Establishing A View On The Market
There are many different ways to read the market and establish directional bias; traders can assess fundamental conditions and form a viewpoint based on the comparison of economic indicators and central bank policies, traders can also make purely technical decisions perhaps based on the readings of indicators such as Stochastics or RSI. However, what is undoubtedly an important stage of the learning process for the vast majority of traders is learning to read price action.
Whilst referencing technical indicators can be a convenient guide helping to remove subjectivity and streamline the analysis process, due to the lag in technical indicators it is far superior to either combine these readings with a view on price action or to simply turn to the price action itself
So first of all, what do we mean when we say price action?
Typically, whenever traders talk about price action they are referring to two related yet separate elements; the first being candlestick patterns and candlestick reading and the second being chart patterns and structural analysis.
In this first part, we will consider candlesticks so let’s begin by first of all confirming what a candlestick and how the information can be useful to us.
A candlestick has four individual data points, though sometimes they can overlap. Candlesticks give us the open, the high, the low and the close of the candle.
The shape of the candlestick can vary depending on the activity of the session giving us clues as to the prevailing market sentiment. Within the variety of candlesticks that occur there are a few repeatable shapes that typically suggest certain outcomes, two of the best candlesticks to look at are
- The Pin Bar
- The Engulfing Candle (Outside Bar)
The Pin Bar is a classic reversal candlestick. Looking at a bearish pin bar then, which suggests a reversal lower, the candlestick is giving us the following information.
Buyers started strongly driving the price higher on the session, however, once price reached a certain point, sellers stepped in and drove buyers sharply lower with a price ending the session near lows. This candle tells us that there was an acute shift in sentiment during that session, alerting us to the potential of a continuation lower. The best locations for these candlesticks is to find them at key resistance such as a retest of broken support, trend line resistance or Fibonacci resistance.
The bullish pin bar then is simply the inverse of the situation described above, whereby sellers started strongly initially to take price lower before buyers stepped in, and drove the price back up to close the session near highs, signalling a potential reversal higher. Accordingly, the best locations for these candlesticks is to find them at key support such as a retest of broken resistance, trendline support or Fibonacci support.
The next key candlestick which is also a classic reversal candle is the Engulfing Candle or “Outside Bar”. Similar to what we saw with the Pin Bar, the Engulfing Candle represents an acute shift in sentiment.
The candle displays a strong rejection of the previous candle so in the case of a bearish engulfing candle, whilst price had been moving higher over the previous session, sellers have now totally overwhelmed buyers and driven price firmly lower to actually close beneath the low of the previous session. This strong rejection suggests a likely continuation lower. Again, being a bearish candle, the ideal location for these patterns is to find them at key resistance such as retest of broken support, trend line resistance or Fibonacci resistance. However, these candles can also be useful in trading breakouts whereby the candle closes beneath a key support level, suggesting a further breakdown, and can be a great way to enter a bearish trend.
The bullish engulfing candle then is simply the inverse of the situation described above whereby price had been moving lower over the previous session before buyers totally overwhelmed sellers and drove the price higher to close the session above the previous session highs. This strong rejection signals a likely continuation higher. Accordingly, the best locations for these candlesticks is to find them at key support such as a retest of broken resistance, trendline support or Fibonacci support. The candle can also be useful in trading breakouts whereby the candle closes above key resistance, suggesting a further breakout, and can be a great way to enter a bullish trend.
Location is key
When it comes to successfully trading these candles or more accurately building them into a viable strategy, location really is key. The issue that many new traders have is that they try to trade every single candle which matches the above criteria without considering location. We looked at some of the ideal locations for each pattern, and if you can stick to trading only the very best setups and learn to be patient instead of trying to trade every sub-par setup, you will stand a far higher chance of being consistently profitable in the long run.
…Next time we will look at chart patterns and how the varying formation of price can suggest the likelihood of certain moves happening.