Thursday, August 23, 2012

What does profit taking look like?

Initiating trends tend to make correlation trades divert or breakdown temporarily.  When the trend terminates via profit taking, the correlation trades tend to revert.  This reversion is not necessarily a complete reversion...but in that direction.  The past 3 days are a good example of this.

In the treasury market, the recent initiating buying that started yesterdays trend occurred on the 21st.  You can see from the chart that, at at the time, stocks and bonds were correlated, moving in lockstep.  Then, by the yesterday afternoon (the day after the initiating buying), as the trend in bonds gained strength, treasuries broke away from stocks and the 2 lines diverged.  Then today, as the treasury traders began taking profits, the 2 lines converged back to each other.  This is the most typical example of an initiating trend (undersupply condition - followed by supply distribution - followed by profit taking and consolidation).

So, the next time one of these setups takes place, we now have a metric for measuring and confirming the existence of the pattern, and thus, how to trade it.

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