By definition, technical analysis is the study of price action and its impact on future market behaviour. According to its tenets, a wide variety of analytical tools are used to put pricing fluctuations into the proper context.
Perhaps one of the most overlooked aspects of technical analysis is the identification of market structure. Also known as "market state," it is the set of prevailing characteristics exhibited by the development of price action.
Without an adequate scrutiny of market structure, the study of price action, both past and present, can prove flawed. Market structure is constantly evolving from one phase to another, and comes in several basic forms:
Many say that identifying market structure is an artform, a product of extensive experience and expertise. While that may certainly be true, there are distinct attributes unique to each type of structure that take away some of the mystery.
Depending on one's perspective, rotation can be a complex topic filled with nuance. However, the basic concept is not a difficult one. A market that is in rotation is simply moving horizontally in comparison to a macro trend. Also known as "range bound" markets, rotation is defined by price action that is choppy and confined to a limited trading range.
Markets enter rotation for several reasons:
- Lack of participation: Rotational markets often occur under slow conditions. Low traded volumes are commonly associated with limited volatilities and range-bound price action.
- Market indifference: Trader and investor hesitance to take or alter open positions can lead to rotational markets. Factors that fuel indifference include time of day and a perceived price level nearing equilibrium.
Successfully navigating rotational markets can prove difficult for inexperienced traders. Understanding when a market is in full rotation, how long it will stay there, and how to properly align risk and reward are challenging tasks.
Although similar to a rotational market, a consolidating market occurs when a product's trading range experiences a pattern of tightening price action. Also referred to as "compression," consolidating markets often precede a breakout or directional move in price.
A market is most likely to enter consolidation due to the following factors:
- Uncertainty: A pending economic data release can prompt market participants to employ risk-limiting strategies.
- Support and resistance levels: The presence of clearly defined support and resistance levels can confine price action to a specific range. In the case of heavy volume, the limited range can serve as the starting point for a breakout.
Consolidating markets are traded by incorporating a variety of technical approaches, including multiple time frame analysis and chart patterns such as the pennant. Many active traders employ strategies such as breakout trading or short-term scalping to capitalise on a pending move in price.
Market liquidity is a big factor in trading consolidating markets. Ample volume must enter the compressed market to drive pricing directionally. If it does not, the likely scenario is a "false breakout" and the failure of price to extend the consolidated range.
By far, the most popular market state to trade is a pronounced trend. One of the most basic concepts in all of trading, a trend is the obvious direction of price action facing a given product. Trends can be long or short in duration, extending rapidly or grinding slowly.
The old trader axiom "the trend is your friend," is taken as gospel by many. even in the modern electronic marketplace. It is undeniable that trend trading affords market participants several inherent advantages:
- Easy to identify: On a price chart, a trending market structure is obvious. In contrast to rotational and consolidating markets, trends are marked by a directional move in price.
- Large profit potential: Trends are capable of continuing for extended periods producing extremely positive risk vs reward scenarios.
A broad spectrum of strategies may be employed on a trending market. Some of the more common ones include buying or selling retracement levels and market entry based on momentum oscillators.
Also referred to as a "correction," a market that is in reversal exhibits price action that is contrary to the prevailing trend. Depending on the time frame, reversals can occur in minutes or over the course of days and weeks.
Market reversals occur for numerous reasons:
- Changing market sentiment: Any change in the prevailing sentiment towards an asset class or product may cause a market to enter reversal.
- Technical levels: Upon price hitting a valid technical level, a trending market may reverse.
- News items: Breaking news events can change the direction of price rapidly. Geopolitical concerns or economic data that surprises market participants can act as catalysts for market reversal.
Correctly predicting the "top" or "bottom" of a trending market is a tricky business. Traders employ many strategies incorporating a variety of technical tools to optimise trade entry. Indicators such as Stochastics, MACD and Bollinger Bands are commonly used to identify price exhaustion and reversal trade setups.
No matter the asset, its price can either go up, down or stay the same. Accurately identifying the state a market is in can be a valuable part of gaining the proper perspective towards future price action.
Deciding on whether or not a market is rotational, trending, consolidating or entering reversal is a crucial aspect of successfully limiting risk while maximising reward.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…