This edition of Profit Talk covers aspects of technical analysis, often referred to as “chart reading”. The subject focus is on how to properly quantify supply and demand zones for use with directional style trading.
05/01/2017 Profit Talk ~ Quantifying Supply & Demand
Welcome to the May 1st 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
This edition of Profit Talk we’re going to cover some aspects of technical analysis, often referred to as “chart reading”. We will continue the conversation on technical analysis and the subject of demand and supply as covered in the February 20th, 2017 edition of Profit Talk. The specifics of quantifying zone quality will be our focus. We’ll review a previous lesson on Zone Quality Quantifier #1 and we’ll cover the next Zone Quality Quantifier called Trending Only Zone Types
Proficiency in chart reading can be a great benefit for those interested in taking directional style trades. As covered previously, directional trading can be challenging and most people who attempt it without the specialized knowledge necessary meet with failure. But, those that persevere and gain their way in, find the world of directional trading can be incredibly profitable.
Make sure to use the Profit Talk archive page category filter to review the ½ dozen or so other editions covering the subject of directional trading.
Adding Alpha
When it comes to pure directional trades, the challenge comes with the statistical probabilities for success. Statistically speaking, a stock has a 50/50 chance of moving in either direction. This fact can create a problem when trying to profit from a directional move. Investing with a 50/50 chance becomes a zero sum game in the end.
Fortunately, there are steps that can be taken to skew the odds a bit more in the favor of the directional trader. The science and art of technical analysis can go along way to support the investor interested in taking directional trades. Technical or “Chart” analysis is the study of historical price and volume behavior with the intention of using the information to predict future price moves.
In my experience, I’ve seen that proper use of chart analysis does have the ability to increase the odds for success when directional trading. This is because all price behavior is really human behavior or emotion playing out through the buying and selling of the particular asset. Detractors of technical analysis try to argue that price doesn’t have any memory and therefore has no predictive value. They are forgetting one vital truth about price. Price comes from people and people definitely have memories. As you know, people have very long memories, especially when it comes to pleasurable or painful experiences. Financial or otherwise. This fact creates the foundation which supports technical analysis.
The price chart is a flowing history of investor emotion involving the particular asset. That is good news for investors because emotions do hold some predictive value.
Fear & greed associated with money and investing displays cyclical patterns. These patterns play out over and over again and reveal themselves in price which is displayed in graphical form on the chart.
The key to useful chart analysis is to break the information down to the essential facts about price behavior, or more accurately, people’s behavior in the market place. There are two key factors that must always be kept at the forefront when performing chart analysis. These factors are trend and supply & demand.
The power of trend has been well documented by successful traders for centuries. Although, the idea of using trend in your chart analysis may fall in and out of favor among the financial pundits, don’t let short term popular culture thinking steer you off course with your chart reading. Let me make something very clear, trend will NEVER go out of style when it comes to its influence on price. Trend is to price what the tide or prevailing current is to a body of water. A chart analyst who ignores trend is like a pilot of a ship ignoring the tide or prevailing current of the water they are navigating.
The other key factor to consider when performing technical analysis is where the supply & demand areas are located. In the end supply and demand determine everything, even trend. The trend direction and momentum is determined by supply and demand. Uptrending markets are doing so because the buyers outnumber the willing sellers. Price must go up in order to incentify sellers to sell.
Demand and Supply
When it comes to directional trading, nothing will enhance your success more than an ability to locate high quality supply and demand areas on a chart. As covered previously, big picture trend direction has a huge influence on price behavior. But, as I’ve also said, there is something even more important than trend direction when it comes to future price action. It’s what determines trend in the first place. I’m referring to demand and supply.
The terms support and resistance or demand and supply are used to describe areas where market technicians have determined that either buyers, in the case of demand or support, or sellers in the case of supply or resistance, are numerous enough to change the current market direction. That is to either reverse the current direction or cause sideways price action before continuing the current price direction or trend.
These levels are generally categorized by three types, a classic trend line, a moving average or a horizontal level. The classic trend line is not generally used in our strategies as it is too subjective. A moving average however, will provide objectivity and can act as a support/demand area in an uptrend, or as resistance/supply in a downtrend. But only when in the correct “big picture trend”. They tend to be weak levels to use when going counter to the bigger time frame trend.
The horizontal style supply & demand zone is typically the strongest type of level. Horizontal levels or zones are areas where in the past price either reversed direction (pivot lows/highs) or reacted strongly in the current direction after a short lived countrend move or a pause in price. In uptrends those instances are often referred to as a drop-base-rally or rally-base-rally respectively. (Figure)
In down trends they are the exact opposite, rally-base-drop and drop-base-drop. (Figure)
Another type of horizontal zone forms when price breaks through what was previously an area of demand or supply. This causes the area to become opposite of what it was. Previous supply that fails is now demand and previous demand that fails is now supply. This type will often appear on the chart as a “stair stepping” pattern. (Figure)
Quality horizontal demand and supply levels are considered the best indicator to determine whether price will experience a change. This change may be a reversal or sideways price action, sometimes called basing or range bound price action. This information can be used to trade an asset directionally or as options traders, we have the ability to take advantage of sideways or range bound trading through the use of non-directional trading strategies. Technical or price knowledge provides better insight on certain habits of price. This chart reading skill combined with the correct option strategy works well to increase your edge when trading.
The problem with Quality horizontal levels is that they are very subjective. Especially when adding the word quality. We don’t like subjectivity, it’s inconsistent and we desire consistency. Also, they are difficult to measure in mathematical terms, so we cannot write strategies, scans or indicators to assist us in finding trades and determining the parameters of the trade.
So, why do we use them? Because, they are probably the best indicator to determine whether price will react when in that particular area or “price zone”, and when these zones are combined with our other technical analysis, the probabilities of having a successful trade increase dramatically.
Quantifying Demand and Supply
We have used the term Quality Horizontal Level, the key word here being Quality. At Profit Effect I have developed a system for quantifying the word quality when it comes to demand and supply levels. We use what I call “Quality Quantifiers” to rate the particular supply or demand level. In the February 20th, 2017 edition of Profit Talk we covered the first Quality Quantifier Zone Quality Quantifier #1 – Explosive Move Away from Zone.
Let’s review Zone Quality Quantifier #1 and then I’ll introduce Zone Quality Quantifier #2 – Trending Only Zone Types
Zone Quality Quantifier #1 – Explosive Move Away from Zone
The best indication of a demand/supply imbalance having occurred on the chart is an extreme price move. Let’s look to the charts to find some examples.
This first step is to clear your chart of any indicators. The chart should have just the candlesticks and the time and price information….x and y axis.
First, take a moment to look at the chart back through time and get a feel for the type of moves that have occurred in the past.
Look for moves that jump out at you with either a gap or extended range candle ERC. (Figure)
Look for areas that mark a turn in price after a significant trend in one direction, sometimes referred to as pivot lows and pivot highs.(Figure) Also, look for areas that during a strong move in one direction, pause for a few small range bars, a bit of basing or perhaps a Doji and then explode in the same direction as before.(Figure)
When these moves or dramatic price changes happen, they will leave people “wishing”. Yes, wishing they had or wishing they hadn’t. That is bought or sold at that price. These sitting orders not only exist in the hearts and minds of the average retail trader, who got “juked” by the move, but more importantly, banks and institutions who build large positions, are caught in these dramatic moves as well. And, they will have existing, unfilled orders sitting in these areas.
The fact that price left the area in a dramatic fashion proves that there was an imbalance in the number of buy and sell orders, so price had to move to fill the orders. Period, there is no argument if this happened. The only question is, when price returns to the area are there enough orders to reverse or at least affect price in a way that can be useful to us.
Zone Quality Quantifier #2 – Trending Only Zone Types
The second zone quantifier we’ll cover today is Zone Quality Quantifier #2 – Trending Only Zone Types
These zone types are only used when the Long Term “big picture” time frame trend is in harmony with the trade direction or “trade bias”. These zones generally fall into two categories, those derived from a moving average or trend line and those that are horizontal.
When using a trendline or moving average we can create a zone based on some mathematical calculations such as ATR or Historical Standard Deviation to create a zone around the moving average or trend line and thereby give us the ability to define the parameters of the trade. These values are used to determine the entry and exit rules.
The horizontal style of demand or supply zones that appear on charts often show up in a “stair stepping” style that is formed when, in the case on of an uptrend, a previous top or supply zone is violated and price has broken through and continued higher. This price action can often times create demand in the direction of the prevailing trend. So, when price retraces and returns to the area where price broke through, you’ll often find demand which then causes price to turn and continue the trend. (Figure) These areas can be used as entry zones for bullish trades.
A downtrend is just the opposite of the uptrend. Horizontal supply zones are formed when previous demand breaks, changing it to a current supply zone. When price returns, these areas can be used to enter bearish trades. Just like with bullish trades, the big picture trend must be inline with the trade direction. This means when looking for bearish trades, only use markets that are in a big picture downtrend.
Use these incredibly helpful insights to price behavior to help guide your directional trading decisions. I think you’ll experience a world of difference when it comes to the results you achieve with your directional trades.
Review the February 6th edition of Profit Talk “Directional Trading Philosophy” where I explain some of the lessons learned from years of personal experience and countless hours of creating and backtesting strategies for directional trading. The insights I share with you are what I consider to be the best lessons learned from these experiences and everything I share is the same criteria I use.
Takeaways
The top takeaways this week are:
First, it’s always about Trend. Big picture trend direction determines trade direction.
Second - Look for explosive moves away from an area. This is a sign of a supply/demand imbalance. The first Zone Quality Quantifier is the first criteria I look for after determining trend direction
Third, Trend Only Zone Types are easy to find and plentiful enough to provide an almost endless stream of opportunities while adhering to a quality, rules based system.
Market Outlook
This past week started out with a big gap up on Monday. The move was based on the enthusiasm of the European markets after the French election. The US and most of the world markets were up at the first of the week and traded sideways to down slightly as we moved through the week. All the major US markets are once again flirting with all time highs.
Volatility was absolutely crushed last Monday and traded down most of the week. We’re in the middle of earnings season and there are numerous reports and data being released this week. Plus, the Federal Reserve chairperson is speaking and the FOMC Statement is being released. I’m hoping for some two sided price action and a rise in volatility. We’ll see what the week brings.
The high impact reports due out this week include:
(Last Figure)
As always these reports have the ability to move markets and create opportunity for the trader who is prepared.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
Welcome to the May 1st 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
This edition of Profit Talk we’re going to cover some aspects of technical analysis, often referred to as “chart reading”. We will continue the conversation on technical analysis and the subject of demand and supply as covered in the February 20th, 2017 edition of Profit Talk. The specifics of quantifying zone quality will be our focus. We’ll review a previous lesson on Zone Quality Quantifier #1 and we’ll cover the next Zone Quality Quantifier called Trending Only Zone Types
Proficiency in chart reading can be a great benefit for those interested in taking directional style trades. As covered previously, directional trading can be challenging and most people who attempt it without the specialized knowledge necessary meet with failure. But, those that persevere and gain their way in, find the world of directional trading can be incredibly profitable.
Make sure to use the Profit Talk archive page category filter to review the ½ dozen or so other editions covering the subject of directional trading.
Adding Alpha
When it comes to pure directional trades, the challenge comes with the statistical probabilities for success. Statistically speaking, a stock has a 50/50 chance of moving in either direction. This fact can create a problem when trying to profit from a directional move. Investing with a 50/50 chance becomes a zero sum game in the end.
Fortunately, there are steps that can be taken to skew the odds a bit more in the favor of the directional trader. The science and art of technical analysis can go along way to support the investor interested in taking directional trades. Technical or “Chart” analysis is the study of historical price and volume behavior with the intention of using the information to predict future price moves.
In my experience, I’ve seen that proper use of chart analysis does have the ability to increase the odds for success when directional trading. This is because all price behavior is really human behavior or emotion playing out through the buying and selling of the particular asset. Detractors of technical analysis try to argue that price doesn’t have any memory and therefore has no predictive value. They are forgetting one vital truth about price. Price comes from people and people definitely have memories. As you know, people have very long memories, especially when it comes to pleasurable or painful experiences. Financial or otherwise. This fact creates the foundation which supports technical analysis.
The price chart is a flowing history of investor emotion involving the particular asset. That is good news for investors because emotions do hold some predictive value.
Fear & greed associated with money and investing displays cyclical patterns. These patterns play out over and over again and reveal themselves in price which is displayed in graphical form on the chart.
The key to useful chart analysis is to break the information down to the essential facts about price behavior, or more accurately, people’s behavior in the market place. There are two key factors that must always be kept at the forefront when performing chart analysis. These factors are trend and supply & demand.
The power of trend has been well documented by successful traders for centuries. Although, the idea of using trend in your chart analysis may fall in and out of favor among the financial pundits, don’t let short term popular culture thinking steer you off course with your chart reading. Let me make something very clear, trend will NEVER go out of style when it comes to its influence on price. Trend is to price what the tide or prevailing current is to a body of water. A chart analyst who ignores trend is like a pilot of a ship ignoring the tide or prevailing current of the water they are navigating.
The other key factor to consider when performing technical analysis is where the supply & demand areas are located. In the end supply and demand determine everything, even trend. The trend direction and momentum is determined by supply and demand. Uptrending markets are doing so because the buyers outnumber the willing sellers. Price must go up in order to incentify sellers to sell.
Demand and Supply
When it comes to directional trading, nothing will enhance your success more than an ability to locate high quality supply and demand areas on a chart. As covered previously, big picture trend direction has a huge influence on price behavior. But, as I’ve also said, there is something even more important than trend direction when it comes to future price action. It’s what determines trend in the first place. I’m referring to demand and supply.
The terms support and resistance or demand and supply are used to describe areas where market technicians have determined that either buyers, in the case of demand or support, or sellers in the case of supply or resistance, are numerous enough to change the current market direction. That is to either reverse the current direction or cause sideways price action before continuing the current price direction or trend.
These levels are generally categorized by three types, a classic trend line, a moving average or a horizontal level. The classic trend line is not generally used in our strategies as it is too subjective. A moving average however, will provide objectivity and can act as a support/demand area in an uptrend, or as resistance/supply in a downtrend. But only when in the correct “big picture trend”. They tend to be weak levels to use when going counter to the bigger time frame trend.
The horizontal style supply & demand zone is typically the strongest type of level. Horizontal levels or zones are areas where in the past price either reversed direction (pivot lows/highs) or reacted strongly in the current direction after a short lived countrend move or a pause in price. In uptrends those instances are often referred to as a drop-base-rally or rally-base-rally respectively. (Figure)
In down trends they are the exact opposite, rally-base-drop and drop-base-drop. (Figure)
Another type of horizontal zone forms when price breaks through what was previously an area of demand or supply. This causes the area to become opposite of what it was. Previous supply that fails is now demand and previous demand that fails is now supply. This type will often appear on the chart as a “stair stepping” pattern. (Figure)
Quality horizontal demand and supply levels are considered the best indicator to determine whether price will experience a change. This change may be a reversal or sideways price action, sometimes called basing or range bound price action. This information can be used to trade an asset directionally or as options traders, we have the ability to take advantage of sideways or range bound trading through the use of non-directional trading strategies. Technical or price knowledge provides better insight on certain habits of price. This chart reading skill combined with the correct option strategy works well to increase your edge when trading.
The problem with Quality horizontal levels is that they are very subjective. Especially when adding the word quality. We don’t like subjectivity, it’s inconsistent and we desire consistency. Also, they are difficult to measure in mathematical terms, so we cannot write strategies, scans or indicators to assist us in finding trades and determining the parameters of the trade.
So, why do we use them? Because, they are probably the best indicator to determine whether price will react when in that particular area or “price zone”, and when these zones are combined with our other technical analysis, the probabilities of having a successful trade increase dramatically.
Quantifying Demand and Supply
We have used the term Quality Horizontal Level, the key word here being Quality. At Profit Effect I have developed a system for quantifying the word quality when it comes to demand and supply levels. We use what I call “Quality Quantifiers” to rate the particular supply or demand level. In the February 20th, 2017 edition of Profit Talk we covered the first Quality Quantifier Zone Quality Quantifier #1 – Explosive Move Away from Zone.
Let’s review Zone Quality Quantifier #1 and then I’ll introduce Zone Quality Quantifier #2 – Trending Only Zone Types
Zone Quality Quantifier #1 – Explosive Move Away from Zone
The best indication of a demand/supply imbalance having occurred on the chart is an extreme price move. Let’s look to the charts to find some examples.
This first step is to clear your chart of any indicators. The chart should have just the candlesticks and the time and price information….x and y axis.
First, take a moment to look at the chart back through time and get a feel for the type of moves that have occurred in the past.
Look for moves that jump out at you with either a gap or extended range candle ERC. (Figure)
Look for areas that mark a turn in price after a significant trend in one direction, sometimes referred to as pivot lows and pivot highs.(Figure) Also, look for areas that during a strong move in one direction, pause for a few small range bars, a bit of basing or perhaps a Doji and then explode in the same direction as before.(Figure)
When these moves or dramatic price changes happen, they will leave people “wishing”. Yes, wishing they had or wishing they hadn’t. That is bought or sold at that price. These sitting orders not only exist in the hearts and minds of the average retail trader, who got “juked” by the move, but more importantly, banks and institutions who build large positions, are caught in these dramatic moves as well. And, they will have existing, unfilled orders sitting in these areas.
The fact that price left the area in a dramatic fashion proves that there was an imbalance in the number of buy and sell orders, so price had to move to fill the orders. Period, there is no argument if this happened. The only question is, when price returns to the area are there enough orders to reverse or at least affect price in a way that can be useful to us.
Zone Quality Quantifier #2 – Trending Only Zone Types
The second zone quantifier we’ll cover today is Zone Quality Quantifier #2 – Trending Only Zone Types
These zone types are only used when the Long Term “big picture” time frame trend is in harmony with the trade direction or “trade bias”. These zones generally fall into two categories, those derived from a moving average or trend line and those that are horizontal.
When using a trendline or moving average we can create a zone based on some mathematical calculations such as ATR or Historical Standard Deviation to create a zone around the moving average or trend line and thereby give us the ability to define the parameters of the trade. These values are used to determine the entry and exit rules.
The horizontal style of demand or supply zones that appear on charts often show up in a “stair stepping” style that is formed when, in the case on of an uptrend, a previous top or supply zone is violated and price has broken through and continued higher. This price action can often times create demand in the direction of the prevailing trend. So, when price retraces and returns to the area where price broke through, you’ll often find demand which then causes price to turn and continue the trend. (Figure) These areas can be used as entry zones for bullish trades.
A downtrend is just the opposite of the uptrend. Horizontal supply zones are formed when previous demand breaks, changing it to a current supply zone. When price returns, these areas can be used to enter bearish trades. Just like with bullish trades, the big picture trend must be inline with the trade direction. This means when looking for bearish trades, only use markets that are in a big picture downtrend.
Use these incredibly helpful insights to price behavior to help guide your directional trading decisions. I think you’ll experience a world of difference when it comes to the results you achieve with your directional trades.
Review the February 6th edition of Profit Talk “Directional Trading Philosophy” where I explain some of the lessons learned from years of personal experience and countless hours of creating and backtesting strategies for directional trading. The insights I share with you are what I consider to be the best lessons learned from these experiences and everything I share is the same criteria I use.
Takeaways
The top takeaways this week are:
First, it’s always about Trend. Big picture trend direction determines trade direction.
Second - Look for explosive moves away from an area. This is a sign of a supply/demand imbalance. The first Zone Quality Quantifier is the first criteria I look for after determining trend direction
Third, Trend Only Zone Types are easy to find and plentiful enough to provide an almost endless stream of opportunities while adhering to a quality, rules based system.
Market Outlook
This past week started out with a big gap up on Monday. The move was based on the enthusiasm of the European markets after the French election. The US and most of the world markets were up at the first of the week and traded sideways to down slightly as we moved through the week. All the major US markets are once again flirting with all time highs.
Volatility was absolutely crushed last Monday and traded down most of the week. We’re in the middle of earnings season and there are numerous reports and data being released this week. Plus, the Federal Reserve chairperson is speaking and the FOMC Statement is being released. I’m hoping for some two sided price action and a rise in volatility. We’ll see what the week brings.
The high impact reports due out this week include:
(Last Figure)
As always these reports have the ability to move markets and create opportunity for the trader who is prepared.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
