To trade the break or fade the break, that is the question. The set up before entry is the key, the price trigger is secondary.
Until now one of the longest lived and most popular trend dynamics indicators around has always been ADX which stands for Average Directional Index, but as I will outline here this index has its shortcomings. One of its major shortcomings is that it is slow to reflect the momentum of a trend. This indicator needs to get above thirty or thirty five before a trader can have confidence in the trend’s ability to get carry over. Furthermore, if this indicator turns lower it doesn’t imply that the trend has reversed. To the contrary, it can continue for an extended period of time.
The %C Indicator which stands for % contraction is much faster than ADX and has some boundaries, it is rare for this indicator to get below thirty and rare for it to get above sixty. Besides having relative boundaries it also cycles faster than ADX for trading purposes. It is also suitable for top down approach to technical analysis.
Over time traders have compiled empirical studies that reveal breakouts – of some proportion of the time- lead to more trends in the direction of the breakout. Such a condition is called range or volatility expansion. The remainder of the time the breakouts are faded and should be viewed as reactions. Such a “condition” can be called volatility contraction or a trading range. However, it is important to remember that ranges are not limited to a horizontal direction.
In addition to trading range and breakout markets, there is a third major market condition that can exist and should be avoided for a system to be profitable: flat or dead markets. Pull up any chart of any bar size and place the “price channel” indicator, which is “standard” with TradeStation around the bar chart. Your empirical study should reveal that there are only three market conditions:
1) Flat or dead markets, a condition for floor traders in which prices rarely get to either side of the channel band and in which the pattern from open to close is seldom repeated in the next bar;
2) A tradable range, in which each side of the channel is a touch off for a reversal of an inside trend, and suitable for desk traders. Direction from open to close and from bar to bar is consistent from one side of the channel to the other;
3) Volatility expansion, where breakouts outside the range get carryover in the direction of the breakout. This condition is suitable for desk traders to take advantage of.
Being able to predict what condition the market is in and when it is about to change allows you to know whether you should stand aside the market when it is dead, or “fade” the breaks (enter on reactions) when the market is locked in a range or go in the direction of the breakouts when conditions have turned in an expansion. That, in large part, is the essence of the Holy Grail: having the ability, the indicator, to call market conditions. Direction, therefore, becomes a secondary consideration. Rather the primary decision is to do I fad the range (e.g., use an oscillator to pin point buying lows and selling highs) or do I trade the breaks (e.g., use a moving average cross over for my entry tool to buy high in order to sell higher or sell short low in order to buy to cover lower ).