- 2000: Volume 9, No. 4 Defining Where Corrections Begin and End Within a Trend

Some of the very best technical tools have a "you are here" quality to them. Like the sign at the entrance to the shopping mall, they help define where you are within a vast and seemingly unorganized structure. Sometimes knowing where you're at within the market environment, just like at the mall, is half the battle.

Two of the more difficult tasks for a market technician are determining exactly when a market begins a countertrend correction, and then determining when the correction ends and the trend resumes. "Swing Momentum" is a means to do this simply, accurately and unambiguously by combining some basic TA tools; a simple moving average crossover, the MACD indicator and a very short-term moving average envelope.

Once you determine what the trend is for the particular time frame you're looking at (this technique works equally well in various time frames), use four- and nine-day simple moving averages in combination with the MACD indicator to indicate whether the current market "swing" is in the direction of the trend, counter-trend, or neutral. If the MACD line is above its trigger line and the four period moving average is above the nine period, swing momentum is seen as being up (see "1" on Figure 1). Conversely, swing momentum is seen as being down if the MACD is below its trigger line and the four period moving average is situated below the nine (see 2). If only one of these indicators reverse, resulting in the moving average cross and MACD lines pointing in opposite directions (3), swing momentum retains the previous signal. Waiting for both components of this indicator to change direction before assuming a change in swing momentum has taken place is sometimes a period or two slower to catch the market turns, but I've observed that this is a good trade-off because it seems to filter out a lot of market noise and false signals.

Figure 1

Now, how to use this technique. Suppose you look at 10-year note futures and determine the trend is down, but the market is approaching support and some technical studies suggest that at least a corrective rally is imminent. How do you determine if, and when, a correction begins? And then, how do you know when the downtrend resumes?

Once the bullish moving average cross and MACD trigger line cross occur, assume a countertrend correction has begun (1). Once the correction begins, it will remain in force until either a) both indicators cross back over to the downside to signal the resumption of the downtrend (4), or b) the market continues high enough to signal a bullish trend change.

In addition, overlay a 3-period exponential moving average of the high and low over a standard O-H-L-C bar chart to establish a trading envelope. This envelope helps to measure the market's strength or weakness within a particular momentum swing. If swing momentum is up, the lower boundary of the band will typically closely contain prices on the downside as the market works higher. Using the previous example, if the market has begun a corrective rally, the 3-period exponential moving average of the low will usually loosely contain prices on the downside while the correction is in force. If the correction is still healthy and valid, prices may touch the bottom of the envelope briefly on an intra-day (or intra-period) basis, but will typically not linger there for long and will close near the upper boundary. Once prices start spending more time near the lower moving average, this is a warning signal that the swing may be coming to an end and the downtrend may be close to resuming, even though the MACD and moving averages may not have crossed back over to the downside yet. Once these indicators turn downward, the end of the correction and resumption of the downtrend are confirmed.

Now that the downtrend has resumed, the upper boundary of the moving average envelope can be used to define where rallies should stall if bearish swing momentum is still in force, and also becomes a potential low-risk area to initiate short positions within the existing downtrend (see arrows). Considering a typical trend has large, broad directional (impulse) swings and relatively short, abbreviated countertrend corrections, initiating new short positions at the upper boundary of the moving average envelope is a relatively low-risk method of entering an existing trend shortly after a correction has ended.

John Kosar is, CMT, is a Chartered Market Analyst for BridgeNews in Chicago.