Last updated on April 4th, 2020
The auction in any market is straightforward:
- There are two types of market participant- buyers and sellers
- The degree to which these buyers and sellers are motivated by current price or market behavior
Yes, there are lots of nuances to complicate things but the fundamentally important factors are straight forward.
For example, a buyer might believe silver is too cheap at a certain price and therefore places a bid at that price hoping to take advantage of what they believe to be an over-extension lower.
As an aside, when I trade over-extensions in price, I am playing a mean reversion type trade setup.
When Participant Strength Is Equal
A potential seller of silver might be holding a long position and decide that if the market breaks quickly lower (maybe due to a news release) then they must exit that trade.
But what an individual market does is the sum of its parts – the sum of everything that buyers and sellers do.
Buyers and sellers can be poorly matched with the majority viewing current pricing as too high or too low or they can be well matched overall where buyers and sellers are equal.
- Where there is a mismatch there is an imbalance or a trend.
- Where participants of each type are roughly equal in strength, there is balance or a range.
Markets move back and forth between imbalance and balance and I want to focus on the balance part of that equation – what many of us call a trading range.
What a balance shows you is that for whatever reason, buyers and sellers have become temporarily matched in strength. The market moves one way as buyers step in and then back the other as the sellers return it back down.
In some cases the majority of the activity happens somewhere near to the center of the range and the volume distribution resembles a bell curve.
In others cases there can be a skew to one side of the balance. But what it shows is low activity at the extremes of the range indicating that these prices are not widely acceptable.
Balances can be in the form of trading ranges for example or even pennants if you consider classical charting patterns. The key is that the market is moving sideways, not in any sustained direction. This can be seen on very long time frames down to very short time frames.
The thing is balances can form for a variety of different reasons and in a variety of different ways.
- They can form after a large directional move as the market ‘rests’
- They can form before a highly anticipated announcement as participants are reluctant to commit in either direction – think FOMC release
- They can form if the market has priced in all currently available information.
Quickly identifying when and why the market is starting to range can stop you from taking trades against the probable action and create a plan of how to trade when the market breaks and starts moving in a specific direction.
Breaks Of Ranges Are Important To Market Movement
The key to understanding why balance is important is that to break balance, something must have changed. Due to the fact that both buyers and sellers are active and that one side will end up losing by the very nature of a balance, the market is building up steam for its next move.
When a trending market has moved into balance, trend traders will still be buying as they hope the downward movement is merely a pullback. If the market then breaks against them, they will need to exit.
There is also the trader who will play the range, hoping to buy the bottom and sell the top of each move. When the market breaks an extreme of the balance, they will need to exit too.
There are generally three ways in which a market can break out of balance but really only two mechanisms.
Lack of follow-through
The first is if the balance loses tension and a move out of it fails to create a strong directional move. It’s important to note that a balance range can also extend without breaking and this is often what happens when there’s not an increase in trading activity when price extremes are probed.
Tests of extremes
The second is where the market tests above or below its extremes and then either continues in that direction if it finds more of the same activity or if it doesn’t, opposite activity steps in with some confidence in the knowledge that the first break has failed to precipitate additional activity in that direction.
Often it will be the second mechanism, tests of extremes, by which the market breaks and when it does, it’s pretty reliable that a decent directional move will follow.
Here are examples of the three ways a market can break its balance:-
As you can see in these examples, the moves following the break-down of balance can be substantial.
Whether you specifically look for ways to trade a break from balance or you simply use the activity to reinforce your current strategy, identifying balance early on then monitoring the market as it moves to imbalance can help you get on the right side of the market. Sometimes, the simplest ideas can be the best.
Use The Breaks Of Ranges As Information
If you are not someone who trades breakouts or positions prior to breakouts, the move of the market can inform the trading strategy you use.
As an example, the second chart shows a strong break and those traders who use pullbacks as a means to enter a trade are rewarded.
We see a lazy breakout of balance in the first graphic and this may cause a trader to use a lower time frame for trade setups. When markets are not having movements that are simple to understand, using a lower time frame can actually show some strong trending action.
In the end, breaks of balances are events you can trade or use for information. Whatever suits your comfort level and your ideas about trading is the one you should focus on.