A. ISOLATING STRATEGIC CORRECTIONS In Part 1, we defined a primary trend and provided examples showing that almost ALL major corrections back to quarterly price levels REVERSE BACK in the direction of the primary trend. The only exceptions occur when the primary trend itself reverses and these events are infrequent. Here in Part 2, we touch on the notion of "ideal trade location" and "variant perception." You'll need to download the chart set titled charts_2A.zip (below). We'll focus on three major situational opportunities that occur in markets where the risk-reward is asymmetrical -- which means the risk exposure is a fraction of the potential reward. IDEAL TRADE LOCATION. We call these three situations "ideal trade locations" because they represent optimal price regions for making portfolio adjustments (initiating or closing out shorts and longs). But ideal trade location also varies according to: 1) the type of market environment you are facing; and 2) the location of price relative to rising or declining quarterly equilibrium levels. Markets exhibit a high degree of efficiency, but they are not 100% efficient. This means profits holding long or short inventory are difficult, but possible--and even highly probable, if you are selective about where you initiate changes in your long or short inventory. VARIANT PERCEPTION. Profitable trading situations tend to coincide with a divergence in the perceptions of various kinds of traders as to what exactly is occurring in a given market. This type of divergence is called a "variant perception." We'll illustrate how this manifests on a chart shortly. The first of three ideal trade locations is what we call a "strategic correction". STRATEGIC CORRECTIONS. When the primary trend is up, a retracement back to rising quarterly equilibrium is a strategic correction. NOTE: retracement into strategic sell zones present a set of opportunities to increase short inventory or reduce long inventory. Chart 1. In the chart (right), there are four strategic corrections in Crude Oil. During strategic corrections we really need a finer degree of resolution in order to monitor price action more closely in order to execute trades. Chart 2, left, is a weekly chart, not a monthly chart. This chart has the higher timeframe quarterly equilibrium displayed (light and dark blue lines). STRATEGIC BUY ZONES. We call the zones (green boxes) between the most recent quarterly equilibrium estimates (the light blue lines) and actual quarterly equilibrium (the dark blue lines) a "strategic buy zone." In Chart 2, there are three strategic buy zones visible in Crude Oil. NOTE: In a strategic correction, the ideal trade location for initiating changes in long and short inventory is within a strategic buy or sell zone. In primary trend bull markets, when price moves into strategic buy zones, the correct strategy is to increase long inventory and decreasing short inventory. <<page 2>> STRATEGIC CORRECTION IN GOLD. Chart 3. In the Gold weekly, left, the deep reaction in Gold into the 6/14/06 low was a strategic correction into a strategic buy zone. Since the quarterly equilibrium is still rising the move into the strategic buy zone was a move below rising value. Chart 4. All tradables (commodities, futures, stocks, stock indices, bonds, FOREX pairs and individual stocks) obey the same primary trend rules described here. Here is the Google monthly chart, at right. Pull up your own daily or weekly chart for Google and you'll see that even in a large trading range the extreme reactions within the range often resolve as strategic opportunities that emerge around quarterly equilibrium. <<page 3>> VARIANT PERCEPTION. Momentum traders tend to naturally gravitate to high frequency (daily, and intraday timeframes) because momentum itself tends to be transient and short-lived. But, high frequency timeframes also tend to be noisy and more difficult to read. Value traders, on the other hand, tend to naturally gravitate to low frequency data points (monthly & quarterly timeframes) because value-based analysis tends to incorporate much larger quantities of time. Chart 5. In May-June '06 the daily SPY (at left)appears to be in a high momentum move down, a disorderly freefall. Chart 6. The low frequency monthly chart, at right, indicates that what appears to momentum traders as a high momentum move down with no bottom in sight in the daily timeframe (refer back to Chart 5) is in fact a orderly move to value and equilibrium in a higher timeframe. This is an example of variant perception among different groups of traders in a marketplace observing the same price, only at different frequencies. In this particular case, momentum traders perceive that the probability for a continuation of the move down is higher than the actual probability. This error in perception is because major reversals occur at rising quarterly equilibrium levels (as illustrated in Part 1). Meanwhile, value traders perceive that the probability for a continuation of the move down is low because they correctly expect major reversals to occur at rising quarterly equilibrium levels. This does not mean value traders are always correct and momentum traders are always wrong. It means in this particular configuration value traders have the edge. As we'll see in the next installment, there is a different set of dynamics where momentum traders have the edge over value traders. This post is also available as a PDF. I also publish this type of analysis (in more detail) free for a range of important current markets as PDFs. If you want to follow current live examples; learn more about putting this to work and how to manage trades simply go to my blog http://www.street-noise.net/articles/ Find the gray box on the right side column where you can drop me an email address. It's currently FREE to all.
The 3rd installment now posted to Trading forum under: "What Works in Trading & Why: Tactical vs Startegic Correction (Part 2B)"