No matter what strategy or system you end up trading with, having a solid understanding of Price Action will only make you a better trader. If you love simplicity and minimalism, you’ll want to become a “pure” Forex Price Action trader and remove all unnecessary variables from your charts.
Price Action is simply how prices change over time - the action or movement of price. It is readily observed in markets where there are sufficient liquidity and price volatility, as the Forex market, but anything that is bought or sold freely in a market will demonstrate some sort of price action.
The concept of price action trading embodies the analysis of basic price movement as a methodology for financial speculation, as used by many retail traders and institutional traders. Since it ignores the fundamental factors of security (Stocks, Commodity, Forex) and looks primarily at the security’s price history, it is a form of technical analysis.
What differentiates price action trading from most forms of technical analysis is that its main focus is the relation of a security’s current price to its past prices. This past history includes swing highs and swing lows, trend lines, and support and resistance levels.
The trader observes the relative size, shape, position, growth (when watching the current real-time price) and volume of the bars on an OHLC bar or candlestick chart.
There are three basic skill groups:
Trading psychology is also critical but will not be covered here. Suffice to say instilling focus, self-discipline, and a passionless, objective attitude towards losses and wins is critical to your success.
So, to make your PC into a personal ATM you need to master the following skills:
• Analysis: What is the most likely movement in the price
• Trading Strategy: deciding under what market conditions to enter a trade, on what side.
• Money Management: deciding how much to risk on each trade and when to take profits.
To get an overall picture of the trend as well as strong support and resistance levels we review larger timeframe charts like the weekly price charts or the daily charts; then move to a smaller time frame of charts like the 4 hourly and the hourly charts; before finally using the 30, 15 or 5 minute charts to determine a good entry point.
On any particular time frame, whether it’s a yearly chart or a 1-minute chart, the price action trader will almost without exception first check to see whether the market is trending up or down or whether it’s confined to a trading range. The concept of a trend is one of the primary concepts in technical analysis. A trend is either up or down or ranging sideways. An upwards trend is known as a bull trend, or a rally while a bear trend or downwards trend is where the market moves downwards.
For the complete novice, an upwards trend can be described simply as a period of time over which the price has moved up. More specifically we are looking for at least two higher highs and two higher lows to establish a new trend and a series of at least 3 higher highs and higher lows to confirm.
A bear market or downtrend trend is where we see a series of lower lows and lower highs. In price action trading the assumption is of serial correlation, i.e. once, in a trend, the market is likely to continue in that direction until it provides a reversal signal.
A ranging market or sideways trend is not so easily defined, but it is what exists when there is no discernible trend. It is defined by its floor and its ceiling, which are always subject to debate. A range can also be referred to as a horizontal channel. A ranging market often displays horizontal price movement when the forces of supply and demand are nearly equal.
A sideways trend is generally the result of the price traveling between strong levels of support and resistance. A sideways trend is often regarded as a period of consolidation before the price continues in the direction of the previous move. It is not uncommon to see a horizontal trend dominate the price action of a specific currency pair for a prolonged period before starting a move higher or lower.
A Support Level or a Resistance Level is a price level that the market has rejected at least twice and is keeping the market from reaching through to new levels. The support/resistance of an identified level is deemed to be stronger the more times that the price has historically been unable to move beyond it.
There could be many reasons as to why the price has been rejected at these levels; accumulation of buy orders (at a support level), or sell orders (at a resistance level); buyers are attracted by the lower levels (support level), or sellers attracted by the higher levels (resistance level); buyers think or feel the market will go higher (support), or sellers think or feel the market will go lower, etc.
Support/resistance is often found at a round price level such as 0.9000 or 1.1000. Many inexperienced traders tend to buy/sell when the price is at a whole number because target prices or stop loss orders set by retail traders and some large institutional traders are placed at round price levels rather than at prices such as 0.9004 or 1.9234. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit prices because these areas often represent the prices that are the most influential to an asset’s direction.
3 Simple rules to draw perfect support and resistance levels
Fibonacci is a very popular tool among technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the thirteenth century. Price Action Traders use the Fibonacci retracement or extension levels as potential support and resistance areas. Since so many traders watch these same levels and place buy and sell orders on them to enter trades or place stops, the support and resistance levels tend to become a self-fulfilling prophecy. Traders also use the Fibonacci extension levels as profit taking levels.
Again, since so many traders are watching these levels to place buy and sell orders or to take profits, this tool tends to work more often than not due to self-fulfilling expectations.
Fibonacci’s sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series. And to price action traders, it is not the mathematical relationship that matters but the fact that price often seems to react to the key Fibonacci ratios of 61.8%, 38.2%, and 23.6% - moving towards these levels like magnets; then away from them quickly too when either rejecting or moving through them. In technical analysis, Fibonacci retracement or extension is created by taking two extreme points (either a major peak/trough or major support/resistance) on a price chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 61.8%, 78.6%, and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. There is a Fibonacci tool in Metatrader4 that is easy to use once you know what you are doing.
In addition to the ratios described above, many traders also like using the 50% levels. The 50% retracement level is not really a Fibonacci ratio, but it is used because of the overwhelming a tendency for an asset to continue in a certain direction once it completes a 50% retracement.
One key observation of price action traders is that the market often revisits price levels where it reversed or consolidated. If the market reverses at a certain level, then on returning to that level, the price action trader expects the market to either carry on past the reversal point or to reverse again. The trader takes no action until the market has done one or the other. It often brings higher probability trade entries, once this point has passed and the market is either continuing or reversing again.
Price action traders do not take the first opportunity but rather wait for a second entry to make their trade. For instance, the second attempt by bears to force the market down to new lows represents, if it fails, a double bottom and the point at which many bears will abandon their bearish opinions and start buying, joining the bulls and generating a strong move upwards. Also as an example, after a break-out of a trading range or a trend line, the market may return to the level of the break-out and then instead of rejoining the trading range or the trend, will reverse and continue the break-out. This is also known as ‘confirmation’.
Price action traders often use this second touch as their entry point for a trade.
A reversal bar signals a reversal of the current trend. On seeing a signal bar, a trader would take it as a sign that the market direction is about to turn. An ideal bullish reversal bar or pin bar should close considerably above its open, with a relatively large lower tail (30% to 50% of the bar height) and a small or absent upper tail, and having only average or below average overlap with the prior bar, and having a lower low than the prior bars in the trend. A bearish reversal bar would be the opposite.
Reversals are considered to be stronger forex signals if they are the extreme point is even further up or down than the current trend would have achieved if it continued as before, e.g. a bullish reversal would have a low that is below the approximate line formed by the lows of the preceding bear trend. This is an ‘overshoot’. Reversal bars as a signal are also considered to be stronger when they occur at the same price level as previous trend reversals.
The price action interpretation of a bullish reversal bar is that it indicates that the selling pressure in the market has passed its climax and that now the buyers have come into the market strongly and taken over, dictating price which rises up steeply from the low as the sudden relative paucity of sellers causes the buyers’ bids to spring upwards.
This movement is exacerbated by the short term traders and scalpers who sold at the bottom and now have to buy back if they want to cover their losses.
Buying weakness and selling strength is the art of buying pullbacks. A pull-back is a move where the market interrupts the prevailing trend or retraces from a breakout but does not retrace beyond the start of the trend or the beginning of the breakout. This type of price movement might be seen as a brief reversal of the prevailing trend, signaling a slight pause in Momentum.
Often pullbacks are seen as buying opportunities after a currency has had a large price movement.
It is important, however, to analyze closely any pullback as it may be a sign of a definite trend reversal or a slight pause in the trend, each having very different trading implications. One price action entry technique is to follow a pull-back with the aim of entering with-trend at the end of the pull-back. Here is our process;
Establish the main trend first (either uptrend or downtrend) on the hourly time frame. Exponential Moving Average - EMAs (50, 100 & 200) and trend lines can be used to determine the direction of the main trend.
After determining the direction of the trend on the hourly time frame, we will drill down to the 30-minute chart then the 15-minute chart in order to establish that the trend is in the same direction as the hourly trend. We also monitor pullbacks on these time frames to know if the phases are in sync.
On the 5-minute chart, we plot the trend lines. We wait for the price to extend past the trend line and enter upon the return to the trend line. Wait for price to retrace back to the trendline price and actually stall at the trend. Entry is on the formation of the next candle or bar above the trendline.
A breakout occurs when the price “breaks out” of some kind of consolidation or trading range. A breakout can also occur when a specific price level is breached - such as support and resistance levels, pivot points, Fibonacci levels, etc. With breakout trades, the goal is to enter the market right when the price makes a breakout and then continue to ride the trade until volatility dies down.
When trading breakouts it is important to realize that there are two main types:
Knowing what type of breakout you are seeing will help you make sense of what is actually happening in the big picture of the market.
Breakouts are significant because they indicate a change in the supply and demand of the currency pair you are trading. This change in sentiment can cause extensive moves that provide excellent opportunities for you to grab some profits.
After a breakout extends further in the breakout direction for a bar or two or three, the market will often retrace in the opposite direction in a pull-back, i.e. the market pulls back against the direction of the breakout. A good way to enter on a breakout is to wait until the price retraces back to the original breakout level and then wait to see if it bounces back to create a new high or low (depending on which direction you are trading).
A breakout might not lead to the end of the preceding market behavior, and what starts as a pullback can develop into a breakout failure, i.e. the market could return back into its old pattern. If the market breaks out by five ticks and does not hit their profit targets, then the price action trader will see this as a five tick failed breakout and will enter in the opposite direction at the opposite end of the breakout bar to take advantage of the stop orders from the losing traders’ exit orders.
In the particular situation where a price action trader has observed a breakout, watched it fail and then decided to trade in the hope of profiting from the failure, there is the danger for the trader that the market will turn again and carry on in the direction of the breakout, leading to losses for the trader. This is known as a failed failure and is traded by taking the loss and reversing the position. It is not just breakouts where failures fail, other failed setups can at the last moment come good and be ‘failed failures’.
When a market has been trending significantly, a trader can usually draw a trend line on the opposite side of the market where the retraces reach. Any retrace back across the existing trend line is a ‘trend line break’ and is a sign of weakness. This is a clue that the market might soon reverse its trend or at least halt the trend’s progress for a period.
A trend channel line overshoot refers to the price shooting clear out of the observable trend channel further in the direction of the trend. An overshoot does not have to be a reversal bar since it can occur during a with-trend bar. Sometimes it may not result in a reversal at all, it will just force the price action trader to adjust the trend channel definition.
Trading trend line breaks is simple; our first step is to locate a strong upward trend. Apply a trendline to help visually spot out that trend and to use it as a “barrier” for price action. Now we wait for price action to break through the trendline and head downwards, in which a sell order may now be entered. Now that we have a live sell order open and locked in some forex pips, our next focus should be to plan for an exit. Based on our knowledge of candlestick reversal patterns, we will not only use this for entries but for exits as well. To exit an open position, the trader must recognize the reversal patterns and exit that trade accordingly.
When the market reaches an extreme price in the trader’s view, it often pulls back from the price only to return to that price level again. In the situation where that price level holds and the market retreats again, the two reversals at that level are known as a double top bear flag or a double bottom bull flag, or simply double top / double bottom and indicate that the retrace will continue.
A pull-back is very common after a double top or bottom and even more common after a triple top or bottom This is similar to the classic head and shoulders pattern. A price action trader will trade this pattern, e.g.a double top, by placing a sell stop order1 tick below the bar that created the second ‘top’. If the order is filled, then the trader sets a protective stop-loss order 1 tick above the same bar.
During strongly trending markets, the majority of Forex traders trade profitably and comfortably, but once a trend is over all kinds of problems arise: trend-following forex strategies no longer work, frequency of false entry signals increases, bringing additional losses which eat up earlier accumulated profits. Taking into consideration that the Forex market spends up to 50% time in a non-trending, sideways state, the knowledge of how to deal with range-bound markets becomes vital.
Once a trader has identified a trading range, i.e. the lack of a trend and a ceiling to the market’s upward movement and a floor to any downward move, then the price action trader will use one of two strategies; they will use the ceiling and floor levels as entry points, trading back to the mean or average; or they will use the ceiling and floor levels as barriers that the market can breakthrough, with the expectation that the break-outs will fail and the market will reverse (see breakouts above).
Since trading ranges are difficult to trade, the price action trader will often wait after seeing the first higher high and on the appearance of a second break-out followed by its failure;
this will be taken as a high probability bearish trade, with the middle of the range as the profit target. This is favored firstly because the middle of the trading range will tend to act as a magnet for price action and secondly because the higher high is a few points higher and therefore offers a few more points of profit if successful.
And thirdly due to the belief in the two attempts rule the market will result in a tradable move in the opposite direction.
Regardless of the analysis and signals used, prior to entering a trade, a trader must go through a decision-making process that he or she has worked out in advance.
Understanding what is Price Action and how does it work is important, but if you want some help, the MetaTrader 5 platform offers a useful Forex Price Action toolkit and our trainers can provide you the right guidance. Play around in demo forex and notice how Price Action indicators can make you serious money.
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