Price Action: Trading Broad Bear Channels (Part 2)

Observing market behavior:

Price breaks through the trendline, then declines again. You draw a new line, then keep repeating this process. Each time a trendline is broken, you draw a new trendline. These lines become increasingly flat, the trend becomes increasingly weak, usually also increasingly broad, and eventually transitions into a trading range.

Every broad channel contains trading ranges, and some trading ranges last many bars.

When the market is in consolidation, it often breaks above the prior high and then reverses down, or breaks below the prior low and then reverses up. Sometimes it even breaks above relatively important highs, but as long as a downward reversal follows, traders will continue to go short, betting the bear trend will continue — just becoming broader and flatter.

When the market is in a trading range or broad channel, "second leg traps" are very common. The market rallies, then produces a second leg up that looks like it is about to form a bull trend, but the second leg fails and the bear trend restarts.

All bear trends require a series of lower highs, and breakouts above minor lower highs are very common.

As with all trading, you should diagnose the market's state as early as possible so you can trade it appropriately.

All major reversals are inherently lower-probability trades, with only about a 40% chance of forming a trend. But as long as your reward-to-risk ratio reaches at least 2:1, the mathematical expectation of these trades is reasonable.

Some traders want a higher win rate. They will wait until three to four consecutive bull bars close above their midpoints before going long. At that point, they use a wider stop loss and will add to the position if the market pulls back.

Broad bear channels usually ultimately transition into bull trends, but within a bear trend, all rallies are just bull legs.

In a broad bear channel, although it is still a bear trend, many bounces are large enough that bulls can make money through swing trading or scalping.

If you see the bear trend starting to produce relatively deep pullbacks, it is more likely a broad bear channel rather than a tight channel.

Once it enters a broad bear channel, bulls will start buying at the prior low, and some bears will also cover their shorts near the prior low to take profits. Bears will start selling rallies rather than chasing shorts at new low breakouts.

Once the market makes a new low, they close their shorts to take profits, which is why you see strong bear breakouts that quickly fail.

At new lows, bears cover their shorts because they begin to doubt whether the bear trend can continue extending. So they take profits at new lows. Bulls know bears will do this at new lows, so bulls also buy at new lows.

Then bears choose to go short near the middle third of the previous down leg. Bulls take profits here because they know these reversals are most likely only minor reversals.

This forms a "staircase pattern." When pullbacks reach above the breakout point, it shows that bulls who bought at lower levels are making money.

Bulls can make money even in a bear trend. This usually means the bear trend has weakened, so you should consider that the market might be a broad bear channel rather than a tight channel.

Once bulls realize this, they will start buying at new lows and prior lows.

The key is to watch the strength of these bounces. Once bulls discover that limit-order buying at the prior low is profitable — meaning the market bounces above the breakout point after each decline — they will become more confident and start buying at every new low, even adding at lower levels.

A bear trend requires continuously producing lower highs, especially "major lower highs." A major lower high typically leads to a strong decline that makes a new low.

In a broad bear channel, "second leg traps" are very common, because a broad bear channel is essentially very similar to a trading range — just slightly downward-sloping.

You will see strong second legs that lead traders to think there will be a powerful breakout with follow-through, but the market quickly reverses, trapping traders in "chasing highs to buy" or "selling too low" traps, because the entire channel is really just a downward-sloping trading range.

Bulls can make money by "buying at new lows and adding at lower prices." They usually use wider stop losses.

In a bear trend, bears will progressively raise their stop loss to just above the most recent "major lower high."

A "major lower high" means that after this high, an obvious downward reversal or strong bearish breakout occurs, usually making a new low.

Some traders prefer using very wide stop losses, only giving up when the market is clearly no longer in a bear trend. Others will stop out when a seemingly "decent" major high is broken, then wait for the market to reverse before going short again.

Deep pullbacks in broad bear channels. As long as the market continues to form "lower highs," it is still in a bear trend.