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In this post, we will discuss what the term “Market Structure” means when performing technical analysis in stocks, Forex, or any other securities or commodities and how it could affect our trading strategies.
What is Market Structure?
The term market structure refers to the properties and characteristics of a specific market environment. While in business, this might encompass things like pricing policies, competition characteristics, etc.., in technical analysis we focus mainly on the characteristics of a price chart of a specific market.
In technical analysis, market structure can refer to historical support and resistance levels, long term trends or behavior. Determining market structure is a very important step in technical analysis as we can use it to forecast future events with better probabilities as we will see in the next few sections.
Perhaps the most important market structure characteristics in any market are historical support/resistance levels. These levels have a very high degree of importance to technical analysts because these levels represent very important price targets to market participants such as retail and institutional investors.
Such price levels could be considered as too “cheap” or too “expensive” price levels for investors. For example, when the price of a currency reaches a historically bottom, a lot of investors line up to buy at such price as they think that this is the lowest that the price could go, and that they are getting a very good deal.
Similarly, if the price of a stock reaches a historical resistance, investors remember the last time that prices were rejected from those levels, and they begin to sell, as they think that the price will not go any higher than that.
Luckily for us data analysts, we do not need to go around the street asking people what they think is a cheap price for a commodity. We just have to look at the chart.
As you can see in the chart above, the price of silver held the support line for more than a year!. Therefore, investors got accustomed to this level serving as a bottom, causing the price to bounce up every-time it reaches that support level. Let us take a look at the next chart.
As you can see, historical resistance lines also serve as future resistance levels. Notice how the support line was eventually broken. We will discuss such scenarios later in the post.
Another thing to keep in mind are historical trends. These could be a very long term trend of a commodity increasing or decreasing in price. This not only serve as a good technical indicator but also as a good way to measure the long term market sentiment towards a stock or commodity.
Take for example the following chart of the price of Bitcoin.
Here, we used a logarithmic chart as it can show a clearer picture of the long term price of an asset. This is because linear charts do not show the magnitude of price moves as well as log charts. For example, if something goes from $1 to $10 is much more significant that if something goes from $1000 to $2000, and we need to see that on the chart.
Here, we see a historical trendline that was forming from 2012 till the end of 2018 where it was eventually broken. After the trendline was broken, it continued to serve as resistance.
Handling prices at historical levels
Now that we know that historical levels and trends need to be measured and defined, how do we handle situations when the price of a commodity is near such historical levels?
Sadly, there is no one size fits all solution for such situations, but there are some guidelines that we should keep in mind which could improve our chances of success.
No trendline or level holds for ever
As you saw in our previous examples, historical levels and trendlines are very important levels which are likely to hold. But just like everything in chart analysis, nothing can be 100% guaranteed.
Therefore, it is important to keep in mind that such historical levels will not hold for ever. Resistance lines eventually get broken and support levels are bound to break at one point.
The rule of thumb is, the more times you test a support/resistance line, the more likely you are to break it on the next try. The reason for this is quite simple. If you continue to test a resistance line, you will eventually run out of sellers at that level. Similarly, when you frequently test a support line, you will eventually run out of people who think this price is a good price, as the price often visits that level, and they might wait to step in at a lower price, breaking the support line.
The bottom line is, we should not blindly buy or sell at a specific level just because it is a historical resistance, support or a trend line. One must do their homework and make sure that the other indicators support a bounce or a rejection.
When market structure is broken, it is a big thing
Another important thing to keep in mind is that once market structure is broken, we should take that extremely seriously. Take for example the next chart.
In the chart, the green line has been a support line for BTC for over a year. Once it got broken, the price fell by over 43%.
When you break market structure, prices tend to move sharply. This is because previous support levels that traders used to rely on no longer function, and the market scrambles, moves sharply, trying to find a new bottom.
Similarly, when prices break a historical resistance (specially previous all time highs), it is common to see sharp moves to the up side, as traders jump in on a stock out of fear of missing out (FOMO), trying to make a profit with the price move. There are no more boundaries or known resistance levels to hold the price back.
The lesson here is, when you suspect a break in market structure, you need to make sure you are ready for a potential big move.
Combine volume with market structure
It is common for prices to pierce historical trend lines for a short period of time, only to bounce off of them. However, one telltale which could help us determine of market structure will be broken is to look at the volume. Take the following chart as an example.
As you can see in the chart, the price broke the support line and stayed below it. This serves as the first clue that we will break the market structure as we did not have a quick bounce above the support line.
The second clue which increases the significance of the move is that the volume increased and stayed elevated after breaking the support line. This indicates that the move is a strong one with a lot of momentum behind it.
Therefore, it is important to keep an eye on volume when approaching any important levels on the chart.
Now that you have learned how to spot market structure characteristics, it is time to put your newly found skills to practice!. Therefore, I advise you that after you finish reading this article, that you go to your favorite trading platform and find out market structure characteristics for your favorite stocks and securities. Namely:
- Find out historically significant levels of support and resistance.
- Find out how the volume behaved when the price broke those historical chart lines.
- Can you tell the difference between a test of a historical level and when those levels are actually broken? How much lower or higher do prices go? Do you see a difference in volume activity?
In this tutorial, we discussed what market structure is in chart analysis. We discussed why such chart characteristics and levels are significant and what are the consequences of breaking historical support and resistance lines.
If you liked this post or if you have any questions, then please let me know in the comments section below 😉