Price Action traders do not look at the market transition as a pattern, but instead draw a logical story from it. Patterns usually do not have proper consistency, but when we add a story to the pattern, it will bring a significant change to its consistency. Price Action traders stress a lot on this because the key to success in trading is consistency.
Transition is nothing but a market reversal. There are numerous strategies on reversals on the internet. However, an explanation of how does a reversal happen and why does it happen is nowhere to be found. If a trader is unable to answer these questions, the probability of him or her succeeding in their trades becomes quite less. Therefore, in this article let’s try to understand the market transition with pure logic.
What Is a Reversal?
When a market is trending and a trade that goes along with the trend no longer works, basically, the market violates the rules for a trend. This is when we can say that the market is switching directions.
Understanding the Traders’ Mentality
Let us understand the thought process of the trader while reading the charts. This can help you in differentiating an average trader from a professional trader.
In the example below, what do you think the public is doing? Well, since it an uptrend, everyone’s buying. Every time the market pulls back, they hit the buys.
Figure – 1
Now, after the price pulls back, it does not make any higher high (Figure -2). The price comes back to the S&R area. This is where more people jump in to buy, thinking that the market is holding the S&R level. But, this time the price doesn’t even go to the recent high, but instead drops lower. Here, they think that they’re getting better discounts, so they continue their buying process. And as the price begins to move in their direction, they are convinced that the market is going up. Some traders add in positions as well. Notice that, in this whole process, the flow and the direction of the human brain are still in the buying side.
Figure – 2
Moving forward, the market drops below the support level (Figure- 3). Here, there are two things that happen. One, everyone in the buy gets stopped out. Two, panic sets in the mind of the public, as their trend pullback buy has failed. Following that, the price pulls back to the buyer’s area. This movement makes them re-think, wondering if the entire set-up is still a buy? This is because their mind is still in the buy zone.
Then, the price drops down very aggressively. This confirms everyone that it is a sell. Therefore, once the ‘sell’ has already taken off, the public jump in for a sell. But, now it is too late. This is the reason we have a 95:5 ratio. 95% of the people hit the sell at the bottom, while only 5% hit the sell at the top.
Figure – 3
What is Happening Behind the Scenes?
This topic will go through the pure logic behind the occurrence of reversals.
In the figure shown below, the market is in an uptrend. Assume that you are the big market player. This means that you move the market. You also have information that the general public doesn’t have. Continuing with the example, let’s say you know for sure that the market is going to fall drastically and you have $7 billion to go short. However, you cannot hit $4 billion for a sell at one shot; because the order won’t be filled at good prices. So, you decide to play the game of building up orders at high prices.
Figure – 4
As the market is in an uptrend (Figure – 5), let’s say the people are buying at the rate of $1 billion. So, you hit $1 billion for a sell. This results in the price drop. Now, seeing the price at the support, more people jump in for a buy. This time let’s say the people buy at a rate of $2 billion. So, you hit $2 billion more for a sell. The price drops again and comes back to support. Now, you have $1 billion left to sell. Also, the other large players realise what you are up to. So, the demand to buy reduces. The price doesn’t even climb to the recent high. Seeing this, you sell the remaining 1$ billion at a lower price. Now you have successfully completed building up all your orders. Also, this time, the price drops below the support because more and more smart traders have understood that the market is preparing to go down. Hence, there are no big buyers in the support region to take the price up.
Figure – 5
Now, as the price keeps dropping, you offload your cash every step of the way. In other words, as the price continues to drop down, you close some of your positions and to close a short position, you must take the opposite trade, i.e., you must buy the asset. This results in the market moving up a little. In technical terms, this is known as a pullback. Therefore, a pullback essentially means that the seller is taking profits.
Here is another interesting bit of logic: To close your short position, you must perform a buy. Thus, there must be someone willing to sell. This is where the public comes in. Seeing the market falling, many traders hit the sell and indirectly satisfy their sell order with your buy order.
Figure – 6
Here’s the take away from this lesson:
When the big players are closing their positions and getting out of the trade, the public, on the other hand, is helping them with that by entering the trade. Hence, the large players always win, while the public loses most of the times. Therefore, to stay ahead of the game, one must always read the market the same way the way big players do.
If you understand what the big players are up to, you can take your trading skills to a whole different level. Hence, placing yourself in the shoes of the big player and analysing the market will place you on a reliable path to find success in trading.