NORMAL MARKET BEHAVIOR
How Markets Work
Markets have been around forever. They put buyers and sellers together in the most efficient manner possible. Financial Markets are no different than those of real estate or other goods. They are constantly searching for prices that bring buyers and sellers together.
Financial markets have their idiosyncrasies and once you understand them, you will have a much better understanding of where to enter, when to place a stop or limit order, when to be concerned and when the market is doing just what you expected, and your trade idea remains intact.
Understand the basics
Learning to read charts takes time and its more than memorizing patterns. But charting alone will not make you successful. You have to understand context. You have to develop a process.
Most traders fail. That is a fact. Part of developing a process is understanding normal market behavior and how to recognize opportunity.
This may be the most important lesson of all, understanding A-B-C-D. I can tell you that I was slow to grasp this concept. The idea is simply that markets do not move in straight lines. They move up 5, down 1, up 3, down 3, up 4, down 3. There is a rhythm to this typical market behavior, and traders need to both understand and expect it.
Imagine a man going up a ladder. He takes a step, then another, then another, and he finally gets to the height he is trying to reach. His journey leads him straight up. That is NOT the way markets work!
Now instead imagine the same man on a ladder. This time he climbs a step, then two, then three, but as he tries for the fourth step he slips, falling back a step. Here he gathers himself and once again goes up the steps, one more, two, three, then he falls again, this time retracing two steps. This is how typical markets work and it is often referred to as ABCD.
A refers to the first three steps, B refers to the first fall back. C is the subsequent three more steps up, then D is the fall back again. What is this all about?
This is the market trying to find the proper price to match buyers and sellers. Most importantly this is typical, normal, market behavior and must be understood. There are variations of course, such as news events and retracements from major highs and lows, but moving up, then back, then up, then back again, is typical. You need to know this, so that when you go long at 10, and the market moves to 13, but then falls to 11, that doesn't necessarily mean that you are wrong. You have to expect these types of market moves.
Buyers and sellers compete with each other every day in financial markets. It takes something significant to convince either side to stop. If a stock is at 10 and goes the 13, then falls back, new traders often wonder why. Maybe at 10 there were not many sellers and the stock did move, but now at 13, there will be sellers thinking this price is too high. That mentality happens all day, everyday. New traders enter as price moves up or down.
Markets find a proper price and typically stay there. What a market always wants most to do, is whatever it has been doing most recently. So when breakout attempts happen, they usually fail. Sellers step in when price is too high, buyers come in when price is too low.
You are watching price move lower but it cannot break out of balance and bounces back. You are convinced that price will move higher quickly, and it begins to do so. You go long with more leverage than you should, but only because you "know what will happen". But to your dismay, price again tries to go lower.
Never forget that price will try, try, try again. Two tries are simply mandatory, 3 are called a wedge because they happen so often, 4 happen with some frequency as well, but if all fails, then the rebound!
Markets trade up, they trade down. But they typically don't go from Bull to Bear or Bear to Bull. Instead, they go from Bull to Trading Range, or Bear to Trading Range. Then the market decides where to go next, continuing the previous move, or instead reversing, but there is typically a period of consolidation while traders decide which direction price will go. This leads from up, to trading range (as in this chart). Then up or down from there.
It is exceptionally common that markets follow this path.
Al Brooks states one can trade with the same price action theories in all markets. Though this may be true, all markets do not trade alike. Bond futures trade with less intraday volatility than Dow or S&P, and their moves are often prolonged, allowing for more swing trades. Oil futures move with much volatility, and longer trends. Both Bonds and oil react to specific news items weekly. Check your broker's margin requirements for different markets and you will see huge differences because of differences in volatility. You must know the market you trade.
What time of day are you trading? There are huge differences in how the market trades at different times of day.
Stocks have a lot of volatility in the morning. They often trade lower first, before they test up. Lunch is often dull and slow, typically doing what was done in the morning hours, and the afternoons can find continuation patterns, much more active than lunch, but less than mornings.
Markets often can continue moves that were begun the day prior. Watch for end of day moves, and look to see if they are not continued the next morning, which is often the case. Be sure to note overnight highs and lows and nearby pivot price points from previous trading. These will affect price going forward regardless of the prior days action.
There is a lot of variation from day to day, but at certain times markets have much more volatility than others. This includes the open, news announcements (ex: fed reserve minutes 2 pm), and immediately prior to the close. The open and close reliably have much more volatile patterns. The open is a bit more predictable than the close, but both can offer much opportunity and much risk. The close will often reverse moves, but a trader who gets in early often gets hurt as markets will seek out prior lows and highs to run the stops.
For the first many years I traded I thought that what happened on a five minute bar was "noise". Al Brooks taught me that that the 5 minute bar close matters, and knowing this, can lead to better entries. Watch prices on 5 minute bar closes, see how often they change in the last 30 seconds of the bar formation. These are intentional moves by traders trying to influence perceptions of other traders.
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