Understanding the market direction

There’s a reason why the title does not say predicting the market direction. It says understanding the market direction. There is a massive difference between the two.

If you are in the prediction game, you are bound to be disappointed when the prediction goes wrong. But in the other case, you are just seeing and reacting to what the market is doing, which is so much better.

Both emotionally and practically, if we are detached from the prediction game, the trading process will be smoother.

What does it mean to understand the market direction?

Financial markets anywhere in the world do pretty much the same thing. There is a price for which buyers and sellers fight. But there are not usually same number of buyers and sellers. This imbalance moves the price.

When there are more buyers than sellers, the price goes up. When there are more sellers than buyers, the prices go down. It’s as simple as that.

For short periods, it’s also possible that there is some sort of equal fight between the two teams. This is when the price moves sideways.

Even in the sideways market, there is movement of price, but when looked from afar, it looks as if the price is not struggling. It is in a stable range and balanced.

By understanding the market direction, we know if the price is going up, or down, or sideways.

This price movement when plotted across a time vs price graph, we can analyse the price fluctuations better. And also maybe draw some analyses by looking at the chart.

Here’s a sample price chart for Bitcoin / USD pair on the 5 minute time frame.

The blue line is an indication of price movement across time.

Understanding the market direction is to see the price chart and be able to say which way the price has been going, and which way it is going now.

Is it going up, or is it going down, or is it going sideways. That’s the question that all traders are trying to answer constantly.

Now, by looking at the chart if you said something like, “well it looks like the price was going up initially, then dipped a bit on the top and now it seems to be moving sideways to the right”, then you would be correct.

It’s quite simple, isn’t it? Just look from the left to the right and say what’s happening.

Here’s another chart for us to practice. It’s the same Bitcoin / USD pair on the same 5 min timeframe. Just a different time in the past somewhere.

Look at it for a minute and think about what is your understanding of the market direction.

If your thoughts are in the lines of “hey, looks like the price kept dropping all the way, just spent some flat time in the middle though”, then that’s good.

So how did we arrive at this understanding. We didn’t use any complex tools or indicators. We didn’t even see any candlesticks yet. But we were still able to read the market behaviour.

All we needed was our naked eye. This is what I call as child’s mindset.

If we would have shown the same charts to a child, we would get similar views on the price direction. It’s very important that all traders have this kind of view point.

Sometimes, all the knowledge of charts, indicators, swing highs, swing lows, trend lines, moving averages etc., can become so overwhelming that we lose sight of the basics.

So let this be a reminder to you to keep things simple.

Why is the market moving?

To answer this question, let’s look at it from an out-of-market perspective.

Imagine we are in the audience of a game in a stadium. We are not participating in the game, just observing things from the stands.

The game is being played between two teams, Blue and Red.

Let’s say the game they are playing is Tug of War, where both teams try to pull a rope from each end and the rope goes to the strongest team.

In a typical Tug of War game, if any one team is able to pull to rope all to themselves, they are declared the winner. But in our game, the rules are a bit different.

The rope in the game we are watching is of infinite length. Also, there is no time limit to this game.

At the beginning of the game, both teams started with 10 players on each side, and they are all of pretty much equal strength. There are some 100 players on the sidelines who are neutral players. These players can choose to join any side at any time.

The goal of the game is to have as much rope to one side as possible. So the neutral players will always want to join the winning side. They are free to exit when they want to, of course, and join back the neutral sideline.

So when the game started, and both teams start to pull the rope, it hardly moved. It’s very stable in its original place. Let’s see what happens next.

Reds dominate

Now as the time progresses, some players start to get tired in the Blue team for example. And the rope just starts to pull towards the Red team a bit and away from the Blue team. This brings more energy and enthusiasm to the Red team players and they start to pull harder.

The rope moves further towards Red team. Looking at this, the neutral players on the sidelines, now think that the Red team is leading the battle. So some of them join the Red team.

The Red team is now stronger than before with the addition of new players. So the rope is moving even more towards the Red side. This is looking like a great opportunity for more neutral players to join the Red team.

Naturally, some more neutral players join the Red side. Rope moves further and further towards the Red team. It seems to us, the audience, that the Blue team players have almost given up and the Red team will eventually win. But..

Red becomes weak

But something else starts to happen. Now some of the Red team players start to feel the exhaustion. Some of the neutral players who joined the Red side can feel it too.

With energy levels getting lower, the strong pull which the Red team enjoyed so far, is diminishing in strength. The movement of the rope slows down a bit. The neutral players on the sidelines are very observant of this shift.

Some of the neutral players, who are tired from being in the Red team so far, have come back to the sideline. The other neutral players, who haven’t played yet, are seeing that their mates are starting to come back.

This is making the Red team weaker now. The rope, which was swiftly moving towards the Red side, has now become almost stable.

Blues dominate

What’re the Blue guys doing meanwhile? They don’t feel as much pressure as before and with renewed enthusiasm, they pull the rope harder towards them. Some neutral players now start to join the Blue side.

You guessed it. The Blue side is getting stronger with new players. There’s fresh energy this side.

And the whole cycle just repeats itself. Hope you saw that coming.

What was the objective of the neutral players? To join the winning side. That’s all they do.

And since this is a game of infinite length and time, they keep shuffling between the two sides. Because of that, the balance keeps tilting.

Hope you are able to see how this relates to our understanding of the market direction. If not, let’s continue to learn.

What’s this game have to do with financial markets?

Hmm, I’m glad you asked. The game analogy I chose is to put out the market mechanics in a fun way.

The rope in the game is our price. The red and blue teams are buyers and sellers. And like the neutral players, new players keep coming in and out of the market as fresh buyers and sellers.

That’s why the analogy makes perfect sense. The analogy helps us in understanding the direction of the market or the game.

The movements the rope made during the endless game of Tug of War are the price fluctuations. The exhaustions in the game are profit bookings and position exits.

Remember the line charts we saw before? Yes, the Bitcoin one. The line in the chart is our rope. It’s making waves as buyers and sellers fight for dominance in an abyss called the market.

Ok, time for some theory.

Market phases

The different movements the rope made in the game, and the price made in the Bitcoin / USD chart, happen in cycles.

Like we saw in the game, the reds were dominating initially, then they got exhausted, then the rope moved towards the blues. And the cycle repeats.

Same thing happens in the financial markets. Here’s some market jargon. There are 4 market phases and they repeat in cycles.

• Accumulation
• Up trend / Mark up
• Distribution
• Down trend / Mark down

To put these in our game context, let us assign roles to the teams. Reds are buyers, Blues are sellers.

The phase where the reds had the initial advantage, is the buyers gaining strength. This phase is called accumulation. Price moves side ways here. The current price is attracting new buyers.

Next, the rope moved too much towards red. This phase is called Mark up. The buyers were in total control here. Price makes higher highs here. Demand is rising for this market.

Next, the reds start to exhaust, the neutral players retreat. This phase is called distribution. The buyers are exiting out of their positions or turning into sellers (the blues). Price moves side ways again. Demand is no longer rising, but not falling either.

Lastly, the blues dominate. This is where sellers take control and this phase is called down trend. Price makes lower lows here. Demand is decreasing.

Got it? Always keep these phases in mind while trading. Understanding that the market direction is always changing is key.

To know more about these phases, check this page on Investopedia. https://www.investopedia.com/terms/m/market_cycles.asp

Hey, but why were we the audience?

Yes, because market doesn’t care about us. Just like any game doesn’t care about each audience member.

In trading, even though we are making buy and sell trades, our individual positions would not in any way affect the price movements.

In other words, when placing a trade, we are just speculating, just betting that one side will be dominant. Just like betting on a football game. Our bets won’t affect the game.

But, since we are watching the game live in the stadium, we can take advantage of it. Unlike each player in the game, we have the bird’s eye view of the entire game.

We can actually see the rope moving between teams. Once we see that a team has an advantage over the competition, we place our bet with the broker that this team would win.

When a football game starts, the score is 0–0. So placing a bet here would be risky. But once a team scores a goal, we can bet that the team would win. If the same team scores twice, the risk on our bet is further reduced.

Same goes with the markets. As the buyers make higher highs, we can go along making new bets in the buying direction. We can continue to do so until the high scores stop. Now sellers might be starting to score. Now we change our stance and bet with the sellers. Get it?

Great theory, but how to use it in trading?

Good question. It’s not enough to understand just the market direction. We also need to be able to use this knowledge while trading live charts.

Pulling back our Bitcoin chart again.

As you can see, we were in the mark up phase earlier, where price moved with higher highs and then moved sideways in the distribution phase. We might still be in that phase for now as we move right.

How do I know this? Because, to the right of the chart, price is not making lower low sequence like in the down trend phase. It is moving sideways.

So how do we trade this chart?

Simple. As long as you see higher highs, jump in anywhere and put stop loss just under the previous higher low.

When you stop seeing new higher highs, like in the middle of this chart, you don’t enter into a buy position now. Just wait for a retest of the last highest high.

Retest could happen immediately, or slowly. But eventually you will see it on the chart.

Markets don’t move from mark up phase to down trend phase immediately. There has to be a slow and natural shift in balance. So we wait for it.

You may see the retest in the form of double, triple tops, or head & shoulders patterns. It doesn’t matter which patten confirms it, as long as the retest fails, we are good.

Once the test is completed, we should be able to see that the higher low that caused the retest, should fail. In our chart, it could potentially be the higher low that is marked below.

So, that’s it. No indicators or candlesticks. You could just trade off with a line chart because now we know how the market cycles work. But candlesticks offer a little more information than line charts. But that’s a session for another day.

If you would like to know what size to trade and how to manage your capital effectively, I would recommend you to read my blog post on professional money management.

Ok, let’s wrap this post with a quick summary.

Conclusion

What have we learnt here?

Understanding the market direction is very simple. A child could do it.

Market is an endless Tug of War between buyers and sellers. No side can dominate forever.

New players keep coming and going in and out of the market.

We are just the audience witnessing the Tug of War game. We are not the actual market movers.

All we do is just bet that some side would have an advantage for the near future. And if the bet wins, we make money.

Markets move in cycles. Buyers come in, take prices up. Buyers dry out or become sellers. Sellers come in, take prices down. Then back to square one.

How to trade — higher highs — buy. No new higher high — exit ‘buy’. Lower lows — sell. No new lower low — exit ‘ sell ‘.

Finally, thanks so much for reading through this long post. I really appreciate it.

Hope you found some value. If you did, please do leave a little review down below and hit the like button.

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See you in the next one!

Cheers,

uday

Trade at your own risk. My writings are for educational purposes only.

Uday Kiran Kavaturu

Originally published at https://udaykavaturu.com on June 9, 2021.