Market structure is a useful concept for traders to make sense of moves in the market. Identification higher highs, higher lows, lower highs and lower lows allow traders determine market structure.
- Higher highs and higher lows represent a bullish market structure:
- Lower highs and lower lows represent a bearish market structure:
When the market is in a bullish structure, the price action displays a series of higher lows and higher highs. When the market structure is broken, then it could provide a sign to go short on the asset.
A bullish market structure is invalidated once the higher low is broken and the price action will often enter a downward trend. When the bullish structure is broken, traders could go short.
Once the asset makes a lower high and then a lower low, it confirms the market structure as bearish. Alternatively, traders could wait until a lower high is established before going short instead of going short as soon as the higher low is broken.
A bearish market structure comprises lower highs and lower lows. A bearish market structure is invalidated when there is a break of the swing high and often turns into an upward trend, establishing a higher price level and then a higher low.
For instance, the chart below shows a bearish market structure which is invalidated by a break above the lower high. The market then displays higher highs and higher lows.
Traders could either enter a long position once there is a break above the lower high, or wait for a higher low to be established and confirm the bullish market structure.
When looking at different timeframes, it may be the case that the higher timeframe may have a bullish market structure while a lower timeframe may have a bearish market structure.
The higher timeframes are more important and traders should look for a break of the bearish market structure on the lower timeframe. In the reverse case where the higher timeframe has a bearish structure, and a lower timeframe has a bullish structure, traders should be on the lookout for a break of the short-term bullish structure and go short.
In sideways (or ranging) markets, the price action either displays: lower highs and higher lows (known as a triangle formation), or higher highs and lower lows (known as a widening formation).
In both cases, the direction is uncertain until the price action displays a series of lower highs and lower lows (or higher highs and higher lows).
Triangle formation (lower highs and higher lows)
The triangle formation often resolves itself in the triangle midpoint, where new trends often start.
Widening formation (higher highs and lower lows).
Often, a widening formation leads to a breakdown of the pattern by reversing the prior trend. For example, if the widening formation occurs after an uptrend, then the pattern is usually broken and results in a change in the trend leading into the pattern.
While breaks of market structure are not 100% accurate, it is a useful tool for understanding price action, as well as where buyers or sellers are gaining strength. In a bullish or bearish market structure, Fibonacci retracement levels can be used to identify potential higher lows or lower highs to determine entries into long or short position respectively.