Price Action excerpts

(from Chapter 1 of "Reading Price Charts Bar by Bar", Al Brooks, 2009)

Why does price move?

Why does price move up one tick?  It is because there is more volume being bid at the current price than being offered, and a number of those buyers are willing to pay even more than the current price if necessary.

This is sometimes described as the market having more buyers than sellers, or as the buyers being in control, or as buying pressure.

Once all of those buy orders that can possibly be filled are filled at the current price (the last price traded), the remaining buyers will have to decide whether they are willing to buy at one tick higher. If they are, they will continue to bid at the higher price.  This higher price will make all market participants reevaluate their perspective on the market. If there continues to be more volume being bid than offered, price will continue to move up since there are an insufficient number of contracts being offered by sellers at the last price to fill the requests to buy by buyers.

At some point, buyers will start offering some of their contracts as they take partial profits. Also, sellers will perceive the current price as a good value for a short and offer to sell more than buyers want to buy.

Once there are more contracts being offered by sellers (either buyers who are looking to cover some or all of their long contracts or by new sellers who are attempting to short), all of the buy orders will be filled at the current price, but some sellers will be unable to find enough buyers. The bid will move down a tick. If there are sellers willing to sell at this lower price, this will become the new last price.

Do big dogs lead or follow price action?

Since most markets are driven by institutional orders, it is reasonable to wonder whether the institutions are basing their entries on price action, or whether their actions are causing the price action.

• The reality is that institutions are not all watching AAPL or SPY tick by tick and then starting a buy program when they see a two-legged pullback on a 1-minute chart. They have a huge number of orders to be filled during the day and are working to fill them at the best price.
• Price action is just one of many considerations, and some firms will rely more on it, and others will rely on it less or not at all. Many firms have mathematical models and programs that determine when and how much to buy and sell, and all firms continue to receive new orders from clients all day long.

The price action that traders see during the day is the result of institutional activity and much less the cause of the activity.

• When a profitable setup unfolds, there will be a confluence of unknowable influences taking place during the trade that results in the trade being profitable or a loser.
• The setup is the actual first phase of a move that is already underway and a price action entry lets a trader just jump onto the wave early on.
• As more price action unfolds, more traders will enter in the direction of the move, generating momentum on the charts, causing additional traders to enter.
• Traders, including institutions, place their bids and offers for every imaginable reason, and the reasons are largely irrelevant. However, one reason that is relevant, because it is evident to smart price action traders, is to benefit from trapped traders. If you know that protective stops are located at one tick below a bar and will result in losses to traders who just bought, then you should get short on a stop at that same price to make a profit off the trapped traders as they are forced out.

Since institutional activity controls the move and their volume is so huge and they place most of their trades with the intention of holding them for hours to months, most will not be looking to scalp and instead they will defend their original entry.

• If Vanguard or Fidelity have to buy stock for one of their mutual funds, their clients will want the fund to own stock at the end of the day.
• Clients do not buy mutual funds with the expectation that the funds will day trade and end up in all cash by the close.
• The funds have to own stock, which means they have to buy and hold, not buy and scalp.
• For example, after their initial buy, they will likely have much more to buy and will use any small pullback to add on. If there is none, they will continue to buy as the market rises.

Some beginner traders wonder who is buying as the market is going straight up and also wonder why anyone would buy at the market instead of waiting for a pullback.

• The answer is simple. It is institutions working to fill all of their orders at the best possible price, and they will buy in many pieces as the market continues up.
• A lot of this trading is being done by institutional computer programs, and it will end after the programs are complete.
• If a trade fails, it is far more likely the result of the trader misreading the price action than it is of an institution changing its mind or taking a couple ticks of profit within minutes of initiating a program.

The only importance of realizing that institutions are responsible for price action is that it makes placing trades based on price action more reliable. Most institutions are not going to be day trading in and out, making the market reverse after every one of your entries. Your price action entry is just a piggyback trade on their activity, but, unlike them, you are scalping all or part of your trade.
 
Waiting for the right setup
 
There are some firms that day trade substantial volume. However, for their trades to be profitable the market has to move many ticks in their direction, and a price action trader will see the earliest parts of the move, allowing her to get in early and be confident that the odds of a successful scalp are high.
 
That firm cannot have the market go 15 ticks against them if they are trying to scalp 4 or 8 ticks. As such, they will enter only when they feel that the risk of an adverse move is small. If you read their activity on the charts, you should likewise be confident in your trade, but always have a stop in the market in case your read is wrong.
 
Also, since often the entry bar extreme is tested to the tick and the stops are not run, there must be institutional size volume protecting the stops, and they are doing so based on price action.

• In the 5-minute Emini, there are certain price action events that change the perspective of smart traders.
• For example, if a High 2 long pullback fails, smart traders will assume that the market will likely have two more legs down.
• If you are an institutional trader and you bought that High 2, you do not want it to fail, and you will buy more all the way down to one tick above that key protective stop price. That institution is using price action to support their long.