Price Action: Trading Broad Bear Channels (Part 4)

Bears sell in the middle or top third of the most recent decline — that is, they go short in the upper half of the most recent bear leg. Therefore they do not go short at the bottom but rather at higher levels. This results in a lack of selling pressure at the bottom, causing a steeper bounce, even a "buying vacuum" that quickly pushes price up to resistance and the sell zone, and the market may even enter "Always In Long."

Bulls will think they have won, but the market rallies into the sell zone, and bears go short again, betting this bull breakout will fail and the market will decline again to make a new low. So bears sell strong bull bars after a strong rally, or go short at reversal points after a strong bounce, betting this bounce is only a minor move that will ultimately make a new low.

When the market enters the upper third or upper half of the sell zone, bears overwhelm bulls, and bulls choose to take profits and exit. Most bulls are only scalping because they know the market is in a bear trend. The market then declines again. Bulls close their long positions, and bears begin building new short positions.

In a broad bear channel, you will often face two reasonable stop loss locations, both of which make sense. For example, if we have a double top structure followed by a breakout to a new low, that level is a reasonable stop loss location.

If you use a tighter stop loss, each trade's loss is smaller, but you will be stopped out more frequently. If you use a wider stop loss, the loss is larger when triggered, but it triggers less often. If you use tight and wide stop losses respectively over ten trades, your total profit will be roughly the same. In other words, as long as the stop loss location is reasonable, regardless of which one you choose, the final result will be similar. Bears using tight stop losses will go short on downward reversals.

You might wait for a large bear bar and a follow-through bear close, then sell at the close. The 50% retracement has always been very important because from a probability standpoint, it favors trend continuation. The market is in a bear channel, continuously forming lower highs and lower lows — a weaker trend that often consolidates sideways and sometimes even rallies strongly, temporarily putting the market in "Always In Long." But since it is a bear trend, by definition, it is more likely to continue falling than rising. Therefore, probability favors the market continuing to make new lows rather than breaking above the "major lower high." If the market declines and then bounces to about 50%, the bear's risk is above and the reward is below — risk equals reward. But because it is a bear trend, it is more likely to reach the downside target first rather than the upside stop, so even though risk and reward are equal, probability makes this a positive expectancy trade.

Bears sell at the 50% retracement of the bear leg. Some use limit orders; others place sell stop orders when price reverses down. If you go short at the limit price, your profit target is a new low, and the stop loss is above the high. Therefore reward approximately equals risk, but because it is a bear trend, probability is on the bears' side. This makes the bear trade's equation positive. If you believe this is a bear trend, you believe there is a 60% probability of continued decline, so even if the risk-reward ratio is not superior, the high probability can compensate.

The stop loss should be set above the most recent "major lower high." Profit targets are set at the prior low or at upward reversal points. For each new bear leg, traders go short on pullbacks to the 50% level, betting the market is still in a bear trend and more likely to make a new low than to break above the major lower high. This approach is usually correct. You can go short, set a target where risk equals reward, and with a 60% probability of reaching the target, this trade has positive expectancy.

Many traders prefer using stop orders to enter. They place orders below the prior bar. When price reverses down, especially when the bar is a bear bar, they enter short. Then they take partial or full profits at the prior low or at reversal points, or exit at the end of the trading day. This is the end-of-day session. If you go short here or anywhere in this area and do not plan to hold overnight, you should close the position before the end of trading. If the market breaks strongly to a new low, any pullback will likely reach that low first rather than returning to the previous high.

Every broad bear channel contains multiple trading ranges, some of which are nested within larger trading ranges. Trading ranges are usually in "breakout mode" — meaning the probability of rallies and declines is roughly equal. But on a higher time frame, the market is in a fairly tight bear channel, meaning that even if there is a bull breakout, the market will very likely eventually continue down.

Every trading range within a bear trend contains a bottom pattern and also contains a continuation pattern — a bear flag. So every trading range is both a bear flag. Bear trends continuously form trading ranges, and every trading range has a buy pattern.

Once a breakout occurs, bears will look for some kind of "measured move target down." In a bear trend, every trading range is a bear flag or contains a bear flag. Examples include wedge bear flags, two-bounce bear flags, and head-and-shoulders bear flags.

When the market is in a trading range, the probability of both bull and bear breakouts is close to 50%. But as long as the market continues to form a series of lower highs, the probability of a successful downward breakout from the trading range bottom is higher. Therefore, bears find it easier to make money on higher time frames.

No channel lasts forever. Channels eventually evolve into trading ranges. There is only a 25% probability of a successful breakout with a strong decline into a new bear trend. There is a 75% probability that such a breakout will not last long and will eventually evolve into a trading range or even reverse upward.

Broad bear channels contain a lot of two-sided trading. Eventually bulls will gain dominance and the market will form an upward move. This broad bear channel will ultimately become a bear leg within a trading range, and it will also trigger a bull leg. Once the chart starts forming a series of higher highs, traders must close their shorts because this is no longer a bear trend but a bull trend. As long as the bull trend is strong enough, bears will stop going short.