Trading is an applied science. The profit for day trader comes from the good discipline driven by fact and evidence. Likewise, the profit for any systematic trading is the fruits of the good market analysis driven by fundamental and technical knowledge. To access more profits as a trader, you will need an improved discipline and technological advancement together allowing you to see the predictable behaviour of the financial market. Many traders will highly emphasize that the technology is the key to success in this end. It is especially the growing trend in the recent electronic trading environment.
We are very fortunate to put our new Trend Filtered ZigZag indicator forth in the line of the technological advancement. Every trader knows the ZigZag indicator. There are few variations of ZigZag indicators. Most of them are slight variation of each other. Somehow, the trend filtered ZigZag indicator is unique among them. Trend Filtered ZigZag indicator was born from our research on Equilibrium Fractal Wave. The way the indicator built was based on the separate modelling of trend and Fractal wave within one price series, as it is indicated from the Price Pattern Table in earlier research (Figure 1). The good news is that this new technological advancement offers many amazing benefits over the standard ZigZag indicator. Here we will try to connect this amazing indicator with the popular volume spread analysis techniques.
Figure 1: Price Pattern table listing the market dynamics in five categories.
Introduction to Excessive Momentum Trading
The distinctive difference of Trend filtered ZigZag indicator is that you can observe peak and trough deviated from actual highest and lowest in your chart. This is probably something new to the capabilities of the typical ZigZag indicator. Typically, ZigZag indicator will always place peak at the highest level and trough at the lowest level. This is not the case for the Trend Filtered ZigZag indicator. For example, while peak in Trend filtered ZigZag indicator stops at 1.1000 for EURUSD, the high of EURUSD can go above 1.1000 towards 1.2000 or 1.2500. Now the price and the peak are being deviated from each other. I call this unique phenomenon as the Excessive Momentum. Technically this behaviour is happening when the gap between Fractal wave and actual trend are growing. This happens when actual trend moves beyond the defined range by Fractal Wave. Up until this explanation, you might be still plain confusing with the concept of excessive momentum. To make things easier for you, consider that trend as the force behind the continuation move in the market whereas Fractal wave as the force behind reversal movement in the market. Trend is there because people follow other people. Reversal movement is there because of the feedback loop created by strong and weak holder selling or buying their stock when price goes too high or too low.
Typically, we will have these two forces in balance in the market. During Excessive momentum, this balance is broken. It means that the continuation force was greater than reversal force since the trends was driving further beyond the defined range by Fractal wave. Now probably you are starting to make some sense. That is good. Your intuition will start to tell you that this excessive momentum can provide good trading opportunity. When the balance is broken marginally, we can consider it as the market anomaly. Two potential scenarios can drive the occurrences of Excessive momentum. Firstly, the excessive momentum could be caused by some irrational price reaction like the late comers buying stocks after the stock have gone up too much. Secondly, the excessive momentum could be caused by strong belief of the crowd that the price will continue to go in the same direction. Whichever scenario is driving the excessive momentum, it is where we can observe the crowd psychology clearly. Excessive momentum provides the market timing. In this point we will introduce the volume spread analysis to make further sense with excessive momentum trading.
To explain the associated trading strategy with Excessive momentum, it is best to point out the four-market phase concept by Richard D. Wickoff (1873-1934). His framework is widely known as the Volume Spread Analysis. His four-market phase description is the most interesting subject among many traders. It is one of the most intuitive explanation behind the market dynamics.
The four-market phase includes accumulation, mark up, distribution and mark down (Figure 4). Four-market phase is the systematic view of market cycle. Volume spread analysis further extends accumulation and distribution areas into sub phase A, B, C, D and E (Figure 6 and Figure 7). These sub phase zone looks like some sort of sideways market. To be honest, I do not use the sub phase A, B, C, D and E for my trading because identifying these phase can be subjective and it is difficult to achieve them in systematic manner. Our focus here is more on accumulation and distribution area, the pattern made up from supply and demand fluctuations.
I believe that accumulation and distribution area can serve as useful entries in our trading operation. One thing trader should know is that Wyckoff Price Cycle is schematic and conceptual. In real world, we can not expect accumulation and distribution to arrive in turn always. Be more realistic. Figure 4 is only schematic diagram. In real world, any stock price can go up, rest and can go up again for fundamental reason. Likewise, stock price can go down, rest and can go down further. We can not expect that accumulation will always arrive after distribution. In fact, we can have as many accumulations as possible after accumulation. We can also have as many distributions as possible after distribution. I have drawn more realistic view of accumulation and distribution to prevent newbie’s getting wrong picture on the market behaviour around accumulation and distribution area (Figure 5). The difference is in your trading direction. When we have accumulation area after accumulation area, we will have continuous buy trend. When we have distribution area after distribution area, then we will have continuous sell trend. When we have accumulation and distribution area in turn, then we will have reversal opportunity. We will trade at turning point.
Simply speaking, sideways market zone in Figure 6 and Figure 7 can always serve as the springboard for the previous trend as well as for the reversal point. In addition, we could assume that accumulation area is where demand is exceeding the supply. Hence, price will go up after accumulation area. The distribution area is where supply is excessing the demand. Hence, price will go down after the distribution area. It is undeniable that these accumulation and distribution areas are important because this is where we get strong fresh momentum to start new trend or reversal. Placing your entry around these areas will increase your odd to win in the financial market. When these areas are identified correctly, market is much more profitable for your trading.
Figure 4: Four market phase concept in Volume Spread Analysis (source from StockCharts.com).
Figure 5: Realistic View of Four market phase concept in Volume Spread Analysis.
Figure 6: Sub phase A, B, C, D and E for Accumulation Area (source from StockCharts.com).
Figure 7: Sub phase A, B, C, D and E for Distribution Area (source from StockCharts.com).
Now if you are convinced how important these zones are, let us get back to the Excessive momentum. Excessive momentum can serve you as the systematic tool to detect these accumulation and distribution areas. Individual excessive momentum can be considered as an accumulation or distribution zone described in the four-phase market. You can consider the C point of Excessive momentum as either selling climax or buying climax. The difference is that some zone will provide you the reversal trading opportunity. Some other zone will provide you the continuation trading opportunity.
For example, in Figure 8, we can observe that excessive momentum detects the accumulation and distribution in turn. In this case, excessive momentum zone will provide you the reversal trading opportunity. You will trade against previous trend. Besides that, in Figure 9 and Figure 10, we can see continuation zone examples. In both case, excessive momentum detects the starting point of the fresh momentum of previous trend. In this case, our trading direction is the same as previous trend. Good news is that detection of excessive momentum is systematic using the trend filtered ZigZag indicator. Hence, detecting Wyckoff phase is no longer subjective but it is fully automatic now. Another added bonus is that excessive momentum produces two reliable breakout levels for your trading (Figure 10). The breakout levels are the point C and point D of excessive momentum zone. Beside your knowledge of accumulation and distribution area, these two breakout levels will provide you more solid evidence towards your trading direction. You can use these breakout levels for high probability trading setup.
Here is the summary for your potential volume spread trading setup with Excessive momentum zone. At the simplest trading setup, you can just use the two price levels at point C and point D in your breakout trading. This is easy and simple for any trader. However, this is rather short-sighted approach. Real benefit comes when you are able to identify accumulation and distribution area accurately with excessive momentum zone. With this long-sighted approach, you would try to make a big picture if the zone is continuous or reversal. With this knowledge, you can increase your odd win.
In conclusion, volume spread analysis setup with excessive momentum zone is not a rocket science although detection of excessive momentum requires the sophisticated algorithm. Your trading will start by identifying excessive momentum zone in the first place. Trading execution is a lot like the breakout trading throughout the zone at first. When you spot the direction of accumulation and distribution area correctly, you would be able to move your stop as the price move according to your prediction. Since it will detects these important zones automatically. Your trading will be much easier but more accurate.
Figure 8: Accumulation and distribution area detected for Reversal opportunity by Excessive momentum indicator.
Figure 9: Distribution zone for continuation detected by Excessive momentum indicator.
Figure 10: Distribution zone for continuation detected by Excessive momentum indicator.
Figure 11: Two referencing price levels for breakout.