Law #1:
The markets are fractal in nature. That is, they display similar states and patterns in
all degrees of time. Whether you’re looking at one day’s action on a 1-minute time-frame, or 3
year’s action on a daily time-frame, the same principles and types of patterns are at play. In
fact, if we were to show you a chart without showing you the x-axis and y-axis and their labels,
you wouldn’t be able to tell if the chart is of a time-frame spanning years, or one spanning
minutes.
Law #2:
In any given time-frame, the markets can either be trending or balancing. There’s
one of two things the markets can do. They can facilitate trade at a given range of prices
agreed to be value by the aggregate forces of buyers and sellers (balance), or they can move
directionally in search of new value areas as one side overpowers the other for a sustained
period of time (trend).
Law #3:
Price moves in a series of thrusts and corrections. Prices don’t move straight up or
down. They first make a directional move, then hit a stopping point, which forms a swing high
(in the case of up moves). After the stopping point, price moves counter to the directional
move in a corrective action. The correction can be vertical, in which case it is often called a
‘pullback’, or horizontal (correction in time instead of price), in which case it is a balance or
trading range on the time-frame that is smaller than the directional move.
Law #4:
Price discounts all information efficiently, but not perfectly. Any information that
becomes known about a market gets factored into the price very quickly. That is why it’s a
losing proposition to trade based on rumors, tips, analyst opinions, and otherwise. If it’s
publicly available information, the price has already likely discounted it and there is no edge in
trading based on it. On the other hand, since price is not perfect at discounting all information
(because the market participants are emotional human beings who are not perfectly rational),
the market can often overreact to information and go too far in one direction or the other.
These inefficiencies often end up being great trading opportunities.
Law #5:
Trends start from balance areas or after major climaxes. The majority of the time,
trends start from balance areas. They breakout to one side or the other of the balance area, as
either the buyers or the sellers overpower the other side. The other side often gets caught on
the wrong side of the market and is forced to exit their losing positions quickly, which adds to
the initial momentum of the new trending move. When trends start after major climaxes, one
side (either the buyers or the sellers), gets too emotional and either buys out of hope and
greed at prices that are too far above true value, or sells out of fear at prices that are too far
below true value. In both cases, the other side aggressively responds to the price being too far
from value and the price snaps back quickly the other way. Here too, the late buyers or sellers who were acting on emotion get stuck in losing positions and are forced to exit quickly, further
intensifying the price reversal and new trend.
Law #6:
A trend in motion tends to stay in motion. The laws of physics help us understand that
when an object is in motion, it will take a major force in the opposite direction to stop its
motion. The same is true in the case of trends, and because one side is aggressively moving the
market with directional conviction, often based on underlying economic factors, it will take a
major force from the other side or a change in character to get the trend to stop. Explained
from another angle, crowd psychology ensures that once a trend is in motion, other
participants will be attracted to it for no other reason than the need to conform and join the
masses. Social proof is powerful, and it tends to keep trends in motion.
Law #7: Trends end in climax or balance. This law follows naturally from Law #5. If trends start
after a climax or a balance, then they must also end in a climax or a balance. So the trend will
keep going until buyers and sellers reach a point of equilibrium and prices start balancing, or it
will keep going until it attracts the laggards (the uninformed masses) who pile in emotionally
and move prices too far in that direction- causing a climax when the other side responds
aggressively to price being too far away from true value.
Law #8: High volume on the vertical scale signifies directional conviction and a rejection of
value. It’s the major institutions who start moves, because major moves need a large volume
of orders as their fuel, and the large volume of orders comes from the institutions with millions
and billions of dollars to spend. Once they commit to a certain direction with conviction, their
orders create large volume in any given time-period, which shows up as large vertical volume.
This volume fuels a move away from currently established value, and often is the cause of new
trends that go on to move price to a new value area. However, once a trending move is already
established, it can keep going without large volume because of its momentum and crowd
psychology. Finally, high vertical volume coming after a sustained directional move often marks
a climax, and the directional conviction it points to is that of the uninformed retail crowd,
which is wrong the majority of the times.
Law #9:
High volume on the horizontal scale signifies value. When the market spends time in
a certain price range, trade is transacted there. The more time and volume gets transacted in
an area, the more that area becomes a place that signifies an agreement between buyers and
sellers of what value is. The price range becomes accepted as a value area. Value areas can be
formed on any given time-frame, from a small 1 minute intraday time-frame that has a value
area spanning several hours, to a large daily time-frame that has a value area spanning several
months. Remember, the markets are fractal in nature.
Law #10: Previous market behavior influences current market behavior. Since the market is
made up of people, and these people are all looking at the same charts, important highs and
lows will be seen by everyone, and many people will buy or sell at these areas simply in
anticipation of others doing so. In that sense, we get a self-fulfilling prophecy. In another
important sense, previous market behavior (which can be referred to as market structure),
influences current market behavior because of the very real reason that the previous behavior
was simply showing which side was in control of the market and to what extent, and now as
we revisit those areas the same participants may still have the same view and have more
orders to fill there. Also, those that previously missed the move may now elect to get in there,
and those that were caught on the wrong side of the move may elect to exit their position if
given the chance. All of this often causes the market to react at certain places where it had
reacted before.
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