Market anatomy

Guts of a flag, bowels of a megaphone

pace and size, tempo and wave length

As discussed in Balance and Imbalance, Initiative and Response, the entire market is made out of these phenomena.  There is nothing else.  This discussion of flags and megaphones builds on the same ideas. 

The point is, we don’t have to look hard, or cherry pick to find situations where these things happen.  Everything that happens is some version or variation of balance and imbalance.

Cherry picking involves finding the prettiest versions of the phenomena.  Your prettiness may vary.  Or rather, it will definitely vary.  But it is all still the same phenomena.

Sometimes it’s easier to find these things on a very large time frame.  Price ultimately tends to form fairly pretty large fractals of common patterns. 

Zooming in, price tends to look noisier at first, and it takes practice to pick out the smaller fractals as they are forming, since they often start to look like one thing, then become their opposite. 

A flag is a balanced consolidation pattern.  It compresses and coils price.  And we expect price to squirt out of it.  Usually a continuation of the direction that came in to the flag.

old golf flag, weekly chart

A megaphone is the opposite, a widening balance, or consolidation pattern, where price gets looser and looser, and eventually reverses.  Usually counter to the direction price came in to the pattern.

oil megaphone

Questions we want to think about:

Why do these phenomena happen?  What are market participants doing behind the chart pattern? 

How do we estimate how long the phenomena will last, and how far the move out of them will go?  How do we trade them?

Variations:

We can expand someday on the topic of variations.  But note that variations exist.  And most of their action can be understood in light of the analysis of the primary phenomena, below.

flags: consolidations with no “flag pole,” descending vs ascending wedges.

INTC 20 year consolidation

We can use this 20 year Intel chart to illustrate a couple of variations.  As a whole, it’s a bullish consolidation over many years. Within it, there is contained a descending wedge type consolidation, a bullish formation….but the type that often does what this one did, breaks up, and then later fails.

Overall though, from 2002-2008, you may have said to yourself (in super slow motion), but wait, isn’t this a giant bear flag, that “should” complete down.  You might have thought, WFT, is Intel gonna go out of business.  Is it gonna be 2 buck chuck?  Surely the completion of that giant down wave will take this thing to pennies.

Well, look at the little highlighted oval.  The market dutifully did its technical job of “completing” the bear flag to the downside, when it took at the 2002 low.  It made a super crappy low for 4 months, that looked like it was headed in to the gutter.  Then, in your face bears! 

Megaphones: at the top of a trend vs at the bottom of a correction, square ranges or slight widening.

SPX pattern mash up

Look what the SPX has been doing lately.  It’s a smorgasbord of patterns, all contained within a megaphone.  First there was a square type range.  Then it tried to fall out of bed, formed a megaphone at the bottom, then faded back up.  It completed the 80% rule, retracing the square range, while channeling upwards.  What’s next, SPX?

Ranges: ranges within ranges, or distributions. 

EUR-USD 18 mo bear flag ranges 7-30-16

This is a chart snapsnot of the Euro/Dollar that I made a while back for a blog post. You can see, contained within the giant bear flag, many little fractals. 

WHY!?!

Why do these phenomena happen?  What are market participants doing behind the chart pattern?

All of these phenomena are caused by actual buyers and sellers, taking positions, hitting targets and taking profit, or being wrong and getting stopped out.

As a beginner, we look at patterns, and how they tend to play out, and try to formulate a plan on that basis.

But from the very beginning, I was asking why?  Like an infant.  I wanted to know WHY these things were happening.

For me, it’s important to have an idea of the mechanism behind the action, in order to feel confident in my plan.  It’s not enough for me to observe THAT it happens.

When we just look at charts historically, we see the finished patterns, they always all make sense.  But if we don’t live through the action, or replay the action, we don’t see how we can get fooled, what appears to be one pattern becomes it’s opposite, and is subsumed in a larger fractal.

An apparent bear flag can become a giant W shape, double bottom, and instead of completing lower as a bear flag would, there is a big reversal to the upside.

There has to be more to my thinking than simply the belief that a pattern is forming, or some pattern that is there will follow through in some expected way.

Looking at charts historically, it seems like it would be easy to figure these things out, and make a fortune.  But in the heat of the moment, with your account bleeding, it’s a knack to keep your wits about you.

Serial

In a Bull Run (a bear break is the same, only opposite)

These things happen in serial fashion.  Consolidation leads to explosion, creating the flag pole phenomena.

Part way up the pole, price consolidates again, forming the bull flag.  It then erupts in the same direction, and goes equally far, or less far.

Then, again, consolidation, and pop.

gold run up

Eventually, the pop goes less far than the last.  Then a seller wave in the opposite direction takes more than half of the last pop.  Then another wave of buyers negates them in the direction of the pop, but just gets a little past the earlier high.

The wave lengths get longer than standard deviations.  Seller and buyer repeatedly negate each other.  This creates the megaphone phenomena, indicative of a reversal.

The guts of a flag

Sorry I’ve chosen the infantile anal stage for my metaphor.  You could probably equally liken the consolidation phase to the gathering excitement of a lover, athlete, concert fan, and the explosion of adrenaline and endorphins as price erupts ups.  But no, I’ve chosen guts and bowels. 

What is happening during consolidation? 

As price narrows, compresses, what is happening is, over time, more and more people are taking positions, long and short.  They have their stops above and below.  They have opposite ideas.  As price narrows, more and more participants place their bets.  Fewer and fewer get stopped out.

So what you end up with is a series of layers of buy stops (of the shorts) above the layers in the flag, and sell stops (of the longs) below the layers of the flag.  Like strata in erosion.

TSLA flag anatomy

(BTW, this specific example did not happen to be a bull flag, even though it completed up.  It was a consolidation.  Just a pretty example.)

So as the trade gets crowded with positions, to repeat, all the shorts have placed buy stops above, and the longs have placed sell stops below.

At all those levels, you also have new sellers above, and buyers below.  But those become fewer and fewer, because during the consolidation, most people have already taken their position.  And everyone knows each of those levels are not the places to place a new order in that direction, but to abandon the idea, and stop out.  So there are only a few stupid new people at each of those levels that actually want to initiate a new position…or big swinging dicks, who want to fool everyone, and mess up the pattern with their big size.

So that, when one side takes firm control, when you get an “innovator,” who is willing to buy up (in an upward break, for instance, like in the example above), there are only a few actual sellers up there.  So when he makes a large order, he plows through several price levels, buying all the inventory for sale through several price levels.

This triggers a series of short stops, which are buys, adding fuel to the fire lit by the innovator.  One innovator can buy through all the layers in the flag and a bunch more layers above, but quick chasers also often start buying too, trying to catch the wave early.  “Breakout traders.”

This causes the big impulse seen as a flag pole, or the trend up out of the flag, as above.  It goes until the innovator and all the breakout-traders/wave-catchers have spent their wad.  Then it tops and fails.

New buyers start setting orders that back fill in the wave, wherever they think the product is “cheap.”  As the wave grows above 1 standard wave length, these orders will trail it up at approximately half its size.  If the wave is anything up to 2 standard deviations, it is likely to fall halfway back, and then resume the rise for a higher crest.

If the wave keeps growing without pulling back (the Innovator is a bigger player, or more chasers believe in the opportunity, and the buying keeps plowing through more sellers above), and the wave grows larger than 2 times 1 standard wave size, the orders will tend to trail up at a slowing pace, but will usually trail the top by at most 1 standard wave size, one standard deviation, for that time frame.

This is why larger waves create the pole and flag look, on a bar chart.  Why the pennant hangs up high, and doesn’t fall back to half mast, if the “pole,” or up wave, is tall.

So maybe the guts metaphor in this instance is more appropriate to the bear flag, and for the bull situation I should have used the lover’s eruption, or the enthusiastic hoot of adrenaline and endorphins.  Whatever.

Anyway, does this happens because people consciously calculate these levels, or because they instinctually sense them, or because the market is traded algorithmically?  Yes.

So this happens again and again, until it doesn’t.

The Bowels of the Megaphone

Ok, since we went with the bull phenomena, the alimentary metaphor now starts to work better, when the phenomena tops.  Price is about to poop out. 

At the tops and bottoms, price action tends to widen, instead of consolidate.  Why?

If price had been going up, we still have committed buyers, on various time frames.  We don’t know the depth of the innovator’s commitment.  Maybe he’s a giant hedge fund, and he thinks this instrument is the next Apple with a new iPod thingy.

He is going to buy up every pull back for months or years.  This is every long-term, William O’Niel style trend-follower’s wet dream.

To add another example, since I’m a futures trader, maybe this is Exxon loading up on oil futures, because they want to lock in oil at a series of prices.  They are actually buying millions of barrels of oil, and they will just buy more on every dip.  Not because they want to support or cause a trend, but because they actually want the product.

Then beneath these bigger picture market driving innovators, there are a series of traders with different sizes and time horizons.  Some of them are happy to catch one continuation after a bull flag completes with a higher wave, and they will start selling.

Some of them may have a bigger idea.  They are not Exxon or the giant hedge fund.  But they think or believe they detect the action of that bigger entity.  And there are a series of layers of these sizes and time frames.

So the smaller time frame guys start selling at the top.  It’s not just that the up initiative has petered out.  It’s not just a lack of more buyers.  Now actual sellers are appearing.

However, the next time frame higher than them perceives this as a buying opportunity.  So first you get a sub-standard wave length down, then a standard wave length or more up.  But there is no one big left behind it, so it doesn’t go very much higher.

Then you get a standard wave length or more down, as the next bigger set of players senses a temporary top.

If falls until a bigger time frame sees price as cheap again, and may cause a new mini-initiative up, a slightly higher high.  And then the next size up sells.  And so on.  The wave sizes grow.  And you get a megaphone widening pattern.

megaphone anatomy

At some point all the medium time frame players are exhausted.  The longs have given up.  They realize this is not going higher for now.  They start to sell their positions.  And they are fueled by active short sellers, who want to catch the top.

Price keeps falling, seeking the next time frame bigger, seeking buyers.  When it falls halfway back to wherever the whole phenomena started, then new buyers step in, expecting the original buyer to start adding, and often price makes a bigger fractal wave.

Oil off the bottom

If it falls through 50% on a shorter time frame, players start to throw in the towel, and figure the big guy left the room.  They start to sell more, and the down move continues.

On a larger time frame, another significant, strong line in the sand is 61.8% (the fibronnanci #) of the initial impulse wave.  Is this because people literally calculate this, or because they sense price as cheap instinctively, because it is built in to nature that fractals are formed like this, or because algos are coded to react to this level?  Yes.

As an aside, there are a whole series of Fibonacci levels, where price often does react.  However, 50% and 61.8% are the big kahunas.  And think about it.  Half of anything.  You don’t need Fibonacci to tell you that’s a thing.

After that, the final last stand is the place where the innovators initiated the impulse in the first place.  Will they show up again?  Often the answer is yes.  Or at least enough people believe it is yes, that buying reappears at the exact spot where there were buyers before.

If this spot was the breakout from a bull flag, it’s a “breakout-retest.”  Often the phenomena will happen all over again, bigger than the first time.

Double bottoms

If it’s a place buyers appeared before, and took price up, but it was not a consolidation, that is a double bottom.  That is a different phenomenon than what we are discussing.

But in short, double bottoms usually will support on the first test, at least for a bounce.  It deserves a fuller discussion elsewhere.

But in short a double bottom is considered a “poor low,” and needs to be “repaired.”  Which means price “should” explore beyond that level at some point.

But there are variations where a double bottom can be a significant bigger picture bottom.  Depending on context.  Again, more later.

If price comes back to the level a third time, it looks increasingly like it wants to explore further.

But this is also the location where you might start to see a megaphone phenomenon forming.  It could be the formation of the edge of a range.  And trading that situation has been discussed elsewhere.

And that brings us full circle.

A flag is a tightening range.  A wedge is a widening range.  And then then there are plan vanilla square ranges.

As discussed in “Balance and Imbalance,” and “initiative and Response” the whole market is made up of these two conditions.

And it can be said that all initiative is response on a higher time frame, and all responsiveness (consolidation) is part of a bigger picture initiative.

How do we estimate how long the phenomena will last, and how far the move out of them will go?

This is the real meat of the matter.  Now we know what is happening.  But how do we play it?  How do we make money?  How to we not go terribly wrong and lose a lot of money?

The short, general, mostly useless answer is, the parts of the phenomena are relative to the wave sizes of which they are a part.  And the waves sizes tend to be a function of time frame, or tempo.

Although, sometimes a larger than normal wave happens unusually quickly. And that is meaningful.  Noteworthy.  Tradable information.

But the real answer is that we use historical context.  We look for where buyers and sellers were before.  So we are looking at the same phenomena, just a larger fractal of it.

oil historical breakdown

That’s how an initiative trade can also be a responsive trade, and vice versa.

And why the idea of “catching a falling knife” is ultimately meaningless.  Every level everyone chooses to enter a market is a “falling knife,” if they are a buyer. (And what’s the converse?  Never, I admonish thee, NEVER try to pop a rising balloon, Timmy Trader!)

Unless your product has been lying there dead for a long time.  In that case you’re not catching a falling knife, you’re just sticking your money in a dead thing and hoping it will come to life.  Hey, sometimes they do!  (Not very often.)  I only mention this, since it’s the most common newbie strategy.

Accumulation

One important point, as an afterthought (last, but not least.)  A reason why large trends can go in bursts, in fits and starts, is because if a buyer is very large, like a large hedge fund buying a stock, or our example of Exxon buying oil futures, there is only so much of the product on the market.

They buy as much as they can, without artificially inflating the price with their own buying pressure.  The want more.  But as price goes up, there are less and less sellers, because more and more people feel they can get a higher price.

So if the large entity just kept buying all at once, they would pay an astronomically high price for their later shares or contracts, which would cause a parabolic price spike, followed by a giant crash.  So they have to buy a load, then wait for the market to settle down.  Then start buying again.

This is known as “accumulation.”  The converse is “distribution,” and works the same way, in reverse.

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