When the fundamentals, or economics, line up with the technicals or chart patterns, in a particular market the situation possesses synergy that can give the trader more confidence than when trading on just one alone. Instilled with greater conviction, the trader is less likely to get shaken out of a position due to short-term whipsaw action or market noise.
Similarly, viewing the price action of a security through multiple time frames can also give traders greater confidence when the charts line up to give the same trading signal. For example, when an indicator gives a buy signal on monthly, weekly and daily charts, that is a powerful signal to enter a long position.
However, as with all good things, this situation is rare. It isn’t often that all of the charts line up. In fact, it is more common to see conflicting signals from the charts covering different time frames.
When the charts disagree, a strong case can be made for deferring to the long-term chart, but it doesn’t necessarily end there. After all, countertrend moves can be strong and also provide profit opportunities. The time context should also dictate the choice of strategy, product selection and risk management.
TIDES, WAVES & RIPPLES
Robert Rhea, one of the market’s first technical analysts, compared market movements to tides, waves and ripples. The analogy is pretty simple. Tides are the market’s major moves that can last many months or years. Waves are intermediate-term moves of weeks or months. Ripples are short-term and daily price swings.
According to Rhea, traders should ride the tides, which have the most power and offer the best trading opportunities. Waves offer opportunities to get in or out of a market’s main moves. Ripples should be ignored.
Obviously, the market isn’t always that simple. The financial markets are not nearly as orderly or predictable as tides and waves. Yet, when talking about time, the comparison makes sense. The tide is a powerful force that can move prices over sustained periods of time. So-called bull and bear markets can last for years or decades and create or destroy massive amounts of wealth.
We all have heard adages such as “don’t fight the trend,” “the trend is your friend,” or “don’t confuse a bull market for brains.” Yes, even your brother-in-law can make money in a bull market — when the tide is lifting all boats.
When the waves in the tide move in the same direction, the long-term and short-term charts might give similar trading signals. For example, when the daily and the weekly charts are both trending higher and various trend-following indicators are confirming the move, there is no reason to second-guess the signal. It’s time to ride the wave and the tide.
However, other times, charts and indicators can give conflicting signals regarding trends and direction when viewed over different time frames. “When times collide” (below) provides the eight-month daily price action of the 10-year Treasury note through early December 2006 and a weekly chart going back to mid 2002.
The daily trend is clearly up, and it appears that Treasuries are reaching the upper end of a trading range. The moving average convergence-divergence (MACD) indicator hints at overbought market conditions. As a result, a trader with a bullish position on the 10-year might view any temporary weakness as a possible move back toward trendline support, or a mere pullback in an otherwise healthy six-month uptrend.
A zoom out to the longer-term trend reveals a less bullish story about the 10-year (second chart in “When times collide”). The six-month uptrend is still clear. However, it is amid a major downtrend. In addition, a modest pullback no longer seems like an opportunity to initiate a long position off of trendline support. Instead, it hints at a potential end to a countertrend rally. In this case, the daily and weekly charts tell two very different stories.
In the book “Trading for a Living,” Alexander Elder recommends traders “examine the long-term chart first. It allows you to trade only in the direction of the tide — the trend on the long-term chart.” If the long-term trend is the tide, then the first chart in “When times collide” represents the wave, and a bearish tide is pushing the 10-year lower in the weekly chart.
As a general rule, technicians will defer to the indicators on the long-term charts when a conflict arises.
For example, the longer the length of the trendline and the more time it encompasses, the more solid the trend. When a 12-month trendline is broken, it has more important implications than when a three-month trendline is broken. The same is true of many other trend-following indicators such as the MACD.
In the 10-year T-note charts, the signal is the same on both the daily and weekly charts — both have reached overbought levels and hint at reversal. However, when there are conflicting signals, traders have learned to defer to the signals from the monthly or longer-term chart. Respect the tide or risk getting washed away at sea.
SOLVING THE TIME DILEMMA
Obviously, the ideal situation is for time frames to deliver the same message. In that case, there really is no need to mull over the situation. Just do what the indicators tell you to do. Such synergies are powerful, but relatively rare.
Concurrence from indicators across multiple time frames is the exception rather than the rule. Moreover, if the long-term trend, or the tide, is the most powerful, and arguably the most profitable, there are times it makes sense to give greater weight to the waves on the daily charts or even the ripples from the five- or 15-minute charts.
While the long-term trend should never be ignored, it is also possible to generate profits from countertrends and even ripples. However, the market approach should be different. To be specific, by being aware of the time context, the trader can answer important questions about strategy selection, risk management and adjustments.
For example, day-traders feed on the ripples. These ripples are short-term price moves that represent what most traders consider noise within a long-term trend. The moves may or may not be related to the economics or fundamentals of the long-term trend. For example, Treasuries can rally following the release of a strong economic report if they have suffered significant losses heading into that report. The buy-the-rumor-sell-the-fact phenomenon can often lead to short-term moves opposite to the long-term trend or tide. As a result, successful day-trading does not necessarily depend on solid analysis of the fundamentals and economics underlying the tide, but depends more on risk management and the ability to book frequent smaller profits.
The wave is often viewed as a countertrend move and an opportunity to enter a position in the direction of the main tide. For example, “Short or no short?” (below) shows the Elliott Wave projection for another move lower in the 10-year T-note. It assumes that the tide will push prices lower and the latest six-month rally is actually a wave against the tide, or an opportunity to take a short position.
However, while the latest wave might indeed be a countertrend, the rally would be a grueling six-month period for any trader holding a short position in the Treasury market. In truth, most futures traders would probably prefer to trade the wave rather than the tide during that time.
Yet, to ride the wave for profits, the trader should also take into account the time factor and the risks of a move back in the direction of the main trend. In that case, the trader might opt for using options or spreads rather than futures, placing tighter stops and accepting smaller profits.
Trading the tide is obviously a longer-term approach and calls for wider stops and the ability to stomach significant corrections. Instead of using options or futures, many long-term players prefer to use fund shares or exchange-traded funds. For example, an investor with concerns about the outlook for Treasuries might short shares of the iShares Long-Term Bond Fund (TLT) or buy shares of the Rydex Inverse Government Long-term Bond Fund. Futures in combination with options to limit risk or spreads are also viable for trading in the direction of the tide.
SEE THE WHOLE PICTURE
The degree of difficulty in either fighting the tide or feeding in the ripples is quite high. Instead, traders should keep these points in mind.
The best trading opportunities occur when synergies are identified. For example, when trading signals are in sync over multiple time frames, the trader will have more confidence when initiating the position and will be less likely to be taken out of a position by whipsaw action or market noise.
At times, looking at charts over multiple time frames can give conflicting signals, and when this occurs the trader will generally defer to the long-term chart.
Finally, an understanding of the time context is important when considering various market approaches or strategies. Time can help answer important questions about strategy selection, product choice (futures, options or securities) and stop-loss placement.
Frederic Ruffy is senior writer and trading strategist for options educations firm Optionetics. He can be reached on the message board at www.optionetics.com.
