Chapter Three

The Right Price

Now we turn to the counter balance of volume which is price, and forgive me
for a moment if we return to Jesse Livermore and one of his many quotes
which I mentioned at the start of this book:
“there is nothing new in Wall Street. There can't be because speculation is as
old as the hills. Whatever happens in the stock market today has happened
before and will happen again”

Now to use and paraphrase this famous quote, I would say that there is
nothing new in trading. As I said in chapter one, Volume Price Analysis has
been around for over 100 years. The same is true when we consider the
analysis of price, and the only representation of price which truly changed
how traders studied and analysed charts was in the introduction of candlestick
charts in the early 1990's.
Fads come and go in trading. Something that was in 'vogue' a few years ago,
is no longer considered valid, and some 'new' approach is then promoted. One
approach which is being marketed heavily at the moment is 'price action
trading' or PAT. This is as it sounds. Trading using an analysis of price, with
no (or very few) indicators, which I find strange. And my reasons are as
follows.
Imagine suggesting to Jesse Livermore, Charles Dow, Richard Wyckoff, and
Richard Ney, that we had devised a new and exciting way to analyse the
markets. The ticker tape print out would now ONLY show the price, but NO
volume. I'm sure Jesse and the others would have been struck dumb at such a
suggestion. But don't worry. In this book I explain price action trading, which
is then validated with volume. So you get two approaches for the price of one
here! Now that's what I call value for money!!
However, I digress. Living close to London as I do, and just a stone's throw
away from The President, is the old LIFFE building, the London International
Financial Futures and Options Exchange. As a frequent visitor to this part of
London, I would often drive past this exchange, and at any time during the
day, would see the traders in their different brightly coloured jackets, dashing
out to grab coffees and sandwiches before rushing back to the floor of the
exchange. Without exception these were generally young men, loud and
brash, and in fact on the corner of Walbrook and Cannon Street there now
stands a bronze statue of a floor trader, mobile phone in hand. These were the
days of fast cars, and aggressive trading, and it was ironic that this was the
world where I started my own trading career, with FTSE 100 futures orders
filled on the floor of the exchange.
This was the world of adrenaline pumped traders, yelling and screaming
using unintelligible hand signals, buying and selling in a frenetic atmosphere
of noise and sweat. It was positively primordial where the overriding emotion
emanating from the floor was fear, and obvious to anyone who cared to view
it from the public gallery.
However, the advent of electronic trading changed all of this, and the LIFFE
exchange was one of many casualties. All the traders left trading and moved
away from the pit, and onto electronic platforms. The irony is, that most of
the traders, and I have spoken to many over the years, failed to make the
transition from pit trading, to electronic trading, for one very simple reason.
A pit trader, could sense not only the fear and greed, but also judge the flow
of the market from the buying and selling in the pit. In other words, to a pit
trader, this was volume or order flow. This is what a pit trader saw and
sensed every day of the week, the flow of money, the weight of market
sentiment, and the trading opportunities that followed as a result. In other
words, they could 'see' the volume, they could see when the big buyers were
coming into the market and ride on their coat tails. This is the equivalent of
volume on the screen.
However, without being able to see, judge, and feel the flow in the pit, most
of these traders failed to make a successful transition to screen trading. Some
succeeded, but most were never able to make that move, from an
environment where price action was supported by something tangible.
Whether they would call it activity, order flow, sentiment, or just the 'smell of
the market' this is what brought the price action to life for them, and why they
struggled to succeed with the advent of the electronic era.
Pit trading still continues today, and if you do get the chance to view it in
action, I would urge you to go. Once you have seen it for real, you will
understand why volume is so powerful in supporting price, and why I believe
the exponents of PAT are simply promulgating something different for the
sake of it.
Whilst it is undoubtedly true to say that price action encapsulates all the
news, views and decisions from traders and investors around the world, and
that with detailed analysis we can arrive at a conclusion of future market
direction, without volume we have no way of validating that price analysis.
Volume gives us our bearings, it allows us to triangulate the price action and
to check the validity of our analysis. This is what the pit traders of old were
doing – they would see a price move, validate it by considering the order
flow in the pit, and act accordingly. For us, it is the same. We simply use an
electronic version of order flow which is the volume on our screens.
But, let me give you another example.
Returning to our auction again, only this time there is no physical sale room.
Instead we are joining an online auction, and perhaps now you can begin to
imagine the problems that the ex pit traders encountered. We have moved
from the physical sale room, where we can see all the buyers, the number of
people in the room, the phone bids and the speed of the bidding. In a physical
sale room we also get a sense of where the price starts to pause. We see
bidders become fearful as the price approaches their limit and they hesitate
with the next bid, just fractionally, but enough to tell you they are near their
limit. This is what the pit traders missed.
In an online auction we are logged in and waiting for the auction to start. An
item we want to buy appears and we start bidding. We have no idea how
many other bidders are there, we have no idea if we are playing on a level
playing field. All we see is the price being quoted. The auctioneer, for all we
know, could be taking bids 'off the wall' (fake bids in other words) which
happens more often than many people think. The reason is that all good
auctioneers like to encourage auction fever – it’s good for business, so they
use every trick in the book.
Meanwhile back to our online auction. We continue bidding and eventually
win the item.
But, have we got our item at a good price? And, in this scenario we are only
referring to price and not value, which is a very different concept. Besides, I
hope by now, you are beginning to get the picture. In the online auction all
we see is price.
Therefore, in a real online ‘auction’ of trading, do we really want to base our
trading decisions solely on price? Furthermore, the great iconic traders of the
past would have given us their answer, and it would have been a very
emphatic NO.
Once again I accept it is an imperfect example, but one which I hope makes
the point.
To me, a price chart with no volume is only part of the story. Price does
encapsulate market sentiment at a given and precise moment in time, but with
so much market manipulation prevalent in so many markets, why ignore such
a valuable tool which is generally provided free.
Whilst price is a leading indicator, in itself, it only reveals what has gone
before, from which we then interpret what is likely to happen next. Whilst we
may be correct in our analysis, it is volume which can complete the picture.
In a manipulated market, volume reveals the truth behind the price action. In
a pure market, volume reveals the truth behind market sentiment and order
flow.
So, let's take a closer look at price, and in particular the effect that changes in
technology have had on the four principle elements of a price bar, the open,
the high, the low and the close. And the most significant change in the last
few years has been the move to electronic trading, which has had the most
profound effect on two elements of the four, namely the opening and closing
prices.
Scroll back to the days of Ney and earlier, and the markets in those days only
traded during a physical session. The market would open when the exchange
opened, and close when the exchange closed at a prescribed time. Trading
was executed on the floor of the exchange, and everyone knew when the
market was about to open or close. This gave the opening and closing prices
great significance, particularly on the open and close of the day. The opening
price would be eagerly awaited by traders and investors and, as the closing
bell approached, frenetic trading activity would be taking place as traders
closed out their end of day positions. This is now generally referred to as
regular trading hours (RTH), and is the time the exchange is physically open.
Whilst this principle still applies to stock markets around the world, with the
NYSE trading from 9.30am to 4.00pm, and the LSE open from 8.00 am until
4.30 pm, what has revolutionised the trading world is the advent of electronic
trading.
The platform that really changed the game was Globex, introduced by the
CME in 1992, since when virtually every futures contract can now be traded
24 hours a day. Whilst the cash markets, such as stocks, are restricted to the
physical time set by the exchange, what has changed, certainly with regard to
this market, has been the introduction of electronic index futures, which now
trade around the clock. What this means, in effect, is that the opening and
closing prices of the cash market are now far less important than they once
were.
The reason is simply the introduction of Globex, as electronic trading has
become the standard for index futures, which are derivatives of the cash
market indices. The ES E-mini (S&P 500) was the first to be introduced in
1997, followed shortly afterwards by the NQ E-mini (Nasdaq 100) in 1999,
and the YM E-mini (Dow Jones 30) in 2002. With these index futures now
trading overnight through the Far East and Asian session, the open of the
cash index is no longer a surprise with the futures signalling overnight market
sentiment well in advance. By contrast, in the days before the advent of
electronic trading, a gapped open, up or down, would have given traders a
very strong signal of market intent. Whereas today, the open for the major
indices is no longer a great surprise as it is forecast by the overnight futures
markets.
Whilst it is certainly true to say that individual stocks may well react for a
variety of reasons to sentiment in the broad index, generally all boats tend to
rise on a rising tide, and therefore likely to follow suit. The open and the
close for individual stocks is still significant, but the point is that the index
which reflects market sentiment will be broadly known in advance, making
the open less relevant than it once was.
The same could be said of the closing price. When the physical exchange
closes, stocks are closed for the day in the cash markets, but electronic
trading continues on the index future and moves on into the Far East session
and beyond.
This facet of electronic trading also applies to all commodities, which are
now traded virtually 24 hours a day on the Globex platform, and both
currency futures, and currency spot markets also trade 24 hours a day.
The electronic nature of trading is reflected in the price chart. Twenty years
ago, gap up or gap down price action would have been the norm, with the
open of a subsequent bar closing well above or below the close of the
previous bar. These were often excellent signals of a break out in the
instrument, particularly where this was confirmed with volume. Such price
action is now rare, and generally restricted to the equity markets, which then
catch up when the physical exchange opens the next day. Virtually every
other market is now electronic such as the spot forex market, and as we have
just seen, indices catch up with the overnight futures as do commodities and
other futures contracts.
The open of one bar will generally be at exactly the same price as the close of
the previous bar, which reveals little. This is one of the many effects that
electronic trading is now having on price action on the charts, and is likely to
continue to have in the future. Electronic trading is here to stay, and the
significance of these elements of price action in various markets will change
as a result.
If the market is running 24 hours a day, then the open of one bar will simply
follow the close of the previous bar, until the market closes for the weekend.
From a price action trading perspective, this gives us little in the way of any
valid 'sentiment' signals, which makes volume even more relevant in today's
electronic world – in my humble opinion at any rate!
However, let's take a look at an individual bar in more detail, and the four
elements which create it, namely the open, the high, the low and the close,
and the importance of these from a Volume Price Analysis perspective. At
this point I would like to say that the only price bars I use in the remainder of
this book, and in my own trading are candlesticks. This is what Albert taught
all those years ago, and it is how I learnt.
I have tried bar charts and thought I could dispense with candles. However, I
have returned to candles and do not plan to use any other system, for the
foreseeable future. I do understand that some traders prefer to use bars, line
charts, Heikin Ashi, and many other. However, my apprenticeship in Volume
Price Analysis was with candlesticks and I believe its true power is revealed
when using this approach. I hope, by the end of this book you too will agree.
Therefore, I want to start by dissecting a typical candle and explain how
much we can learn from it. In any candle, there are seven key elements. The
open, high, low and close, the upper and lower wicks and the spread as
shown in Fig 3.10. Whilst each of these plays a part in defining the price
action within the time frame under consideration, it is the wicks and the
spread which are the most revealing in terms of market sentiment, when
validated with volume.
Fig 3.10 A Typical Candle

Perhaps the simplest way to visualise the price action contained within a
candle, and is applicable regardless of timeframe (from a tick chart to a
monthly chart), is to display the price action, as a sine wave, with the market
oscillating back and forth, as buyers and sellers battle for supremacy.
The image in Fig 3.11 is a visual representation of this price action and in this
case it is the buyers who are triumphant. However, the price action could
have taken a different journey in creating this candle. It is the completed
candle which is important.

Fig 3.11 Price Action As A Sine Wave

Let's start with the spread which reveals the sentiment for that session.
A wide spread between the open and the close indicates strong market
sentiment, either bullish or bearish, depending on whether the closing price
finished above the opening price or below it.
A narrow spread between the open and the close indicates sentiment which is
weak. There is no strong view one way or the other. The wicks to the top and
bottom are indicative of change. A change in sentiment during the session.
After all, if the sentiment had remained firm throughout, then we would have
no wicks at all. This is the equivalent of our online auction, or physical
auction, where the price opens at one level, and closes at a higher level once
sold. The price action would simply create a solid candle with no wick to the
top or the bottom, and in the context of trading, suggesting strong and
continued sentiment in the direction of the candle.
This is the power of the wicks and why, when used in combination with the
spread, reveal so much about true market sentiment. It forms the basis of
price action trading, which is perfectly valid in it's own right.
However, why stop at this point and refuse to validate that price action with
volume? This is something I simply cannot understand and perhaps any PAT
traders reading this book can convince me otherwise. Just drop me an email
as I am always happy to learn.
So, as you can see, the length and context of the wick, whether to the upside
or the downside is paramount in Volume Price Analysis, and the easiest way
to explain this is to consider some further visualisation examples, which will
help to make the point.
Let’s take two examples and the first is in Fig 13.12. Here we have a wick
where the price has opened, the market has moved lower, and then recovered
to close back at the open price. In the second example in Fig 13.13 we have a
wick where the price has opened, the market has moved higher and then
moved lower to close back at the open.
Let's analyse what's happening here with the price action and market
sentiment. In both cases we can be certain that this is the profile of the price
action, since the closing price has returned to the original opening price. So
there is no guesswork. It is true that within the price action, there may have
been ups and downs, pull backs and reversals, but at some point in the
session, the price action hit a low, or a high and then returned to the original
starting point.

Lower Wick Example

Taking the lower wick example first, the price bar opened and almost
immediately sellers were in the market forcing the price lower, and
overwhelming the buyers. Perhaps within the move lower, there were pauses
and brief attempts to rally, which would have been seen perhaps in faster
time frames, and a key part of trading. However, in this session, as far as we
are concerned, the sellers remained in control throughout the first part of the
candle’s creation.
At some point during the course of the session, the buyers started to come
back into the market, wrestling control from the sellers as the market price
had now become an attractive buying proposition. Gradually near the bottom
of the price bar, the sellers finally give up, having been overwhelmed by the
buyers who gradually take control. Now it's the turn of the sellers to be under
pressure, as more and more buyers flood into the market, overwhelming the
sellers and taking the price back higher once again, to finally close at the
opening price.
But, what does this price action reveal? And the answer is two very important
things.
First, that in this session, whatever the time frame may have been, there has
been a complete reversal in market sentiment. Why? Because the selling
pressure that was in evidence during the first part of the candle’s creation, has
been completely overwhelmed and absorbed in the second half.
Second, that the sentiment on the close of the bar is bullish – it has to be,
since we know that the price action closed at the open, so at the instant of
closure, the price must have been rising, supported by all the buying pressure
underneath.
Does this mean that this is signalling a reversal in any trend? The short
answer is no, and you will discover why once we start looking at volume,
which will then give us the complete picture. At the moment we are simply
considering price action which is only half the picture, but the point I want to
make, is that the wick on a candle is EXTREMELY important, and a vital
part of Volume Price Analysis, as is the spread. In this case the spread was
zero, which is JUST as significant as any large spread of the candle.
I hope that the above example has helped to explain what is happening
'inside' the candle with the associated price action. This is a very simple
example, with the price action split symmetrically into a 50/50 window.
Nevertheless, the principle holds good. The price action may have been split
into a 25/75 or even a 15/85, but the point is this – the sellers were
overwhelmed by the buyers during the course of the session that the candle is
representing.
This now brings me on to another area of volume analysis which we are also
going to consider later in the book. I've already mentioned Volume Price
Analysis or VPA several times so far, which is the relationship between
volume and price over the entire life of the candle, but what happens within
the life of the candle for example. Where is the buying and selling actually
taking place, and this is called Volume At Price, or VAP for short.
Whilst VPA focuses on the 'linear relationship' between volume and price
once the candle has closed, VAP focuses on the volume profile during the
creation of the price bar. In other words, 'where' has the volume been
concentrated within the associated price action.
We could say that VPA is our big picture of the volume price relationship on
the outside of the candle, whilst VAP gives us the detail of the volume
profile, 'inside' the candle. This helps to give us an additional perspective on
our 'outside' view – two views of the same thing, but from different
perspectives, with one validating the other. A further triangulation of the
volume and price relationship.
Now let's look at our other example, which was the upper wick example.

Upper Wick Example

In this example the market opened with the buyers immediately taking
control, forcing the price higher, and overcoming the sellers, who are
compelled to admit defeat under the buying pressure. However, as the session
develops the price action reaches a point at which the buyers are beginning to
struggle, the market is becoming resistant to higher prices and gradually the
sellers begin to regain control.
Finally, at the high of the session, the buyers run out of steam and as the
sellers come into the market, the buyers close out their profits. This selling
pressure then forces prices lower, as waves of sellers hit the price action.
The candle closes back at the open price and the session closes. Once again,
there are two key points with this price behaviour which are fundamental.
First, we have a complete reversal in market sentiment, this time from bullish
to bearish. Second, the sentiment at the close is bearish, as the open and
closing price are the same.
Again, this is a stylised view of the price behaviour. Nevertheless, this is
what has happened over the session of the candle, and it makes no difference
as to what time frame we are considering.
This could be a candle on a tick chart, a 5 minute chart, a daily chart or a
weekly chart, and this is where the concept of time comes into play. This type
of price action, accompanied with the correct volume profiles, is going to
have a significantly greater effect when seen on a daily or weekly chart, then
when seen on a 1 minute or 5 minute chart.
This is something we will cover in more detail in the next few chapters.
But, what does this price action look like on a price chart in candle form?

Lower Wick Example

Although the resulting candle doesn’t look very exciting it actually represents
one of the most powerful price actions that you will find on any chart,
particularly when volume analysis is added to it. Price action and volume
then tell us where the market is likely to go next.
And here is another, equally powerful candle.

Upper Wick Example

Fig 3.15 Candle Resulting From Upper Wick Example

Now this is where, for price action trading, the book might stop. After all, we
can now visualise the buying and the selling simply from the price action of
the wick on the candle. But what of course this does NOT reveal, is the
strength of this price action, and perhaps even more importantly, whether this
price action is valid. Is the price action genuine, or is it false, and if it is
genuine, what is the strength of any consequent move likely to be. This is
why I feel price action trading only tells half the story. It is volume which
completes the picture. And in the next chapter we start to consider volume
from first principles.