The
markets will tell you where they want to go, if you let them. What it comes down
to is understanding the market mechanism which underlies price moment. When you
operate with that in mind you can see how it plays out in determining the course
of price action and use it to identify the likely course of action.
So what
is this market mechanism? Well, it's no secret. It's just something most traders
don't give much thought to, even though they are a part of it. The markets are
facilitators of financial transactions. Some involve stocks, some futures, some
forex, but all operate with one primary objective - to create the largest amount
of transaction volume possible. The exchanges are motivated to do this for the
fees they receive and the market markets do it so they can make the bid/offer
spread as frequently as possible. And since it behooves them to have liquid
markets where they can readily transaction business, all other market
participants support this structure, allowing the exchanges and market makers
their profits.
Now, how
do the markets create the largest possible transaction flow? By having prices at
the levels which most participants at a given point in time agree to as value.
That is to say, when a buyer and seller come together they have agreed to the
value of the thing they are exchanging, even if it's just for a split second.
The market's interest in maximizing volume is to ensure that prices at any given
time best reflect the value perspectives of both buyers and sellers. As a
result, price will always move to find the levels at which the most volume
because the market makers, in response to the market environment, will move them
there.
This
continuous pursuit of value by the market makers is what we see playing out on
the charts. If we know what to look for we can identify the levels at which the
market most found that value - meaning the market spent more time at those
levels and/or did more volume there. There are two "high value" areas on the
chart below.

At the
left of the chart we can see a market searching for value. It is moving rapidly
in one direction. Then it finds that value and spends about 10 periods there.
Something happens to change trader's perceptions eventually and the market goes
back into a period of trying to find value again. Notice that twice it runs
through the first "value area" along the way before settling at a
slightly higher
value. That is what markets do - move from periods of stable value to ones where
it's trying to find where the value is and back. It shows up on any chart in all
timeframes and markets.
Candlestick and bar charts don't always make it easy to really spot the finer
points of where the market has established value, though. For that we can turn
to a different style of charting based on the distribution of prices during a
time period. This is sometimes called Market Profile®. Others call it volume at
price, TPO charting, and other variations. The basic idea in all cases is what
you see at right below.

The
graphic above shows 1 day's worth of trading in two fashions. At left we see 30
minute bars in the classic style. At right we see the distribution chart which
shows, for lack of a better description, how often the market passed through a
certain price level. It's kind of like crunching the bar chart together. Count
the number of bars at left which included the 1400 level, then notice that it
matches the number of letters you can see across at the 1400 level on the
distribution chart. The thicker the distribution at any given price level, the
more value was found there by market participants. The thinner the distribution,
the less value.
Now,
knowing that the market makers are going to try to move price to where the
buyers and sellers most perceive the value to be, doesn't it make sense that
when the market is in a transitional phase and is trying to find a new
equilibrium they will see former value area as likely areas for that? It's like
when you find yourself in an uncomfortable position you go back to what you
remember as being a comfortable one. In that way, areas were there was a lot of
value before become attractors - targets.
The
application of these value areas and rejected levels is relatively
straightforward. One of the most useful is in determining the potential of a
given trade. When you can look at a graph and see where the market is likely to
go, you can better identify trades likely to produce the type of reward/risk
profiles for which you are looking.
Let's use
this chart to shape an example.

Each one
of the distributions above (S&P 500 index) represent one day's trading. If a
trader were looking at things on or after the second day with an idea of selling
the market, the high count part of the first day's distribution at 1466 becomes
a very clear target. If the market starts moving lower, it would be very likely
to at least approach that level. It's an area where the market spent a lot of
time the first day (established value), therefore will become an attractor for
future price movements.
Of course
that doesn't mean the market will necessarily stop right there, as things are
rarely that precise. Sometimes it will nail it on the button, but other times it
will come up a bit short and others it will go further (maybe even much
further). But that is part of the value discovery process.
Naturally, there is a bit more to it, but this provides a good start point. If
nothing else, it should give you a different perspective on the idea of support
and resistance.
John
Forman is the author of
The Essentials of Trading, and a professional
market analyst and strategist with 20 years of experience trading stocks,
futures, forex, and pretty much anything else traded by individuals. If you
would like to learn more about how you can identify price targets in this
fashion, you'll want to take a look at the video John has prepared on the
subject.
Click here for more information.
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