Four Guiding Principles of Market Behavior

Interesting discussion at Afraid to Trade, distilling aspects of Trend Following, Technical Analysis and  Dow theory (historically attributed to Charles H. Dow, William P. Hamilton, Robert Rhea and E. George Schaefer) along woth the technical works of Richard W. Schabacker. Each have made major contributions to Market Theory, and were early pioneers of what was to become technical analysis.

These four driving principles of market dynamics are rationale, based on Human Behavior, and have  survived the test of time. These principles can be mathematically quantified; they are more than subjective pattern recognition.

Four Guiding Principles of Market Behavior

Principle 1: A Trend is More Likely to Continue its Direction than to Reverse

Trend is a clearly defined pattern of higher highs and higher lows, often within a channel. Once a trend is established, it takes considerable force and capitalization to break trend.

"Fading" a trend is a low-probability endeavor and the greatest profits can be made by entering reactions or retracements following a counter trend move and playing for either the most recent swing high or a certain target just beyond the most recent swing high.

Principle 2: Trends End in Climax (Euphoria/Capitulation)

Trends continue until some external force exerts convincing pressure on the system in the form of sharply increased volume or volatility. This typically occurs when we experience extreme “continuity of thought” and euphoria of the mass public (that price will continue upwards forever).

However, price action – because of extreme emotions – tends to carry further than most traders anticipate, and anticipating reversals still can be financially dangerous. In fact, some price action becomes so parabolic in the end stage that up to 70% of the gains come in the final 20% of the move.

Principle 3: Momentum Precedes Price

Momentum – force of buying/selling pressure – leads price in that new momentum highs have higher probability of resulting in a new price highs

Stated differently, expect a new price high following a new momentum high reading on momentum indicators (including MACD, momentum, rate of change). A gap may also serve as a momentum indicator.

High probability trades occur after the first reaction following a new momentum high in a freshly confirmed trend.

Principle 4: Price Alternates Between Range Expansion and Range Contraction

Price tends to consolidate (trend sideways) much more frequently than it expands (breakouts). Consolidation indicates equilibrium points where buyers and sellers are satisfied (efficiency) and expansion indicates disequilibrium and imbalance (inefficiency) between buyers and sellers.

For those interested in the technical strategies that follows these precepts, there’s much more at Afraid to Trade.

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Additional Sources:

The Dow Theory by Robert Rhea

Stock Market Profits by Richard W. Schabacker
See also Market Master
http://www.marketmasters.com.au/82.0.html

The Stock Market Barometer by William Peter Hamilton

Dow Theory Today by Richard Russell

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  1. Drew Yallop commented on Mar 11

    Hi Barry,

    You refer to “mathematically quantified” principles. Can you give me some guidance on finding the proofs? I would like to develop some trading rules.

    Best,

    Drew Yallop

    Drew

  2. Carl commented on Mar 11

    As someone who builds black box trading systems for a living, I think that it would be dangerous to believe “Principle 3: Momentum Precedes Price”.

    Momentum is actually a measure of rate of changes of Price.

    Thus, as momentum is a derivative of price, it cannot precede it.

    One could say, “Principle 3: Increases in momentum imply that price will continue in the same direction (either up or down)”.

    …otherwise, the list is pretty good.

    Carl

  3. Philippe commented on Mar 11

    The derivatives are now playing a large role in trend setting.
    Operators may replicate through derivatives above theories but I wonder if they represent the true investment markets upon which these theories have been buit?.

  4. Corey commented on Mar 11

    Carl:
    A couple of notes – indeed, indicators are derivatives of price, yet the concept of “impulse” puts odds in favor for continuation of price in the direction of the impulse (usually following a retracement against the impulse). I don’t mean “the indicator called momentum” (though one exists) but I mean “a critically strong and sudden imbalance in supply and demand” as my term “momentum” or “impulse”. Price gaps also serve as impulses or bursts of momentum.

    I do like your restatement – it adds clarity.

    Momentum (supply/demand imbalance) may also precede price in the technical analysis form of divergences, where momentum wanes (decreases) while price continues its original path. When we observe a divergence on a chart (through indicators), we expect price to resolve in the direction of the divergence.

    I appreciate your comments.
    Corey

  5. Barry Ritholtz commented on Mar 11

    Carl,

    I read that as a description of the force of price movements.

    It also suggests a measure of strength beyond mere point movements, perhaps helpful in identfying how much more fuel exists, or when a breakout is weak, or an exhaustion is setting up. New highs on decreasing volume would be the classic example.

    Think of Home runs in baseball — some dribble over the fence, while others are mighty blasts that break windshields in the parking lot. The run scored is the same, but the pitcher remembers the latter more then the former.

  6. Winston Munn commented on Mar 11

    What is the role of volume in these concepts? This is an area that seems to have no strong concensus except in the most general of ways. Perhaps that is due to volume itself being to vague to quantify, meaning that the internal composition of volume is more meaningful.

    On a generalized basis, volume would seem to be a risk-aversion/complacency indicator, as higher prices on lower volume might be viewed as an aversion to the risk that prices will continue upwards, while low volume on corrections would indicate complacency about the risk that prices would drop further.

    If this is accurate, last week’s gains might be viewed with a jaundiced eye, as the volume in the three major indices occured on decreased volume – which in this hypothesis would indicate risk-aversion and thus should be a somewhat bullish action for the bond market.

  7. Estragon commented on Mar 11

    Maybe the principles are better applied to trading stategies which attempt to predict price action than to price action itself?

  8. MKS commented on Mar 11

    I personally think this sort or any other form of technical analysis is garbage. It is first of all a misnomer to call it technical, there is nothing technical here- only chart reading.

    At any given moment, anything can happen-prices can go further, stop and reverse or stay flat. The technical genius interprets the tape as being caused by one of the above 4 guiding principles of market action, only after the fact.

    Basically, equivalent to some bozo in cnbc or bloomberg interpreting market action to some news, needless to say the news may have been totally irrelevant.

  9. Estragon commented on Mar 11

    I personally believe all forms of analysis are valid if and to the extent they are believed by others.

    For example, if some clown on CNBC has the ability to move prices, the clown is a perfectly valid and relevant tell. Eventually, that particular clown trend will exhaust itself, and another trend will emerge, but in the meantime fading the clown is a low probability bet.

  10. Agustin Mackinlay commented on Mar 11

    Barry,

    Great blog! Just wanted to let you know about the new Liquidity Blog.

  11. Corey commented on Mar 11

    In regards to the question of volume, indeed volume plays a critical role in each principle. In an uptrend, we can expect price to rally on increased volume as more people jump on board (during upswings) and hold their positions (refuse to sell) during the retracement swings. When this natural behavior is disturbed, expect volume to increase rapidly (as in the case of trend exhaustion or climax).

    Uptrends end when all buyers have been satisfied and this is sometimes with a last-gasp mark in increased volatility and volume as people rush in to buy before they miss the move. At some point, there will be no one left to buy and volume will then increase to the downside on sell swings. The same logic applies to downtrends.

    The same goes for momentum. If a news event causes thousands of people to rush into a stock, it will create a momentum impulse. Many professionals refuse to buy into that impulse and will wait patiently for the ‘weak hands’ to be shaken out and then they establish positions after a pullback (increasing volume in the direction of the original impulse and trend).

    In terms of range expansion and contraction, volume decreases during consolidation patterns and increases during expansion, as people are uncomfortable with new price levels, those on the wrong side of the market are forced to liquidate, and further supply/demand imbalances are thrown into the price system.

    While these points concerning volume make sense theoretically, studies show no major correlation in volume analysis and absolute prediction. Volume can only be a guide for confirmation or non-confirmation, and not 100% accurate.

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