This special series originally appeared between Dec. 20 and Jan. 3 on Real Money Pro -- Click here to learn about this dynamic market information service for active traders.
In Wednesday's article, we identified what a balanced auction looks like. As a reminder, a balanced market is readily identifiable as a market that is consolidating, churning or rotating within a defined area. As a market transitions into balance, both buyers and sellers are in general agreement as to what price constitutes fair value.
The logical next step is to address the ways that you should trade such a situation. Successfully navigating a balanced market requires participants to fade, or trade against the edges of balance. Put another way, one must be able to identify the approximate area of acceptance (or value). Then, as price is auctioned toward the outer reaches of said area, one must be willing to trade in the opposite direction. As you can probably guess, a balanced market with limited directional follow-through can be a source of extreme frustration for a participant hell-bent on buying a breakout or selling a breakdown.
In addition to fading the edges of balance, an increased degree of importance is placed on a prior session's reference points. Examples of logical reference points are: a prior session's value area and volume point of control, past buying or selling tails, the regular-trading-hours high and low print or any applicable high or low volume nodes.
As you study the chart above, allow me to provide a bit of context. Prior the above chart's Oct. 29 start date, the E-mini S&P 500 had been trending higher since Oct. 10. In fact, the Es only traded beneath a prior session's intraday low once, in 14 days. It's fair to say that the bullish auction had become long in the tooth and some sort of inventory adjustment was overdue.
As you review the chart above, I'd like you to focus in on the trading from Oct. 31 (the last trading day on the chart). The first thing to take note of is the fact that the session opened inside of the prior session value area (2 on the chart above). An open inside a prior session's value area is an indication that no new information needs to be priced into the market. So, despite the volatility of the prior session, one's initial thoughts should have guided them toward a directionally neutral session.
We've all known traders who complain of buying the high or selling the low, right? Well, that's exactly what happens when one fails to recognize that a market is in balance. If you buy a breakout or sell a breakdown -- generally outside a composite value area -- within a directionally neutral market, the action will frequently result in an asymmetrical situation. But reward would not outweigh risk here. Instead, chasing price in a directionally neutral market will often result in risk far outweighing any potential reward.
Referring again to the chart above, make note of what happened after sellers probed levels beneath the prior session's lows. Lower prices did not attract additional selling; instead, they cut off supply altogether. This is characteristic of a market in balance. Anyone lured into the role of an initiative seller, or selling beneath value, was left with horrible trade location. The resulting move is a rotation back up through the prior session's volume point of control.
Once again, the above example is a clear-cut illustration of how initiative activity -- within the context of directionally neutral, or balancing, auction -- can result in horrendous trade location. As you can see, sellers of the mid-1740s ultimately propelled price higher as they were pushed back out of the market (the rise in price between points 3 and 4).
As with real estate, navigating a balancing market is all about location, location, location. In order to secure favorable trade location, one must have the discipline to remain patient. Instead of moving to meet the market, give the market the time to auction price to you.