Price action trading: The market cycle

September 30, 2014 07:00 PM

Ed Note: This is the third of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets.


Although there is no universally accepted definition of price action, I use the broadest one—it is simply any move up or down on any chart for any market.

Markets are created by institutions so that they can quickly buy or sell when they want at a fair price and with a tight spread. The market is always searching for a price that is fair for both sides, and that is why it spends most of the time in trading ranges, which are areas of agreement.

Breakouts up and down are brief moves that occur because both the bulls and bears agree that the price is too low in a bull breakout or too high in a bear breakout, and the market needs to move quickly to a new area of agreement.

What is an area of agreement? It is a trading range. It is a price range where confusion reigns, and that is why trades rarely look certain. Most of the time, the market is fairly balanced and there are reasonable arguments for both the bulls and the bears. Whenever you feel confused, whenever you can think of a good reason not to take a trade, or whenever you can see both reasonable buy and sell setups, then you should assume that the market is in a trading range.

This is the goal of all markets. They are trying to find a price where the bulls think it is sensible to buy and the bears think it makes sense to sell. As the market works higher in the range, the bulls think the price is less fair and they buy less. Many bulls will take small profits and therefore are now selling. The bears who were shorting a few bars ago see this as an even better value, and they sell more. The imbalance results in the price moving back down.

When the market tests support, which is the bottom of the range, there are fewer bears willing to short, and other bears are taking profits on their shorts and therefore are now buyers. Bulls see the lower price as an even better value than what it was a few bars ago and they buy more. The market then works up to test the resistance at the top of the range. Markets have inertia and when a market is in a trading range, 80% of the attempts to break out will fail.


Enter the trend
Eventually, a breakout will succeed and then the market is in a trend, racing up to the next resistance level or down to the next support level, in search of a price where both the bull and bears once again agree that there is value in trading. This is the next trading range.

As a market is trending, it is constantly trying to reverse, but because of inertia, 80% of reversal attempts will fail and lead to pullbacks and then resumptions of the trend. Each reversal attempt is at a resistance level, whether or not you see it, and it is due mostly to profit taking. Later in the trend, pullbacks become deeper and more complex and counter-trend scalps begin to play a bigger role in the price action.

If a pullback starts to accumulate a lot of bars, the trend fades further to the left on the chart and its effect on direction dissipates. After 20 bars or so, the effect is entirely gone, and the market is then in a trading range. At this point, the probability of the direction of the eventual breakout falls to about 50% for both the bulls and bears. It becomes equally likely that the trend will resume or reverse.

The most valuable skill that a trader can develop is the ability to understand breakouts. Breakouts of what? Breakouts of everything. The simplest breakout is a move above the high, or below the low, of the prior bar, but the market can break out above or below prior highs, prior lows, trendlines, channels, measured-move targets, moving averages or any other form of support or resistance.

If the current bar moves above the high of the bar that just closed, will there be more buyers or more sellers? You are asking yourself whether the breakout will succeed and be followed by enough of a move up for a profitable long trade, or whether it will fail and possibly even reverse, and be the start of a profitable short trade.

There are characteristics of a breakout that increase the chances that it will succeed, and these are all signs of buying pressure. If instead of signs of buying pressure, there are signs of selling pressure on the breakout bar or following bars, the chances that the breakout will fail and reverse down increase.

One important consideration is context, which refers to all of the bars to the left of the current bar. If the market has been in a trading range for 100 bars, the chances that the breakout will succeed are small. As mentioned, markets have inertia and tend to continue to do what they have been doing. When the market is in a trading range, most breakout attempts will fail, even if the breakout races strongly up to the top of the range. This is a buy vacuum test of resistance. Think of the top of the trading range (and all support and resistance) as a magnet. The closer that the market gets to the magnet, the stronger the magnetic pull and the faster the market tends to get drawn to the magnet. Once it gets there, the magnetism greatly reduces and can disappear completely (see “Breakouts: Strong & weak,” below). 
 

How does that happen? In a trading range, as the market is going up, bulls and bears expect the market to reach the top. If you are a bear, you will be inclined to stop selling once it becomes clear that the market will reach the resistance level because if you wait, you can sell at a better price. This means that there is a relative absence of bears just below resistance. Bulls know that once the market gets close, the probability of reaching and even slightly surpassing resistance increases so bull scalpers, such as high-frequency traders, buy aggressively. The buying by the bulls and the absence of selling by the bears often creates a big bull trend bar or several that quickly race to the top of the range. Then, the bulls take profits and bears short aggressively.

The result is that the market reverses, even though it just strongly raced toward the point of resistance. It was in a buy vacuum up to the top, and if it gets near the bottom of the range, it probably will enter a sell vacuum down to the bottom, which will be in the form of one or more big bear bars closing on their lows. However, because most trading range breakouts fail, the market probably will then reverse back up. Eventually a breakout will succeed and a trend will ensue. Signs of building buying or selling pressure within the trading range can sometimes allow a swing trader to enter early, but most breakout attempts will fail.

Microchannels

What type of chart is a five-minute chart? It is usually incorrectly called a price chart. All two-dimensional charts have at least two contributing factors. The dimensions are variables and both contribute to a trend. Although a trend cannot be present without price movement up or down, in some trends, time can be more important than price, especially early on.

Microchannels should be thought of as breakouts, and most usually are breakouts on higher time frame charts. When the bars are small, it is easy to miss what the market is telling you. For example, if there are 10 consecutive bars, which can be small and unremarkable, where each low is at or above the low of the prior bar, this is a 10-bar bull microchannel.

This means that the bulls have owned the market for the past 10 bars, even if the bars and price rise are small. When a microchannel occurs early in a trend, it is often followed by a strong acceleration and breakout. When one occurs at the end of a trend, it is often an exhaustive climax that  soon is followed by a two-legged correction.

Seeing the market cycle

The market is constantly alternating between trends and trading ranges, and this is the Market Cycle. This takes place on all time frames, and the market is usually trending up on some time frames, down on others and sideways on still others. Although many traders try to trade in the direction of a higher time frame, this is not necessary.

All that a trader needs to trade profitably is the chart in front of him, no matter what the market, chart type or time frame. Every chart has plenty of trades if a trader knows how to spot and act on them. Remember, even when a market is sideways, there is often plenty of volume on each bar. Even in the tightest trading range on the five-minute E-mini chart, each bar averages about 5,000 contracts. I usually can see a reason to buy or sell on every bar on every market during the day, and with practice, a trader will learn to spot many more setups than he could possibly ever trade. The keys are learning to spot them early enough to decide that they are worth trading, structuring a trade that makes mathematical sense and then managing the trade appropriately.

The Market Cycle was defined as the unending series of alternating trends and trading ranges that are present on every chart. The cycle has its subtleties. The strongest phase of a trend is the breakout. This has the highest probability of follow-through over the next several bars, but because the stop is often far away, the risk is larger. Also, the market is moving fast, which increases the chance of making mistakes and adds to the risk.

Once the market has a pullback, the trend weakens and enters the channel phase. While in a channel, the trading becomes more two-sided. For example, in a bull channel, bears will begin to scalp shorts above new highs and scale in higher. Because the two-sided trading continues to increase and the pullbacks get deeper and have more bars, eventually a pullback grows so big that the market loses its direction and enters a trading range. Because channels almost always are the start of a trading range and usually are followed eventually by a leg in the opposite direction, every bull channel should be thought of as a bear flag, and every bear channel should be seen as a bull flag.

Once the reversal down is clear, the trading range has begun, and the market usually tries to retrace to the beginning of the channel. Part of the reason for this is that bears begin to scale into shorts after the first pullback begins and they add to their position. Once the market starts down, many bears try to exit their entire position around their first entry, which is the bottom of the channel. They then get out breakeven on that first entry and with profits on their later entries. Because the bears are buying at the bottom of the channel, there is a relative absence of sellers. Bulls remember that the market started up from the bottom of that first pullback, and now that the market is back down to that level, many bulls will buy again, expecting another rally.

Bears will short again where they last entered profitable shorts, which was at the top of the channel. Bulls expect that the market has entered a trading range and will begin to scalp out of longs at the top of the range. Both the bulls and bears switch to scalp mode, buying low and selling high. Bears sell high to initiate shorts while bulls sell high to take profits. The opposite occurs at the bottom of the range. Eventually there is a breakout in either direction and the process begins again (see “Trading range then reversal,” below).

Trends are strongest during breakouts, and the appearance of each bar tends to be consistent with the trend. In a bull trend, there is an abundance of strong bull bars, which means that the buying pressure is strong. In a bear trend, selling pressure is strong. My lists of signs of buying and selling pressure are too long for this article, but are covered in my videos and books. However, “Buying pressure” (below) shows an example of a strong bull breakout and illustrates many signs of buying pressure.

The most obvious sign of buying pressure is a bull trend bar, where the bar closes near its high. It is even stronger if it opens on its low because this is a sign of urgency—the bulls were so eager to buy that they were unwilling to wait for even a small pullback and bought as soon as the bar opened. The bar closing on or near its high meant that bulls bought right up to the top of it. If they are willing to buy high, they almost certainly will buy a little lower, which means that even the smallest pullbacks will be bought.

If the bull trend bar is bigger than an average bar, that is another sign of buying pressure. If there are two or three strong bull bars, this is even a stronger breakout. If the close of the current bar is above the high of the prior bar, this is a gap and a sign of buying pressure. Traders will pay attention to the low of the next bar to see if its low stays above the high of the bar two bars earlier. If so, the gap bar can be a measuring gap and lead to a measured move up. If the close of a trend bar is above some other resistance, like a bear trendline, a moving average, of the top of a trading range, this is more buying pressure, especially if the next bar (the bar after a breakout bar is the follow-through bar) also has a bull close. This increases the chances that higher prices will follow, even if there is a pullback in the meantime. 

The next article covers support and resistance, and the importance of measured moves.
 

Al Brooks, MD, has traded for 27 years. He is a regular contributor to Futures and the author of a three-book series on price action: Price Action Trading: TRENDS; TRADING RANGES and REVERSALS (Wiley). He provides live intraday E-mini price action analysis at www.BrooksPriceAction.com. His video trading course is available at www.BrooksTradingCourse.com.

About the Author

Al Brooks, M.D., is author of the Brooks Trading Course (27 hours of videos at BrooksTradingCourse.com), several books on Price action (Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader, Wiley, 2009, and the 500,000 word, three-book series, Trading Price Action, Wiley, 2012), and numerous articles in Futures Magazine. He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.