Ed Note: This is the third of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets.
Although there is no universally accepted definition of price action, I use the broadest one—it is simply any move up or down on any chart for any market.
Markets are created by institutions so that they can quickly buy or sell when they want at a fair price and with a tight spread. The market is always searching for a price that is fair for both sides, and that is why it spends most of the time in trading ranges, which are areas of agreement.
Breakouts up and down are brief moves that occur because both the bulls and bears agree that the price is too low in a bull breakout or too high in a bear breakout, and the market needs to move quickly to a new area of agreement.
What is an area of agreement? It is a trading range. It is a price range where confusion reigns, and that is why trades rarely look certain. Most of the time, the market is fairly balanced and there are reasonable arguments for both the bulls and the bears. Whenever you feel confused, whenever you can think of a good reason not to take a trade, or whenever you can see both reasonable buy and sell setups, then you should assume that the market is in a trading range.
This is the goal of all markets. They are trying to find a price where the bulls think it is sensible to buy and the bears think it makes sense to sell. As the market works higher in the range, the bulls think the price is less fair and they buy less. Many bulls will take small profits and therefore are now selling. The bears who were shorting a few bars ago see this as an even better value, and they sell more. The imbalance results in the price moving back down.
When the market tests support, which is the bottom of the range, there are fewer bears willing to short, and other bears are taking profits on their shorts and therefore are now buyers. Bulls see the lower price as an even better value than what it was a few bars ago and they buy more. The market then works up to test the resistance at the top of the range. Markets have inertia and when a market is in a trading range, 80% of the attempts to break out will fail.
Enter the trend
Eventually, a breakout will succeed and then the market is in a trend, racing up to the next resistance level or down to the next support level, in search of a price where both the bull and bears once again agree that there is value in trading. This is the next trading range.
As a market is trending, it is constantly trying to reverse, but because of inertia, 80% of reversal attempts will fail and lead to pullbacks and then resumptions of the trend. Each reversal attempt is at a resistance level, whether or not you see it, and it is due mostly to profit taking. Later in the trend, pullbacks become deeper and more complex and counter-trend scalps begin to play a bigger role in the price action.
If a pullback starts to accumulate a lot of bars, the trend fades further to the left on the chart and its effect on direction dissipates. After 20 bars or so, the effect is entirely gone, and the market is then in a trading range. At this point, the probability of the direction of the eventual breakout falls to about 50% for both the bulls and bears. It becomes equally likely that the trend will resume or reverse.