What’s the first step in putting together a puzzle? Is it to gather the corner pieces, or the edges? While that might be a good strategy, the best first step is to identify the box top which shows what one is attempting to assemble. The “box top” is equivalent to, what we call “the context” in financial markets.
Once you understand the context, a trader can then move to the more tactical phase of trading (defining momentum and looking for set-ups), similar to finding corner pieces, putting edges together and completing our puzzle – to extend the analogy.
Many new traders focus on recent price action without understanding the larger context first. If one only focuses on recent price action, both a bullish and a bearish case can be made, only a few bars apart. This leads to seeing contradictions and to adverse signals. Remember that bullish signals tend to succeed in a larger-timeframe bullish environment and fail otherwise.
Coordinating signals with the context (or larger time-frame analysis) is what sets apart stressful, constantly mediocre setups from high probability trading that more often produces home run trades.
There’s a distinct difference between completing a puzzle and financial markets, though. And that is the fact that financial markets can be viewed on different timeframes. So, we need to determine the context on multiple timeframes if we are to determine the direction of trends, as well as get an idea about the magnitude of any further price action. So, how do we determine context?
Probably the easiest way to define the context is the Elliott Wave Principle (EWP) which enables us to spot the market’s current position within the dominant market cycle. Be careful with the EWP, though, since it is not a standalone trading system; but, rather, it’s a growth model that is observable in nature and financial markets. In our way of thinking, Elliott’s methodology reveals where the current price might be in the growth cycle. The chart below shows the bullish side of the growth cycle, and we’ll use that to describe the different phases within.
At the beginning of a new trend, in area B), there is a lot of contradiction in the structure, and the conflict of different opinions is apparent in the sloppy price action. During this nesting period the probability of a successful trade with the larger trend is low; but, the reward is enormous if the trader can control the risk and ride the successful breakouts long enough. Even with the best chart reading abilities, however, trades in this stage offer a low probability hit rate in the range of 33-45%.
In area A) the trend accelerates and a sustainable directional move emerges. The trend becomes obvious; and, therefore, the market’s inertia is very likely to keep it in motion. Yes, we have heard something similar in physics: an object in motion stays in motion. The driving force behind phase A)’s rally is the conviction of the majority of the trader population about the future of the prices. Although here it is possible to define high probability trades, the risk will be always be high because of the high volatility of the market, and the lack of logical close stop levels. Despite the risk, the expected rate of success for any “with trend trade” is easily above 50%, and many times we can assume that it is close to 75%. Throughout this fast moving period we build upon the high probability trades, and not as much on the high risk/reward ratio.
In the decelerating phase (area D) it is still easy to find high probability trades, like 60-70%, but the reward side will be quite limited. The good news is that the market quiets down, even ranges a little bit so we don’t have to take large risks due to volatile price action. At this point, many people start to fight the trend, hunting for the top; although, in this late phase of the trend, the market provides the most orientation points for excellent with trend trades. Instead of “toping process” we purposely name it “deceleration area,” since it is not yet time to go against the old, established tendency in price.
In summary, even the most carefully selected signals and setups provide mediocre results without taking the context into consideration. As a result, without context, the trader performs close to a 50% hit rate, a 1:1 risk/reward; and, therefore, they have a goose-stepping career meandering around breakeven. In order to increase the hit rate, risk/reward ratio and become consistently profitable, one needs to have a good handle on the context and do more than just pick a handsome candle formation.
…and from now on that is exactly what we present to you in our Context Analyses Blog.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.