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Price Action Expansion And Contraction

09/17/10 09:12:55 AM
by Billy Williams

To master price action, to give yourself a solid edge in the markets, there are two things you need to master.

Security:   OPEN
Position:   Hold

Chart patterns have been a staple of trading for the last 100 years or so because they reflect low-risk trade setups within the price action themselves. Still, they are poorly understood by beginners and often become a source of frustration, especially when trying to master some of the more esoteric price patterns like iron butterflies, Fibonacci extensions, Elliott wave theory, Gartley, and so forth.

To be fully understood, there are two things that you must understand about chart patterns that are fundamental: first, they reflect the psychology of the market, and second, there are two basic forms of price action that must be fully understood in order to use chart patterns effectively.

All price patterns reflect the psychology of the market overall, but more important, the traders who are actively trading the particular trading instrument that is forming it. The battle for control of the direction of the price action's trend is conducted daily between both the buyers and sellers, but oftentimes, that battle is an internal one shared collectively within those traders. Each trader brings his or her individual hopes, desires, and aspirations to the market, and when they are in jeopardy, they fear the results. Likewise, when those hopes look as though they could be realized, euphoria and excitement begin to snowball, then greed.

Fear and greed are reflected in the price action in the two most basic forms: contraction and expansion.

All patterns, to a degree, are forms of price contraction that result when the dominant trend stalls, settling into a trading range. Rising triangles, double bottoms, triple bottoms, head & shoulders, and all the other patterns are symptomatic of price contraction. It is within these chart patterns that the battle for control of the stock takes place as traders compete with each other and their own emotions for control of the trend.

Expansion in price action is where one side has wrestled control from the other competing side, moving the price action firmly in a given direction. This type of price action is marked by price gaps in the direction of the primary trend, strong close in the upper range of the price bars in the direction of the trend, and price bars that have expanded price range two or three times their normal trading range in the direction of the trend as well.

By scanning the market for trends that are in place, you can start to identify periods of price contraction where a stock's trend has stopped making higher highs and higher lows in a bullish trend, and lower lows and lower highs in a bearish trend. It is in these points of hesitation where the trend has slowed that a chart pattern can emerge for a low-risk setup.

Simple indicators, like Bollinger bands (Figure 1), can help because they are an indicator of price volatility that is set by two bands, upper and lower, that are predicated on a stock's price volatility. They act as a visual reference where if the two bands begin to close and point inward reveal points of contraction within the stock's price action.

FIGURE 1: OPEN IN BOLLINGER BANDS. Opentable Inc. traded in a very narrow range with the Bollinger bands closing inward revealing a contracted price range. On August 4, 2010, OPEN exploded through its upper band, expanding its price range upward into a new bullish move.
Graphic provided by:
When price explodes from these contracted points trading through one of these outer bands, it reveals that either the buyers or sellers have regained control of the trend and can help you time your entry into the move and ride the momentum.

The best training for spotting chart patterns is to spend time looking at charts while looking for trends that under expansion and marking periods of contraction in the price action. By training yourself this way, you train your cerebral cortex, the part of the brain that is responsible for visual identification, to easily identify profitable entries in the market as it will more quickly spot chart patterns and give you a solid edge in attaining your own hopes, desires, and aspirations in your trading.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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