Talking Points:
- Traders can use price action to grade market conditions, observe trends, and identify support and resistance.
- In this article series, we aim to teach traders how to perform the entirety of their approach with price action.
- In this piece, we look at identifying and grading market conditions; and ascertaining risk parameters.
Over the past few months, we’ve published quite a few articles on the topic of price action. Price action is the study of investigating past price movements to perform technical analysis. Price action can be used in conjunction with technical indicators, or all on its own.
Over the next two articles, we’re going to attempt to teach traders an entire trading approach over multiple strategies using just price action; from the initial tops-down condition analysis to the entry of the position. We’ll follow that up with another two-part series on position and risk management via price action.
Step 1: Identify the Market’s Condition before ever plotting a trade
This is a step often ignored by new(er) traders, but this draws to the old saying of ‘how do you know where you’re going if you don’t know where you’ve been?’
Before you ever think of plotting a trade, you need to know how the current environment relates to the ‘bigger picture.’ This is the incorporation of multiple time frame analysis, and you can really make this as robust or as minimal as you might like.
We explain this topic in the article, The Time Frames of Trading; and we even suggest potential time frames to be utilized by traders based on their desired holding periods. The below chart suggests two time frames, but traders can take this a step further by incorporating a third (longer-term) time frame to get a more full picture of what’s taking place in that market.
Image taken from The Time Frames of Trading
Once the longer time frames have been investigated, traders can look to identify the prevailing market condition so that they can ascertain how the setup on the target time frame (the chart from which the trade will be placed) relates to that bigger picture.
We discussed the three various market conditions, and how each should be approached in the article, The Life Cycle of Markets.
Image taken from The Life Cycle of Markets
After you’ve identified the general market condition on the longer-term timeframes, you know how to approach that market on the target time frame.
Step 2: Identify Risk-Levels to Evaluate Attractiveness of the Opportunity
Once you’ve identified how the near-term chart relates to the longer-term setup, and have accordingly identified whether you’re trading a range, a trend, or a breakout – you can get a more clear picture on how much taking the trade might cost you (in the terms of stop distance). And further to this point – in an effort to avoid The Number One Mistake Forex Traders Make; you can ensure that the profit potential of the position is, at the very least, worthy of the cost (or risk) required to enter.
If you’re trading a trend, you’ll generally want to look at placing your stop below one of the previous ‘swing-lows’ in the market. This way, if the trend doesn’t continue and if a reversal comes into the market, you can exit the position before the loss becomes unbearable. Aggressive stops can be placed at the most recent swing-low, while more conservative stops can be placed below a previous swing (which is further away from current price).
Image taken from How to Attack Trends Using Price Action
If you’re looking to speculate in a range-bound market, which we had discussed in the article entitled ‘The Best Market Environment for Retail Forex Traders,’ the stop goes below support so that if the range breaks out against your position, you can, once again, exit the trade before the loss becomes too unbearable.
The breakout, on the other hand, presents a more difficult question in terms of risk management, as the new high (or low) that triggers the position will often be far away from a previous support or resistance level. And because false breakouts can be so abundant, traders need to look at more aggressive risk-reward ratios like 1-4 or 1-5 (risking one dollar to make four or five).
So traders have a few options when it comes to managing risk in breakout positions. The more common approach is to look for a stop within the previous range before the breakout might take place. As in, if looking to buy with breaks above resistance, traders can look to place their stop slightly below that point of resistance so that if the breakout doesn’t continue (and price moves back into its previous range) the position is closed before the loss becomes outsized.
But if the momentum does continue carrying the position higher (as the logic of the breakout dictates that it should), then the trader can sit in a comfortable position with a tight stop that can be adjusted as momentum carries the position further in-the-money.
This brings up the most interesting (and fun) portion of price action, which is profit taking and managing positions. We’ll discuss these topics further in our next article, How to Trade with Price Action, Part 2.
--- 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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