Price Action in Forex Trading
- Important Tips for Using Price Action Strategy
- Trading Breakouts
- Trend Following
- Double Bottoms and Double Tops
- Cup and Handle Pattern
- Candlestick Patterns
- Final Thoughts
Price Action (PA) is one of the most common trading strategies in the financial market. It is also one of the least understood. The price action strategy is the process of using plain charts to make trading decisions. A plain chart is one which does not have lagging or leading indicators like the relative strength index, commodities channel index, and the money flow index. Instead, traders use the chart patterns to try and forecast what will happen next. In this article, we will look at ways in which you can use the strategy to succeed as a trader.
1.Important Tips for Using Price Action Strategy
Before we look at the various ways of using the PA strategy, there are a few things that you need to know. These details will form part of the foundation of the strategy.
First, while the PA strategy does not involve the usage of technical indicators, we believe that it is necessary to use some technical tools. For example, using some technical indicators and tools like moving averages, Bollinger Bands, and Fibonacci Retracement will help you become a better PA trader.
Second, as you use the PA strategy, you should not ignore the concept of fundamental analysis. This is the concept where you use market news and the economic calendar to predict the direction of the currency pair. This is simply because an economic data or news can cause a major shift on the price action. For example, a sudden hawkish announcement by the Fed can lead to a sharp decline on the EUR/USD pair or the cable.
Third, the PA strategy works well when you have a good understanding of the two major types of charts. In a trending chart, the price of a currency pair moves either upwards or downwards. In an upward trend, it forms a higher high and a higher low. In a downward trend, it forms a lower high and a lower low. In a consolidation chart, the currency pair tends to struggle to find direction.
Fourth, the PA strategy works best when you are using the candlestick patterns. This is because part of the method used in PA is to analyze the candlesticks to predict where the price will move to. Therefore, you should adjust to candlesticks if you are used to trading with the bar charts, renko charts, line charts and other types of charts.
Finally, to trade the PA strategy, you need to understand the concept of support and resistance. These are areas where the price of a chart tends to stop. The easiest way to understand the two is that the support is the floor while resistance is the ceiling where the currency pair struggle to move past. This is shown in the chart below.
A breakout is one of the best methods to use the PA strategy. A breakout can be described as a period when a pair in consolidation ‘breaks out’ past the support or resistance levels. Traders wait for a breakout for two reasons. First, it is almost impossible to make good money when a pair is in consolidation. Second, a breakout leads to a sharper movement in the price of the currency pair. As such, they can make more pips when such a breakout happens.
To understand how you can trade breakouts, you need to understand how consolidation happens. Consolidation happens when there is an indecision in the market about the next movement of the pair. The bulls and bears are not sure about the direction of the pair. As such, the support and resistance levels become very crucial.
A good way to trade a breakout is to consider where there is a strong buildup. A good example of this is shown below. On the chart, the pair has formed a channel and slightly before the breakout, there is a buildup. In most cases, the direction that will prevail is that of the buildup.
However, when you are trading a breakout, you need to understand the concept of a false breakout. This happens when traders move in unison when a breakout happens, only for the price to reverse. Using a stop loss can help you avoid being caught up in false breakout.
Newton’s law of motion states that an object will remain in uniform motion in a straight line unless compelled to change direction by another force. While this law applies in the field of physics, it can also apply in forex trading.
Indeed, trend following is probably the most important part of price action. As the name suggests, the method involves identifying a trend first, and then following it until it reverses. As such, when you identify a trend and follow it, you have better chances of having a profitable trading day. A common mistake most traders make is that they try move against the trend. While it does work when there is a reversal, experience shows that it is very difficult to time a market.
In the example below, we can see that the USD/JPY pair made a double top pattern and then started moving in a downward trend. As such, traders who bought the pair during the decline made a loss because of how difficult it is to time a reversal.
The chart below shows the NZD/USD pair that is in a strong downward trend. Unless there is a change in the macroeconomic data – which is the opposite force – you should not try to buy the pair.
4.Double Bottoms and Double Tops
A common strategy to identify the next trend in forex is by using the concepts of double bottom and double tops. We have mentioned a double top pattern briefly in the chart above.
Double bottoms and double tops are useful tools when identifying the reversal of a trending pair. This is important because of how difficult it is to identify reversals.
A double bottom happens when in a downward trend, the price establishes a bottom. It then attempts to move upwards and then it reverses again to the previous lower point. When this happens, it is usually a signal that a double bottom has happened and the pair will move upwards. As such, a double bottom is usually a strong support level.
A double top is simply the opposite. It happens when two extreme points are formed when the pair is in an upward trend. This usually implies that a downward trend could form. In some cases, there could be two, three or more tops and bottoms. The chart below shows a double bottom and a triple top.
Apart from identifying reversals, double tops and bottoms are useful when using the Elliot Wave analysis, which is a unique form of price action. Elliot wave analysis is a concept discovered by Ralph Elliot and has been used for decades. The concept was suggested after observing the movement of different charts. It suggests that financial assets move in waves. The first set of waves is known as impulse wave and the other one is known as the corrective wave. The challenge many traders have is to identify the formation of a wave. A good example of this is shown in the chart below.
In the first point, we focused on consolidation that happens during horizontal chart movements. In this part, we will look at another type of consolidation that you can use to trade currencies. This type is known as triangles. As with the other type of consolidation, the end result of a triangle pattern is a breakout, which could happen in either direction.
There are three primary types of triangle patterns. First, there is a symmetrical triangle pattern. This is where the price of a currency pair is contained by two converging lines that have a similar slope. When there is a symmetrical triangle pattern, the market is usually unsure about the ‘right’ direction of the pair. As such, the market keeps making higher lows and lower highs.
Second, there is an ascending triangle, where the price is contained by a horizontal line that acts as the resistance and an ascending trend line. This line acts as the support of the pair. When it happens, the price tends to struggle passing the horizontal support line.
Finally, there is the descending triangle, where the price is contained by a horizontal line that acts as the support and a descending trend line that acts as the resistance.
When there is a triangle pattern, traders usually wait until the apex level is almost reached. This is where there is a strong likelihood of a breakout happening. As with all breakout patterns, the toughest part is where you identify the breakout. To be safe and avoid a false breakout, we recommend that you wait a bit before you initiate your trade. The chart below shows a descending triangle on the EUR/USD chart.
6.Cup and Handle Pattern
Another popular price action method is the use of cup and handle pattern. A cup and handle pattern is used to make decisions on whether to buy a pair or not. It forms when the pair reverses an upward trend, moves downwards, and then starts moving upwards. To identify it, the pattern will have a ‘U’ shape and not a ‘V’ shape. The depth of the curve should retrace a third or less of the previous advance. It will also have high points on the two sides of the pair. The handle pattern look like a flag or pennant that slopes downwards. This represents the final consolidation or short pullback before the upward trend continues.
There are many ways of trading a cup and handle pattern. However, the one we recommend is shorting when there is a downward trend, and then buying when there is an upward trend. The resistance level will be on the right apex, where the handle pattern will likely form.
The chart below shows a cup and handle pattern being formed on the USD/SGD pair.
The inverted cup and handle pattern forms in a similar way. The difference is that it forms prior to a downward trend and the cup is usually an inverted U.
Another way of trading price action is to analyze the candlestick patterns. There are many such patterns. A good way for you to understand how these patterns work is to read a book called Beyond Candlesticks by Steve Nison, who is one of the most respected price action traders in the world. The book is regarded as a classic in the field of price action. There are several types of candlestick patterns but they are mostly divided into four.
First, there are the single candle lines. These include the likes of the hammer, the hanging man, and the shooting star. Second, there is the dual candle lines, which include the dark cloud cover, piercing pattern, engulfing patterns, and the Harami. Third, there are the window patterns, which include the Three Windows, gapping doji, and the two black gapping candles. Finally, there are the three or more candle lines such as the evening and morning star. A summary of some of these patterns is shown below.
To many starters, price action trading seems like a very difficult task. However, when you get to learn about the basic concepts, you will realize how interesting it is. Before you start using the strategies mentioned in the article, we recommend that you take time to practice them in a demo account. In addition, we recommend that you learn how to combine the strategies with fundamental and technical analysis. This is because all these strategies tend to complement one another.