The First Principles of Trading: Brackets, Trends, and Mean Reversion
- Shantanu R Nakhate
- Mar 1
- 7 min read
The capital market can seem complex, but at its heart lies a simple mechanism: the interplay of brackets and trends. These aren't just lines on a chart; they're the fundamental building blocks that drive price discovery every minute of the trading day, across every timeframe imaginable. Understanding these principles is crucial for any trader looking to navigate the markets successfully. This basic building block itself is the first principle of trading.
Let us see how a bracket in monthly charts looks like
The monthly candlestick chart of ABC Company is shown above. From July to March, the closing prices on a monthly basis are confined within a specific range, with a high point of 1098 and a low point of 833.3. From September to March, the closing prices are consistently bounded by the 988 level.
This pattern forms a bracket on the monthly chart, defined by the bounds [833.3, 1098], where 833.3 represents the low, 1098 represents the high, and the bracket spans 9 months (or 9 candles).
A trend eventually forms in the subsequent months or weeks, breaking above the high level of the bracket. This is known as a breakout point (a positive breakout point).
Now, let's examine the same stock's chart in the daily time frame. You can clearly see a trend forming there as well.
A trend is seen by drawing a trend line by connecting low points of the candle and the next best day low. The best day here is the one which broke the monthly breakout levels.
Let's consider another example with stock XYZ in the monthly time frame. From September 2019 to November 2020, the closing price consistently remained within the 17.85 level. In December 2020, the stock broke through the 17.85 level.
In June 2019, the stock reached a high of 36.58. However, in July 2019, it experienced a mean reversion, dropping below the 17.85 level.
Mean reversion is a powerful concept in financial markets. It suggests that prices tend to return to an average level over time, preventing extreme deviations from a stable range. This phenomenon helps maintain balance and control in large systems.
The concept of mean reversion forms the basis of the second principle of trading. A buyer with strong long-term conviction had entered the market in June 2019. By July, this buyer had exhausted his/her purchasing power or risk tolerance, leaving no immediate buyers in the market. So, in July 2019, since there were very few buyers the mean reversion occurred.
Eventually the stock price consolidated, testing the psychology of the buyer of July 2019.In March 2021 it finally broke the Max high level of 36.75 which was driven by June 2019 buyer. This meant that the thesis found by buyer of June 2019 is now acceptable by the broad market participants. The market then took out the levels of 36.75 with extreme confidence, forming the candle pattern as shown below. It formed an unstoppable trend in monthly time frame.
If the price levels ever had fell below the 36.75 level, it would signal an extreme mean reversion force that could potentially drive the stock price to zero.
To capitalize on the phenomena of brackets and trends and effectively transfer money from the charts to your account, you need to develop a robust strategy or process.
Sample Strategy/ Process
A basic trading strategy should include three key elements: Position Size, Buy Level, Sell Level, and Stop Loss Level.
For the XYZ company, in the first trade, you can set the Buy Level at 17.85, the Sell Level at 36, and the Stop Loss Level at 17. For the second trade, you can set the Buy Level at 36.8, leave the Sell Level undefined to let the trade run as long as the trend remains intact, and set the Stop Loss Level at 35.
Below is the daily time frame chart for the same stock, XYZ. In December 2020, the stock confidently broke through the 17.85 level on a daily basis. It then formed a bracket around the 36.75 level in the daily time frame. A practical approach for implementing the second trade would be to buy above the breakout level of this daily bracket formation, around the 36.75 level, and set the stop loss at 36.
Why go through all of this?
You may not have the expertise to fully understand the underlying asset, and there are numerous human biases to overcome. Additionally, a myriad of factors can influence price movements in the market. By following a well-defined process with clear stop-loss levels, entry levels, and target levels, you can maintain the integrity of your portfolio. This approach allows you to capitalize on gains from market exposure and ensures that you utilize your capital in the most controlled and effective manner possible.
Let us now look at a 3 screen charts, which have 3 different time frames. Monthly, Weekly and Daily.
This shall further help us in understanding the bracket and trend mechanism, the first principle of trading.
Below is the COAL INDIA stock price chart in 3 screens.
In above screen you can clearly visualize the past as it happened in various timeframes.
On 7th of September 2023 the dominator candle arrived with the hand of confidence, crossing the 248.15 levels and dictated the rest of the trend that eventually formed. If ever, the levels of 248.15 were broken on closing day basis after 7th September 2023 close, the stock price would likely have reverted back to the monthly bracket.
The picture is taken in hindsight and hence it may feel good to the person studying or seeing above charts and thinking of getting an easy double for their money in a year. So let me disappoint you now and say that it is only a feel-good picture. It is not going to make you money unless you implement the process exactly as per who you are and as per what you learn from this blog. What we are learning here is the bracket and trend mechanism. We want to see bracket and trend in various timeframes to make quality decisions. The game is teaching us how to play the game. It is good to note that this place does not understand English or any other language in this world on which your thesis, your convictions are created either, based on wrong or right information.
Notice that in the above charts, the daily timeframe consistently trends upward until February 2024.
Weekly charts also show strong trend and then around March 2024 we start to see a bracket formation in weekly charts and also the monthly charts. Bracket Bounds [402.5,487.6]
We can observe the price oscillating around the 444.69 level. This area is referred to as the value region for the stock, representing the market participants' best estimate of its fair value at this particular time. The underlying asset, in this case, Coal India, generates revenue through its core business operations in the physical realm, such as mining and processing coal. Additionally, it may hold valuable land assets and enjoy certain monopolistic advantages. Fluctuations in coal prices, driven by high demand, can significantly impact the company's earnings and profitability. While these factors will manifest in future financial results, market participants are already aware of them and adjust the stock price in anticipation.
Given the vast number of market participants—over a billion people worldwide—it takes just one confident individual to analyze various scenarios and influence the market. On September 7, 2023, such a confident hand initiated a buy order, which the market subsequently agreed with. Had this trade been a speculative gamble rather than a well analyzed decision, it would have likely faced severe mean reversion, punishing the trader for taking undue risk.
Let's now examine more brackets and trends in shorter timeframes.
On 7th September 2023 we can see in 75 min time frame the bracket [237.3. 242.55] was taken out and then 248.15 level was taken out and not even in 3min charts it ever moved back down to 248.15 levels.
Examining the charts above should have helped you understand the concept of brackets and trends. A bracket, or range-bound region, is an area on the chart where you can draw a horizontal line around which the price oscillates, bounded by a high and a low range.
Below is the monthly chart of Coal India. The horizontal line is at the 217.99 level, with the bracket bounds defined by the range [190.5, 248.15]. This bracket spans 13 candles.
Conclusion
In this blog, we've explored the foundational principles of trading: brackets, trends, and mean reversion. These concepts are not just theoretical; they are the practical tools that traders use to navigate the complexities of the capital markets. By understanding how brackets form and how trends develop, you can make more informed trading decisions.
We've also discussed the importance of developing a robust trading strategy that includes clear entry levels, exit levels, and stop-loss points. This structured approach ensures that you can capitalize on market opportunities while protecting your capital.
Remember, successful trading is not just about understanding charts and patterns; it's about implementing a disciplined process that aligns with your personal trading style and risk tolerance. The examples and strategies we've covered here are meant to guide you, but the key to success lies in your ability to adapt and apply these principles effectively.
As you continue your trading journey, keep experimenting with different timeframes and strategies. Use the three-screen approach to analyse monthly, weekly, and daily charts, and always stay vigilant for emerging trends and bracket formations.
Disclaimer
Please note that the content of this blog is for educational purposes only and should not be construed as trading advice or financial advice of any kind. The information provided here is based on general market observations and personal insights. It is not intended to be a substitute for professional financial advice.
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Thank you for reading, and may your trading endeavours be both insightful and profitable. If you have any questions or need further guidance, feel free to reach out. Happy trading!
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