Why do prices move?
Markets are in constant change. The price fluctuates hour after hour. Every minute a pattern of ups and downs is continually developing. Thus, what do we mean by market classification?
The search problem
The markets are changing continuously driven by the laws of supply and demand. A market is a meeting place for buyers and sellers. When sellers and buyers have the same power, supply and demand are in equilibrium and the price moves in a tight range. When buyers outnumber sellers the price goes up. Conversely, if sellers outnumber buyers, the price moves down.
Larry Harris, in his book Trading and Exchanges Market Microstructure for Practitioners, says that trading is a “search problem”.
A buyer must find the right seller, while a seller should meet the right buyer. Everyone wants to buy or sell at the best possible price. A buyer seeks sellers accepting low prices. A seller looks for buyers admitting high prices.
That is a search for a fair price as well. The fair price is a consensus of all market participants at one instant, taken with all the information available at the time. If some event or news change the perceived value of the asset, a new equilibrium between buyers and sellers has to be discovered. That equilibrium search is naturally performed by price action. Since the new information does not mean an automatic new valuation, it takes time to find the new fair price. That is the origin of a trend.
Trading is an (almost) zero-sum game. The gain of a trader plus costs is the loss of another. Poorly informed traders tend to lose, while well-informed traders and market manipulators tend to win.
Market Classification by Price Action:
There are basically three market types:
The price tends to increase over time, even months or years, although not straight up. It moves in waves, but the overall bias is to the upside. Usually, volatility tends to be low or moderate, meaning the wave moves most of the time decisively.
Chart 1 – EURUSD Bull market. (Click image to enlarge)
The price tends to fall. Sometimes the drop takes much less than it took to grow. These sharp movements are counteracted by retracements. Volatility tends to be higher than in bull markets.
Chart 2 – EURSD Bear Markets and their Bull retracements (click on the image to enlarge)
The price moves in a horizontal channel. This channel may be tight or separated. It can be seen as a consolidation area, after a strong upward movement, or a price floor after a considerable drop.
Chart 3 – USDCHF sideways market after a bear market( CLick to enlarge)
When the asset is a Forex pair bull and bear tend to be similar because a bull market for one component of the pair is a bear market for the other component. Therefore, there is a kind of symmetry on the forex pairs not fund in other assets or markets.
The Dow Theory
The Dow Theory is the foundation of chart analysis and price forecasting, applying to stocks, financial markets and commodities. Charles Dow was the first analyst to create an index to forecast the health of the Economy. The index was devised to smooth out the noise of its individual components and reveal the hidden patterns of the overall market action.
Dow said that the market moves in three waves as the ocean. He called the waves, Primary, secondary and daily fluctuations. Charles Dow compared major advances and declines with tides. The Tides sustained secondary reactions he called waves, and waves were shaped by ripples. We can see that this theory is the foundation of another popular theory: The Elliott Wave Theory.
Chart 4 – The Dow Jones Index showing the several stages described by the Dow theory. (click on the image to enlarge)
Basic principles of the Dow Theory
1.- The Averages discount everything.
At the time Charles Dow thought about an index, liquidity was low and a powerful investor could manipulate a particular stock for his purposes. An index was thought to erase these individual manipulations and reveal the true essence of the overall market health.
2.- Trend Classification: Primary tides, secondary swings, minor daily fluctuations
Bull and Bear Market formation
A Bull Market is marked by a breakout signal that moves the price above the preceding trading range. The bull market is confirmed when prices move above the high of the preceding rally. Nowadays it is also determined by the price being above its 200-day Simple Moving Average.
Chart 4 Bull Market confirmation.
A Bear Market is identified by the price failing to make a new high, and then, a breakout moves the price below the preceding trading range. Today, a bear market is confirmed, also, when the price moves below its 200-day moving average.
3.- Bull / Bear Market Phases
During the last stages of a price dip, smart traders, thinking there is a good chance with low risk, start accumulating positions. This activity creates a support level. Sometimes, this price floor is briefly violated to the downside, stop orders are executed and, then, the price moves back up again above support.
After this market deception to trick the uninformed traders, the price starts to rise, initially with uncertainty, securer as momentum builds in the final moments of this stage, the price races on higher volume.
In the final phase of the impulsive wave, smart traders,
begin selling while the price is still moving up. Finally, the action reaches overbought levels. A sort of wall seems to have been placed: It is a level of resistance.
At these prices, more people are willing to sell than bulls can manage, so the price stalls. The last buyers do not have the power to move the prices above that point.
Now it is evident for traders that the current price is too high. The price had an overextension caused by too much optimism during the bull run. Now they no longer believe the price can be sustainable. Therefore previous buyers now join the sellers’ side.
The price starts falling. Next, price rallies as if a new leg up could occur, but then it sinks again creating fresh lows. Price creates several up-down phases, but with lower highs and lows than on the previous phase.
The price arrives at a new support which
cannot be broken. Therefore, a new accumulation phase begins.
Sometimes, the selling phase does not create a bear market. Instead, the price moves in a wide horizontal channel which serves as consolidation for the price.