Yesterday I sent out to my free newsletter subscribers a lesson I had written a couple years ago dealing with what I call the PAUSE formation. The reason for this was that a market that I had been sharing future cycle turn dates on had formed the early warning sign for a PAUSE formation and may present an opportunity for a trade. At the very least, it should help those looking to learn more about cycle turns, swings, pivots and other associated phenomena to cycles. The more you understand a tool or indicator the better you can exploit it.
The PAUSE formation is very simple to identify. But what I want to discuss first is what to look for in order to determine a POTENTIAL PAUSE formation. Unless you have some advanced warning, who cares what the formation is after-the-fact?
Let’s start from the basics. In dealing with market cycles, it has to be understood that market patterns are the result of the cumulative effect of several cycles. But to make it really simple, let’s just call each time frame a single cycle that has its own frequency and magnitude. Yes, this is extremely simplified, but should help those new to cycles altogether.
If you look on a MONTHLY price chart, that being a price chart where each price bar represents a complete month of trading, you are looking at a LONG-TERM view of the market in question. We’ll call the market GOLD.
If we look at the MONTHLY chart of GOLD, you can see that prices have just been moving higher each month. So you could say the LONG-TERM cycle is moving up right now. Simple to view, right?
If we look at the WEEKLY chart of GOLD, where each price bar represents a complete week of trading, we can see that each week is making new highs. So let’s say the INTERMEDIATE-TERM cycle is moving up also.
On the DAILY chart, where each price bar represents a single day of trading, we can see that price has been pulling back (down) from the recent top high on 1/20/06. A very small pullback, mind you, but the direction is still down. So we could say that the SHORT-TERM cycle is going through a down swing.
Can you visualize this? It really helps if you can.
Now consider that the LONG-TERM cycle has more power than the INTERMEDIATE-TERM cycle. And the INTERMEDIATE-TERM cycle has more power than the SHORT-TERM cycle. And all of these are working and doing their thing at the SAME TIME.
If the LONG-TERM cycle happens to be moving up, and the INTERMEDIATE-TERM cycle is moving up, what chance do you think the SHORT-TERM cycle is going to have when it wants to start down again? Quick answer: Just take a look at your daily chart of Gold and look at the 12/29/05, 1/5/06, 1/18/06 price bars. Each of these made a new daily low and then were quickly overruled by the stronger upward moving cycles. Now we see 1/24/06 making a lower low than 1/23/06. What are the odds it can continue in this direction for several days? It has longer-term cycles working against it.
Now cycles are more complex than this. But hopefully you can get an idea as to what I’m trying to get across. Cycles can support or oppose each other. If you can visualize the monthly chart making new highs, but currently the weekly chart is making a new lower weekly price bar low, what you have is an intermediate-term cycle in its downward swing (cycles swing up and then down and start over again) while the longer-term cycle is still in its up swing. You have opposing powers that will tend to cancel each other out at various points in time. And riding on these is the short-term cycle that as far as the longer-term cycles are concern is just noise. Yet, when the larger cycles are canceling each other out, the ‘noise’ or short-term cycle will become more visible and you will see nice swings as the market is moving more sideways on the lower time-frame charts.
It is during strong trends either up or down that have a washout effect on short-term cycle turns. As you can see with the daily chart of Gold, the swings are there but start and conclude quickly in order to continue in the strong upward trending direction.
Now that you have a better understanding of cycles, we can now cover the PAUSE formation in a clearer light.
While long-term and intermediate-term cycles help those of us who analyze charts for such cycles to determine the longer-term direction of prices, it is the short-term daily chart and lower-time frames that are used to ‘fine-tune’ our trade entry. The idea is to keep risk low and catch a new move as early as possible.
With GOLD, for example, we can see the long-term and intermediate-term direction has been up. So the power behind higher prices on the lower time-frame daily prices is strong. This suggests that as we determine where the daily turns are likely to occur using daily cycle turn dates (based on short-term cycles), we are going to want to catch the swing bottoms they produce rather than try to short the swing tops that precede them. As the saying goes, TRADE WITH THE TREND! No wonder this has passed the test of time.
The PAUSE formation is when you have a short-term cycle that is due to oppose the strong longer-term cycles and makes an attempt, only to fail to complete the swing (confirm). A good example is the 1/9/06 price bar in Gold. Note how this price bar made a higher high and then is followed by a price bar that does not move above it. Although the next price bar did not make a higher high, it also did not make a lower low. This is called an INSIDE bar.
The short-term cycle was actually topping and trying to correct (down) at this time. Yet the longer-term cycles were just too strong to allow the lower time-frame cycle to complete its swing with a full confirmation. Confirmation requires that a following price bar make a lower low in comparison to the prior price bar (for swing tops. Bottoms are the opposite). So in the case of the 1/9 new high, had any price bar formed later with a lower low than the price bar prior to it, then the 1/9 high would have confirmed as a swing top (assuming this lower low occurs prior to price eventually exceeding the 1/9 high).
The 1/9 price high turned out to be a PAUSE formation top. As stated earlier, it is an attempt to form a swing that is cut short of confirmation.
At the beginning of this article I stated that such a situation can be anticipated in advance. Can you see how based on what you have learned so far? You start off first expecting the swing based on a cycle turn date (when a cycle is due to turn). In the case of rising prices, you see a new high occur when the cycle is due to turn. The next trading day does not make a higher high, yet it does not make a lower low either (inside bar). This is called a POTENTIAL PAUSE formation. In a strong up trend market, this potential becomes very strong and likely. Since you have resolved not to oppose the longer-term cycles that are moving up, you do not attempt to sell suspected swing tops on the daily chart. And with the potential for a PAUSE top situation, you are even more resolved not to sell. However, the PAUSE now gives you an opportunity to go with the trend on the buy side. How? When price decides not to confirm the swing top but rather ‘breakout’ above the high (of the pause high bar) that preceded the inside bar, you can use that as an entry signal.
It has been my experience that these breakouts, when a counter-swing was originally expected due to a cycle date calculated, provides excellent trading opportunities. Many times these breakout moves are strong ones. When you consider the fact that the market was strong enough to resist the short-term cycle from completing a confirmed counter-trend swing, these are clues to hop on board the train.