Baz’s questions on this subject stimulated more than a dozen e-mails! Thanks Baz (G).
Whenever I receive a question like this i.e. a question from a reader of Nature of Trends, I am placed in a quandary. On the one hand, I don’t want to answer the same question a dozen times and I do want to assist readers. On the other, I want to be fair to the buyers of the book. If I describe the contents of the book in detail in a free blog, there would be no need to for anyone to buy the book.
So, I make a decision on a situation-by-situation basis.
I’ll go into detail for this question seeing the requests I have received.
Figure 1 sets the context of the problem. After an Initial Price Movement (IPM), XA, the market forms a complex correction. After the high at C is formed, the question is posed: is there any way of determining whether a breakout is likely to valid or false.
FIGURE 1 Context of Problem
The algorithm in Nature of Trends is one answer to the problem. Last night’s blog (http://tradingsuccess.com/blog/market-profile-terminolgy-360.html) laid out the theoretical underpinnings; tonight I’ll lay out a step-by-step example.
FIGURE Market Profile ADUS
Figure 2 shows that the IPM takes 27 days. The POC hat 11 hits – 11/27= .4074. The current retracement of the IPM is 0.5523.
FIGURE 3 Excel
Now let’s turn to Figure 3: the Excel sheet containing the algorithm. The ideal ratio (.8 x .5 = .40). In Column ‘G’, I type in the time ratio .4074; in Column ‘H’, I type in the price retracement, .5523. I then multiply the two giving a product of .2250.
By comparing the current ratio with the ideal, we have a rating that can be turned into a probability assessment, a probability assessment that answers the question: what is the likelihood that development has completed? With that information, a trader can develop strategies to protect himself against a false breakout. The assumption is a breakout is unlikely to be false if development has completed.
In this example, there is a 56% probability that development has completed i.e. ‘normal’ development has completed. All things being equal, in ‘Normal’ development, I accept as valid, the breakout in the direction of the previous impulse move (in Figure 3’s case, acceptance above ‘A’ ) and, as suspect, the breakout against the previous impulse move (in Figure 3’s case acceptance below ‘B’) . This is based on the maxim that ‘all things being equal, a market will exit congestion in the direction of the prior trend’.
The key words of course, are: “all things being equal”. As is the case with all my analysis, context is the critical element. I say this because I don’t want to be read as suggesting today’s breakout in the AUDUSD is valid.