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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