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Understanding Market Structure

Welcome to our first lesson in Learning Price Action entitled Understanding Market Structure. This is an important concept in technical analysis, and is crucial to becoming a more consistently profitable trader, as it forms an understanding of what phase the market is currently in; and where the market could be heading in the near future.

Understanding what phase the market is in, whether it is in a bullish uptrend, a bearish downtrend, or a trading range, will help you to trade in the direction that the market wants to go rather than against it. This knowledge will allow you to trade along the path of least resistance, where the probability of success is greater, and will result in more consistent trades.

Reading Market Structure may seem difficult when you first start trading but it is an important skill can be used in any type of market, including stocks, bonds, futures, forex, commodities, cryptocurrencies, etc. This lesson is designed to help you acquire the skill of understanding and reading market structure.

In this lesson we will explain the definition of Market Structure before explaining how to identify the various types of market structure, and then move on to explaining how market structure can be incorporated into our trading decisions. Let us begin by defining what is meant by the term 'Market Structure'.

What is Market Structure?

Market Structure

The term Market Structure refers to what could be called a broad organizational framework of the market created by the structural forces of supply and demand, on the one hand, and the psychological and emotional forces of fear and greed, on the other. These forces underpin the nature and characteristics of the major trend that dominates the market. This trend is shaped by the competing forces of supply (selling) and demand (buying), as well as their psychological and emotional aspects, and can be classified as one of three states: a bullish market, a bearish market, or a ranging market, depending on which force is dominating the market at the time.

Due to the multitude of participants in the market, and the psychological and emotional constitution of each participant, the forces of supply and demand are not uniform and fluctuate constantly. As a result, the market price does not move in a straight line; it advances and declines constantly to a lesser degree, regardless of nature and direction of the overall trend that moves at a larger degree, as traders enter positions and close positions to take profit or cut losses. Consequently, the Market Structure can be thought of as encompassing different degrees or levels significance, with each degree or level shaping its own trend. This is something that Charles Dow alludes to in Dow Theory, as does Ralph Elliott in The Elliott Wave Principle. These technicians suggest that the market consists of a major trend that shows the overall direction of the market; an intermediate trend printed by the advances and declines of the major trend; and minor trends printed by the advances and declines of the intermediate trend. Together these different levels of trends print swing highs and swing lows, and support and resistance levels, as the price action proceeds across the chart.

Types of Market Structure

As mentioned earlier, the states, or trend that the current Market Structure can be in can be classified into one of three states: a bullish market, a bearish market, or a ranging (non-trending) market. These states depend on which force is dominating the market, and the extent of that force, at the time. As a trader, you always want to be on the side that is dominating the market as this is the path of least resistance, but you also want be flexible enough to shift positions as the market shifts from one state to another.

Bullish Market Structure

FIG. 1: Higher Highs

A bullish Market Structure is characterized by an imbalance in market forces in which demand is greater than supply. More traders want to buy but there are not enough traders willing to sell at these price levels, hence, demand is out stripping supply. As a result, prices advance, making higher highs and higher lows as buyers increase their asking price in search of willing sellers. This is the basic characteristic of an uptrend and will continue for as long as it makes higher highs and higher lows.

Figure 1 shows the price action printing a series of higher highs (down arrows) and a series of higher lows (up arrows). The left arrow indicates a lower high! An uptrend shows signs of weakening and a possible end when it starts making a lower high. This indicates that the balance of forces is shifting as demand is drying up or supply is increasing at these price levels. This shift could result in the end of the bullish uptrend.
Bearish Market Structure

FIG. 2: Lower Lows

A bearish Market Structure is characterized by an imbalance in market forces in which supply is greater than demand. More traders want to sell but there are not enough traders willing to buy. Here there is too much supply at these price levels. As a result, prices decline as sellers lower their asking price in search of willing buyers. The result is a trend with lower highs and lower lows. This is the basic characteristic of a downtrend and will continue for as long as it makes lower highs and lower lows.

Figure 2 shows the price action making a series of lower lows (up arrows) and a series of lower highs (down arrows). The left arrow indicates a higher low! When a downtrend starts making a higher low, it shows signs of weakening and indicates a possible end to the bearish downtrend.
Ranging Market Structure

A ranging Market Structure is characterized by a balance in market forces in which supply and demand are in equilibrium. As a result, the price meanders in a sideways direction. This is often referred to as a non-trending, sideways market. As a trader, you always want to be on the side that is dominating the market, however, in a ranging market, there is no dominant force. Most traders will stand aside while the market resolves itself in either the buyers or the sellers favor and resume trading once the market takes either a bullish or a bearish market structure. More advanced traders will use support and resistance levels, channels, and chart patterns for trading opportunities.

If you want to trade in a ranging market structure, it is advisable to reduce your position size and tighten your protective stop loss.

Using Market Structure

Market Structure indicates which market force is currently dominating the market. You always want to be trading on the side that is the current dominating force as this will be the path of least resistance. Therefore, you want to be a buyer whenever the market structure is bullish and demand out strips supply; and you definitely don't want to be a buyer in a bearish market where supply out strips demand. When supply out strips demand you would rather want to be a seller though short selling is generally a risky endeavor that requires greater attention to detail. When neither selling nor buying is dominating the market it is time to stand aside and wait for the market to tip in favor of one side or the other.

It is important to remember that more often than not, a trend does not reverse immediately to the opposite direction. More often than not, it will transition through a period of a period of sideways, ranging movement before either continuing in the previous direction or moving in the opposite direction. This is a ranging market structure. Trading in a ranging market can be difficult, which is why most traders will refrain from trading until the market turns either bullish or bearish. If you attempt to trade a ranging market, it is advisable to reduce your position size and tighten your protective stop loss.

Remember, trading survival is dependent on managing and reducing your losses.

Next Lesson

Dow Theory