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How to Find Important Price Levels on a Chart
06/14/2010 11:05 am EST
There are many aspects to short-term and longer-term trading. Where to enter, where to place your protective stop loss order, where to take profits, trade duration, risk management, position sizing, trade management, and much more are key considerations when trading. In my humble opinion, I would argue that the key to doing any of these things correctly comes down to where you are "entering" the market. Entering the market correctly means entering as close to the turn in price as possible. This allows you to put on the largest position size with the least amount of money at risk. And, by entering at the turn in price, you are farthest away from your profit target, which means the "reward" side of the equation is as great as it can be.
So, the question is, how can we determine where the market is going to turn with a high degree of accuracy? In short, price turns at price levels where supply and demand is most "out of balance." So, what does that picture look like on a price chart? The following are some (but not all) things to look for when identifying a price level where you should expect the market to turn in the future:
How Did Price Leave the Level?
The Logic: The stronger price moves away from a price level, the more out of balance supply and demand are at the level.
Price can move away from a level in one of three ways. First, it can be a gradual move away from the level. Second, it can be a strong move away from a level with big red or green candles. Lastly, price can gap away from a level. Obviously, the gap away from a price level is the strongest and represents the biggest supply and demand imbalance.
How Much Time Did Price Spend at the Level?
The Logic: The less time price spends at a level, the more out of balance supply and demand are at the price level.
This is contrary to conventional thought. Most trading books want us to look for price levels where lots of trading activity took place and price levels with lots of volume. Think about it, if price is able to spend lots of time at a level, supply and demand can't be that out of balance. The more out of balance supply and demand is at a price level, the fewer the transactions will take place. Less transactions means lower volume. So, we should look for levels where very little trading activity took place with less volume. Don't believe everything you read. Most thought the world was flat at one point; look where that herd mentality thinking got us.
How Far Did Price Move Away from the Price Level Before Returning to the Level?
The Logic: The farther price moves away from a price level before returning to that level, the greater the profit margin and probability.
When price moves far away from a price level before returning to that level, this means that the supply or demand level is typically far out on the supply and demand curve, far from equilibrium, which is exactly where we want our entries to take place. When supply and demand levels are far out on the curve, this means the rubber band is stretched, and the more it is stretched, the more likely it is to snap back. For example, if there is a supply level and price initially falls a great distance from it, two things make this a high probability and strong profit margin opportunity. First, because price fell far from this level, when it rallies back, we would be selling short to someone who is buying after a very large rally in price, which is a big mistake for the buyer. This is good news for the seller and increases the odds on that short entry. Second, we measure the distance from the supply level to the lowest low before price rallied back to the supply level (for our short entry) and this becomes one of our profit targets, which makes the reward side of the equation ideal. When it comes to identifying low-risk, high-reward, and high-probability trading opportunities, a solid understanding of the core concepts of supply and demand are the key to identifying where the most ideal entries into markets are.By Sam Seiden, instructor, Online Trading Academy
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