The Four Basic Trades
Over the past four lectures, we have laid out a framework for understanding the foundations of price action, and how the natural movements of the market create patterns as prices move from one area to another. All of this theory is very important to understanding the market, but traders also need clear rules on when to enter and exit a market. Before we focus on specific trades, setups and patterns, it is important to realize that, from a purely technical perspective, there are only really four trades. Trends can either continue, or they can end, which is to say support and resistance can either hold or break. There is nothing else. This leads to the following classes of trades:
- Trend Continuation
- Trend Termination
- Support/Resistance Holding
- Support/Resistance Failing
Let’s look at each of these in a little more detail to see the factors and characteristics that distinguish each of the classes.
Trend Continuation
Psychology and personality play a huge part in trading success, but from a statistic perspective the best trades, by far, are trend continuation trades. Trends, once in motion, tend to continue, so in making these trades you are aligning yourself with one of the fundamental principles of price behavior. Newer traders, or traders struggling to achieve consistent profitability, will probably find that their attention should be on this class of trades above all others.
Figure 1 Idealized Example of Trend Continuation Play
These trades go by many names: pullbacks, flags, pennants, consolidations, triangles, but the key element is that you find a trending market and try to enter in the direction of the trend. From a risk management standpoint, these tend to be easy trades to manage because you should be in them as long as the trend is intact. Because you are trading with the statistical tendency of the market (for trend continuation), these trades can be more forgiving than some of the other classes—you can make mistakes with early or late entries and the power of the trend will bail you out.
Most of the trades that offer phenomenal realized risk-reward are trend continuation plays where you enter a trade with small risk, and the trend continues and extends into multiple legs. There are many possible refinements to this trade. For instance, you can enter on pullbacks in well-established trends, or you can enter pullbacks in new trends after breakouts or trend termination patterns. Each refinement brings some necessary adjustments to risk points and position management, but, as a class, these are easy and consistent trades.
Trend Termination
Figure 2 Idealized Example of Trend Termination Play
If trends are more likely to continue than to reverse, why would a trader ever want to trade against the trend? There are several good reasons. For one, trends obviously do end and there are patterns that can highlight exceptional risk-reward opportunities. Secondly, even if you were to choose to focus on trend continuation plays, you should be intimately familiar with trend termination patterns. Why? Because, as a trend continuation trader, the set of trend termination trades represent your losing trades. If you understand the patterns that suggest a trend is losing momentum or reaching an exhaustion point, you will be better equipped to manage your existing trades.
There is also a psychological element. As the saying goes, if the only tool you have is a hammer, you will tend to think of every problem as a nail. If the only pattern in your trading repertoire is trend continuation, then you will either have to display super-human patience, or you will find yourself applying those patterns in many inappropriate market environments. Trying to trade continuation in trading ranges, or in trending markets that are overextended and primed for reversal, is not a formula for success. Well-rounded traders have a deep understanding of all elements of price action and market structure.
The best possible outcome of a trend termination trade is that you have caught the exact turning point as the market rolls over into an extended trend in the other direction, but be careful. These are called trend termination trades, not trend reversal trades for a reason! Many times, when trends end, the result is an extended trading range. Being involved in such a range is usually not a good use of your financial, mental or emotional capital, so clear exit rules are essential.
The chart above shows only one particular kind of trend termination trade. The idea behind all of them is that a market has been trending, and then the trend stops. This can happen with a failed test (a lower high as in the chart above), multiple tests, loss of momentum, or exhaustion – these are all subsets of the trend termination class and each of them have very different entry points, stops and profit targets. There are many classical chart patterns (double and triple tops, rounding tops, etc) for end-of-trend trades, but traders will probably have better results focusing on the concepts behind the patterns than the those patterns themselves. Managing these trades can be difficult, and it is very important for a trader to not fight the trend when he is wrong. Many of the disastrous trading stories you will hear feature a trader making a trend termination trade that fails, and adding to the position as the trend continues to move against him. Some people are not psychologically equipped to handle these trades as it is very important to be able to quickly reevaluate and admit the trade is not working. Fighting the trend does not make you a hero. It is actually one of the quickest, most efficient, and often most dramatic ways to exit the trading business!
Support/Resistance Holding
Figure 3 Idealized S/R Holding Trade
Already we have some potential overlap in these trades because trends end by support and resistance holding. The difference, however, is that S/R Holding trades are properly applied in non-trending environments. There are many possible variations of these trades, but they all work on the tendency of non-trending markets to establish support and resistance areas that are respected on further tests.
This is a class of trades that looks very easy, but can be a little bit more difficult to actually execute. It is easy to find charts that bounced back and forth between levels, but in practice support and resistance are often wide ranges rather than exact prices. You cannot limit your risk to a few cents because often support will be violated, only to hold a little lower. All that has happened is that the market has expanded the confines of the range so you should still be in the trade. On the other hand, breakouts do happen and being caught on the wrong side of a breakout is very painful. In addition, profit taking is difficult because there is no clear tendency for the market to move to the other side of the range. Perhaps some profits should be taken in the middle of the range, but the fact is that price action within a trading range is highly random.
This is the most difficult set of trades, and for many traders, the least profitable. Regardless, understanding these patterns and the trading opportunities they generate, is important.
Support / Resistance Failing
Figure 4 Idealized Example of S/R Failing (Breakout)
Again, there would appear to be some overlap, because trends break support and resistance, so it would appear that this class could describe trend continuation plays. However, the difference is that these are essentially breakouts out of non-trending action (consolidation areas or trading ranges). Understanding how S/R hold will give you ideas about when they are likely to fail and lead to a successful breakout trade. Understanding bigger picture market structure will give the trader some idea about whether a breakout is likely to be good only for a small scalp, or whether it is likely to be the beginning of a trend that will continue for a long time. In fact, many trend continuation trades can be entered on breakouts of consolidations within the trend.
Risk management can also be a challenge on these trades, as failed breakouts can feature very sharp moves against the position, but some breakouts spend a lot of time consolidating before they really take off. These are bread and butter trades for many traders, and can really reward time spent to understand the setups and patterns.
So, that’s it. There really are only four fundamental classes of trades. Another important level of understanding is that these trades follow each other in a natural progression. When a market is trending, trend continuation trades will work. At some point, the trend will end and failed trend continuation trades become successful trend termination plays. There are two possibilities now. It is possible, though unlikely, that the trend has reversed and now trend continuation plays in the opposite direction are the right plays, but it is far more likely for the market to spend some time in consolidation. In these ranges, support / resistance holding plays will rule. Eventually, the range will breakout with a Failure or Support or Resistanceand a new trend will begin. Even if a trader chooses to only focus on one class of trades (which is not a bad idea for the developing trader), good understanding of the others is very important because this is actually the framework for a profound understanding of price action and market structure.
