Staying with the trend is the oft-stated goal of many an investment strategy and this article proposes a long-term strategy technique applicable across most markets which will aid investors in achieving precisely that. The results below show a phenomenal track record on 4 major currency pairs back-tested over the last 8 – 35 years, with consistently high returns (see table of results below).
I have noted during my work as an analyst that major trend changes often exhibit an early characteristic which distinguishes them from mere ‘corrections’ of the prevailing trend. This is not true all the time but many times it is. This characteristic is that major trend reversals tend to occur with an initial ‘explosive’ change in price. This is the initial lift-off stage of a new trend. Corrections can have this characteristic too but it is more often the case that they don’t because it tends to be a characteristic of longer term cyclical market changes.
Expressed in another way it is the angle of ascent or descent compared to the angle of the established trend which helps differentiate the two types of market activity. In a reversal the angle tends to be sharper in the direction of the new trend than in the direction of the dying trend. This is illustrated in the diagram below:
The diagram above represents idealized price activity with a bear market in progress at the beginning until prices bottom and then rise again in a countertrend rally. The major change in trend is signalled by the rapid sudden rise after the low. ‘y’ and ‘z’ degrees represent the angles of ascent and descent and the odds favour the occurrence of a reversal when y is higher than z over the same period of time. This can be represented mathematically as:
Reversal = y degrees > z degrees
Corrections tend to exhibit the opposite, which means the angle of the main trend tends to remain the more acute as shown graphically below:
In this case the mode of market behaviour could be represented mathematically as
Correction = y degrees < z degrees.
It seems so simple and obvious but in many ways it makes perfect sense. A large amount of initial energy is required to change and promote an established trend. I found that where this initial thrust was absent the odds favoured the anticipation of merely a corrective phase before resumption of the existing trend.
I found, further, that the AMR worked best on a longer term monthly timescale. Looking at new highs or lows and bars either side it is possible to make an accurate judgement about the strength of a correction or reversal and which category the market activity might fall into.
Whilst it could be possible to measure angles in real time and compare them, this approach would be complicated to develop although it provides and exciting area for further research.
There is however a much simpler way which avoids complex trigonometry and yet encapsulates the core principle of the idea of a sudden explosive change in direction.
By simplifying the application of the principle it can be adopted quite easily as a strategy technique. Using the height of price bars as a guide and using monthly bars it is possible to measure the rate of ascent and descent of a move quickly and easily. At market turns, where the price bar in the opposite direction to the established trend is stronger and higher then the preceding bar it signals that the ascent is an AMR. Where the bar is weaker it signals a correction.
The pictures below show how the principle is applied in practice bar by bar. Fig 1a represents the initial green bar. The next requirement is for another bar which makes a new low/high, and a third bar which fails to make a new high or low and actually breaks down to below or above the low/high of the first bar. This signals a reversal. Figs 1a, b and c show the progression of the bearish version of the setup.
|Fig 1a||Fig 1b||Fig 1c|
The trigger for the analysis technique’s signal occurs at point ‘a’ on figure 1c.
The Bullish Version is the inverse of the above setup and is shown below:
|Fig 2a||Fig 2b||Fig 2c|
The bullish buy signal would be triggered at the high of candle 1: point b on the diagram.
When the market fails to break above either points ‘a’ or ‘b’ during a setup the signal is a correction.
Apart from the classic set-ups described above I have included a variation which is not original. Obviously the main principle is that the market rebounds in a more acute move to the move which it preceded and so I have widened the definition to include monthly key reversals too. A monthly key reversal is a bar which posts a new high or low and then during the same bar reverses posting a new low or high respectively. The diagram below shows a bearish key reversal from the chart of the GBP/USD:
The signal for the key reversal variant works a little differently from that of the classic
3-bar setup. Given that the usual signal point has already been surpassed by the 2nd key reversal bar the signal is given at the low/high of the key reversal bar and is triggered when the 3rd bar passes below or above that point.
Below is an illustration of some real examples of AMRs using EUR/USD.
Real examples of AMRs:
Trading the signals
The trading system derived from this analysis technique is illustrated above and derives its signals from the set-ups themselves. This is because the triggering of stops means de facto that the reverse signal has been given and a new order in the opposite direction is triggered at the same time, thus the trader is kept in the market for most of the time.
Were we trading the signals in the above chart of the EUR/USD we would start by placing a stop order to buy at the May ’07 candle highs and our initial stop loss at the June 07’ candlestick lows. July would have triggered our buy order since it broke the May highs. August set up another buy order with a lower low and September’s long marabuzo candle would have triggered another buy order at the July highs. We would now place stops for both orders at the August lows. At the end of October we would move our stop up to the September lows in the unlikely event that the market turned around and came back down rapidly triggering a short. November’s shooting star produces a more likely reversal opportunity and we would move our stops and short trigger up once again to the October lows, but once again the market remains bullish and keeps rising. The next major opportunity to go short occurs in March ’08 but although there is a move down the market fails to take out the February lows so our long trades are still running. Eventually in July ’08 there is an acute enough reversal to trigger the stops on both our longs and open a short order. After the devastating bear of 2008 the market reverses in ’09 but there is no AMR to close out our shorts and open any longs. Eventually in November ’09 there is another acute decline which opens a second short order so we are short 2 contracts. June’s hammer has currently created another AMR set up which would require a breach of May’s highs 1.3342 – a considerable reversal to trigger. Given there are only 3 more trading days remaining of the month it is unlikely to happen.
As can be seen from the example above the trading system derived from this set-up is a simple low maintenance turn-key style strategy which is also quite good at keeping a trader in the trend. All that is required to operate the system is to check the monthly charts at the end of each month and move the stop-and-reverse orders to the high or low of the last candle. What’s more back-tested for major currency pairs it has proven very profitable for most, although particularly for dollar pairs (see attached excel file for results).
The signal created by the AMR can either be used in conjunction with other indicators or as a stand alone investment strategy. The signal works best in volatile markets so it could be optimised using Average True Range to avoid losing signals in sideways markets.
If being used as a stand alone investment strategy then the following additional rules apply:
- If a key reversal occurs go back a month before the first month to find out the direction of the trend. If up then the key reversal is bearish, if down then bullish.
- Allow for pyramiding: if multiple signals occur in the same direction as is one of the beauties of the strategy and often the case then allow pyramiding. When a signal in the opposite direction is triggered then close all the trades in the pyramid. Use the most recent trade entry point for stop placement and remember to make the stop/buytocover orders for all the contracts in the pyramid!