Market Structure: The analysis we use to skip (and we shouldn't)

11 paź 2022

Hi traders, today we want to explain why market structure analysis is as important as a good entry signal strategy.

Note: For this article, we differentiate the entry signal from the market structure analysis. In some cases, the entry signal considers also the market structure but in these cases, we could easily split the set of rules into rules to define the market structure, and the rules to enter the market (entry signal). So we will consider it as two steps or phases.

One of the most common mistakes (which I did a lot in my trading early years) is that traders tend to focus on finding the best entry signal, the SL level, and the target, which is great but is only half of the work.

Only with this part and with proper risk management, you can be profitable. However, this is only the mechanical part of the trading strategy which, in most cases and especially if the entry signal is based on indicators, could perfectly be automated as these are only a set of rules (based on indicators or other technical analysis tools) that trigger the entry signal.

What it is as important as the SET (Stop, Entry & Target) is the analysis of the market structure of each asset. By that we mean that we should know:
- What is the current cycle of the asset? Where did the cycle start?
- Is it bullish or bearish?
- Is it impulsive or corrective?
- When and at what level this cycle is expected to end?
- Which structure this cycle has?
- and so on…

This is the part that was tougher for me to learn, and it is the part that requires more time and experience. Detect the subtle difference that very similar market structures can have and differentiating them will take you time. Do not misunderstand me, it is not rocket science, but it can be tricky.

The market does not use to move on perfect defined structures we can easily identify, most of the time it can be difficult to detect these structures.

We use the Elliot Wave principle mainly (but not only) to help us “find” the right market structure of each asset.

How we see the Elliott Wave principle (EWP) in one sentence would be:

It is a set of rules that help us to divide the market in impulse and corrections to know where and when each of these cycles has started and also to forecast when AND WHERE it is expected the cycle will end. It can sound not too much but believe me it is a lot.

Even though the Elliot Wave principle (EWP) rules are perfectly defined, to apply them on the chart would be not 100% objective and, therefore, the same rules can be applied differently by each trader on the chart. This is why it takes more time to identify the right way to interpret and apply the EWP rules to the chart and this is the reason why it is the part that used to take more time for the trader to be proficient in.

We see and use the EWP as a guideline or a map structure of the asset we are analyzing, (VERY IMPORTANT) we do not use EWP alone to enter the trade. We use it to know the structure of the asset and to infer the most probable direction that the price will take in the future. With EWP as the base of our trading strategy, we will use other analysis tools like the correlation between the different asset groups or the market dynamics to refine the assets that give us the maximum options of having a winning trade (after applying the entry signal strategy).

Another very important point we want to make clear from the beginning is that we should be flexible in our predictions. We do have a clear view of the structure that we think the market is having at this moment for each asset. However, we need to be prepared to be wrong, by that we mean that we need to know and be aware of what are (if any) the other potential structure the cycle we are analyzing can have. This is why we will not enter a trade based on the wave count only and we need the other tools we mentioned before.

Therefore, and to wrap it up for this lesson, EWP gives us a lot of crucial information that is the base of all our trading strategies. To summarize it and make clear how we use the EWP, we use EWP to:
- Know the Right side of the market for each asset (Long or Short)
- Detect whether the asset is in an impulsive or on a corrective cycle and its internal structure
- Project the zone where the asset is expected to end the correction (to apply there the entry signal strategy)
- Project the level where the impulse wave is expected to end (which would be different depending on the wave we are in) (Target)

All these will help us to find zones where we can apply our S.E.T. (Stop-Entry-Target) rules to maximize the overall return of our strategy as it will increase a lot our Winning percentage.

Have an amazing and successful trading day

TRS team