|Most attempts at trying to interpret or classify types of price action are imperfect because of the focus on what price has done without taking into account what price is doing in the present. This view at sizing up the markets is responsible for more frustration on the part of beginning traders and aspiring market technicians than any aspect of trading because it is flawed from the beginning. It is flawed from when a trader first looks at a chart and puts up a false blind on everything he does from that point. |
This misguided approach is also responsible for most mechanical traders' arrogance in dismissing technical analysis, leading to the suggestion that a monkey throwing darts at a wall of stock symbols has more chance of success than a beginning trader attempting to use price action as a starting point for sound trade decisions.
The phrase "price action" should have an emphasis on "action," a verb that implies movement. It is the study of that movement that is king to all basis of trade decisions.
Next is context, or the market itself. If movement is king, then context is the kingdom itself. The context of the market is made of two parts: expansion and contraction otherwise known as trends or trading ranges. See Figure 1.
|FIGURE 1: ALXN, WEEKLY. ALXN on the weekly chart was in an obvious uptrend. It experienced two periods of contraction, trading ranges, during its ascent that each offered different opportunities: a continuation entry in the direction of the trend, and a market reversal into a new bearish trend.|
|Graphic provided by: www.freestockcharts.com.|
|Trends, or expansions, exist when there is an imbalance between buyers and sellers and one side has control of price. Once one side has control then there is a persistence of driving price higher if the bulls control price, or drive price lower if the bears have control of price.|
Trends are predictable and if you learn how to spot trends in any underlying instrument, then you are likely to make money consistently and achieve returns that would make George Soros green with envy.
The dilemma with trend trading is that there are many false starts and the winning percentage of trades tends to hover around 50% or lower, as a rule.
|FIGURE 2: ALXN. At point A, price broke higher out of a trading range where a bullish flag pattern developed and into a resumption of the stock's uptrend and then, at point B, price broke down out of a trading range where a small inverse head & shoulders pattern developed.|
|Graphic provided by: www.freestockcharts.com.|
|Trading ranges, or contraction, is when bulls and bears are typically matched in terms of buying/selling power and price oscillates between two price points where one side or the other has dominance and can force price back from where it initiated its initial movement.|
Trading ranges are common and many traders make a living, and a very good one, just trading back and forth between support and resistance.
However, trading ranges offer other advantages that are not commonly understood by most traders much less practiced by the trading community at large. See Figure 2.
|The first advantage is that trading ranges can allow you to trade in the context of a larger trend. While trading ranges are commonly formed at a given price range by scaling up in time, you can identify the larger trend at play and use support/resistance points to trade into that trend.|
For example, if the daily price chart is in a trading range but the weekly price chart shows a bullish trend in place, then you want to look at taking a position at the support price point on the daily price chart to put yourself on the side of the dominant trend.
Second, trading ranges can be an inflection point for a market reversal. In the same example, if the weekly price chart is bullish and there is a trading range on the daily price chart, you would want to look for a breakdown below the daily price chart's support level to confirm that the trend has reversed to bearish.
|This early detection lets you catch a potentially lucrative market reversal just as the bears are taking control and ride the meat of the new downtrend early on.|
Contraction and expansion -- trading ranges and trends -- form the essential building blocks of the market's structure and provide the starting point for all reliable trading approaches and decisions. It is from this structure that you can filter, measure, define the criteria, and develop sound approaches to successfully trading the market, and it all starts with identifying the movement of price action in the present moment and taking the appropriate action when called to do so.
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