neutral market is any other condition. Once again, this is very simple.
However, it is simple only if we agree on what a high or low is. And that has traditionally been a subjective decision. First, let’s make a definition. The highs and lows that we are looking for will be called swing highs and swing lows. That will clear up some confusion with the highs and lows on each daily bar.
I’ve circled a number of swing highs and lows on this chart during the period August through November. In this chart, you and I likely agreed on where the swing highs and lows were. We intuitively agreed. We didn’t have a rule that said what constituted a high or low because, as humans, we can intuitively agree.
But what if we disagree? What if you pick one high and I don’t agree? What about the high five bars before the end of August? We skipped over those because we agreed that they were not important or significant. So the real key is to understand which swing highs are significant. We intuitively skipped over the insignificant highs and lows. But there may come a time when we may disagree on the significance of a given high or low. It would be better to have an objective way to determine the significance.
My friend Tom DeMark is perhaps the most innovative technical analyst in history. He has probably added more and better technical indicators than anyone in history. One of his innovations is the idea of creating objective standards for what was traditionally considered subjective. For example, how do you label Elliott Waves? More germane to this discussion:
What highs should be used to create a downward sloping trendline? His objective criteria eliminates the subjectivity that is often found in such types of technical analysis as Elliott Wave and classical chart analysis. No longer will you and I disagree about the proper slope of a trendline or the Wave count.
First, let me clarify some terms. The words high and low have two meanings. They can refer to the high or low of a given day’s bar (or candle) or the high or low point of a move over several or more days. Let’s call this
last meaning swing high and swing low. So the highs and lows on the chart that I circled are swing high and swing lows.
Basically, DeMark showed that certain swing highs and swing lows are significant and other swing highs and swing lows are insignificant. The way he did it was ingenious.
I think we can agree that the high in the middle of April is more important than the highs in the middle of October. We can see that very clearly on the chart. DeMark created a method for determining how significant a swing high or swing low is. (The following is my interpretation of what I learned from him. Give him the credit for the initial genius and I’ll take the blame for screwing it up!)
The basic idea is to identify every swing high with an objective rating system. The high in mid-August is the most important high on the chart because it is the highest high on the chart. The lows made in December
and January are the two most important lows because they are the lowest lows on the chart. Major highs and lows show up as major highs and lows because they are the most extreme.
DeMark’s rating system is simple. Choose a swing high or swing low in Figure 2.1. For example, let’s look at the first circled high on the chart from August. Now, look at the bar after this one and all the bars to the left
of it. To be defined as a swing high there must be one bar to the right that has a lower high than the day we are looking at and at least one bar to the left of it with a high lower than the high on the day we are looking at.
That simple test defines a swing high (reverse everything for a swing low). We have objectively defined every swing high. The circled bar at the high in August is a swing high but the bar to the left is not. Note that it has a bar to the left with a lower high but the bar to the right, the circled bar, has a high that is higher than the bar’s high. So it is not a swing high. The bar to the right of the circled bar is also not a swing high because it has a lower bar to the right but the circled bar has a higher high than the bar that we are looking at.
The next step in the analysis is to rank the swing highs and lows. We do this by simply counting the number of bars to the left of the bar in question. Let’s do this with the highest bar in August. We know that it is a swing
high because it has at least one bar on either side of it with a lower high.
However, there are 41 bars to the left of it with a high on the bar that is lower than the high on the circled bar. I would call that a 41-bar swing high because there are 41 lower highs to the left of it. There might be even more than that but we got to the edge of the chart.
Let’s now look at the next circled bar to the right of the one we just looked at in Figure 2.1. That would be a low four days after that major 41-bar high. Once again, let’s count bars. We know that there is one to the
right and 10 bars to the left before we run into a bar that has a lower low.
I’d call that a 10-bar low.
You can go through all the highs and lows on the whole chart rating them by how many bars they have to the left. It is clear that we intuitively rank bars with higher numbers as being more significant than bars with
fewer numbers. This then leads to the concept that we can now use objectivity when describing chart patterns. For example, we can now agree that we will only draw up trendlines that connect five bar or higher lows.
Looking at the chart, identify all the five-bar lows and draw a trendline connecting the two most recent five-bar lows. We will never disagree about where to draw the trendline because we have agreed that five-bar lows are significant.
Which leads to the next step in our journey. What bar level is significant? What bar level should we be focusing on to eliminate little random blip movements and keep us focused on what is really important?
My experience is that three-bar highs and lows are significant and that two- and one-bar highs and lows are not. Of course, there can be exceptions but that is a strong general rule. Markets can often retrace against the trend for a day or two but rarely will they move three days without it meaning something.
To check this, look back at Figure 2.1 and look for three-bar highs and lows for trend analysis. I find that this bar level keeps me in the trend and avoids getting stopped out on random little blips.
Let me digress for one moment. Every technique I teach has a stop loss attached to it. Most techniques taught in other books have stops attached to them. For me, I want every stop loss technique to have two attributes.
First, the stop should only be triggered when something significant happens. I don’t want to be stopped out on some little squirrelly move in the market. Or perhaps just one big trade moves the market. I only want to exit a trade on a significant move.
Second, I only want to be stopped out when I know that I am wrong. As long as there is no evidence that my original thesis is wrong, I must stay with the trade. I’ll let a trade go against me a little when that movement is
insignificant and does not invalidate my original trade idea.
The ranking of swing highs and lows allows us to measure how significant a move is, thereby satisfying condition number one. We will not be stopped out on trivial moves but only moves that have some power behind them. Later in the chapter, I’ll show you how this ranking allows us to satisfy condition number two.
From now on, I’m going to focus only on significant swing highs and lows, previously defined as three-bar highs or lows. We’re going to ignore all swing highs and lows that are two-bar highs or lows. Let’s take a look at Figure 2.2. This chart shows the same currency pair over basically the same time frame but I have changed the circles from what I intuitively identified as significant swing highs and lows to what I have now objectively defined as three-bar high and lows. Note that there are not too many changes. The chart is roughly the same. However, now the significant highs and lows are objectively defined. Using our agreed-upon definitions, our significant highs and lows would be the same.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
