Fundamental Market States (trend vs range)

The most fundamental, basic aspects of any chart, forex, equities, ANY financial chart are crucial to understand before even considering looking more indepth at any kind of manual trading. Even for automated system traders, this information is essential reading if only so you can understand what your EA is basically looking at and what people are talking about when they say “the market is trending” or “this is a trending robot” and truely understand what is meant or even what the reason behind these states is.

This topic is extremely simple.  At any one time, at any financial market you are looking at, price will be doing one of two things:-

1. Trending; or

2. Ranging (sometimes called “congestion”, “range”, “neutral”)

Trends

Trends are the real “action” points we see on our chart. They are the distinct moments when we see price is going somewhere. This is where you make (or lose) the most money in forex and where price is advancing or declining at its fastest.

Ranges

Ranges are the quiet periods on the chart, where you see price just merrily bouncing up and down a little (or sometimes a lot) but not going anywhere in particular. Sort of like a quiet Sunday lunch, you might get up and wash the dishes but mostly you are just ambling along doing your thing and chilling out. Price is neither here nor there and has no real direction to it. Sometimes it may appear to go to sleep entirely and the charts may print lines which are almost entirely flat.

Price is much more likely to be in a range at any moment in time than it is to be in a trend. You will typically learn elsewhere that markets trend for 20% of the time and range for 80%. I am inclined to agree with them although have no verified this reality through scientific testing for myself. I won’t quibble about numbers though, whatever the exact figure is (perhaps 78.63527% ranging?) it is very clear upon studying a chart along its horizontal time axis, that most of the time is taken up by ranging periods.

Why?

The markets are a reflection of the state of mind of humans, a study in psychology if you like.  Indeed charts and finance are of great interest to mathematicians like myself who also have a keen personal interest in human psychology. What unfolds on our charts before our very eyes is an incredible, perhaps miraculous up to the minute printout of the condition of traders minds from one moment to the next. I think most people would agree that psychology and mathematics do not usually go hand in hand, but learning just how much trading is like psychology can be a real eye opener when you truely understand the impact of it. What is more, you do not need to have a doctorate in mathematics OR psychology to be able to get a grasp of the nature of what i am explaining.

Peeking behind the lines on the chart then, here is my explanation for what brings about our cycle of trending and ranging markets:

When traders see ACTION on the chart, there is a tendency to want to join in on the action and make money out of it. Therefore, when price appears to be rising, perhaps on the basis of good news, people begin to feel positive. Price is rising, the sun is shining, all is looking great. So we enter a buy trade.

Unfortunately that is not the end of the story. If we all entered that buy trade at the same time price wouldn’t keep rising and we wouldn’t make any money. To keep price rising in the trend, we need more and more traders to come on board and buy more and more currency. When there is demand, price will rise, and continue to rise in line with the demand for it.

We are lucky. Today is a very optimistic day and there are lots of traders ready and willing to buy. Some traders don’t buy immediately, they hold off and wait for their own conditions to match up correctly before going with their buy trade. This is fine, since their later demand is still driving price upwards in what is now a great trend. As price rises it becomes more and more obvious that we are in a trend. At the beginning of a trend it is almost impossible to tell if this is a trend or just another ranging ‘wave’. However, at a certain point it becomes very clear and undeniable that this is most definitely screaming “TREND” at you from the chart. The more obvious and strong the trend appears the more people see it and may then buy into that same trend.

After price has risen a fair amount, we start to get edgy. We have made money on our trade and are anxious about not losing it. Do we hold out? How much longer will there be “fresh meat” coming on board ready and willing to buy? How emotional are people feeling today, will they keep buying even when price has already risen so far? On balance we decide that it would be best to bail out of the trade now and take our profit. So we do exactly that. To exit our buy trade we must SELL.

We are not the only people thinking this way. There is a whole crowd of people thinking exactly this. Infact, there is a whole other crowd of people who may be exiting not because they ‘feel’ they are ready but because their take profits have just been hit and they are ready to exit.

The effect of everyone exiting a trade en-mass creates a ’stall’ in the market. There are still buyers coming on board to get in the trend, but there are also a lot of sellers trying to get out of their previous buys. These people trying to exit their trade may finally outweigh the buyers, causing the market to drop slightly. Other people who are a little nervous, who perhaps got in the trade rather late anyway and so are only in profit by a few pips, may be sitting on the edge of their seat a little nervous of the stalling market. The more the market starts to stall, the more sellers will jump on board, trying to exit their trades at profit (and some doomsayers who think the market will reverse and fall may be there too). The market reflects this group psychology and prints it right there on the chart. The demand for currency has dropped, so price drops.

This begins to print a new ranging pattern. The market sits back and absorbs what has just occurred in the trend at this point. Price may bounce around for some time, trying to decide whether to continue on the trend, or to reverse. There is a rush of buyers, then a rush of sellers, but nothing sustained. When price begins to nudge to a high point there is no one confident enough to buy into that as they previously saw price drop off at exactly this point, the market stalls as a result of the lack of buyers. Everyone sees the ranging market, everyone sees the natural visual boundaries forming on the chart at the points where buyers or sellers are not confident. When price nears these boundaries they become self-fulfilling as traders just chicken out and back down, exiting trades or refusing to take on new ones.

Eventually, whether due to further news, optimism, a huge bank transaction/extremely high volume trade, time of the day (it can be anything!) price can and will nudge through these range boundaries. Thirsty for more profits and tired of waiting on the sidelines, people will then jump on board what they see as a new trend as soon as this emerges. The longer the ranging period has lasted, and the tighter and more constricted the range has become, the bigger, stronger and faster the resultant trend usually is as a result. People are just desperate to get into that next trade. This effect can be likened to winding up a spring, over time the coils get tighter and tighter and tighter, until it finally gets released with an explosive move in one direction or another. The tighter the coil the more explosive the spring.

That then, is all there is to markets. Simple cycles of range, then trend, then range, then trend, repeated timelessly again and again, with us collectively being part of the chart rather than the observers which we usually think we are.  If this is a new topic to you, i would urge you to go ahead and look at any chart, any timeframe, any currency and first work on identifying points of trending, which are the easiest to recognise. Then highlight the places of ranging (which are the remaining non-trending areas).

After you have done that perhaps go a little closer and finally try to figure out what the psychology of the crowd was at the moment the ranges and trends you have highlighted on your chart formed. Were people happy to jump on board this trend? Why did this trend last long, or why was the trend short? Did it stall quickly or were there a lot of people ready and willing to buy and keep on buying (or selling)? When price stalled, how long did it remain in a range? Was the range narrow or wide? How large was the trend after this range, and did the trend match the direction of the previous trend or was it a reversal? Are there any points on a chart you can identify where people got totally carried away and wild with emotion about trading and continued buying and buying, or selling and selling, no matter how far and how fast the chart seemed to go? What might have caused this? How can you use this to your advantage?