In its most basic form, Price Action Analysis, also referred to in this Wiki as"Market Mechanics", is a trader's interpretation of the behaviour that price movements displayed on a chart.
In this Wiki, we will explore several areas of Price Action including the basic cycle, trend analysis, support and resistance and more.
Introduction to Price Action Analysis
Market Mechanic Basics
Welcome to our Introduction on Market Mechanics. Here we will lay the foundation for a simple yet powerful approach to understanding the way all financial markets trade and move. This section is the most important part of the course. It lays the groundwork for the rest of the course. Without a deep understanding of this section you should not move on to later chapters.
In trading and investing the simplest approach is often the best approach for the beginning market player and the more advanced as well. There is a theory called Occam's Razor which has proven to be one of the most useful tools for scientific discovery since the 14th century. This theory states that one should not make more assumptions than are needed to find an answer or solve a problem. In simple, terms it means the most simple and least complicated approach is usually the best. Nowhere in the world is this truer that in trading and investing. There is simply too much information available and it can become an almost insurmountable task deciphering it all.
Far too many traders start out by getting involved in rather complicated trading methods. This can lead to a lot of confusion for someone who has little or no experience navigating their way through today’s tough and volatile markets. Whether you are a beginner or an advanced trader, understanding the basic structure of the market before you move on to complicated systems, can help bring clarity to your trading. Trading with an understanding of the market’s basic structure creates purpose. Most people need a simple approach to get into good trades and keep them out of bad trades.
We must first lay the foundation for trading success by training our eyes to understand basic pictures before we can properly identify more complex patterns. This is why we will begin with we like to call a crayon and finger paint approach to identifying cycles and trends.
Many trading losses are the result of trading on the wrong side of the market (buying in a downtrend or shorting in an uptrend). Understanding market mechanics is the key to trading on the right side of the market no matter what time frame or trading style you are using. This will help to keep your expectations of the market in check by trading within identifiable trends and price patterns and not hoping to get more out of a move than the move has to offer.
Figure 1.1 shows the Basic Cycle. This simple picture represents the market’s basic cycle. All stocks, bonds, commodities, currencies, futures, or any other financial instrument you can think of MUST operate within this cycle. It is the only movement possible for a financial instrument to make. Nothing else is possible! All movements that markets can make are found within this simplistic cycle.
Figure 1.1: The Basic Cycle.
Figure 1.2: USDCHF currency pair performing an almost perfect Basic Cycle on the daily chart.
Any financial instrument is destined to repeat this cycle time and time again as long as humans are the driving force behind the market’s price action. Even though many new algorithms and trading robots have been developed in recent years, humans are still the creators of these synthetic actors and humans never change.
Knowing where you are in this cycle forms the basis for you to predict future price movements based on the laws governing this cycle which are psychology and probability. If you know where you are in the cycle you greatly increase the odds of making successful trades and you must have many successful trades for long-term profitability.
The Only Way to Profits or Losses
The only way to profit on the long side is to buy somewhere near the beginning of stage 2 and sell before stage 4 gets underway. The only way to profit on the short side is to sell short somewhere near the start of stage 4 and buy back your short somewhere before the start of stage 2. Don’t worry about the names of the stages in this cycle right now; we will discuss this in great length in the next chapter. For now, just understand that they do exist.
The only way to a trading loss is to go long or buy somewhere near the end of stage 2 and sell near the end of stage 4. The only way to lose on the short side is to sell short somewhere near the end of stage 4 and buy back your short somewhere near the end of stage 2.
Traders who wait for too much trend confirmation become victims of buying tops and selling bottoms (or shorting bottoms and buying tops). If a trader thoroughly understands the only error that leads to losing money in the markets then he will more prone to avoiding it. Figure 1.3 shows you the only ways to profit or loss in a basic cycle.
Figure 1.3 – The only ways to profit or loss
Figure 1.4 – S&P 500 from 1997-2010. The basic cycle repeats over and over in real markets. It’s not just a concept. The basic cycle repeats this way on all time frames.
The 4 Stages of the Basic Cycle
The Basic Cycle is comprised of 4 stages that are dominated by 4 distinct emotions. As long as humans are the main force behind markets price action these emotions and how they affect market behavior will never change. Figure 2.1 shows the Basic Cycle and its 4 stages.
Figure 2.1 – The 4 stages of the Basic Cycle
Figure 2.2 – The EUR/USD currency pair is in a 60 minute stage 4 downtrend but the 1 minute is in a stage 2 uptrend. The stages do not match.
Each stage will call for specific strategies. A strategy that works well for stage 2 may not work well at all in stage 4. An example of a strategy that may work well in one stage but not in another is buying breakouts in stage 2 will tend to work more often than in a stage 4 where breakouts will fail a large amount of the time. Breakdowns will tend to occur far more often in a stage 4 but there will be much more specific strategies in later chapters. The point is that you will need to have a few different trading strategies to be able to pull profits out of any type of market no matter what stage it is in.