FL trend analysis
as understood by dave_b_quick
NOTE: The concepts presented here are the intellectual property of Martin Rosenthal, here referred to as 'FL,' and may not be copied, sold or used commercially in any way without his permission.
NOTE: My current version of the dot
trend rule discussed here is posted here.
There are lots of trend definitions kicking around, but FL's is special. It uses no lagging indicators, so it's able to identify trend changes early and stick with them to the end. This is accomplished by a unique type of wave analysis done on a swing-chart kept by hand on paper. [image] The theory is based on extensive research done at MIT while FL was a fund manager. The results showed that the only thing predictable about market price action is its tendency to trend, and that prices always move in waves. FL's trend definition is designed to make it easy for a trend to start, but hard for it to end. Although simple, the rules are objective so they provide a basis for decisive action. This document will explain all the elements needed to determine the market trend for trading purposes.
Because the method makes it easy to start a new trend, but hard to end the old one, a new trend is considered to start before the old trend has ended. This results in a dual trend condition during periods of trend change. This has a couple of benefits. First, the dominant trend will persist during minor retracements. Second, the areas of dual trend provide a basis for excellent trades in both directions during times of trend ambiguity until a dominant trend prevails. This concept may seem difficult at first, but it will soon be clear. All examples are based on 3-minute bar charts of e-mini SP500 futures. The method is the same for any market, although for thinner markets you may use 15-minute bars.
The only tool needed is charting software capable of displaying a volatility stop set to 9 bars, 2.5 multiplier, applied to a 3-minute bar chart. We will call it the v-stop for short, or VS. [image] This is not used as a stop but as a way to define when one wave ends and another starts, so there is no subjectivity in defining the waves. Every time the v-stop flips from long to short or from short to long a new line is added to the hand-chart. The horizontal lines on the hand chart record the highest price that occurred while the v-stop was long or the lowest price that occurred while the v-stop was short. Although not necessary for daytrading, the same v-stop applied to the daily chart is a useful guide for position trading and for staying in tune with the bigger trend.
The hand chart shows an endless series of up-waves and down-waves. The trend is determined by comparing the high of each wave with the high of the previous wave and by comparing the low of each wave with low of the the previous wave. As we discuss the details of determining trend by comparing highs and lows, don't forget that we aren't talking about just any high or low. For our purposes we are only discussing the highs and lows that are recorded on the hand-kept swing chart. There is no shortcut to skip doing this by hand. It only takes a few minutes a day, and the discipline of doing it in real-time has a fringe benefit as an excellent aid to stay engaged and focused on what's most important.
In an idealized up-trend prices would go up in a series of higher highs and higher lows like stair steps, but when was it ever that simple? Every up-trend will sooner or later make a lower low (LL). This does not necessarily mean the trend is over. In fact, in FL's analysis a LL in an up-trend is called a "powerbuy." Entry triggers for trading a powerbuy will be discussed elsewhere. For this discussion we're only interested in the powerbuy for its importance in determining trend.
There are two ways a powerbuy can occur, either as a traditional ABC retracement with a lower high followed by a lower low or directly after a higher high. Either is equally valid. Powerbuys get their power because a lower low in an up-trend represents an oversold condition. If the up-trend is intact, the powerbuy will reach new highs. If it fails to reach a new high, turning down before reaching the level of the previous swing at B, the lower high that is formed is considered the start of a new downtrend. The turning point is called a "dot1" or "dot1 down" (to distinguish it from the higher low at the beginning of an uptrend which is also called "dot1" or "dot1 up").
Here's a summary. The powerbuy is a lower low in an uptrend. If the uptrend is to continue, the powerbuy should lead to new highs. If the powerbuy fails to make a new high, the lower high (LH) that results is called dot1, and will be assumed to be the beginning of a new down-trend. The dot1 starts a new trend but, and this is very important, the dot1 does not end the old trend. So if a powerbuy ends in a dot1, there are now two trends in effect. If price immediately drops 3 points below the low that made the powerbuy, the old up-trend ends there. This may not happen right away, or at all, and a dual trend may continue for some time. The dual trend condition can provide excellent opportunities to trade long and short, as you will soon see.
Here's another quick review. In FL's method there are 3 possible trends: up, down, or dual. The dominant trend becomes the only trend three points below a failed powerbuy (or 3 points above a failed powersell, we'll get to that in a minute). Don't bother measuring 3 points below a powerbuy that is successful in making new highs, because, if you read carefully above, before a new trend direction can be considered a powerbuy must fail to make a new high, forming a dot1. This may seem too simple, but if you examine a bunch of trend changes you'll soon conclude for yourself that a trend has never, will never, can never change without a powerbuy failing to make new highs or a powersell failing to make new lows. If you do your homework you will soon appreciate the simplicity, elegance, power, completeness and timeliness of this definition of trend change.
You may have guessed the definition of a powersell already. It's the exact opposite of the powerbuy in every respect. A powersell is simply a higher high (HH) in a downtrend. This can happen in either of the 2 configurations as in the powerbuy. If the downtrend continues, the powersell will make new lows, often with vigor because of the overbought condition represented by a HH in a downtrend. If the powersell fails to make new lows, that is a dot1 up, the beginning of a new uptrend. Remember that the dot1 starts a new trend but doesn't end the old trend, so starting at the dot1 there are two trends in effect. The dual trend condition continues until prices move 3 points above the failed powersell.
Dot1: The failswing where a powerbuy fails to make a new high, or where a powersell fails to make a new low. The dot1 is considered the start of a new trend direction, but it does not end the old trend direction. The old trend direction ends only if prices move 3 points above the failed powersell or below the failed powerbuy. So you can conclude that wherever you see a dot1, a dual trend will be in effect from that point.
Dot2: A generic name for a powertrade, either powerbuy or powersell. Dot2 refers to the swing point that forms the powerbuy or powersell for wave analysis purposes.
Double top or Double bottom: is considered a failswing
Dual Trend: This is the trend condition that exists between the time a new trend starts and the old trend ends. The new trend starts at a dot1, when a powertrade fails to reach its objective. The old trend ends 3 points past a failed powertrade. When dual trends are in effect every higher high is a powersell and every lower low is a powerbuy.
Failswing: Also "failed swing," or FS. This is any wave which fails to reach the previous swing. A HL or a LH is a FS. A dot1 is a specific type of FS( see definition above). A failswing may be with the trend (e.g. HL in an uptrend), or against the trend (e.g. LH in an uptrend).
LL: A lower low on the hand-chart which records waves defined by flips of the volatility stop (9/2.5) on the 3-minute chart.
HH: A higher high on the hand-chart which records waves defined by flips of the volatility stop (9/2.5) on the 3-minute chart.
Powertrade: A powerbuy or powersell, also called dot2
Powerbuy: A lower low in an uptrend (or in dual trend). The power comes from 2 sources. First, it's oversold in an uptrend. Second, it's a place where breakdown players who are bucking the trend get faked out and go short. As they get stopped out it's extra fuel for the long side.
Powersell: A higher high in a downtrend (or in dual trend). The power comes from 2 sources. First, it's overbought in a downtrend. Second, it's a place where breakout players who are bucking the trend get faked out and go long. As they get stopped out it's extra fuel for the short side.
Swing: also Swing Low or Swing High. A wave in price action or a turning point in price action as in the top or bottom of a wave in price action. For dot trend analysis the swings under examination are the highs and lows of waves defined by the volatility stop.
Volatility stop: Called v-stop
for short or VS. A line drawn automatically by the charting software
above or below the market prices. It is like the parabolic stop in that the
line is below when prices are trending up and flips above when prices are moving
down, but is calculated differently from the parabolic stop. The lines are calculated
Long: [highest price] - [2.5 x (average range of the last 9 bars)]
Short: [lowest price] + [2.5 x (average range of the last 9 bars)]
Only one line is displayed at a time. If long, the line flips to short on bar close below the v-stop line. If short, the line flips to long on bar close above the v-stop line. Not all charting softwares include the v-stop. EnsignSoftware has had it for decades.
Wave: For dot trend analysis a wave is considered to end when the volatility stop flips. This definition is better than traditional kagi or point & figure waves which used a fixed retracement value, because the volatility stop adapts to current volatility. Mathematically, a wave ends when price has retraced 2.5 times the ATR of the last 9 bars, applied from bar close. The top of a wave is the highest price traded during an up-wave of the volatility stop. The bottom of a wave is the lowest price traded during a down-wave of the volatility stop.