There are 3 universal laws within trading. In previous articles we have discussed The Law of Demand and Supply and the Law of Cause and Effect. Today we will discuss the third law; The Law of Effort vs. Result a simple concept, yet the most powerful or should I say the most practical out of the three laws and used daily (if one trades in an intraday environment).
Understanding the Laws
One can look at the laws through the following lens; The Law of Supply and Demand is the theory of price movement with The Law of Cause and Effect giving us the patterns of price movement, as in the natural rhythms of the market from a macro perspective; trading range into breakout (the trend) back to trading range into breakout and so on. Cause and Effect is also useful once a position has been initiated as we have potential targets in mind, or one can gain vital data if the effect is not in line with the cause (out of sync).
The Law of Effort vs. Result
This leads us nicely into our new law that is Effort vs. Result; the amount of effort (being volume) should be in sync with the result via the price action (the bars spread, from high to low) The two have a symbiotic relationship: large volume (effort) should produce a large spread (result) they work together in harmony, however once the price/volume relationship is out of sync/violated or not in harmony, our ears must perk up and pay close attention to the market, especially if we are at a structural location.
To determine whether a case of Effort vs. Result is present we must compare the bar in question to previous bars spread and volume, as these are our reference points, our gauge to determine whether the price/volume relationship is compromised.
The Law of Effort vs. Result may appear similar to that of Cause and Effect as we are looking for anomalies; however the application is vastly different. With Cause and Effect we measure the Cause from a macro perspective using multiple bars, as in a trading range, an apex, a flag or any other form of price containment pattern, where as with Effort vs. Result we apply on individual bars within the market, ergo we are much closer to the market therefore our law has an immediate effect.
Comparative and Relative Analysis
To use Effort vs. Result effectively we use a tool aptly named ‘comparative and relative analysis’ the trader will compare the spread and volume to other local bars say the last 10, 15 or so (comparative) and the same bars relatively, as in the bars that are similar in nature say 30, 40, or 50 back.
What do I mean by the bars being the same in nature? Example; if price is at support where we have had 3 previous touches the trader would compare the spreads and volume of each touch (relative analysis). Yet at the last touch we would also compare the local bars for spread and volume – this being comparative analysis.
Example: (helps to draw) price is falling to support with narrow spreads, closes off the lows and declining volume, touch support and print a wide spread up bar closing firm with over average volume – we would say that demand is in control for these local bars, we have evidence of buying at support and disconfirm supply with the narrow spreads and declining volume, everything is good, as it should be.
Now for the extreme; the market has had two previous touches of support that ends in a solid bounce (example above) yet for the third touch we approach support with selling of good quality; wide spreads closing weak and high volume. Price touches support for the third time and the market prints a narrow spread up bar with higher volume than the supply bars on the approach, here lies our anomaly, something is amiss, we have a case of Effort vs. Result via the small narrow spread up bar at support with very high volume, the spread/volume relationship is out of sync. When this action occurs the trader must be very attentive and carefully analyse each bar thereafter to establish what the anomaly meant (if anything).
How this law gives you an edge
The question remains, how does The Law of Effort vs. Result provide the trader with an edge? Extreme cases of Effort vs. Result (if contextually correct) one can initiate a position instantly via the close, a complete setup that has extremely high odds. Day to day trading Effort vs. Result can often provide the trader tell tale signs of market turns, ergo reversal plays, as the Effort vs. Result bar contains the opposing force of the trend and therefore alerts us to a potential pullback and or/market turn. If the trader is in position one can cover or initiate a counter trend play.
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Going forward as our bases have been covered via the 3 Universal Laws of trading, we will incorporate the laws into trading opportunities within the current markets, across all time frames and asset classes.