Our universe and our reality can roughly be divided into two distinct states – Chaos and Pattern. Whereas Chaos is the absence of life, random and, at least to us, nonsensical occurrence which we do not even classify because our very being comes from pattern. It begins in our cells, the way they work together each taking on a different function in order to create order, or pattern, thus giving us life. Furthermore our consciousness is devised to further make patterns out of the chaos of reality and thus we invented language, mathematics, art, and credit cards. Very much like life itself, the stocks operate in these two states, Chaos and Pattern.
The first patterns to recognize in stocks are market stages. This is the first line of technical analysis that is used to determine whether we are trading in a trending environment or in other words a patterned environment, or a trend less and chaotic one. Obviously we are only interested in a patterned environment in order to be able to predict the movement of the stocks, and want to avoid chaotic trading where we have no edge.
The four stages are as follows:
Stage 1: Accumulation:
This is a period following a decline in which the bulls and the bears wrestle for control without any clear winner. It is usually a chaotic and treacherous environment with no clear direction full of false breakouts and reversals that can cost you.
Stage 2: Markup
In this stage the bulls are clearly in control, the trend is going higher with a clear pattern of higher highs and higher lows. This is the most favorable environment for a trader in which the most profit can be realized at the lowest risk.
Stage 3: Distribution
Following the bull market comes another chaotic period in trading. The fight between the bulls and the bears is back on with similar characteristics to stage 1. There is no clear trend in this chaotic state and it is to be avoided until the trend resumes or a reversal takes place.
Stage 4: Decline
When the bears win the fight in the distribution stage, we enter the stage 4 decline. This is a clear down trending pattern formed by lower highs and lower lows. A great place for shorts but not as safe as stage 2 bullish plays because violent reversals are common and thus a more intense risk management strategy is to be taken.
Please maximize the following image and study it carefully. I will show you each stage in more detail further down.
Now as interesting as this may be, you may asking yourself how this applies to fractals and trading. This pattern of stages is self similar in that it occurs in various time frames at different times. The constant struggle between buyers and sellers make it so different time frames will display various Stages at the same time. In order for a price’s direction to have the biggest force and thus the highest probability of going in a certain direction, many if not all the Stages need to line up across all time frames. I will go more into this once I get to the trading portion of this series.
On the following image you will see a stock Intermec Inc (IN) Try to identify the stages in these various time frames. Clockwise they are Daily, 30 minute, 10 minute, and 2 minutes. You will see that the Daily, 30 minute, and 10 minute are clearly in a Stage 4 decline though alignment has just occurred recently. The Daily chart show that from 5/4 to 5/18 there was a pullback from the downtrend. The 30 minute chart shows that it went into a Stage 2 and then a Stage 3. Once the 30 minute chart resumed into a Stage 3 Decline, that decline was strong and fast and the 10 minute chart will corroborate this. Currently, all the trends are aligned except for the 2 minute chart which is in a short term Stage 2. One can expect that once it breaks this uptrend and that the seller regain control, a strong move downwards should be in order. There is however a strong note to add here, the broader markets have tentatively reached a bottom from the latest decline. Should the markets start a new Stage 2 uptrend, surely this stock will have a high chance of a reversal which could signal the end of it’s powerful downtrend.
As you can see, when the patterns line up, we have a strong move in the direction. This self similar pattern follows the same principals as fractals and can be used to place high probability trades. This, however, is only the first step in a much more define strategy of technical analysis. Stay tuned for more.