How to trade directionally

The illustrated elements of trading

Initiative and response

There are two conditions in any market: balance and imbalance.  Initiative and response.  Like binary code, the entire language, or music, of markets is built out of this duality.

All possible directional trades can be planned in the context of these two conditions.  You could say there are only 2 types of trades, although there may be a lot of nuance, perhaps infinite variation.

Markets and trading tend to lend themselves well to metaphors.  They reflect nature and life.  And duality is a common theme in reality.

In one quasi mythical origin story I recall, the I Ching , arguably the prototypical book, was written when the progenitor scratched one solid line and another broken line.  That’s all he wrote.  The rest of the I Ching was implicit.  Man and woman.  Yin and yang.  Self and other.  Everything that will or can happen.

Reality can be seen to be fabricated on a foundation of duality.

It may seem like hyperbole, an overstatement, to attribute to markets and trading such profound characteristics.  But in my opinion, it is accurate and fair to suggest that markets mirror the fundamental characteristics found in nature.  We’ll see.

Imbalance and Balance

In trading, it is commonly said, that balance leads to imbalance, and vice versa.

Balance on a bar chart is seen as a sideways consolidation, or a range.  Imbalance is seen as an initiative thrust.  Movement back and forth within balance is “responsive.”  Movement out of balance is “initiative.”

balance and imballance

The yellow circles are imbalance.  The grey boxes are balance.  This is taken from current action in the SP500.

How to trade balance

Trading balance is a responsive trade.  It is traded from the outside in.  The 80% rule says that whenever price goes outside of a range, and comes quickly back in, 80% of the time, it retraces to the other side of the range.

In this chart of the US dollar index, the light green circle was a buy, because price fell out of the range, then entered back in.

DX 80% rule buy

There was the additional confirmation of the bounce off the channel line.  It’s always nice to have some additional back up, or support of some kind, to add confidence to an idea for taking a position.  The primary targets on this type of trade would be the middle of the range, and the other side of the range.

How to trade imbalance

Trading imbalance is a go with the flow sort of thing.  Buy pullbacks, or short pops, depending if the initiative is up or down.  The expectation is that as long as price sticks in the top 50% of an initiative up thrust, it is likely to continue and test further.

Sometimes price may pull back 50% of the initiative impulse, providing an entry.

gold 50% pullback

Other times, if the impulse is particularly big, price may not pull as far back.  In that case, the consolidation for continuation creates the phenomena known as a flag.

TSLA flags

These flag consolidations on the TSLA run up did not pull back to 50% of the impulses that drove them there.

And by the way, while these are cherry picked examples, they are by no means rare.  I did not have to look hard to find them.  These phenomena happen all the time.  And in fact, all market (auction) action can be seen as composed of these principles, and variations on them.

On the topic of variations, in the TSLA chart, notice the first flag actually looks like its flying off a flag pole.  The second version looks different, but it’s the same thing: impulse, consolidation, continuation.

There are various conditions which support each type of entry.  I’ll try to outline the conditions.  But getting to know them is like learning any skill, it’s partly a study of examples, and partly experience.

One rule of thumb is, measure 1 standard deviation, on the time frame you are looking at.  Anything bigger than that can be considered an initiative move.  A standard deviation is the average wave length for that time frame.  It is also how volatility is measured in options.

You can eyeball this, or measure it mathematically.  If you trade the same instrument routinely, you will get to know the standard wave lengths on your time frame.

If the initiative movement is slightly more than 1 standard deviation, the 50% pullback may happen.  If the move is considerably more than 1 standard wave length, the flagging phenomena may be more likely.

As we dig deeper, we’ll explore ways to fine tune entries, targets and stops.

Time frames and fractals

I have provided examples of these phenomena on large time frames, many days, weeks or years.  But it’s often said that auctions are fractals.  (And markets are btw auctions.)  These same phenomena happen over the course of minutes in a day, days, weeks, and years.

Here was TSLA today, with 5 minute candles:

TSLA intraday flag

After the initial drop, we can see that the up move became a new initiative, because it took back more than 50%, and then more than 61.8% of the early morning down move.  So the down initiative was canceled, the up initiative flagged, and then made the expected continuation move.

Zooming in even further on this chart, using 1 minute candles, we can see that the down move was composed of two tiny bear flags (balance areas), which led to continuation.

TSLA 1 minute waterfall

This is a chart I chose at random.  TSLA is not an instrument I trade.  And in fact, I have seldom even been trading stocks.  I’ve been training on and trading futures.  But these phenomena happen in all instruments.

It’s often recommended that new traders pick one or two instruments, and trade them regularly, to get to know their behavior.  I trade mainly oil futures (/CL) and SP500 futures (/ES).

Once you understand that these principles of behavior, initiative and response, balance and imbalance, constantly occur on all time frames, there is a reasonable argument that day trading offers the best training environment.  Because you get several trades a day, where you can learn to observe, and play these actions.

The skills gained can later be applied on various time frames, and to various instruments.

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