Price Action Basics VII

Initiative, liquidation and responsive breaks Hi, fellow traders, let’s continue our studies in price action. Interpreting charts can be not very complicated, and I would say – good setups look pretty simple, but in most cases this simplicity requires astute eye and some practice.

Many of you are familiar with concepts of «overbought» and «oversold» market. Conventionally, if price is going up and momentum is slowing down, we see signs of overbought market, and, the opposite – when price is going down and momentum is slowing down, we see oversold market.

But is it fair for every market condition?

Market is a huge pie, where interests of different traders from different timeframes are crossing over. The overbought/oversold situation above occurs only when market is dominated by short-term traders. But let’s first get familiar with concept of domination. What doest it mean, that market is dominated by short-term traders? It does not mean that nobody is there except short-term traders, it means that they are the driving force for the market.

By the way, short-term trader does not necessarily mean lack of money on deposit. It only means that horizon of a trader is relatively small. In most cases, it’s short term traders who are responsible for initiative and liquidation breaks.

If you we see movement that is going to be highly volatile and starting from inside of the trading range, it’s probably a «cascading effect» - something that is created by «fear of missing out» - many traders are chasing this movement and will lead to fast auction, raising prices higher and higher. In auction market theory it’s called "initiative break", it means that something is happening very quickly, with significant expansion in volatility, and maybe – volumes. But volumes can be not interpreted easily in this case. When volume is increasing (or decreasing) inside of the trading range, this information can be misleading, because there are too many types of traders participating inside of the trading range – from algos to scalpers, and increased volume can be a result of those guys’ overtrading

What about "liquidation break"? This is the opposite to "initiative break". It occurs when traders who have been involved in the action (during initiative break) are closing their positions. Usually, volatility is also increasing, traders are scared due to some news announcement or they simply put their stops below similar levels again causing cascading effect. Really, there’s nothing new under the moon – traders often act like a herd, and they rarely try to find their own particular niche and instead do what is comfortable and conventional – say, buying on the moving market and selling on the falling market.

Now, what if market makes quick break from outside of the range of the day? It is called «responsive break». More often than not, responsive breaks represent activity of other timeframe traders who are building their positions using high prices (of course, short positions). We should take into consideration that other timeframe traders are not too urgent – they don’t want to push price down here and now, they understand that market has opportunity to go down in medium term time perspective and they want to be in this movement, but they are interested to accumulate inventory before the rally, that’s why they are acting upon a good price, but not expecting to get good timing for their trades.

So, responsive activity can be the sign of market that will at least hold near current prices for a while.

Why in the world do we need to know this? If you know market structure, if you know who is involved and what happened in the recent past, it would give you better understanding of possible opportunity (or it's absence)

For example, if you've seen that market has liquidated, and before that it has auctioned higher with initiative break, you can make conclusion that short-term traders were in, now they are out. Market has become more neutral and nothing really happens - market needs more information to generate movenent to whatever side.

Or if you see several responsive breaks to the downside, it can be possible indication of big player accumulating position. Does it mean that price will necessarily go in his favor? No, even big players are losing money, but if you see any setup confirming short position, your view may be supported by those attempts of responsive activity.