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How to Trade - 4: Going From Analysis to Synthesis

Before exploring the information above, it will be helpful to review the previous three posts in this series, as this post will integrate much of the information from earlier.  In the first post, we took a look at the importance of determining who is in the market, whether they are leaning toward buying or selling, and noting the prices at which they are transacting.  These variables tell us whether a market is rangebound and cycling versus trending, and they alert us to markets that are getting stronger and weaker. The second post introduced the idea of context--how short-term moves are nested within longer time frame activity and how trade opportunities are created by the lining up of shorter and longer time frames.  We also explored how the use of event time can create more stable time series of prices, so that we can more readily perceive market cycles.  In the third post, we examined the ideas of breadth, strength, and momentum, all of which help us understand phases of market cycles, particularly at longer time frames.

Gathering all this information and taking note of what it means is an essential part of market analysis.  We generate trading ideas, however, by putting our analyses together into a coherent picture.  It is that integration of data/analyses that I refer to as synthesis.  It is the crucial creative element in trading.  The creative, successful trader synthesizes information to generate perspectives that aren't readily visible from charts and individual pieces of data. That ability to put the puzzle pieces together and see bigger pictures is an important element in what sets expert traders apart from the consensus herd.

OK, with that during mind, let's interact in a few synthesis.

Going into this morning's market, my breadth data have been positive as we've moved to new highs.  The number of new highs versus new lows, however, and particularly my measures of momentum such as the number of stocks generating buy versus sell signals on various technical systems have stalled.  We are not seeing a meaningful increase in the number of stocks making short-term new lows, but neither are we breaking out to new highs across the majority of market sectors.  Volume has been light in SPY and the new highs have been limited to a handful of sectors and overseas markets.  Overall, the picture has been one of a range bound market with waning upside momentum.

If you click on the chart above (Sierra Chart platform), you'll see what I was looking at on my screen earlier this morning.  At the top left you'll see the horizontal bars at different prices, representing how much volume has transacted at each price.  The point of control--the center of where we've established value over the past several days depicted on the chart--is 3039 in the ES futures.  The prior point of control had been around 3020, so we have been accepting value higher.  That keeps me in a bullish mode.

Note that the chart is denominated in event time, with each bar representing 20,000 contracts traded.  As a result, we draw fewer bars during slower overnight trade and more bars during busier periods.  The red horizontal lines that I have drawn in depict shorter-term market cycles.  Note that, according to this view, we have recently seen a cycle bottom around 3032.50, which is above the early morning lows from yesterday.  With the bullish behavior of setting value higher over time and the potential bottoming of a cycle at a higher price low, I am leaning bullish in early morning, pre-opening trade.

(By the way, the blue arrows show how volume at the offer price tends to wane as the upward phases of cycles mature and how volume at the bid price tends to wane as market cycles bottom.  With ongoing observation, you can become quite good at tracking the strengthening and weakening within cycles.  During normal market hours, the NYSE TICK and other uptick/downtick measures also help track the maturing of market cycles.)

The middle bars and bottom oscillator track volume at offer versus volume at bid for each volume period.  Note at the right side of the chart, earlier this morning, the hitting of bids had diminished significantly, helping us identify a potential cycle low.

Integrating this information, I was a buyer early in the morning a bit before 7 AM EST around the 3035 area.  My hypothesis is that we had seen the lows from the overnight session; my stop is below that area.  I expect that, at minimum we should retest the 3039 point of control and quite possibly the recent market highs.  We did indeed touch that 3039 level prior to the NYSE market open, leading me to take profits.

This is a very simple trade, typical of what I do.  I look at multiple time frames and pieces of information and construct a view of the market based on trend and cycle behavior.  Having analyzed the pieces of information and then synthesized a view, I structure a coherent risk/reward structure for my trade that tells me where I'm wrong (we drop below what I assumed was a cycle low) and tells me where we should go if I'm right (first target the point of control; later target the prior day's highs.  Because today is a Fed day and flows will be unusual, I was particularly aggressive in taking profits at the first target.

Should we see a truncated up-phase for the new market cycle and a seeming top at a price level below yesterday's highs, I would be open to selling this market, given the stalling out of my momentum measures.  As I look at the market in early NYSE trade, that scenario appears to be unfolding.

The big takeaway here is that you're using market-generated information to fuel an understanding of what the market is doing, and you're creating the trade (and its management) based upon that understanding.  There is much, much more to trading than looking at price charts and looking for "setups".  My hope is that these posts inspire you to look more deeply into markets and find the opportunity that others, who are so eager to trade, miss.

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