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The Great Validator - Price Action

The Great Validator - Price Action

2014-06-14 03:00:00
James Stanley, Strategist
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Talking Points:

In our last two articles, we’ve taken a closer look at the study of Support and Resistance in the Forex market. In our first piece, we looked at static studies utilizing a couple of different methods. In our last piece, we dug down the rabbit hole of Fibonacci. In this article, we’re going to look at how traders can see if any of these levels actually matter: We’re going to talk about price action validation.

The Big Picture

What makes support or resistance matter?

Traders reacting to these levels are what make the study relevant. After all, if we’re looking for resistance at 1.7100 on GBPUSD, and if the pair just rips beyond that level without so much as a stall, was there really resistance at 1.7100?

No, there wasn’t. This is why price action matters so much; by analyzing how markets have reacted to particular price levels in the past we can draw assumptions towards how they may react to those same prices in the future. Otherwise, support and resistance is an esoteric shot-in-the-dark.

Price action is the most basic study of supply and demand in a market. If something good happens in a particular market, and more investors want to buy that security to reflect that improvement or good news, then this will create more demand as buyers look to accumulate said asset. It will also likely create lower supply, as those holding that security when the good news happens are less likely to sell at lower prices. Something good happened right? So, those that are already long will command a higher price before being interested in closing out their investment.

So to reflect this heightened demand, and lower supply – prices move up accordingly until sellers become more willing to provide liquidity to a market that can satisfy the heightened demand from buyers.

Support and resistance are those inflection points in a market in which sellers overpower buyers (creating price movements lower, or resistance); or which buyers take over sellers (as demand outstrips supply – highlighting support as prices move higher).

Price Action Swings highlight support or resistance with changes in order flow/trend

The Great Validator - Price Action

Created with Marketscope/Trading Station II; prepared by James Stanley

The exact price-point at which a market reverses creates what is called a ‘price action swing.’ We discuss this in-detail in the article, Price Action Swings.

How to Incorporate Price Action into an Analytical Approach

A price action swing is, in-and-of-itself, a form of support or resistance. After all, this is the very essence of resistance (or support) since an actual reaction was seen at that specific price. This beats an esoteric mechanism of imagining potential levels that don’t actually elicit a reaction.

Where price action really helps traders is using it to validate support or resistance found through other mechanisms such as we looked at in Static Support and Resistance or Fibonacci. This is often called ‘confluence’ of support or resistance since that price level has multiple reasons for traders to react, thereby changing the supply/demand flow in that particular market. We discussed confluence of support and resistance in the article The Power of Confluence in the Forex Market.

Price Action Swings at Support or Resistance validate that level

The Great Validator - Price Action

Created with Marketscope/Trading Station II; prepared by James Stanley

Noticing a price swing at a support or resistance level serves as validation that traders have, in-fact, reacted to that price once it became traded in a market. This shows us that traders may react to that level in the future; and while this is the furthest thing in the world from a ‘sure-thing,’ it does afford the trader the opportunity to look for a trade with a strong risk-reward ratio (which is the only thing a trader will ever actually have control of in their approach).

This validation that’s provided by the price action swing can then become a theoretical hypothesis for the trader; that prices may react to that level in the future in a similar manner as they have in the past.

This affords the opportunity for the trader to look at a swing or reversal in that market by placing their stop on the other side of the swing (so that if a price reversal doesn’t continue the trader can look to mitigate the loss on the position). If the reversal does take place, they can look to reap two, three, or four times their initial risk amount; and they can actively look to avoid The Number One Mistake that Forex Traders Make.

We covered this type of approach in the article How to Catch Swings in the Forex Market, and in our next piece we’ll get much more in-depth behind the concept of entering positions based on support and/or resistance.

--- Written by James Stanley

Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.

James is available on Twitter @JStanleyFX

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