Part 1 - A Beginner's Guide to Breakdown TheoryThe Concept Of Supply & Demand
The price movement of the security is the result of demand(buyers) & supply(sellers):
If the supply is more than the demand, there are more sellers than buyers than sellers, which results in a price fall.
If the demand is more than the supply, there are more buyers than sellers, which results in a price surge.
If the demand equals supply, price consolidates in the range.
Demands = supply
This is an equilibrium area in which demand and supply are equal. The price forms the value area, where both buyers and sellers are equally satisfied with the current price movement. Neither buyer is looking for a price surge nor the bear is waiting for the plunge, at least for some time. The supply and demand are a deadlock or clueless about the upcoming dominance.
Let's take an example to understand these supply and demand conditions:
- The provided chart of TESLA shows a real-time example of the supply and demand effect on the price. In the beginning, Demand pressure was more than Supply pressure, and The stock started rising as buyers outnumbered sellers. As the stock price rose, some buyers started losing interest in purchasing more shares due to the high price. Eventually, the demand and supply pressures reached equilibrium.
- At this point, both buyers and sellers were satisfied with the price movement, as the demand matched the available supply. At high prices, sellers began to take advantage of the situation by selling their stock, leading to a decrease in price. The supply of stock exceeded the demand, and buyers were unable to respond with further bullish moves.
Elements Of The Breakdown Theory:
(1) Value Area:
As the name implies, the value area is the price zone where most trading activities happen. In the value area, buyers and sellers are satisfied and agree with the current price movement. Purchasers are Neither interested in the further price surge nor do sellers agree to a decline in the price during the equilibrium period.
Value area includes two boundaries:
Upper boundary: It represents the supply pressure, which stops the security of the price rise. If the stock crosses down the upper band with volume, the price may be ready for a bearish move. The price signals a weak structure if it fails to trade above the upper band for a long time. This structure is a bearish move.
Lower boundary: It illustrates the demand pressure, which stops the security of the price fall. If the stock crosses up the upper band with volume, the price may be ready for a bullish move. The price signals a strong structure if it fails to trade above the lower band for a long time. This structure is a bullish move.
(2) Excess:
The excess price can be identified above the upper band and below the lower band. It shows a clear rejection of a certain price level and it reacts as support and resistance levels. It indicates the intuition of long-term traders.
The price spends minimal time outside the value area. It tends to reverse its direction and move back inside. It can create an opportunity for traders to sell above and buy below the value area.
For example, the price falls below the lower band but then reverses the movement. Traders can take advantage of this by buying the security with a tight stop loss, aiming for targets up to the upper band or potentially higher.
- The provided chart depicts the daily timeframe of SHREECEM stock from May 1999 to July 2001 . During this period, SHREECEM experienced four excess at the upper boundary and three at the lower boundary of the value area. At 3rd excess of the lower boundary, buyers couldn't respond by a strong bullish move, and sellers rule the movement by supply pressure.
How to draw value area/ Equilibrium?
Step 1 : Obtain a price chart of the tradable instruments(stock, commodity or forex, etc.) with a suitable time frame. As per my observation, daily and, or lower is better.
Step 2 : Look for an area on the price chart where the price is moving within a specific range.
Step 3 : Mark the trading area with the highest trading activity with good volume, which will be marked as a value area.
Step 4 : Mark the area with relatively low trading activities where the price couldn't stay for too long at a certain level, which will be marked as excess.
Step 5: Clearly separate the value area from the excess price areas to visually distinguish between the two.
Step 6 : Observe the repetitive up and down movements within the value area.
Step 7 : Extend value - boundaries rightward on the chart. Observe how price reacts near boundaries for future insights.
Example 1:
- AAPL has formed five price excesses, two above the upper and two below the lower boundary. After selecting the chart, I separated the excess from the price zone.
- Generally, We need to find a price range where most prices touch the upper and lower boundaries. Any prices above the upper boundary or below the lower boundary are considered excess.
Example 2:
- In another Apple chart, the price has formed three excesses. The first excess happened when bulls couldn't overcome the volume of sellers and ended up losing momentum. The second excess occurred when sellers were unable to break below the lower band and lost their strength. At the third excess, AAPL couldn't generate bullish volume, and sellers dominated the selling.
Finally, the price fell to the lower boundary, and bulls responded with a massive volume. Demand exceeded supply, and sellers were outnumbered.
Example 3:
- In the hourly timeframe chart of AMZN, the stock was experiencing a downward trend and entered a consolidation phase. Two excesses were observed, one at the upper boundary and the other at the lower boundary.
- At the second excess, bulls responded with a sharp decline, but they were unable to maintain their momentum above the upper band. This lack of sustainability in their upward move increased the confidence of sellers, leading them to drive the price down for a longer duration. Sellers increased the supply and pushed the price of AMZN down with a gap and strong volume.
Example 4:
- It is the EURUSD 4-hour timeframe chart. EURUSD has more than nine price excesses, with five above the upper boundary and four below the lower boundary. The 5th excess marked the most significant response from buyers, countered by sellers. Subsequently, the length of the excesses decreased.
- At the 9th excess, the buyers' initiative to push the price above the upper boundary couldn't be sustained, as the sellers' trading volume exceeded that of the buyers.
In the next part, we will delve into the other components in more detail.
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