Chart Types to Depict Market Behavior
• Candlestick charts (or standard bar charts) are good at showing the trend of market prices.
• Market profile charts quickly show you the time / volume accumulated at any particular price, and are good at showing where value is (the place where the majority of time/volume is, as shown by the bell-shaped curve).
• Both charts are good at showing where price rejections happened. Candlestick charts will show these as shadows / wicks on a candle, and market profile charts will show them as low volume areas (or areas with only one letter on the chart in the case of time-based profiles).
• Unless you trade a market where volume information is not available (like the Forex market), using a volume-based profile is easier than a time-based (letters) profile.
Interpreting Market Internals in Context
• The power of the market internals comes when you look at them in context. When at key reference areas, they can provide early tells for the eventual direction of market moves, or allow us to better time expected reaction.
• It’s dangerous to try to over-read the internals, especially out of context. Don’t look to trade off of them based on every little wiggle. If you use them as general gauges for the health of market movement and the type of day we’re likely to get, while looking for divergences at key reference areas, they will serve you best.
• Multiple divergences in the A/D Line at a key reference area could be a great early tell that we’ll get a sizeable reaction the other way. This becomes especially useful when we’re in situations where it’s unclear whether the major trend will continue, or an intermediate term trend the other way will ensue. Divergences in the A/D Line could tip the scale one way or the other.
• If we’re hitting a major key reference area intraday, and it’s a wide key reference area from a larger time-frame, sometimes it’s hard to know where within that large key reference area could actually reverse during the current day. NYSE TICK extremes can help you better time potential reversals. If the context says that the odds are high that the key reference area will hold, then hitting an extreme in the TICK could alert you to a potential exhaustion point and a good area for the reversal to take place. (Unless it’s a pure trend day, in which case it’s almost never a good idea to stand in its way).
• If you see a clear divergence in the A/D Line at a key reference area, an extreme in the NYSE TICK could help you time the likely reversal in that area.
• This previous point hints at an important principle: the more factors that align, the more the probabilities are compounded in favor of a certain scenario unfolding. The highest odds moves take place when the trends are aligned on different time-frames, and we’re at a key reference area(s) aligned with the trend, and we’re seeing divergences and extremes that point to an exhaustion of the current smaller counter-trend move.
The Real Nature of Intraday Market Behavior
• Although the possible variations of market behavior during any given day are virtually infinite, we can identify some broad categories of days that assist us in putting similar types of market action in the same mental compartment for better and quicker analysis.
• The Pure Trend Day is a day that opens on one extreme, makes directional movement throughout the day (with small balances), and closes at the other extreme. It is the most high conviction type of day, with one side of the market in complete control throughout. It occurs about 2% of the time.
• Another variation of the Trend Day is the Double Distribution Trend Day, where the market opens on one extreme and closes on the other, but the directional conviction is not consistent throughout the day. Rather we often will start the day with a small balance, and we’ll have a larger balance occurring mid-day or late in the day. It happens about 5% – 10% of the time.
• The Pure Balance Day, or what is also referred to as a range-bound or non-trend day, is a day where there is very little sustained directional movement. Buyers and sellers are in equilibrium, and the market moves sideways all day in a small range. Often we’ll stay within the first hour opening range and make no real range extensions. This type of day occurs about 5% to 10% of the time.
• The Normal Variation Day is a day in which the market extends the first hour opening range to one side or the other. By definition, this type of makes either its high or low of the day in the first hour of trading. This happens because after that first hour, one side takes control of the market. This type of day is the most common by far, and it occurs 50% to 60% of the time.
• The Neutral Day is a day in which the market extends to both sides of the first hour opening range. Both buyers and sellers take turns being in control, and the end result is often a day which ends up neutral overall. However, if the market ends up closing at one extreme or the other, this means that one of the sides won the battle that day, and the overall day will be accordingly bullish or bearish (even though the name seems to imply complete neutrality). This type of day is the second most common, and it happens about 25% to 30% of the time.
• The first hour opening range is a key reference period, because often the institutions (which are the primary force moving the markets) are most active in this period and tend to set the tone early on. Therefore, extending beyond this range shows control by one side or the other.
• The high or the low of the day will be made in the first hour of trading about 70% of the time. It’ll occur in the first 30 minutes of trading about 40% – 50% of the time. (Stats are based on studies of the S&P 500 futures. Although most markets will likely be similar, verify them in the markets that you trade by taking a random sample of days).
• To gauge the day type, you need to use a “day time-frame” setting on your chart, instead of a 24 hour setting. Find out the official opening hours of the market you trade and put the setting on that time. If you trade the Equity Index Futures you’ll set it at 9:30am EST – 4:15pm EST, for instance.
• What’s important is not to memorize definitions of day types, but rather just to use them as broad structures to organize your thinking about the market in the intraday timeframe. Don’t get hung up on seeing if we made range extension by a tick and wondering what you should label the day. It’s the overall concepts that matter, and it’s what they tell you about who is in control of the market that day, and where the high and low are likely to take place, that really matters.
The Real Nature of Market Behavior
• To understand anything, you have to understand what its purpose is and who its participants are.
• The purpose of any market is to facilitate trade. Understanding this allows us to think of market behavior in terms of value (places of fair prices where trade facilitation can occur), and price probes away from value (in search of new areas of value).
• Since the participants of the market are human beings, and human beings are creatures of habit with repeatable psychological and emotional patterns, human psychology greatly affects the perception of value and the resulting price behavior.
• Any market has intrinsic supply / demand fundamentals that affect it, but supply and demand is itself affected by human psychology. So these two things interplay to cause price behavior and value determination.
• Prices that are too high will cause a lack of demand, and the seller will take prices lower to sell inventory. Prices that are too low will cause a surge in demand as buyers scoop up all inventory. Prices will naturally have to go too high and too low in order to discover what the correct value is, and where normal trade facilitation can take place.
• Keeping this simple framework of price discovery, value, supply / demand, and human psychology will allow you to understand the more complex financial markets at a deeper level. And once you have a deeper understanding of the dynamics of market behavior, you’ll be in a position to trade them much more profitably.
The 10 Laws of Market Dynamics
• Law #1: The markets are fractal in nature. That is, they display similar states and patterns in all degrees of time. Whether you’re looking at one day’s action on a 1-minute time-frame, or 3 year’s action on a daily time-frame, the same principles and types of patterns are at play. In fact, if we were to show you a chart without showing you the x-axis and y-axis and their labels, you wouldn’t be able to tell if the chart is of a time-frame spanning years, or one spanning minutes.
• Law #2: In any given time-frame, the markets can either be trending or balancing. There’s one of two things the markets can do. They can facilitate trade at a given range of prices agreed to be value by the aggregate forces of buyers and sellers (balance), or they can move directionally in search of new value areas as one side overpowers the other for a sustained period of time (trend).
• Law #3: Price moves in a series of thrusts and corrections. Prices don’t move straight up or down. They first make a directional move, then hit a stopping point, which forms a swing high (in the case of up moves). After the stopping point, price moves counter to the directional move in a corrective action. The correction can be vertical, in which case it is often called a ‘pullback’, or horizontal (correction in time instead of price), in which case it is a balance or trading range on the time-frame that is smaller than the directional move.
• Law #4: Price discounts all information efficiently, but not perfectly. Any information that becomes known about a market gets factored into the price very quickly. That is why it’s a losing proposition to trade based on rumors, tips, analyst opinions, and otherwise. If it’s publicly available information, the price has already likely discounted it and there is no edge in trading based on it. On the other hand, since price is not perfect at discounting all information (because the market participants are emotional human beings who are not perfectly rational), the market can often overreact to information and go too far in one direction or the other. These inefficiencies often end up being great trading opportunities.
• Law #5: Trends start from balance areas or after major climaxes. The majority of the time, trends start from balance areas. They breakout to one side or the other of the balance area, as either the buyers or the sellers overpower the other side. The other side often gets caught on the wrong side of the market and is forced to exit their losing positions quickly, which adds to the initial momentum of the new trending move. When trends start after major climaxes, one side (either the buyers or the sellers), gets too emotional and either buys out of hope and greed at prices that are too far above true value, or sells out of fear at prices that are too far below true value. In both cases, the other side aggressively responds to the price being too far from value and the price snaps back quickly the other way. Here too, the late buyers or sellers who were acting on emotion get stuck in losing positions and are forced to exit quickly, further intensifying the price reversal and new trend.
• Law #6: A trend in motion tends to stay in motion. The laws of physics help us understand that when an object is in motion, it will take a major force in the opposite direction to stop its motion. The same is true in the case of trends, and because one side is aggressively moving the market with directional conviction, often based on underlying economic factors, it will take a major force from the other side or a change in character to get the trend to stop. Explained from another angle, crowd psychology ensures that once a trend is in motion, other participants will be attracted to it for no other reason than the need to conform and join the masses. Social proof is powerful, and it tends to keep trends in motion.
• Law #7: Trends end in climax or balance. This law follows naturally from Law #5. If trends start after a climax or a balance, then they must also end in a climax or a balance. So the trend will keep going until buyers and sellers reach a point of equilibrium and prices start balancing, or it will keep going until it attracts the laggards (the uninformed masses) who pile in emotionally and move prices too far in that direction- causing a climax when the other side responds aggressively to price being too far away from true value.
• Law #8: High volume on the vertical scale signifies directional conviction and a rejection of value. It’s the major institutions who start moves, because major moves need a large volume of orders as their fuel, and the large volume of orders comes from the institutions with millions and billions of dollars to spend. Once they commit to a certain direction with conviction, their orders create large volume in any given time-period, which shows up as large vertical volume. This volume fuels a move away from currently established value, and often is the cause of new trends that go on to move price to a new value area. However, once a trending move is already established, it can keep going without large volume because of its momentum and crowd psychology. Finally, high vertical volume coming after a sustained directional move often marks a climax, and the directional conviction it points to is that of the uninformed retail crowd, which is wrong the majority of the times.
• Law #9: High volume on the horizontal scale signifies value. When the market spends time in a certain price range, trade is transacted there. The more time and volume gets transacted in an area, the more that area becomes a place that signifies an agreement between buyers and sellers of what value is. The price range becomes accepted as a value area. Value areas can be formed on any given time-frame, from a small 1 minute intraday time-frame that has a value area spanning several hours, to a large daily time-frame that has a value area spanning several months. Remember, the markets are fractal in nature.
• Law #10: Previous market behavior influences current market behavior. Since the market is made up of people, and these people are all looking at the same charts, important highs and lows will be seen by everyone, and many people will buy or sell at these areas simply in anticipation of others doing so. In that sense, we get a self-fulfilling prophecy. In another important sense, previous market behavior (which can be referred to as market structure), influences current market behavior because of the very real reason that the previous behavior was simply showing which side was in control of the market and to what extent, and now as we revisit those areas the same participants may still have the same view and have more orders to fill there. Also, those that previously missed the move may now elect to get in there, and those that were caught on the wrong side of the move may elect to exit their position if given the chance. All of this often causes the market to react at certain places where it had reacted before.
Understanding Volatility and How to Measure It
• Other than direction and condition (or state), the other quality of market behavior that we can observe is volatility. That is, how much vertical movement we are getting in any given period of time.
• Greater volatility is the result of a significant change in the market participants’ perception of value. The change may have been brought about by major geopolitical or economic events (that fell out of line with expectations), or really anything that affects the fundamental supply/demand relationship. The larger the change in perception of value, the greater the volatility we’ll see, as prices move to efficiently factor in the new information. • When we add human psychology to the mix, we get a more complete picture of volatility. When greed or fear are rampant, crowd behavior takes hold and people act as a herd. This herd behavior, in turn, adds to market volatility. It’s especially evident in the case of fear, as the markets tend to fall much faster than they rise, because fear is such a powerful emotion.
• Periods of great uncertainty, in which there is an interchanging environment of hope and fear, are also a condition in which we see a higher level of volatility.
• Finally, volatility itself breeds more volatility (i.e. it can be self-sustaining and selfperpetuating). The reason for this is that sharp market movements end up becoming ‘forcing points’ which cause rapid liquidation or short-covering, thereby increasing the volatility. For instance, if prices start dropping very rapidly and show large downside volatility, this rapid drop will cause a lot of traders (and big trading institutions) to be on the wrong side of the markets and see their losses mounting rapidly. As they react with fear to exit quickly (yes, even the big institutions panic), their sell orders cause prices to drop even faster, which then puts more people at a loss and causes more liquidation, and so on. It’s a domino effect, and the higher the volatility, the more this effect is seen.
• At the heart of the ‘mechanics’ of volatility, i.e. how prices actually move rapidly in a large range, is volume. The more vertical volume we see in any given time period, the more ‘fuel’ there is to move the market a given number of points. So a high volume of orders on the sell side for example will fill up all of the buy orders sitting in the market quicker, and therefore cause a larger and quicker price drop than a small amount of sell orders. Trade volume is what moves the markets, and the more volume, the more movement (i.e. volatility) we’ll see on average in any given period of time, all things being equal.
• The Average True Range indicator (ATR) is one objective measure of historical volatility. You can set the lookback period to any time you want. A 10 day ATR tells you the average range of a day over the last 10 days. This is helpful not only for seeing the general volatility environment at a glance (and quickly knowing how it compares to past volatility environments), but also for gauging the likely price boundaries of the current day. If we are seeing a 15 point range on the day so far, for instance, and the 10 day ATR is 16 points, the directional move we’re seeing at the moment in the day may be near an exhaustion point if it doesn’t have abnormally high volume and conviction. Likewise, if the ATR is 40 points and you’re seeing trending conditions during the day but we’ve only moved 20 points, there’s a good chance the trend has quite a bit more to go.
• The VIX is a measure of implied (as opposed to historical) volatility. What this means is that as we look at the price of options, we can imply what the volatility expectations of market participants are for the near future. If traders think volatility will be high, options will be priced high, and vice versa. What they think volatility will be in the near future, in turn, is influenced by what is currently happening in the markets on the geopolitical / economic front. If uncertainty or fear is currently high, traders will project this into the near future and expect volatility to be high. This is why this indicator is referred to as the fear index or fear gauge. It shows what the level of fear is in the market, which ends up directly affecting the volatility we see in the present time.
• Volatility is cyclical in nature. This can be clearly seen by looking at a historical chart of the VIX, or even one of the ATR for that matter. What we see are periods in which high volatility reigned supreme on average, followed by periods of low volatility, and so on. The length of the cycles is not exact, and we should mention that even volatility is fractal in nature. That is, not only do we see volatility cycles on multi-year periods, but we see them all the way down to the intraday level, where we get periods of large directional movement followed by slower smaller ranges as we balance.
• The last way to gauge volatility is by looking at volume. High volatility environments will generally have high volume on the vertical scale, while low volatility environments will have low volume. Seeing abnormally high volume coming into the markets can serve as an early tell of higher volatility that will likely ensue. It’s not an exact science by any means, but it can serve as a useful general gauge.
• Understanding the basics of volatility and how it’s measured is very important because it’ll end up influencing every other facet of trading. Everything from how you enter, to where you exit, to where you place your stops, to how much position size you use, will all be greatly influenced by the volatility conditions you’re in.