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Market Skill-Builder
Financial Markets & Financial Software The Skill-Builder for Financial Trading - Financial Training Software.

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Distinguishing Reversals from Corrections (1)
Impulse Vs. Drift

The answer is that we watch for and act upon two separate types of event: :

1) We watch the action of the market (concentrating on the short-term price-chart) for signs of significant changes in momentum and volatility.

1a) as evidenced by the alternation between "Impulsive" and "drifting" price-action:

• Trading rule: always trade in line with the impulsive move and against the direction of the drift..

• In the example on the left, the second up-move is what is expected when the first is interrupted by the brief period of down-drift. This is because down-drift indicates that, on balance, the pressure is on the sell-side (probably due to profit-taking by short-term traders who were in the move early and now consider the market to be "overbought"). There is, however no real pressure or conviction in the selling (or the price would be falling faster). This process "frees-up" future buying-power as it means that there is a declining total of long positions in the market, some of which will be re-established by trend-following operators when and if the market accelerates up. Note that this type of pattern often occurs half-way through the larger move.

• In the example on the right, the trend has remained the same, but momentum and volatility have declined significantly. This is a warning that the trend is likely to change at any time. This is because while, on balance, the market is still buying and few profit-takers are supplying the demand, "buying energy" is clearly less strong than it was. This indicates that most participants who want to be long already are, and very few of them have already taken their profits. There is therefore a lot of potential supply and few potential new buyers available to support the price when the balance turns. The down-move, when it develops, is likely to be sharp as everyone heads simultaneously for the exit. This is therefore an excellent opportunity to reverse from long to short close to the "top of the drift" (which is likely to be the extremity of the move, thus maximising profit on the both long position being closed and the new short position as well as minimising the size of the loss to be taken if the up-trend re-asserts itself rather than reversing as expected).

Note that "Drifting" action can take more complex forms, as on the left where two brief periods of down-drift are separated by a sharp up-period. The principle remains the same and this pattern is bullish. (In market parlance "Bullish" = likely to go up, "Bearish" = likely to go down)

Positions taken "against the drift" (in either direction) should be protected by stops at a level above or below the market which would represent a re-acceleration of the market in the same direction as the drift, two examples: