Posted on: 31 Jul, 2019
The art of reading an uncluttered chart via price action patterns becomes one of the purest forms of staying in sync with a market’s order flow. Mastering price action, therefore, is akin to understanding how orders enter the market via traders making decisions and the opportunities that these actions in the market create.
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The ability to trade any asset class from the lowest to the highest time frame charts with no reliance on the analysis of fundamentals and little to no weight on the role played by technical indicators, but instead to purely trade based on candlestick or chart patterns, is what’s popularly referred to as price action trading.
Traders who fall under this category of price action trading have come to the conclusion that the best opportunities don’t necessarily have to emerge by cluttering the charts with lagging technical indicators.
A price action trader that makes his trading decision derived off price alone, taps into the benefit of getting the information in real-time, rather than experiencing the lag of an indicator to trigger a certain signal. Another risk of using an excessive number of indicators is that you have to process a lot more information.
On the left, a price action trading chart. On the right, a chart cluttered with indicators.
But nothing is fixed in stone in trading, which is why pragmatism and an approach with a certain degree of discretion on the use of a limited number of indicators can too be of benefit, even if that should be a secondary factor to simply aid the assessment of the market conditions at play.
A price action trader has the firm conviction that the manifestation of price changes through candlestick or chart patterns contains all the information needed to find an edge under the right context.
For a price action trader, defining that context or environment traded rather than making calls based solely off patterns in isolation is absolutely cardinal. The art of reading the market is to take a holistic overall view, moving away from the reading of individual patterns. So, that’s where the subjectivity to use some technical indicators may come handy in order to define if the market is for instance trading or ranging.
Traders on a quest to trade successfully through price action should brush under the carpet the notion that markets follow by nature chronic random patterns with no systematic way to define a strategy with an edge.
But you can easily fall victim of that misconception if discarding under what context price action patterns occur. By combining the most recent price history and the current environment at play, price action traders put the odds in their favor to be able to trade repeatable formations that offer opportunities with a statistical edge.
Context, both in life and in trading, matters.
As part of the process to cement the groundwork of any price action strategy, a substantial amount of time should be devoted to backtesting the particular patterns more akin to your style. Are you looking to enter engulfing candlestick patterns in line with the trend at a key area of support or resistance? Test it first.
Following price action trading sets you out on a journey with raw price data at the core to recognize trading patterns such as a stop-loss runs, a failed or successful breakout, a climactic move, and related observations, with the ultimate purpose to evaluate how the market responds to specific areas in the chart or events.
Price action traders should also recognize that there are adaptations from interpreting price action beyond simply trading patterns. It can also reveal relevant information in terms of order flow, removals of liquidity, formations of demand or supply areas, through the speed and magnitude of price movements for instance.
The benefit of trading price action in the forex market, as opposed to other financial instruments, has to do with the vast amount of liquidity available with over 5 trillion USDs worth of business traded daily, which makes price action trading more effective as the more liquidity, the more technically-oriented the market becomes.
Another distinct benefit of trading price action, in an era where automation has taken over, is that one is not restraint to only trading manually. With the right coding skills or by outsourcing the job to a professional, automating one’s favorable price action strategies is perfectly viable. This is a clear incentive for those traders with time constraints due to working on a day job yet interested in having involvement in trading activity.
So, in a nutshell, price action trading, is the art of finding, through price fluctuations and its responses via candle patterns, the rhythm of a market in order to spot favorable entry and exit points for the aim of making profits. This process comes under the umbrella of mastery in risk management and psychology, which is a whole different topic altogether which goes way beyond the purpose of this article.
1. Candlestick patterns
Before we delve into the nature of candlestick or chart patterns, one must be familiar with a candle’s anatomy, which comes down to four main components: the open, close, high and low.
As the name indicates, the "open" of a candlestick depicts the valuation of the asset when the period starts, while the "close" tells us at what price it trade when the period has finalized. The "high" and "low" represent the highest and lowest prices printed during the period analyzed.
Another feature as part of a candlestick terminology involves what’s referred to as “the body”, which represents the section of the candlestick filled with a particular color, which is the distance from the open to the close.
Lastly, what’s known as “the wick” or “the tail” consist of the thin lines above and below the body. These are areas that in the real of price action trading can also be called “shadows” (upper and lower).
Source : Yahoo Finance
An important distinction to make is that candlestick formations are simply the manifestation of order flow, which is the summation of all buys and sells executed in response to events in the chart. These events can be broken down into two forms. Technically-derived candlestick patterns or news-led candlestick patterns.
The first type is what most traders will pay attention to as the frequency to base one’s decision on candlestick pattern motivated by a technical reason, be it a rejection off a support or resistance, tends to dominate.
But the price action trader is also on the lookout for high-impact events, for instance the election of US President Trump back in November 2016, and what clues can be obtained from the candlestick pattern.
Remember, without context, which is what will be touched upon in the following section, candlestick or chart patterns will carry little to no weight to make consistent trading decisions with a statistical edge.
2. Market context
The right set of circumstances that surround the creation of price action pattern form the cornerstone to validate a trade as an attractive opportunity to enter a position. We cannot fully understand and assess a potential price action trigger unless we can define the environment we are in..
We can break down the three stages of a market into range-bound, uptrend and downtrend.
As a rule of thumb to determine if a market is under a range-bound context, a mechanical and objective way to go about it involves using the Bollinger band indicator. In the first instance that the lower and upper band turn flat, that’s when we can start to look for levels of references to draw a box, with a break and close outside the periphery of the range drawn the confirmation that the market has found a resolution outside of it.
The rationale to explain the other two phases (up and downtrend) can be bundled into one. Each trader should determine, through their own findings, the set of measures used to validate that a trend is active.
There is a sea of options, from market structures theory, the application of moving average crossovers, a single moving average as a baseline to gauge the trend, the formation of trendlines, you name it. It really depends on the set of variables one is most comfortable with, backed up by rigorous backtesting.
A couple of options to assess a trend are illustrated in the example above
3. Order flow
Another important component to analyze the current conditions of a particular market includes the type of order flow. Is the trend developing in a constructive manner by experiencing commanding and impulsive movements in the direction of the trend followed by corrective candles?
If, on the contrary, an active trend is validated to the downside as in the example below but order flow is much more balanced with each rotation into new lows not achieving much distance below the previous low, a price action trader with the proper understanding of order flow would find this situation as a warning sign.
4. Timeframe confluence
To further increase the odds of getting the trend direction right, a common strategy is to crosscheck if the current trend in the timeframe one uses as the entry trigger is in alignment with higher time frames. Here, to avoid falling into the trap of analysis paralysis, it is recommended not to pick more than two time frames higher, whichever you decide to use. For instance, if I am looking to enter positions off the hourly chart on the USD/JPY with the trend, I want to make sure the 4 hour and the daily also agree.
An instance of USD/JPY with the hourly, 4h and daily timeframe all align in favour of a downtrend continuation
5. Support and resistance
Out of the barrage of options that exist to identify the areas on the chart most relevant to find a price action candlestick trigger, none beats the power of the ‘old school’ support and resistance areas.
Example of a EUR/USD hourly chart with h1, h4, daily support and resistance areas identified.
The reason lies in the ability we all have as traders to easily eyeball where these levels are located in the chart. This makes such levels the most universal form of reference for participants to use. It also makes the selection of these vicinities objective in nature as the market can easily agree on their location.
As a result, they act as a magnet to attract and repel prices due to the liquidity that resides near-by. Since every participant can spot the whereabouts, it is precisely at these junctures where the larger share of stop placements will be found, which creates pools of liquidity, hence areas of interest worth fighting for.
All the prep that you have conducted by identifying and grading each and every level of interest in the chart, from higher down to lower time frames, serves the ultimate purpose of you knowing what fights you want to get involved in. Because you know this is an area of liquidity that acts as a magnet to attract and repel prices, which puts you in a good position to ride a move if you happen to pick the right battle.
I’ve fleshed out further details about the concept of trading support and resistance in this article.
6. Tick volume
Here is another golden nugget that can put you ahead of the game. Instead of accounting for price action as the ultimate trigger, while respecting the context and other important points discussed above, those traders that look to marry up price action and volume can add yet another layer of evidence to their edge.
Once the price action trader is able to properly contextualize recent price action patterns and the tick volume attached to it, alongside its recent evolution, that’s when new inputs of a story are revealed.
Volume is the accelerator of a car, price movement the actual car motion, while support and resistance is a ‘hill’. Driving up a car through a steep hill by just pressing the gas softly won’t cut it. More power (gas) must be applied. The study of volume can be of real value to tells us a story about the intentions of market participants.
Example of a price action trade with volume confirmation in the GBP/USD daily chart.
The more tick volume generated in the forex market in a particular candle during high-liquidity times, the more involvement it exists by the smart money (big boys). Therefore, a particular candle pattern formed at the right area, with the right pattern, and sufficient volume activity, gives us yet another piece of evidence.
Again, if you’d like to find out more about tick volume trading, check out this article I put together.
7. Average true range
The average true range (ATR), which is a technical analysis indicator that can be found as a free tool in any trading platform, measures the average volatility of an asset for a particular period of time. This indicator is of great use for price action traders, as it helps to define the placement of orders and stop losses.
Volatility in forex should be a central theme as part of a price action trader’s process, no matter what asset class or instrument one trades. Volatility, which can be easily gauged through the ATR indicator (default period tends to be 14), is what defines our considerations in terms of risk management.
In the example above, I’ve shared an example of a EUR/AUD daily chart. The key takeaway should be that when a price action trigger occurs yet the volatility of the candlestick is out of whack, that should be a red flag that the market, more often than not, will need to correct due to the overextended nature of the candle.
Similarly, if we enter a trade at a level a price action trader would consider to be an optimal one, ATR can also act as the key determiner to give us an objective distance to place our stop loss, in other words, the level in the chart that if hit, it will prove our assumption wrong and get the price action trader out for a loss.
We need to differentiate two categories when trading based off price action. The first one corresponds to the entry triggers that occur after a particular pattern, comprised of multiple candles, forms in the chart. The second category involves standalone candlestick patterns as the trigger mechanism to get us into the market.
There are more price action patterns out there than you’d ever care about to study. I am talking literally hundreds of them, which is why I personally recommend a website that does an excellent job in classifying them under different categories (candle patterns and chart patterns). Thomas Bulkowski's site is the real deal. Tom has also written a few books on the subject including “The Encyclopedia of Chart Patterns.”
Let’s now look at the most popular price action patterns broken down into 5 candles and 5 chart patterns.
1. Pin bar
It’s a candle pattern that consists of a long wick or tail (shadow) with the body smaller in comparison. If the body closes bearish, as the image below, with losses after the candle period is concluded, it’s referred to as a bearish pin bar. If the rejection off the high is substantial yet the body still closes bullish, while not ideal, it can still be considered a bullish pin bar under the condition that the wick or tail is large enough. The more volume that the pin bar carries, the more credence that a follow-through move will be seen as it translates, in the case of a bearish pin bar, that sellers have absorbed an awful lot of bids on the way up.
2. Engulfing bar
This candle pattern is characterized by the formation of two candles, each of different colours, with the body of the second fully engulfing the body and tail of the first one. The close of the second candle should be on the last third as a sign of conviction by the side creating the reversal. When an engulfing candle pattern occurs, it means there has been a sudden shift in order flow, and it communicates that the prospects of a reversal in favor of the direction of the engulfing candle are on the rise, if other factors also agree. The more volume in the formation of the pattern, the better as it tells us more involvement by large capital accounts.
3. Outside bar
This candle pattern has a lot of similarities to the engulfing pattern, with the subtle difference that the second candle must have a higher high and a lower low than the first candle as part of the pattern. The close of the second candle, as in the case of the engulfing, should be on the last third of the bar as a rule of thumb. When an outside bar occurs, an aggressive shift in order flow ensued, also known as order book sweep. The more volume in the formation of the pattern, the better as it tells us more involvement by large capital accounts.
4. Inside bar
The pattern is made up of two candles. In this case, the first candle must engulf the second one, which must be smaller and within the delimitations of the first candle. The high of the first candle is higher than then high of the second candle, and the low of the first candle is lower than the low of the second candle. This candle pattern simply means a period of equilibrium or consolidation in the market. Inside bars are great patterns to play for a follow up move in line with the dominant trend. They tend to be validated by the breakout of the low or high of the first candle, often referred to as the mother candle.
5. False breakout bar
This is one of the most deceiving candle patterns out there, as the repercussion tends to be a reversal move in the opposite direction of the breakout. For this candle pattern to occur, we need three candle, the first two will form what it’s been explained as the inside bar set up, while the third candle or bar will be a pin bar after the high or the low of the mother bar gets broken but rejected right off the bat. The formation of the pin bar in the context of an inside bar then leads to what’s known as a fake move, with traders then piling in to join the contrarian trade and retest the opposite side of the mother bar where stop will be placed.
6. Flag pattern
This chart pattern is considered a continuation pattern in line with the dominant trend. The onset of the pattern occurs when an impulsive move up or down is followed by a corrective pullback with a series of lower highs and lower lows that allows us to draw a channel. In the case below a bullish flag pattern is illustrated. The impulsive move and the subsequent correction is a clue that the order flow is still favoring a follow-through continuation move. Once the price breaks to the upside of the channel with a surge in volume (ideally), it validates the bull flag entry. Note, this pattern tends to be quite tight in its range and should consist of only a few bars (up to 15-20 max).
7. Ascending/descending triangle
The triangle pattern is also characterized by its continuation dynamics. It’s best when it occurs in established trends. Its initial setting comprises a double top (ascending triangle) or bottom (descending triangle), followed by a series of higher lows, which in order flow terms, it translates into buyers adding further upside pressure by compressing price into a narrower upper range. On the flip side, if a double bottom is followed by a series of lower highs, that means sellers are taking control for an eventual breakout. In both cases, the pattern validates the moment that the price sees a breakout, with an increase in volume ideal.
8. Double top/bottom
The double top/bottom is one of the most sought after patterns by price action traders as it tends to offer an attractive risk-reward given its trend reversal characteristics. The double top is formed after price retests a previous high and fails to break as long as the interval between the first and the second test of the high has a minimal separation in between. The double bottom is created when two lows by a minimal separation are created. In the case of the double top, once the low in between the first and second high gives in, that’s when we find the confirmation needed to enter into a short. As usual, a breakout of high volume will increase the chances that the pattern becomes more reliable for further follow-through continuation.
9. Head and shoulder pattern
The pattern receives its name from the similarity of the pattern to a head and shoulder. For the pattern to carve out until its full completion, we need two separate leg high (the shoulders) with a higher high (the head) in between. The H&S pattern is a bullish reversal pattern, while the inverted head and shoulders pattern corresponds to the bearish reversal pattern, characterized by two low legs with another lower low in between. In both instances, when the breakout of the 2nd shoulder is confirmed, which as part of the pattern terminology, we’ll call it ‘the neckline’, that’s when the pattern is ratified.
10. Falling/rising wedge pattern
This pattern is best to be traded in the context of a trend with an impulsive nature, followed by a series of lower lows and lower highs (in case of a falling wedge), which allows for drawing trendlines, connected by a series of peaks and troughs. Once the price breaks through the descending trendline connecting the highs, that’s when the pattern gets its validation with an increase of volume on the break preferable as it would indicate a commitment by market participants to extend the move in the direction of the breakout.
From all the concepts shared in this guide, if I had to blend it all into one single key take away, it would be that the art of reading an uncluttered chart via price action patterns becomes one of the purest forms of staying in sync with a market’s order flow. Mastering price action, therefore, is akin to understanding how orders enter the market via traders making decisions and the opportunities that these actions in the market create.
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