One thing you really need to keep in mind when using these concepts is to keep the overall trend in mind. Know what kind of market you are in across multiple time frames and know which way the market is trending. If it is in an uptrend, you look for bullish setups. If it's in a downtrend, you look for bearish setups. That is very important. What this post is about is giving you structure and setups inside of a trend to make higher probability decisions. For example say we are in an uptrend and bears have an unreasonable distance to get through in order to make a new lower low, giving the bulls a big leg up. Using these techniques you can gauge where the buyers are likely to step in to attempt to put in a higher low and continue to uptrend. Also you should note that for the most part, I wait for the reaction before trying to find out what kind of setup is taking place. For example, I don't draw out 5 demand zones and try to guess which one is going to hold. I wait for the reaction, then draw the zone and follow it. Last but not least out of the three concepts I am going to be talking about here, I will pick the best fit and only use one at a time. For example, if a Fibonacci retracement pattern is more fitting than a demand zone then I go with that. For this post, because of the market conditions we are in I am going to be using the examples of buyers emerging successful for the most part, but it can also happen the other way.
Supply/Demand Zones:
These are pretty much the most basic type of technical analysis you can follow. They are also extremely powerful, don't under estimate the effect these zones can have on price so long as it is still fresh (untested) no matter how long it has been there for, you will see that if you look at the SPY example at the end. The difference between these and classic price levels is that you want to identify fresh areas of supply or demand that haven't been tested yet, also I feel like these are much more reliable than a classic price level taught on every website in existence, although classic price levels can be useful (I will touch on those in the price patterns section). This is because once an area has been identified as a zone, this means that there was activity taking place at that area. When a zone like that is retested for the first time it is likely that the same amount activity will come back into play due to people either closing their positions at break-even or adding to their positions at the same price after locking in some profit from the first position or a number of other reasons that could be the cause of it. The "why's" aren't as important as the "what's" but understanding why it happens is good to know. To be quite honest, I'm not even 100% about the "why's" and no one is. We have an idea of why, but for the most part we just know it works.
The zones fall into two categories in my opinion; standard and polarity. A standard zone is just when you identify an area of buying interest and when it is retested buyers are expected to appear. Polarity is, for example when you identify an area of selling interest but when retested the sellers fail and it turns into an area of buying interest. The example above is showing both standard and polarity zones.
Standard Zones -
A standard zone is completely identified by what direction price goes after the consolidation, the direction before hand is not so important. It really is a very simple concept so I wont drag on and on about it, instead lets just look at some examples and talk about it. If you have any questions, ask in the comment section and I will add the answer to the applicable section.
A little nuance I feel should be noted about these is that the more powerful the move after the consolidation, the more likely buyers are to come in at that price zone and the more likely another powerful move will come out of it. A perfect example is right here in FFIV. This is live price action so I don't know what is going to happen in the future, but it looks like a powerful move is taking place off of a demand zone that led to a powerful gap up (although I am aware it was earnings related, we are reading price action here). The take-away from this example is; it's not how big the consolidation is but how big the move after the consolidation is that is likely to determine the size of the reaction once re-tested again.
Here you can see that right now BA is catching reaction from a standard demand zone. There is nice price structure and everything looks good so far. You can also look a little in the past and see a nuance to remember. Gap ups with big green bars can create support from the demand generated in them. You can see that in action right there. This isn't always the case but when you see price reacting to a big green bar after a gap up just remember it is likely to find support there. You can consider that a standard zone because you identify an area of buying interest and when it is tested, buyers are expected to appear.
As stated above, this is pretty much when a standard zone turns into the opposite of what it was intended to do. When you identify an area of sellers, but buyers break through it and on the re-test it finds support.. that is a polarity zone. The only thing to remember about these is that for it to be a polarity zone, it has to have a successful re-test on the opposing side. Otherwise either your zone isn't valid or there just isn't a solid direction in the instrument you are trading. Now moving onto examples.
This is a really good example of polarity. It happened twice and the first time you can see a nuance that can give you a heads up that your zone is about to turn polar. That being on the first test of the first zone, you can see that price just kind of stuck to it. The zone caught the price action and held onto it and formed a bull flag type of thing. This often happens in a market that is in an overall uptrend and you are identifying sell zones. Notice that the sell zone without a successful re-test on the opposing side are not valid zones.
A very simple, straight-forward example of a polarity zone. You could argue that I could move the zone down about $1 and just have a standard zone for the bull move that took place. If I were to do that, the current reaction that is taking place would be about $1 above my standard zone, and the pullback after the break above it would not be pulling back into anything. However, that would be a valid argument if we didn't have the data that we currently have. If all we had was that first little pullback off of the supply zone, then yes that demand zone would be in use. Personally though, I would move the zone up after that pullback to the polarity zone took place. Remember these zones are drawn on a reaction basis and it is OK to move them around as you get fresh data.
More examples of both types:
AKAM -- BBY -- BIIB -- BMY -- CSCO -- CSIQ -- WFM -- SPY (the king of the examples - 8 major weekly zones) -- CLF (demand zone from 2005 still holding strong)
Polarity Zones -
More examples of both types:
AKAM -- BBY -- BIIB -- BMY -- CSCO -- CSIQ -- WFM -- SPY (the king of the examples - 8 major weekly zones) -- CLF (demand zone from 2005 still holding strong)
Accumulation/Distribution:
Probably the most well known and re-branded term in the industry is accumulation and distribution. Well I'm going to try to give you a better understanding of how I view it. It falls into two categories with me; broad market accumulation/distribution, and candlestick accumulation/distribution. Broad market accumulation/distribution is just market structure that forms over a large period of time. Some call them basing patterns, its the same thing. The overall market structure in the crude oil chart to the left is a perfect example of broad market accumulation. Candlestick accumulation/distribution can be found anywhere and are pretty much your major candlestick patterns tweaked, but I'll go into more detail below. All those arrows in the crude oil chart are candlestick accumulation examples. Neither of them are setups per say but rather something you want to see for directional bias and confirmations. You may want to use candlestick accumulation to define your risk on a trade. Maybe you want to build a position and use the broad market accumulation to confirm your upside bias.. something along those lines. The most important thing about this is that you are using it in confluence with your overall market trend and other analysis.
Broad Market Accumulation/Distribution -
Here's a shout out to all the knife catchers out there, you gotta pay attention to this and maybe learn something. Markets that have been selling off for a while don't just turn around on a dime, so why buy something while it is still falling? These accumulation patterns run for anywhere from 3-9 months typically, so there is time for you to accumulate positions and still stay on the right side with some confirmation. Just like in the coming examples, you can almost always draw a half way circle below the accumulation or above the distribution.
The way you identify this is, say for accumulation, on every sell off that takes place the sellers loose control of the market and buyers regain control. This continues to happen until there is a broad market structure of accumulation and then buyers take full control and a rally takes place. As always, the best time to use this is in the direction of the overall larger trend (like AAPL for example), but it also can mark tops and bottoms although it shouldn't be used to prematurely call them. To avoid pre-mature bias, some may choose to draw a line in the sand once they have identified some broad market accumulation or distribution (for example in the dollar index below, you may choose to use 79.000 zone as the breakdown confirm level). I could list off so many examples on this because it happens so much but I am going to show a few and I won't explain all of them because it's the same concept I just explained.
A great example of broad market accumulation from gold. Funny how it looks just like the accumulation in the crude oil chart above, right? That's because we are studying supply and demand here, it doesn't matter what market. You can see how on each sell off the sellers failed and buyers regained control of the situation. I'll get into this in the candlestick part but you can also see the candlestick patterns and accumulation bars throughout the turning points where buyers regained control, that is just added confirmation for us. A little tip about this example, broad market accumulation (or distribution) that is spotted on a smaller time frame (like a daily) can also double down as a demand zone on a higher time frame. For example, look at this gold chart. That potential demand zone on the weekly chart is this broad market accumulation on the daily chart.
Bonds were in this broad market distribution pattern for almost 2 years and finally the sell off ensued. You can see how on each rally the buyers lost control and sellers were able to gain the upper hand. There was plenty of time for investors to exit their positions before getting their clock cleaned.
More examples:
Dollar Index -- S&P 500 (very wide) -- AAPL -- Gold (what else do you see in this example?) -- BIDU -- QIHU
The way you identify this is, say for accumulation, on every sell off that takes place the sellers loose control of the market and buyers regain control. This continues to happen until there is a broad market structure of accumulation and then buyers take full control and a rally takes place. As always, the best time to use this is in the direction of the overall larger trend (like AAPL for example), but it also can mark tops and bottoms although it shouldn't be used to prematurely call them. To avoid pre-mature bias, some may choose to draw a line in the sand once they have identified some broad market accumulation or distribution (for example in the dollar index below, you may choose to use 79.000 zone as the breakdown confirm level). I could list off so many examples on this because it happens so much but I am going to show a few and I won't explain all of them because it's the same concept I just explained.
Bonds were in this broad market distribution pattern for almost 2 years and finally the sell off ensued. You can see how on each rally the buyers lost control and sellers were able to gain the upper hand. There was plenty of time for investors to exit their positions before getting their clock cleaned.
More examples:
Dollar Index -- S&P 500 (very wide) -- AAPL -- Gold (what else do you see in this example?) -- BIDU -- QIHU
Candlestick Accumulation/Distribution -
If you have followed me for any amount of time you have probably heard me talk about accumulation/distribution bars. Most of the time when I have talked about this I was talking about a bar that has come 50% or more off the highs or lows. These bars can be very telling when used in the context of the market structure. These are different from a hammer or shooting star because there isn't any tiny details that you have to be so picky about, buying pressure is buying pressure and it should be read as such. The only other patterns I follow are engulfing patterns and I really like to see the bar completely engulf the previous one because that shows more conviction, but it doesn't necessarily have to as long as there is other types of confluence to give it a crutch. The other is a doji, I follow doji's because they signify when momentum is waning to the downside (when looking for an upside trade).
The candlestick accumulation/distribution theory though comes into play when you see clusters of these candlesticks all pointing to the same direction. Sometimes all it takes is one accumulation or distribution bar and others you will get 10 bars all giving you same directional bias. Either way, you always want to use them in context with other support/resistance levels and in the direction of the big picture trend. You may have also heard me talking about looking for reactions, well this is all I am talking about. I want to see the price react to whatever kind of support level I am watching through candlestick accumulation/distribution and then continue in the direction of the trend or confirm a target area to exit swing trades. Again, you always want to be following this in confluence with other support and resistance levels. This paired with support and resistance areas in the direction of the trend can give you very high probability setups. A little tip, this is one of the ways I like to use the volume analysis. I like to see how much conviction is in the patterns that take place and on which candle, but you have to know how to read it because for example sometimes there will be huge volume on a down day but when read in the correct context, that volume is really exhaustion volume from sellers using up all their bullets. But still, this is an area where I like to use the volume. It's just an added bonus.
The candlestick accumulation/distribution theory though comes into play when you see clusters of these candlesticks all pointing to the same direction. Sometimes all it takes is one accumulation or distribution bar and others you will get 10 bars all giving you same directional bias. Either way, you always want to use them in context with other support/resistance levels and in the direction of the big picture trend. You may have also heard me talking about looking for reactions, well this is all I am talking about. I want to see the price react to whatever kind of support level I am watching through candlestick accumulation/distribution and then continue in the direction of the trend or confirm a target area to exit swing trades. Again, you always want to be following this in confluence with other support and resistance levels. This paired with support and resistance areas in the direction of the trend can give you very high probability setups. A little tip, this is one of the ways I like to use the volume analysis. I like to see how much conviction is in the patterns that take place and on which candle, but you have to know how to read it because for example sometimes there will be huge volume on a down day but when read in the correct context, that volume is really exhaustion volume from sellers using up all their bullets. But still, this is an area where I like to use the volume. It's just an added bonus.
COST is showing a great example of candlestick accumulation with that huge accumulation bar along with a halt in selling pressure. If you look at the previous low before it made that nice rally (the earnings low) with the huge candlestick engulfing the previous candle, that is another example (an extreme one albeit) of candlestick accumulation.
All the arrows you see on the chart are examples of good candlestick accumulation. Again, these are places you can define your risk on a trade while at the same time giving you confirmation that buyers are entering at those levels. There is also two polarity zones in here, try to see if you can find them.
Price Patterns:
Price patterns are quite the subjective topic, and I'm not a huge fan of subjectivity in trading. I see a lot of people trying to make patterns out of nothing or really stretching their imagination to find and draw a pattern, and I am totally against that. If I am going to be drawing a pattern it's because it is clearly present, fits into my criteria, and is the best option in that scenario. So what I have done to do my best to avoid subjectivity is use rules for drawing the price patterns, and I have followed these rules for years. I won't go over every pattern out there because you can find them on websites all over the place. I will go over the ones I do use and the criteria that must be met for me to consider them valid. First off, when looking for price patterns always use a logarithmic scale. I always use a log scale anyway because I want to see price action moves remain constant in relation to each other, and it keeps the analysis consistent. That way there is no distortion coming from large moves, and you will find that patterns form much more efficiently on a log scale. So here are the patterns that I use; trend-lines, classic price levels, channels, wedges, Fibonacci retracements & extensions, and the occasional pitchfork.
Trend-lines, classic price levels, channels, & wedges -
For trend-lines, channels, & wedges I have a 3 touch rule. That meaning I need three touches (including the starting point) before I consider it a valid pattern. To me a small consolidation is considered one touch even if it tags the line multiple times in that small consolidation. I'll give an example of what I mean by that in the links at the end. Since wedges and channels have two lines to them, I need three touches on one of the sides and two on the other before I consider it valid. If they don't meet that criteria then they don't get drawn. Again, this is to take the subjectivity out of it and to make sure I am doing my best to avoid drawing a pattern that isn't valid. Also for trend-lines, you shouldn't be a stickler over a perfect touch. I typically picture in my mind the trend-line having Bollinger bands around it or something like that, here is an example. Give price room to breathe around the trend-line.
Wedges are pretty straight forward on when to use them, and that is when they appear and are valid. I love following them because of the simple reason that they are compression patterns. Similar to a Bollinger squeeze.. the theory is as volatility compresses, energy is being built up and will have to be released at the breakout point. Timing this with options is a beautiful thing. As far as trend-lines and channels go, I prefer a nice 45 degree angle when using a trend-line. For channels, I really don't like using them as a sloping channel; I would rather use trend-lines for that. I prefer to use channels as a range bound indicator, in other words I only like them as a horizontal tool. If you must use them as a sloping tool, stick to the 3 touch rule. The only time I use them in a sloping situation is when it is very obvious, as you will see in the DOW chart in the examples.
The only rule that I have with classic price levels is that I need to see price reacting off of the resistance level before it is drawn and factored into my analysis. I do this because with those kind of levels, you really don't know when they will hold and when they won't. To solve that problem I don't worry about classic resistance levels until I start to see reactions off of them, and I only use them when there is no other explanation for support/resistance other than a classic price level.
Here on AIG we have a real nice trend-line. Notice the smooth 45 degree angle and also notice how I'm not a stickler about the multiple touches being perfectly exact on the trend-line. They aren't always exact and that's OK. This is a real time example too and it looks like after holding the trend-line for a while it is catching lift-off to the upside, which is expected.
This chart of CELG is a good example of when I would acknowledge a classic price level. There is no other reason that I can see that there is resistance there so I just chalk it up to a classic resistance level and then it turned into a break out level. There is also a demand zone in this chart.
Oddly enough both of my channel examples come from DOW, but this is not the one I was referring to earlier. This is an example of when I like to use channels. Nice horizontal range bound price action acknowledged by a price channel with enough touches to make it valid. The second example shows when I would be willing to use a sloping channel but that will be linked out at the end.
A great example of when to use a wedge right here. At least three touches on both sides makes it more than valid. Price is still getting reactions off of it.
Wedges are pretty straight forward on when to use them, and that is when they appear and are valid. I love following them because of the simple reason that they are compression patterns. Similar to a Bollinger squeeze.. the theory is as volatility compresses, energy is being built up and will have to be released at the breakout point. Timing this with options is a beautiful thing. As far as trend-lines and channels go, I prefer a nice 45 degree angle when using a trend-line. For channels, I really don't like using them as a sloping channel; I would rather use trend-lines for that. I prefer to use channels as a range bound indicator, in other words I only like them as a horizontal tool. If you must use them as a sloping tool, stick to the 3 touch rule. The only time I use them in a sloping situation is when it is very obvious, as you will see in the DOW chart in the examples.
The only rule that I have with classic price levels is that I need to see price reacting off of the resistance level before it is drawn and factored into my analysis. I do this because with those kind of levels, you really don't know when they will hold and when they won't. To solve that problem I don't worry about classic resistance levels until I start to see reactions off of them, and I only use them when there is no other explanation for support/resistance other than a classic price level.
Fibonacci retracements, extensions, & pitchforks -
Out of these three tools, hands down my favorite is the retracement. I use it only showing the 50% (0.5) and 61.8% (0.618) for the retracement part and I add targets at -0.236 and -0.618. If it is a run away trade, I will add the -1.618 target as well. I use the retracement all the time for swing trading and it works beautifully if you know how to use it correctly. The basis of how I use it is when there is a powerful move, either up or down, I will draw the retracement once I see price reacting around a 50% retracement. Like I mentioned earlier, I always wait to see where the reaction is taking place before choosing which method to use because I don't like guess work. Also I don't use the dead low and dead high of any recent move, I only use the low and high of where the powerful move took place. The main benefit I get out of using it is not to see where price is going to retrace to, but instead where the high probability targets are going to be after it has retraced. That is another reason why waiting for it to retrace before drawing it is good, that way I can fit it correctly and get accurate targets. I believe Fibonacci work is best used for straight-line significant moves in the market. This is because if price is stair-stepping its way up, there is likely to be plenty of demand zones to draw out once a reaction is spotted and that is the better option in that scenario.
Extensions are based on the same theory as retracements, straight-line significant moves in the market. The only difference is that price doesn't retrace 50% and preferably not even close to 50%. The targets I use on extensions are 100% (1.00), 127.2% (1.272), and 161.8% (1.618). A 100% move is the highest probability target since that is just a classic A-B-C pattern, where the distance of A is equal to C. 127.2% is where A x 1.272 = C, and so on with 161.8%. If you want to be more conservative with drawing these then you could wait for a close above the swing high that you drew it on. Conservative or not, the risk should always be defined as trading lower than the swing low you drew out.
Pitchforks are not commonly used so I am just going to touch on them. The only time I ever use them is just for good knowledge. They typically last for extremely long periods of time and it is just good to know that price is still trading inside of that pitchfork. In fact, I would rather use a reliable pitchfork than a sloping price channel. This is because pitchforks are a whole lot less subjective and when found and drawn correctly, can be extremely accurate. However, they are much more rare than a sloping price channel.
You can see what I mean here by a significant straight-line move up. It's important you understand what that is and how to identify it so you can draw accurate Fibonacci tools. It is just a straight move up that was powerful, just like this. The only zone that formed came in exactly where the 50-61.8% retracement is and personally I would rather use the Fibonacci because it has the added benefits of targets. You can also see that I didn't start the retracement from the gap up low, because that isn't where the straight-line move started. There was a small correction before it started and the low that was put in right there is the one I used.
A near perfect example of a straight-line move up is right here in AMZN. Notice where I started the Fibonacci extension tool too. An extension was the best fit for this scenario. There is also a larger extension that could be drawn on this that is actually still in play according to this chart. I will show you in the links after but see if you can find it for now.
A perfect example of a pitchfork. This one has lasted all year in the Russell 2000 and started on the gap up to start the year. I have been following it since I noticed it was happening around June/July. I don't know if this is a common occurrence or what, but I have noticed that the best, longest lasting pitchforks always come after a gap up situation with a correction similar to the one in this example. Like I said before I don't use these for anything but good knowledge to know that the market structure is still strong enough to stay inside the pitchfork.
More examples of each:
AMZN (example I mentioned earlier) -- BA -- BMY -- COST -- CRM -- DDD (sloping channel, stick to 3 touch rule) -- DOW (another sloping channel) -- GMCR -- IWM -- M -- NEM (invalid pattern)
Extensions are based on the same theory as retracements, straight-line significant moves in the market. The only difference is that price doesn't retrace 50% and preferably not even close to 50%. The targets I use on extensions are 100% (1.00), 127.2% (1.272), and 161.8% (1.618). A 100% move is the highest probability target since that is just a classic A-B-C pattern, where the distance of A is equal to C. 127.2% is where A x 1.272 = C, and so on with 161.8%. If you want to be more conservative with drawing these then you could wait for a close above the swing high that you drew it on. Conservative or not, the risk should always be defined as trading lower than the swing low you drew out.
Pitchforks are not commonly used so I am just going to touch on them. The only time I ever use them is just for good knowledge. They typically last for extremely long periods of time and it is just good to know that price is still trading inside of that pitchfork. In fact, I would rather use a reliable pitchfork than a sloping price channel. This is because pitchforks are a whole lot less subjective and when found and drawn correctly, can be extremely accurate. However, they are much more rare than a sloping price channel.
More examples of each:
AMZN (example I mentioned earlier) -- BA -- BMY -- COST -- CRM -- DDD (sloping channel, stick to 3 touch rule) -- DOW (another sloping channel) -- GMCR -- IWM -- M -- NEM (invalid pattern)
Conclusion:
So I guess it turned out pretty long, but only because I was trying to be thorough. I could have split them into three separate posts but I didn't want to do that for two reasons; 1) this is digging deeper into market structure & I wanted that to be in one place, and 2) because this all has to do with supply and demand and I also wanted that in one place. For those of you that do read it, your feed back in the comments may influence others to read it if you feel like it was worth it so I would appreciate that. Go do some back testing and I think you will be enlightened. Also I have a very clear understanding of this stuff and I tried to write it so that you could too, but if there is something you all aren't getting I am more than happy to update it or answer a question if it is just one person mentioning something they don't get.
Anyway, this is really the first educational post that is diving into the meat of the framework that I have already covered in previous posts. This one being about market structure, but I plan to do more getting into the detail of other various topics I have talked about. I just have to think about which one to get into and what I will talk about. I was actually thinking about doing some educational posts outside of technical analysis at some point, for example being in the groove on wall street, understanding what people are caring about and what institutions are eating up at any given time, which news matters when, how fundamentals do help in some cases.. stuff like that. That stuff does give you an edge and is part of my strategy, but I don't know yet. There is a lot to cover before I am done with this educational section. If you all have any feedback on that let me know below.
Hope you learned something here that you end up using..
Trade well,
--Michael
