PRICE ACTION AND MARKET STRUCTURE ON CHARTS
Charts are a way to organize and to structure the flood of information the market generates and can reveal clues about the strength of the underlying forces. There is no one right way to read a chart, but I will share the basic elements of an approach that has been very useful to me over the years.
These tools and this framework have shown themselves to be reliable time and time again, but these are my tools and my method. You must make them your own tools. Use everything here as a collection of ideas from which you can begin to build your own approach to the markets.
Market structure refers to the static structure visible on charts, made up of previous movements in the market and places where those movements stopped.
The key elements of market structure are pivot points and the swings connecting them, both of which may be evaluated either in price (the vertical axis on a chart), in time (the horizontal axis), or in a combination of the two. Price action is the dynamic process that creates market structure.
Price action is also more subjective; in most cases, market structure is concrete. Market structure is static and is clearly visible on a chart, but price action usually must be inferred from market structure. Also, both are specific to time frames, though price action is often visible as the market structure of lower time frames. These definitions and their implications will become clear over the next chapters.
Pivot Points
The basic units of market structure on any time frame are pivot highs and lows (also called swing highs or lows). A pivot high is a bar that has a higher high than the bar that came before it and the bar that comes after it.
At least in the very short term, the bar’s high represents the high-water mark past which buyers were not able to push price, and can be considered a very minor source of potential resistance.
A pivot low is the same concept inverted: a bar with a lower low relative to both the preceding and the following bars. Figure 1.3 shows a chart with every pivot high and pivot low marked. Note that it is possible for a bar to be both a pivot high and a pivot low at the same time, and that pivot highs and pivot lows are very common.
Another name for the type of pivot in Figure 1.3 is a first-order pivot. Though these first-order pivots do sometimes coincide with major turning points in the market, they are so common that they cannot be extremely significant.
Every major turning point, by definition, comes at a pivot, so it is easy to overstate their importance; once you see a chart with every possible pivot marked, it becomes obvious that this structure is so common that it is nearly insignificant.
It is also interesting to consider that most pivots on one time frame mark significant market structures on lower time frames, but this is a complication that we will save for later. As a stand-alone concept, first-order pivot highs and lows have limited utility; their power comes from their relationship to other pivots and their ability to define market structure.
They are like a single brick in a building—not that interesting or useful by itself. Second-order pivot highs (also called intermediate-term pivots) are first-order pivot highs that are preceded and followed by lower first-order pivot highs; again, this structure is inverted for second-order pivot lows.
In Figure 1.4, notice that these second-order pivots begin to define some more significant structural points. It is much more likely that second-order pivots will come at important turning points, but remember that there is no predictive power because this is a pattern that is defined post hoc. They always look far
more significant in the middle of a chart than they do on the right edge. It is also worth noting that there is no law that says second-order pivot highs and lows have to alternate; it is possible to have three second-order pivot highs or lows in a row.
If you are going to use this concept systematically, make sure your rules plan for this situation. Predictably, this concept can be extended on many levels, but in actual practice, most of our focus is on third-order pivots, which usually mark major inflections (see Figure 1.5).
Almost without exception, a trader who could identify these third-order pivots in advance would have nearly perfect entries on both sides of the market. This cannot be done, but it does point out that these third-order pivots delineate the market structure very clearly.
It is worth your time to train your eye to see these pivots quickly; the value in this structure is in providing context for the market’s movements. Once you understand the basic ideas behind this concept, it is probably a good idea to not be too rigid with these structures and definitions.
If you see something on a chart that is fulfilling the basic role of one of these structures but for one reason or another does not exactly fit the criteria, it often makes sense to bend the rules for that case. The goal is to define meaningful market structure, not to blindly follow a set of rules.
It also should be obvious that this is a backward-looking analytical method. This is a problem with all swing or wave methods: they offer fantastic explanations of past market action, but have little or no predictive power at the right edge.
This pivot structure is not intended to be a trading methodology; it is context. For instance, a sharp down move might be interpreted differently if it comes at a point where the market had been making consistently higher second-order pivot highs and lows compared to an environment where they were more randomly distributed.
As another example, a movement that penetrates a significant third-order pivot high or low can sometimes significantly change the market environment. The purpose of this tool is to provide that structure and context, not actual trade entries.