Monday, June 13, 2011

Little, Trend Qualification and Trading

Unless markets are absolutely comatose they swing. There are swing points in uptrends, downtrends, and sideways movement. Ideally the short-term trader buys close to the low swing points and sells close to the high swing points. The savvy trend trader ignores the minor swing points; he simply has to identify when he is about to overstay his welcome. All this is patently obvious in hindsight, hellishly difficult at the hard right edge.

In Trend Qualification and Trading: Techniques to Identify the Best Trends to Trade (Wiley, 2011) L. A. Little offers what he calls a neoclassical model of trends that relies in large measure on defining and qualifying swing points. The classical model, developed and popularized by Charles Dow and his followers, has of late morphed into what one might call the reductionist classical model: “A trend is evident when two consecutive sets of higher highs and higher lows (uptrend) or lower highs and lower lows (downtrend) occur within any given time frame.” (p. 23) This reductionist model, Little argues, doesn’t work: for one thing, it triggers premature exits.

In its stead Little offers a neoclassical model of trend. “The neoclassical trend model no longer consists of black and white—up or down and nothing in between. It displays varying shades of trend. It qualifies trend on a more granular level; a level that allows the trader to make intelligent decisions based more on probability than supposed absolutes.” (p. 26)

For Little, trends should be qualified as suspect and confirmed. The two inputs necessary to differentiate between a suspect trend and a confirmed trend are swing point price and volume. In its most basic terms, “When the current price trades lower (downtrend) or higher (uptrend) than the previous swing point price and volume contracts, the trend is suspect.” “When the current price trades lower (downtrend) or higher (uptrend) than the previous swing point price and volume expands, the trend is confirmed.” (p. 28)

Of course, nothing is ever so simple in trading. First of all, it’s important to identify swing points, both potential and actualized. Any current bar whose high is higher than that of the preceding bar has the potential to be a swing point high. It does not become an actualized swing high, according to Little, until it has remained the highest high for six successive bars. “The time element,” Little writes, “can be optimized for differing markets and equities, but my research has shown that six bars tends to represent the optimal ‘wait time’ across most equities, sectors, and general market indexes.” (p. 31) This can be six days, six weeks, or six months.

Little offers numerous chart illustrations of potential and actualized swing points and of suspect and confirmed trends in a variety of market regimens.

Little admits that “although trend theory is a necessary condition to trading trends profitably, in itself it isn’t sufficient. It is necessary to take the theory and integrate it into a workable and profitable trading system….” (p. 109) The second part of the book therefore deals with preparing to trade, entering and exiting trades, reversals and price projections, time frames, the trading cube, and trading qualified trends. Among the key concepts are anchor bars, which “identify chart price areas where significance exists” (p. 156) (as opposed to swing points, which normally define areas where a price boundary exists), and price zones (not lines).

Naturally, some of the material in the second part of the book is familiar. We encounter, for instance, support and resistance (though viewed as zones, not lines), measured moves (AB = CD), and the usual catalogue of gaps. But Little integrates the familiar with his own contributions and illustrates his points with marked-up charts.

Trend Qualification and Trading is an intermediate-level book for chartists. The only things on Little’s charts are price bars, volume, and labeled lines and zones that go far beyond the standard trend lines. For those who like to mark up charts, this book will be a satisfying read.

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