How to use the cycle to your advantage

Ed Note: This is the fifth of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets.

There are three phases to the market cycle: Breakout, channel and trading range; and traders use different entries, stops and exits, depending on what the market currently is doing. There are trading opportunities on every bar for traders who understand where in the cycle the market is at the moment.

A strong trend is just another term for a breakout, which simply means a move up or down from an established range with little or no pullback. A breakout can be one big bar, two or more medium bars, or five or more small bars. Once the market forms a pullback, traders then will look for a transition into the channel phase. Sometimes there can be a second or third breakout before a pullback leads to a channel. Channels are weaker trends and eventually evolve into trading ranges, where the market is once again neutral and the probability of trend resumption drops once the range has 20 or more bars.

In general, when a trend is strong (the breakout phase), traders will look to trade only in the direction of the trend. As it weakens into a channel, traders will be quicker to take profits and more willing to scalp in the opposite direction, especially if they are willing to scale in as the market goes against them. As the channel phase of the trend transitions into a trading range, traders switch to “buy-low, sell-high” scalp trading.

“Range trading” (below), which shows the five-minute EUR/USD forex market, provides an overview. During the strong bear breakout (highlighted in green), traders will look to short for any reason. They will sell:

  • at the market,
  •  any small pullback as the bar is forming or after it closes,
  • on the close of any bar, whether there is a bull or bear close,
  •  above the high of the prior bar using limit orders,
  •  below the low of the prior bar using a stop order.

The ideal protective stop is above the top of the breakout (the bar 1 high). Some traders are unwilling to risk that much and they might use a money stop, such as 20 pips (ticks) from their entry price. Remember the math. If a trader chooses to risk less, he will have to pay for it with a lower probability of success. Wide stops have a higher winning percentage, but the occasional loser can be as big as several smaller losses with tighter stops. There is no right answer, but some stops are obviously too tight or too wide.

Another way to reduce risk is to trail the stop to just above the high of the most recent strong bear bar. (Trailing the stop in a bear trend means to move the stop down as the market continues to fall.) After each new leg down, traders will move their stop down to just above the most recent lower high.

Once there is a pullback (the turquoise area), the market usually enters the channel phase, but sometimes there will be another breakout or two before the channel begins; at other times, the channel is so small that the market just enters a trading range, as it did here. During the channel phase, traders will be more cautious with their entries. They will no longer short below or above every bar. They will begin to prefer to sell a little higher, like below the low of a bar in a small rally to near the moving average. Many will still be willing to sell above bars and scale in higher if the bar is part of a weak looking buy setup.

The idea is that if the bull reversal setup looks weak, there probably will be more sellers than buyers above the high of the buy signal bar, and therefore selling exactly where these losing bulls buy makes sense. The stronger the bull bars (the more buying pressure), the more the bears will want a strong bear signal bar before shorting.

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