Expansions & Contractions, Part 1 by Dirk Vandycke
The Calm Before The Storm
Every trader wants to be able to predict price moves. But we know that it’s impossible to do so. Instead, focus on finding high-probability setups and manage them well. In this first part of a three-part series, we’ll look at how to identify these profitable setups.
Apart from the use of derivatives, perhaps the only way to make money in the markets is in the difference between the price at which a position was opened and the price at which it was closed. It is every technical analyst’s wildest dream to be able to predict price moves. As that is impossible, the next best thing is try to find high-probability setups and handle them with correct position sizes and the right aptitude for risk management. One way to find high-probability setups is to look for divergences.
EXPANSION AND CONTRACTION
Before you start to look at divergences, you need to be aware that they are closely connected with the contraction and expansion of market prices. You may have noticed that price ranges contract before they expand. I call this the tsunami effect — similar to how the sea recedes prior to the devastating wave that follows. In the same way, volatility and daily range shrink before a stock starts running, thereby sucking all liquidity out of the market. Tsunamis, however, are far rarer than price expansions and the often subsequent trends. The question is, can we detect a tsunami before it floods us?