The Dilemma of Midtrend Entry

Posted April 26, 2017

For many reasons, you may find yourself considering whether to enter a new position after the market has already made a substantial price move. Examples include:

(1) You were not previously following the market.

(2) In an effort to get a better price, you futilely waited for a price correction that never developed.

(3) You were previously skeptical about the sustainability of the trend, but have now changed your opinion.

Faced with such a situation, many traders will be extremely reluctant to trade the market. This attitude can be easily explained in psychological terms. The act of entering a new position after a trend is already well underway in a sense represents an admission of failure. Even if the trade is profitable, traders know their gains would have been much greater if they had acted earlier. Thus, even when you have a strong sense of probable market direction, you might be tempted to think: “I’ve missed so much of the move, why bother?”

As an example, consider chart-oriented traders examining the coffee market in mid-February 2014 (see Figure 1) after not having participated in the sharp price advance prior to that time. Such traders would have noted the market had broken out above the resistance level defined by the January 2014 and October 2013 highs, with prices remaining in new high ground for two weeks—a very bullish chart configuration. In addition, prices had just formed a flag pattern after an upmove—price action indicative of another imminent upswing. However, observing that prices had already advanced more than 37 percent since the November 2013 low (and more than 25 percent in just seven days in late January and early February), traders might have been reluctant to enter a new long position belatedly, reasoning the market was overextended.

Figure 1

Figure 12.2 vividly illustrates the folly of this conclusion. incredibly, as of mid-February 2014, coffee prices had completed only about 35 percent of their ultimate advance to the March high. The moral of this tale is provided by an observation in Reminiscences of a Stock Operator by Edwin Lefèvre: “[Prices] are never too high to begin buying or too low to begin selling.”

Figure 2

The key question is how one enters the market in the midst of a major trend. Actually, the goals in implementing a midtrend position are the same as those for initiating any position: favorable timing of entry and risk control. In this article we illustrate one such method: reversal of minor reaction. This approach is based on waiting for a minor reaction to materialize and then entering on the first signs of a resumption of the major trend. Of course, the precise method would depend on how a reaction and trend resumption were defined. The choices are virtually limitless. For illustration purposes, we will provide one possible set of definitions, which involve a two-step process:

Reaction Count Completion–A “reaction” is identified whenever the “reaction count” reaches 4. The reaction count is initially set to 0. In a rising market, the count would be raised to 1 any day in which the high and low were equal or lower than the corresponding points on the day on which the high of the move was set. The count would be increased by 1 each day the high and low are equal to or lower than the high and low of the most recent day on which the count was increased. The count would be reset to 0 anytime the market moved to new highs. Analogous conditions would apply to a declining market.
Thrust Count Signal–The resumption of the major trend would be indicated whenever the “thrust count” reached 3. Before we can define a “thrust count,” we must first define an “upthrust day.” An “upthrust day” is a day on which the close is above the previous day’s high. (A “downthrust day” is a day on which the close is below the previous day’s low, but we are concerned with only upthrust days because our illustration involves an uptrending market.) The thrust count would initially be set to 0 and would begin being monitored after a reaction count completion. In the case of a reaction in a rising market, the thrust count would increase by 1 on each upthrust day and would be reset to 0 anytime the reaction low was penetrated. Once a signal was received, the reaction low could be used as a stop-loss reference point. For example, the position might be liquidated anytime the market closed below the reaction low. Once again, an analogous set of conditions could be used for defining a resumption of the trend in a declining market.

Figure 3 illustrates the reversal of minor reaction approach using the specific definitions just detailed. The points at which reactions are defined are denoted by the symbol RD, with the numbers prior to these points indicating the reaction count values. Buy signals are indicated at the points at which the thrust count equals 3, with the letters prior to these points indicating the thrust count values. For any given entry point, stop-loss liquidation would be signaled by a close below the most recent stop level, which in this case is the lowest relative low between the reaction count completion and the thrust count signal.

Figure 3

Conclusion

By incorporating mid-trend entry, a trader can avoid initial missed trade oppotunities turning into entirely missed major trends. Any viable mid-trend entry approach needs to combine an entry signal with a well-defined stop-loss exit. This article has illustrated one method of mid-trend entry. Other methods are detailed in the 2017 edition of A Complete Guide to the Futures Market.

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This is the fourth in a series of articles that will be released approximately every two weeks that are based on extracts from the the 2nd edition of A Complete Guide to the Futures Market published in January 2017. (The first edition, which was also my first book, was published in 1984.)

Jack Schwager, Chief Research Officer, FundSeeder

Information on FundSeeder: http://fundseeder.com

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