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Elementary Market Structure

Though much hype and mystery surround these terms, market structure and price action are relatively simple concepts. Market structure is the static record of where prices have been in the past. By learning to read this structure, we are able to see how buying and selling pressure interacted historically. It is important to realize that market structure is a record of the past, but there is, sometimes, predictive value–we are sometimes able to see where one side might be gaining or losing control, or to see that the dominant force is likely to maintain its dominance. These situations can lead to trading opportunities.

Price action is perhaps a more difficult concept than market structure. Where market structure is static, price action is dynamic. Price action refers to how prices were moving when they traced out the patterns of market structure. (Price action, incidentally, can often be inferred from the market structure of lower timeframes.) Market structure is the line left in the sand; price action is the motion of the finger tracing that line.

These concepts create a framework–a context–for the patterns we see in the market. There are tradable elements of market structure, but they also can tilt the probabilities for other patterns or trades that occur within this framework. Market structure and price action are often superior to indicator-derived methods because of the unavoidable lag in indicators which are calculated from price, but it does take some skill and experience to read market structure correctly. Regardless, the elements of market structure are easily definable and are not complex.

pivots1 Elementary Market StructureAssume that we have market data organized into “bars” (or candles) of a specific length. Though most technical analysis starts here, it is also worth spending some time considering that these bars are an arbitrary constraint we place on what would otherwise be an unimpeded free flow of market information. It is useful, perhaps necessary, but do not assume that the bars we see are actually the market. Given bars as a starting point, the simplest element of market structure are the pivot points. These are simply a high preceded and followed by a lower high, or a low with a higher low before and after that bar. Visually, these are small points that “stick out” as temporary price extremes. These pivots are very common, and, by themselves, are not particularly useful for most analyses. More important information comes from second and third order pivots. A second order pivot is a simple pivot (or first order pivot) that is preceded by and followed by a first order pivot. These, and third order pivots especially, often define critically important structural points.

These pivots is that they will always look fantastic in retrospect. Every high and every low is neatly captured with these pivots. If one could do nothing but trade these pivots, endless profits would accrue. Alas, pivots suffer from the same weakness of all wave-based methodologies: a little reflection will show that they depend on later data to define the pivots. We cannot know a pivot is in place until the next bar is completed, and often cannot know a second or third order pivot is defined until many bars later. There is useful information here, but it must be incorporated into a more complete analytical process–it’s not quite as simple to trade this structure as price charts might suggest.

The next step is simply to connect the pivots, marking swings in the market. There are many ways to do this, and it is important to be consistent. In much of my analytical work I use a tool I developed that I called AlgoSwings that marks the swings automatically, but it is certainly possible to do this by hand as long as you are consistent. (A good place to start would be to connect second or third order pivots.) Once the swings are outlined, we can see a few important patterns.

uptrend swings1 Elementary Market StructureThe standard uptrend pattern is a series of both higher highs and higher lows. In an uptrend, the upswings are larger than the downswings; usually in time, but always in price because, by definition, a downswing larger than the previous upswing threatens the integrity of the trend. The downtrending pattern is simply the uptrend inverted. We can glean a lot of information about the relative balance of buyers and sellers from comparing the upswings to the downswings. If buyers falter, we will see shorter upswings. If buyers fail, we will see a downswing that is longer than the previous upswing. If buyers become overly enthusiastic, perhaps they will bid the market up into a buying climax. These are important structures because they often signal an impending collapse, and they are visible on swing charts as downswings are muted or nonexistent, and upswings become much larger than previous upswings.

trading range swings1 Elementary Market StructureThere are a number of specific trend ending patterns, but it we should also consider trading ranges. Markets typically move between trending and ranging activity, and the swing patterns in ranges tend to be much more random. There may be small trends within the range, but these trends will typically end after only a few legs. (It is a little known fact that some of the strongest trends come within higher timeframe trading ranges, but that is a discussion for another day.) Swing analysis in trading ranges is complicated because price movements in ranges tend to be more random. In a range, buyers and sellers are in relative equilibrium, and many traders find that these areas are best avoided.

This has been a brief introduction, but do not be misled by the apparent simplicity. Simple things work. There are many quantifiable and statistically verifiable tendencies around some of these elements of market structure, and many of our trading patterns seek to capitalize on these tendencies. Many traders focus time and attention on indicators, candlestick patterns or other flashy tools, but that time might be better spent seeking to understand market structure. A trader who can understand market structure has his finger on the pulse of the market, and can respond instantly to risks and opportunities as they develop.