This article on How To Identify A Transitioning Market is the opinion of Optimus Futures.
An obvious struggle for any futures trader is coming to grips with changing market rhythms that upsets previously sound trading strategies. Understanding market dynamics to the point where a trader can analyze when a good running trend could be transitioning into a consolidation phase, and when the market could be preparing to break out of that consolidation phase back into a more predictable trend, is truly an art, and one that traders are constantly looking to master.
We wish we could present a simple executable formula that would help you pinpoint when the market is tipping from a consolidation phase into a trend or vice versa, but unfortunately, we can’t. Being able to foresee these natural changes in market sentiment and momentum needs to be developed over time, but only IF you have access to the right tools and education to master your skills. In this article, we lay out five different ways you can possibly pinpoint a transitioning market and be able to prepare for a changing market beforehand, rather than react to a market condition you were not prepared to handle.
Pay Attention to Momentum Indicators for evidence of a Transitioning Market
We are not talking about popular ‘momentum indicators’ that technical traders often use to try and objectively evaluate the market losing steam. While we are not against these indicators, here we are referring to studying the actual market behavior directly to decode any evidence of a transitioning market.
Often times, trading volumes and the actual range (distance between the high and low of the candlesticks) can be very telling of the underlying momentum for an ongoing trend. Lower volumes and / or smaller ranges on candlesticks can be a potential sign of the trend getting exhausted, in turn hinting at the possibility of the market either reversing or preparing for a consolidation phase. On the other hand, increasing volumes or the increasing size of candlesticks within a tight consolidation phase could be indicative of a potential breakout into a sustained trend.
Often times the market may not compromise much on the candlestick ranges but present wicks to either side of the candlesticks which again point to weakening momentum – or in the case of lack of wicks, increasing momentum.
If you notice the action in the highlighted box on the chart above, you will see how the bearish trend transitions into a brief consolidation phase that eventually triggers a sustained up move eventually. Notice the long wicks to the downside on the candlesticks at the bottom of the down trend that triggered the consolidation phase. This phenomenon is where the popular “pin bar” candlestick pattern derives all of its value and merit as a reversal pattern.
Pay Attention to Market Highs and Lows
When in a healthy up trend, a market should consistently print higher highs and higher lows. When in a persistent down trend, the market needs to be posting lower highs and lower lows.
Going by this textbook characteristic of trending market conditions, it should instinctively strike you when you see a bull market that is struggling to post higher highs (or lows) or a bear market that is stalling and isn’t confidently pushing below prior highs and lows.
On the contrary, when in the notorious sideways phase, the market will typically follow no specific pattern of highs and lows relative to past highs and lows, unlike in strong trending conditions. For the thinking trader, there is a wealth of knowledge in these general observations.
If you notice in the chart above, while the market seems to be trading sideways, there is still a noticeable pattern of lower highs and lower lows, indicating at the eventual break to the downside.
Pay Attention to Major AND Minor Support and Resistance Zones
When in a strong trending phase, the market should typically be able to easily push past minor support and resistance areas (often prior highs and lows) indicating of course that the momentum is clearly with the stronger party. As the trend eventually weakens and the market starts to transition into a more indecisive phase, you should see price reacting to even minor support and resistance areas – often simple prior highs and lows.
In the chart above we have identified both the scenarios. Notice how the market seems to be oscillating around midterm support and resistance levels when in a consolidation phase. When it finally breaks to the upside, you will see how prior highs turn easily into real-time support for the market propelling price further up.
Pay Attention to Divergence
This one should come as a no brainer, as many technical traders already consistently use divergence as a tool to pinpoint momentum exhaustion. The tool can also be used to identify transitioning markets.
We have dedicated separate articles to understanding and applying divergence to technical analysis. Here we will just be touching on the crux of the matter.
Price printing higher highs, while a oscillator indicator (like a MACD, or RSI indicator) printing lower highs, or vice versa makes for a classic case of divergence, which can be an excellent tool to identify trends that could be nearing (or already in) their ending phase.
As illustrated on the chart above, higher highs on the price chart match with lower highs on the MACD giving an early indication of momentum exhaustion. The sharp selloff that followed shouldn’t really come off as a surprise anymore.
Unfortunately, as much as divergence is useful in indicating when a market could be transitioning into a reversal or a consolidation phase, it is just as useless to possibly indicate a breakout from a consolidation period into a trending one. This is because the lack of clear and consistent higher or lower highs and lows on the price chart associated with sideways markets can make them incomparable with the highs and lows printed on the oscillator indicator.
Pay Attention to Pattern Formations
While divergence as a tool of momentum change is suited more to a trending market that could be transitioning into a different rhythm, chart pattern formations typically favor consolidating markets, although they can be applied to a certain extent in trending markets too for potential reversal opportunities (as in the case of a rising wedge pattern formation).
From wedges, to butterflies to head and shoulders and double tops and bottoms – there are several popular chart patterns that can trigger a breakout from a sideways consolidation phases. If you are caught in a notoriously choppy market, see if you can extend trend lines or otherwise identify specific chart patterns that could be “squeezing” or “channeling” price toward an upcoming breakout. Some of the best breakout trades are those that are taken at the source of the breakout, and nailing such entries usually require the trader to be anticipating the breakout before it actually occurs.
As you can see in the chart above, one trader could be getting bogged down by the wild and choppy up and down swings from the market while it is tucked within the two red trend lines. Another trader could have the trend lines on the chart observing how the market was tightening and squeezing within a wedge pattern formation eventually breaking to the upside – possibly creating a high probability bullish trade setup.
We have identified a few market mechanisms that you should be keenly observing in order to better prepare yourself against the inevitable changes in market rhythm and behavior. Note however that none of these market dynamics will be able to predict with 100% certainty of a transitioning market, which is why we labeled this skill more as a work of art than an objective exercise. That is also why it can take a trader due time and practice before he or she can frequently cherry pick certain times when the market is about to change behavior leading to either prompt market entries or possibly avoiding pitfalls and potential losses.
There is a substantial risk of loss in Futures trading. Past performance is not indicative of future results.