Pattern recognition is the core cognitive skill involved in active trading. One mistake many beginning traders make is that they equate patterns in markets with chart patterns. For the rational, evidence-based trader, patterns are only meaningful if they have explanatory value.
When trading short time frames, the patterns in markets that are meaningful are ones that track actual supply and demand among market participants. From the sequencing of trades in a market, we can observe increasing or decreasing volume and whether the volume has a directional bias. Across many trades, we can detect trends and cycles. When there is relatively stable participation in markets, we can expect the patterns of trending and cycling that we’ve observed in the recent past to continue in the immediate future. That sets up potential opportunity.
One of the challenges of financial markets is their complexity. Patterns show up across differing time frames, with trends and cycles nested within one another. Thus, at one time frame, we may observe a trend, but at a longer time frame we can see that this trend is simply a directional move within a larger cycle. A true understanding of market patterns requires the ability to place price behavior in proper context. Successful pattern recognition is not merely seeing a trend or cycle on one time frame; it is the understanding of price behavior across multiple time frames.
In practice, that means our tracking of markets needs to be dynamic, not static. We need to be tracking what is happening across shorter, medium, and longer time frames in order to detect the opportunity in their alignment. Meaningful market patterns do not “set up” at any single period, but rather derive their meaning in how they are nested within one another. I recently noticed the ES market cycling on a higher time frame (using charts where each bar represents 20,000 contracts traded) and making a clear higher oversold low on a shorter time frame (each bar was 5000 contracts traded). That led to a profitable trade buying the oversold low and holding until we tested the high of the longer-term range.
At other times, those kinds of patterns will set up in the nesting of much longer time frames and even shorter ones. Only if I am dynamically scanning the market across multiple time horizons can I begin to detect how the longer-term and shorter-term movement are meaningfully related. During that dynamic scanning, I am not looking for trades and I am not at all focused on what I think the market will do or should do. Rather, I am watching across the time horizons with a completely open mind, much as I (as a psychologist) might start a first meeting with person by listening, listening, listening. Eventually, if I observe and listen long enough, a pattern–something meaningful–will jump out at me.
The truly great trades are the ones that come to us.
Image and article originally from traderfeed.blogspot.com. Read the original article here.