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Using Price Action to Catch Swings in the Forex Market

By , Forex Trading Instructor
23 September 2013 19:00 GMT

Talking Points:

  • Traders can use price action to look for trade-able setups in the Forex market.
  • Price Action can show which setups the trader may be able to utilize to buy up-trends cheaply, or to sell down-trends expensively.
  • Traders can use Multiple Time Frame Analysis to get more granular and exacting with their entries in consideration of longer-term trends.

Prices in the Forex market are often driven by fundamental catalysts and events. A good example of this was last week’s Federal Reserve Open Market Committee meeting, in which Mr. Ben Bernanke didn’t deliver the tapering of Quantitative Easing that so many in the market had come to expect.

The difficult part about such fundamental catalysts is that, for the most part, they are unpredictable. And further, even if we could foretell their occurrence, even then – we wouldn’t know exactly how the market would price in that information.

Quite simply, traders need a better edge in the market than ‘guessing’ that a certain event may take place, and ‘hoping’ for the best.

This is where Price Action can come in. Price Action or the study of how traders have moved prices in the past can bring quite a bit of value to the trader’s approach. Price Action can show which trends are strongest; and from there – traders can use this information to plan and plot trades.

Use Price Action to Locate the Strongest Trends

The reason for trading trends may sound very logical, yet many new traders are reticent of doing so. In most new traders, the desire to fade those trends is often much more prevalent than the aim to ride with them. This could not be more wrong; and the reason for that is the central theme of trading:

‘You will never be able to predict the future.’

The goal with trading with the trend is to simply look for any prevailing biases in the market, and looking for them to continue. The picture below will illustrate why this can be so valuable:

Using_Price_Action_to_Catch_Swings_body_Picture_3.png, Using Price Action to Catch Swings in the Forex Market

Created with Marketscope/Trading Station

As you can see in the chart, a nice up-trend had set hold in the market. In general, most new traders will look to go short in these situations, looking for a reversal to come into the market. The Speculative Sentiment Index will usually show as such, with increasing number of retail traders getting short as this up-trend continues to get priced into the market.

But this logic is all wrong.

This up-trend is taking place for a reason. Perhaps it’s in anticipation of a fundamental event (such as FOMC last week saw USD weakness well in advance of the announcement); or maybe it’s because of some technical event.

But the ‘whys’ are far less important than the ‘what’ in this situation.

The way the trader needs to look at this situation is that, at any moment in time, the price in the market is a fair price with which buyers and sellers are meeting to transact business. Future prices may drive higher or lower, and that’s unpredictable; but by simply looking at the recent trajectory of prices, traders may be able to get on the side of the bias in the market by trading in the direction of the trend.

But, it’s not enough to just buy in an up-trend, or sell in a down-trend. As traders, we want to be more calculated in our approach.

Traders can use Multiple Time Frame Analysis to Find Entry Opportunities

The difficult part about trading trends for many traders is that it can appear daunting to buy when prices are higher than they were previously (which is, after all, an uptrend). This is why so many traders embark on counter-trend operations, because it looks more logical to ‘buy the dip’ against a down-trend, or to ‘sell the rip’ against an up-trend.

But again, there is a reason that trend came into the market place; and whatever that reason may be, the trader wants to look to take advantages of these biases as opposed to getting taken advantage of.

This is where Multiple Time Frame Analysis comes in.

The trader can observe the trend on a longer time frame, and then can use a shorter time frame to look for an entry opportunity. For example, if the trader sees a strong up-trend on the daily chart, they can use the 4-hour chart to look to buy that up-trend cheaply.

Or perhaps the trader wants to take a shorter-term view on the market. They can use the hourly chart to grade trends, and the 5 or 15 minute chart to look for entry opportunities in consideration of those trends. This is similar to the fingertrap trading strategy that I teach in the DailyFX PLUS Live Classroom.

The trader can use time frames to suit their goals; the table below was given in the article, The Time Frames of Trading, and can show traders which time frames they want to use based on their desired holding-time/trading style:

Using_Price_Action_to_Catch_Swings_body_Picture_3.png, Using Price Action to Catch Swings in the Forex Market

Time Frame Intervals for Multiple Time Frame Analysis; from The Time Frames of Trading

On the Shorter Time Frame, Traders Can Use Price Action to Look For Entries

After the trend has been observed on the longer time frame, the trader then knows if they want to buy or sell in consideration of that trend.

Traders can look for periods of price action indecision on the shorter time frames to indicate potential entries in the direction of the longer-term trend, as we outlined in the article, The Most Important Price Action Formation is Indecision. A good example of ‘Indecisive Price Action’ is the Doji formation; although there are numerous additional formations that can signal indecision.

In the picture below, we’ve gotten more granular with the trend we investigated earlier in this article.

Using_Price_Action_to_Catch_Swings_body_Picture_1.png, Using Price Action to Catch Swings in the Forex Market

Created with Marketscope/Trading Station

In the above graphic, we’ve taken a more detailed look at the trend from the previous image. Once again, the general trend was strong and to the up-side, so traders want to look for opportunities to buy.

On the chart above, we can see where a retracement in the up-trend took place (highlighted by the red box). Shortly after the retracement sets in, a Spinning Top candlestick formation forms that highlights indecision on the shorter-term chart (this is one of the candlestick formations shown in The Most Important Price Action Formation is Indecision).

The trader can look to enter upon the formation of the spinning top, under the premise that a short-term low may have been made in the market, and the up-trend witnessed on the longer-term chart may come back.

The Most Important Thing for Traders to Look to on This (or any) Strategy

Once again, traders have to assume the future is uncertain. By trading in the direction of the trend, the trader is looking for the bias that’s been witnessed in the market to continue, which may or may not take place.

So it’s of the upmost importance the traders look to use favorable risk-reward ratios. The reason is because of that uncertain future, and the fact that not all trends will continue.

This way, even if prices are perfectly efficient at the time of entry (meaning all known information is factored in); and even if traders are getting only a 40% success rate in the markets; they can still look to be profitable on balance.

We examine this theory in-depth in the article, How to Identify Positive Risk-Reward Ratios with Price Action.

The Number One Mistake that Forex Traders Make is faulty risk-reward ratios. And this is the same type of thinking that gets new traders to fade the strongest trends in markets; the ‘hoping’ and the ‘guessing’ that brings on so many ill effects to the new traders approach.

-- Written by James Stanley

James is available on Twitter @JStanleyFX

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23 September 2013 19:00 GMT