Price Action: A Short-term trading system
Trading based on price action has become popular in these last years, mainly because of traders acknowledging that trading based on technical indicators such as moving averages, RSI, CCI, Stochastics and others have a lagging factor that makes us enter late, when the move already happened.
This happens because technical indicators, all of them, use the previous market action (i.e. last 21 periods or candlesticks) to calculate the final reading, and what happened in the last n-periods has little or nothing to do with that the market will do, say, in the next 10 periods or candlesticks.
In other words, if the market went up on average in the last 21 periods, the indicator reading will point up or give you a long signal, but that doesn’t mean that the market will continue its way up in the next 10 periods.
In order to adopt a Forex price action approach we need to take in consideration 3 main aspects: pressure, level and significance.
1 – Pressure
There are two types of pressure: upward and downward pressure. We have upward pressure when bulls take control over the market after bear dominance and downward pressure when bears take control over the market over the market after a period of bull dominance.
Try to picture this “pressure” on your head, what would it look like? It would look like a “v” shaped pattern as upward pressure or an “inverted v” as downward pressure. Let’s take a look at some images to make sure this is clear.
The first candlestick moves down (bear dominance – red arrow), but at some point, bulls gain confidence and take control over the market (i.e. bulls felt comfortable trading at those levels) pushing the market back up (bull dominance – blue arrow).
If we combine both arrows, we end up with a v shaped pattern (green arrow) with upward pressure.
Does it mean that only known candlestick patters (such as piercings, hammers, shooting stars, etc.) have either upward or downward pressure? NO. In fact, most patterns that have either upward or downward pressure aren’t known candlestick patterns. Take a look at the next image.
This pattern is not known in the candlestick literature, but it still has upward pressure. You still see the “v” market movement.
Next time you see a candlestick pattern, try to picture it in your mind as “v” or “inverted v” pattern, this way you will train your brain to see them as price action, not just as a candlestick pattern.
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2 – Level
Another important concept that describes Forex Price Action, is how the market behaves at a place it already traded before.
I suspect the reader already knows what we are talking about, if the market was rejected from an important level, the next time it comes close to that level, it is likely to get rejected again. And yes, we are talking about regular support and resistance levels.
This is the reason why we always need to pay attention on where the market has been rejected, specially the short term Support & Resistance levels, because at those levels we always should be ready to open our trades (in the direction of the long term market condition). Please take a look at the next chart:
In this chart, where would you open your trades? If I was to trade this chart, I would look for long opportunities around the bottom of the range, because the market gets rejected every time it gets near that level. And short opportunities around the top of the range, again, because every time the market gets close to this level the market gets rejected.
3 – Significance
Due to the nature of the Forex market (OTC: over the counter), it’s impossible to get an exact reading of the volume of the market at any given moment. But there are certain measures that can be used as a “proxy variable”, one of them is the significance of the “pattern”.
The significance of the pattern refers to the size of the pattern that triggered the upward/downward pressure compared to the previous candlesticks.
If we are tracking a “long” signal, we need to compare the size of the pattern that triggered our long signal to the bear candlesticks that formed the previous downward movement.
And vice versa, of we are tracking a “short” signal, we need to compare the size of the pattern that triggered our short signal to the bull candlestick that formed the previous upward movement. Let’s take a look at some images.
The trigger signal in the image above is clearly larger than any of the 3 previous candlesticks that formed the upward movement; therefore it is a significant pattern.
4 – Putting it all together
Please take a look at the next chart:
The pattern (orange square) with downward pressure is formed at an important short term resistance level (green line) and it is also significant (pattern larger than the previous candlesticks). This is considered to be a Forex price action signal to go short.
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