Price Action: Trading Tight Bear Channels (Part 3)

Whenever you look at a chart
and see that it is a trend,
you know the market has a 60% or even higher probability of falling further.

Sometimes you may hesitate:
"These bear bars are not very big,
the market keeps reversing.
Maybe it is not a true bear trend?
Maybe it is just a bear leg within a trading range?"
But look at how tight it is —
you will notice gaps between the low of the previous bar and the high of the next bar,
and then gaps between this high and the next low.
This shows the market is strongly bearish,
and you know it will continue to fall.
Although it may not look like there is a 60% or 70% probability of making money,
when a bear channel is this tight,
there really is a 60%-70% probability
of making money at any time, for any reason, as long as you use a reasonable stop loss.

The channel is very tight.
Even if three consecutive bull bars appear, this reversal is most likely only a minor reversal,
and afterward the market will most likely resume the bear trend.
When you are watching the chart in real time,
you may feel panicked:
"My God, I'm holding a short position, and it's going to hit my stop!"
But the fact is, the probability of getting stopped out is very small.
Without first seeing an obvious minor reversal,
the probability of the market transitioning to a trading range or bull trend is very small.

The longer a trend continues,
the more it tends to weaken
and eventually evolve into a trading range.

Some signals indicating this process may be starting:
For example, this breakout only lasted one bar,
then the market started bouncing.
This may be a signal that the trend is weakening
and may soon evolve into a trading range.

If limit-order bulls buy at the low and add to their positions
and can profit,
and if this pullback breaks above the previous decline point,
that is another signal
that the market may be evolving into a trading range.

Bears start to see prominent tails at the bottom of bars.
This shows that at the close of these bars, traders are buying.
This means bears are weakening,
bulls are strengthening,
and the market may be evolving into a trading range.

You can also observe subsequent price action:
If a series of bear bars appears,
but afterward each bear bar is followed by a bull bar reversal —
a bear bar followed by a bull bar,
then another bear bar followed by another bull bar,
or a bear bar followed by a doji and then a bull bar...

Traders begin buying after the close of strong bear bars
rather than selling.
No longer consecutive bear bars,
but buying behavior begins to dominate.
This means traders are buying at lows —
this is a signal of a trading range: buying low.

Bear bars are no longer particularly large.
Compared to the bear breakout phase at the beginning of the trend,
these bars are getting smaller.
You see the bar bodies getting increasingly smaller,
and the last ones are even bull bar bodies.

As the market continues to fall, momentum is weakening;
as the market continues to probe lower, selling pressure is weakening.
Consecutive large bear bars no longer appear;
a large bear bar is followed by a doji;
another large bear bar is followed by a doji,
rather than two consecutive large bear bars.

Despite this, it is still a strong bear trend,
and you can still use the same trading approach as during the breakout:
sell at market,
sell at the close of bear bars,
or even sell at the close of bull bars.
The probability of further decline is still high.

But as it gradually weakens and becomes more two-sided,
traders begin to only go short on rallies
rather than selling at market or at new lows.

So what is the biggest difference between a "strong bear trend" and a "breakout"?
During the breakout phase, traders go short at the prior low,
betting the market will continue to fall.
But during the channel phase,
they begin taking profits at the prior low
and then re-enter short near the midpoint of the previous bear leg.

So once the trend starts to weaken,
traders no longer go short at new lows,
no longer go short at any time,
but instead tend to only go short on pullbacks.
No longer chasing shorts when the market drops to new lows,
but waiting for rallies to go short.

So traders begin taking profits at new lows
rather than going short.
If the trading range is large enough,
bears may not take profits exactly at the prior low;
they might take profits 1, 2, or 3 points above the prior low.
But bears are indeed buying at lows,
which causes a bounce —
a bounce that breaks above the prior low.

Bears do not want to go short at lows;
they want to sell at highs.
So nobody is going short at the low;
bears are buying and bulls are buying too,
which produces a bounce.

Although it is still a bear trend,
bulls do not want to hold long positions.
They buy at lows and then close out quickly;
even if they add to positions, it is for scalping.
And bears sell again at the midpoint of the bear leg.

So at lows, both bulls and bears are buying;
at highs, both bulls and profit-taking bears are selling.
This is a signal that the channel is transitioning into a trading range.

Early in the channel, when it is very tight,
any bull who buys with limit orders at the prior low
cannot make money.
This is a signal of a strong bear trend.
If limit-order bulls cannot profit from buying at the prior low and adding to positions,
it means the market is very bearish and will most likely continue to fall.

When the channel is very tight,
most bulls will not buy.
These small pullbacks
are mostly caused by bears' partial profit-taking.