theory was that market trends have three specific phases. Remember that while the psychology of market phases can be applied to any market, the bias of the stock market is bullish. Since Charles Dow wrote about the equities market in the early1900s, much of his writings reflect this bullish directional bias.

In other words, most equities traders and investors look for a stock to go up. As Forex traders though, we are equally ready to go long or go short. Please keep this in mind as I go through the phases. It is worth mentioning that Charles Dow never referred to “Dow Theory” in his writings over the course of over 250 editorials. This was done posthumously. However, traders in every market knowingly or unknowingly are affected by the ideas in his editorials even today – regardless of the market they trade.

The first market phase of a trend is accumulation. The psychology of this phase is best described as when investors or traders “in the know” are buying. The fact that these participants are “in the know” also denotes a certain amount of “secrecy” or “stealth” in that the market should not move rapidly higher out of a sideways range. Accumulation phases visually appear on a chart as a range bound market, usually quiet and narrow as if not to call too much attention to the underlying activity. It is for this reason that accumulation usually goes unnoticed.

After accumulation comes the trend or “mark up.” Remember that for stocks, it is an uptrend. However, I want to keep with the idea that as Forex traders, we can benefit from Dow theory as long as we remember that in the currency market accumulation can also be followed by a downtrend. The trend, as I will refer to it for this phase or cycle, is when price typically trades above the resistance or below the support of the accumulation range.

News, data or even volume could be the catalyst for the breakout. Regardless of how the trend began, as it persists, more and more participants notice the move and want to get on board. The only reason an uptrend can continue is that more participant are willing to buy the market at a higher and higher price. It should also be added that these same participants are willing to buy corrections and it is these corrections (or lows in the uptrend) that become the backbone or trendline of the move. An up trend’s backbone is a progression of higher lows.

The final market stage is distribution. Now again I must add that these phases do not always occur one after another as described here. Phases can be skipped; phases can transition from one type of sideways market to another and then can also transition from uptrend to downtrend. The distribution phase is volatile, wide ranging and reflects the psychology of confusion and panic. The name comes from the idea that at the height of speculation, the market participants “in the know” from accumulation and even the early trend participants distribute their shares to the market. The market, in the distribution phase, represents those speculative late-comers. At the top and bottom of strong trends, the speculative frenzy can be seen as holdings change hands and one group realizes profits at the expense of the other. This is the way the market works.

I am not neglecting the downtrend phase or “mark down.” Simply put, after any sideways move just as prices could rally higher through resistance, they can sell-off through support. Regardless, the downtrend phase is akin to the trend phase discussed earlier. Any trend is really the result of imbalance. In a sideways market, like accumulation, there is a certain balance between supply and demand. The more “balanced” a market is, the tighter the range between the floor and ceiling. The wider the range – as in distribution – the less balance there is in the market. But complete imbalance comes during a trend where either the amount of demand exceeds supply (uptrend) or supply exceeds demand (downtrend),

Now while I may not use a strict interpretation of the phases of market trends, Dow theory has had a significant impact on my own trading. It led me to pursue how I could identify the market phases (I refer to them as cycles) with a more real time, objective indicator. The fact is that trendlines are powerful but terribly lagging tools for trend identification.

So having this understanding of market trends, thus began my pursuit of determining what type and how many entry strategies I would need to employ to trade the different psychologies of the market. Based upon Dow theory, there are essentially three phases and therefore three strategies I would need.