Trend detection method - analysis of peaks and troughs

Master Class: Price Action Trading Methods

The idea itself is certainly not new and not radical enough to talk about any revolution in trading. Most, if not all technical indicators were invented with the advent of the PC and the development of electronic trading. They, indicators, are at most 20-30 years old. Some are older, some are younger, but it does not change the essence - all indicators are just a derivative of price.

Let's see what "advantages" the indicators give us?

1. Overbought and oversold levels.
2. Divergence.
3. Filtering(?) of false signals.

Since the indicators essentially simplify the perception of the market, these "merits" for me personally, and not only for me, cause quite reasonable doubts. Hence the conclusion: instead of giving the trader additional information, they:

1. They give it less.
2. They distort the information.
3. They give it with a delay, sometimes a very decent delay.

All the "kitchen" of averaging indicators revolves around these concepts. Why do traders use indicators? In my opinion, they are just trying to shift some responsibility to these filters for the sake of more unemotional trading and to eliminate their own doubts.

Why did I write all this? To protect myself right away from attacks: "you just don't know how to cook them". I know how to use indicators and what they show, and that's why I try not to use them.

And here are my arguments:

1. When you win, do you make a profit because of a change in indicators or price?
2. Indicators by definition can not be leading, because they are built on price.

I hope the idea is clear, let's go on...

Who remembers now, What is a trend and how to determine what phase the market is in? There is a fairly simple, but nevertheless still effective way, in spite of the computer progress. The oldest methods worked before they were invented, they still work. Just few people remember them, relying on machines.

Analysis of peaks and troughs – technique, originally presented as a principle of Dow's theory, still works today, while the theory itself

As long as price is moving in a series of rising peaks and falling troughs, the trend is considered intact. But as soon as rising peaks and troughs are replaced by falling peaks and troughs, the trend has reversed.

Figure 1 shows a series of increasing peaks and troughs. When price fails to make a new maximum (1), this is a signal that the trend may be about to change. However, this will not happen until the price falls below the previous base (2) and we see a declining peak and trough. According to this technique, the trend has changed to bearish.

Fig. 1. Schematic representation of the process of changing the trend to a downward one.

In a bearish trend, prices continue their downward alternation of peaks and troughs (see Fig. 2), until the last price at the last trough is able to update another low (3). The subsequent movement leads the price above the previous high (4), and the series of declining peaks and troughs changes increasing. In fact, the signal appears at point (5), when it becomes obvious that the price has made a new high. At this point, we do not yet know where the next peak will appear, but we do know that it will be higher than the previous peaks and troughs.

Fig. 2. Schematic representation of the process of changing the trend to uptrend.

As we can see by the behavior of the chart at point 6, there is nothing to prevent the price from falling below the trend reversal signal (5), but the chart will still be evaluated as upward trend.

Semi-signals

There are situations when we are in doubt whether a trend change has occurred or not. In Figure 3 we can see that at point 1 the last trough has fallen below the previous one, but this does not concern the last peak, so we have only half of the signal.

What now? We need the new price movement to show a high below the previous high, and then the price falls below the previous low at point 2. This is the half-signal, i.e., much less reliable, because price will probably move far away from the last high; but the probability that the reversal is valid is much greater. Those who don't want to wait for the signal at point Y run the risk of getting into a strong rally like the one shown in the following Figure 4.

Figure 3. The uptrend changed when the peaks and troughs began to decrease.

Fig. 4. Half-signal - a lower trough appears at point 1, which is subsequently cancelled by a new peak.

In this case, prices rose and made a new peak, indicating that the trend never reversed (I will try to look at how to deal with this in the next articles). Half-signals can also appear when the trend reverses from a downtrend to an uptrend.

Semi-signalsOf course, they are not as reliable as the peaks and troughs fully corresponding to the theory, but, as we will see later in the following articles, they too can be traded.

Analysis of peaks and troughs simply must be considered in conjunction with other techniques in the technical arsenal. The difference between the analysis of peaks and troughs is that as an indicator, it assumes a stronger signal than all lagging computer algorithms. Moreover, it is based on traders' psychology, which is known to underlie the price movement.

Consolidations

Sometimes, pullbacks within a trend develop in the form of trading range. Figure 4 shows some sideways movement after a rise. Breaking out of a trading range can be seen as a buy or sell signal on a peak or trough, or as another confirmation of a prevailing trend. In reality, when price breaks out of the range, it violates several minor reversal points, which are actually areas of resistance or support. Taken together, they represent the equivalent of more significant peaks or troughs.

Meaning of peaks and troughs

The value of a reversal on an active peak or trough always and directly depends on the type of trend presented. The longer the trend lasts, the more significant the reversal is. A trend reversal on an hourly chart will never be as significant as a reversal of a medium- or long-term trend, when the formation of peaks and troughs lasts more than a month.

An example of the methodology

Fig. 5. EUR/JPY daily chart.