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Investing 101: FX Price Action

Updated: Feb 9

In today's article on my FX (Foreign Exchange) series, we'll be covering price action. However, first, if you've not read my previous two articles in the series, you can find them here and here!


Previously, I have introduced forex and outlined some jargon that will be used interchangeably from now on in these articles. If you have previous experience trading the markets you can just skip straight to this week's content where I will be focusing on basic price action movements, otherwise it may be a good idea to read through my previous articles to recap the content covered. I will use tradingview.com as a demonstrative tool for various analysis techniques so you can have a go at it yourself!


Price Action

Technical analysis based on price action involves analysing charts and speculating on future price action based on the way it moved in the past. At first, graphs may look like a bunch of zig zags (refer to the meme). However, they are actually very informative and reflect all of the buyers and sellers in the market at any given time, or in other words, the supply and demand of a given currency. When there are more sellers than buyers, the price moves down, whilst the opposite is true when the buyers outweigh the sellers. As a retail trader, it is your job to conduct analysis and

and determine on which side of this tug-of-war you’re at. It is inevitable that you will be on the losing end many times. The biggest market movers are institutional traders.They can trade large lot sizes and thus cause sudden, unpredictable spikes in the currency pairs, ultimately triggering our stop losses. As retail traders we are relatively powerless, and thus, here I introduce you to one of the most important rules in Forex:

Do not attempt to predict the market, follow it.


Types of trading styles

There are four main types of traders out there, and with experience, you will be able to work out what kind of trader you are. Below is an outline of the four trader types:

1) Scalpers hold onto their trades for seconds-to-minutes at a time to catch a small number of pips per trade throughout a day. This type of trading requires many hours spent looking at charts to determine precise entry and exit points.

2) Day traders do not hold trades open overnight to avoid negative price gaps between one day's close and the next day's price at the open. This is even more important over the weekends when potential news releases can trigger a huge sentiment in the market and there is nothing you can do about your open trades until the market opens on Sunday. The market closes at 10pm GMT on Fridays and reopens at10pm GMT Sunday.

3) Swing traders hold onto their traders for several days to weeks. This type of trading requires much less time spent looking at charts, and thus, tends to be the best option for people who have busy schedules. Swing traders typically spend a couple of hours analyzing charts and let these run as they go about their lives.

4) Finally, there are position traders who hold onto their trades for several weeks to months.

These traders rely on fundamentals to guide the price action. For instance, at the start of the pandemic a position trader would know that the value of gold tends to go up in times of economic distress. Combined with the knowledge of the inverse relationship between gold and the U.S. dollar, they would likely go long on XAU/USD (XAU being code for gold). Refer to the daily chart to see how that skyrocketed a whopping 5250 pips. Also, pay attention to the red circles which are precisely when news on Pfizer and Moderna vaccines were released respectively (gold sell-off), an example of how news can temporarily shake up the market. Position trading requires a lot of patience as you will need to wait through all the retracements and determine the precise exit point when the upward momentum ceases.


Time Frame

The first thing you should consider before conducting technical analysis is deciding which time frame you’re going to work within. From my experience, the most efficient traders conduct a multi-time frame analysis. For instance, they may use a daily or a four-hour chart to determine the direction of the market, and then use one-hour or 30min charts to find the best entry point.

For instance, from analysis of several four-hour charts you may decide the bias for the day is dollar

strength, and found what seems a clear indication of NZD/USD collapse. However, when you check the 30min chart, you may notice this pair is at a support level, and thus, decide to wait for a retracement prior to entering. In a hypothetical scenario, if you entered this trade prematurely, you would lose out on a few pips. Additionally, we can never be certain that it will go in our direction, and this retracement could be a whole upward rally of its own! This is when stop losses become absolute crucial. Scalpers would most likely trade in very small time frames. For example, five-minute time frames, to determine exactly where they want to enter and exit their trades.


Candlestick Charts

The most popular type of chart used by Forex traders is the candlestick chart. This is because each candlestick represents the high, low, open and close price for a specific period of time. On a daily chart, a single candlestick will be used to represent the trading activity for that day. Four one-hour candlesticks will give us a single four-hour candlestick, and so on. When the body of the candlestick is filled in green, it means the closing price for that time period was higher than the open (i.e. buyers outweigh the sellers). The opposite is true for candlesticks filled in red. Do bear in mind that in the examples used in this article, my green candlesticks will be blue, and red candlesticks pink- just a colour preference (oh yeah, you get to customize your tradingview charts, which is awesome)! The wicks on either side illustrate the highest and lowest prices at which a currency has traded over a specific time period. Because the total size of the candle body is the candle high minus the candle low, long wicks can indicate exhaustion of either buyers or sellers, and thus if coupled with other indicators may symbolize reversals, particularly if they form at higher time frames. More on this in the next article. For anyone interested, “Japanese candlestick charting techniques” by Steve Nison is a comprehensive book covering candlestick patterns.


Market Structure

Market structure reflects the direction of the market. Bullish market structure is when the price is making a series of higher highs and higher lows, essentially creating something akin to an ascending zig zag. In supply and demand terms, this essentially means that the buyers (bulls) are driving the market. When the price stops creating higher highs and breaks its previous higher lower, the market structure changes its bias to a bearish market structure, driven by the sellers (bears). However, it's advised to wait for at least two closes below the newer low as a confirmation of change in market structure. Otherwise, the new lower low may actually be a “fakeout” before resuming its original direction - fake breakouts are the worst! This is why patience is such a virtue in trading. Allow the market to prove itself, don’t predict it, follow it!

Alternatively, the market might start ranging, which means rebounding off previous highs and lows. This constitutes a period of consolidation before the next directional move. Some traders use fibonacci retracements, candlestick patterns and other indicators to determine whether the market is likely to change direction, which will be covered in the next article. If this is too over your head, I recommend you picking up a couple of books, such as the previously reviewed ‘The Tao of Trading’ by Simon Ree.


Entry points: in a bullish market structure buy at a new higher low, and in the bearish market structure sell at a new lower high.

Tip: it's safer to be a bull in a bull market and a bear in a bear market.


Example

Refer to the one-hour EUR/USD chart below. We can clearly see that this pair is in a bullish market, creating higher highs and higher lows. There is a clear fakeout, where many traders got burned because they didn’t wait for confirmation. Since sellers didn’t hold under the latest swing low, the risk remained to the upside. As you can see, the bullish market structure has resumed shortly after all the bears, and in many cases the bulls who failed to exit the trade, have been taken out. On the 4th of December, this chart stopped making higher highs. Nevertheless, the price is yet to break below its higher low. The price action can now do two things: 1) Break the bullish momentum creating a range of lower lows and lower highs or 2) Resume its upward momentum. There is also a possibility that bulls or bears gain enough power to drive the price action so much that we might not see a lower high until a key price level is reached. However, you have to ask yourself if it's worth entering such a breakout without confirmation of trend reversal/ continuation. Also, It's important to recgonize that what is a change of market structure on an hourly time frame, may be only a retrcement on a daily chart- seek confirmation from a time frame one level above the one you use for entry.


Note: the black resistance line is a key level I got from a daily chart, which COULD mark a significant point of reversal.

Support and Resistance Zones

Support and resistance levels mark areas on the charts from which the price bounces off. Support, therefore, is a price level at which prices are prone to stay above. Resistance is a price level at which prices are prone to stay below. If the price breaks above the resistance level, it becomes support and vice versa, if the price breaks the support level, it now becomes a resistance zone. The relevance of a particular zone is reflected by the number of times the price has bounced off that area and the type of reaction it caused (momentum and velocity). The higher the time frame, the more significant the zone. For instance, you spotted a bullish market structure that has just created a higher low and you’re looking to enter a long position. After drawing your support and resistance zones on a daily chart, you notice that the price is approaching a resistance level with four touch points, meaning four failed attempts of buyers trying to win the tug-of-war. You can reliably assume that the price will likely retrace, turnaround or at least pause at that level. Now let’s say the price does violate and break above it, we can expect a big momentum to the upside due to the initial strength of that zone, driven by the excitement of all the bulls entering new positions. The cool thing is, the price tends to travel between these zones, giving us a lot of trading opportunities!


Trend Lines

Trend lines tend to be a good representation of the market structure. For instance, as the market is creating lower lows and lower highs, there is a tendency for these to align in a descending line. Trend lines are another form of support and resistance, often indicating reversals to. Refer to the one-hour EUR/AUD example below. The pair was creating a series of lower highs and lower lows, which could be joined together with a trend line. On December 1st, we can see the pair broke above its descending trend line. Is this the beginning of upward momentum for this pair or a fakeout? We should wait for two more higher low and higher high formations to see whether the bulls really takeover.


Tip: The more aligning factors there in your favour, the stronger the possibility of price going in your direction.

Example

Let’s take a look at USD/JPY example below. In the first chart I marked out key levels on a daily chart. You can see how some levels were stronger than others and how they reliably predicted exact reaction points. As of March, USD/JPY has clearly entered a bearish market structure phase and as the price breaks through the support levels, they turn into resistance. The second chart is USD/JPY on a four-hour time frame with more marked key zones and a trend line. Pay attention to how I only highlighted the most relevant levels to future price action. We can see that previously sketched out daily resistance is being violated. In turn, the trend line appears to be respected with many precise touch points. Furthermore, it now coincides with the new four-hour resistance level.


Entry point: Each time the price reached the descending trend line it would’ve been a good opportunity to enter a short position. Also, note that there were also buying opportunities each time it touched the bottom trend line, however because we decided we were in a bearish market structure, it could be too risky to enter long positions due to the possibility of sudden price collapse. However, once you master your risk management, precise entry point and tight stop loss could’ve made entering long positions a profitable venture.


Tip: I use the rectangle tool to mark out my zones (look at the cursor on the second graph)


Currency Pair Correlations

In Forex, currency pairs move in correlation. A positive correlation means that two currency pairs move in tandem, and a negative correlation means that they move in opposite directions. This is of course to a certain extent, whereby some currency pairs are perfectly correlated, and others not so much. For instance, if you do your analysis on GBP/USD and found a short set-up, but at the same time a long set-up on EUR/USD, there might be something wrong with your analysis. This is because the two pairs have a positive correlation of above 80 per cent on a daily chart. This does of course depend on the time frame you’re working with, because with smaller time frames this correlation does diminish. So, if you want to scalp a retracement in one currency pair, whilst swing the other, there is a chance you will secure both TPs, however, it is evident that you will be going against the market structure in at least one of the pairs. Some traders love retracements as they’re able to analyse exactly where these will occur, and thus it is absolutely an option if you learn how to! However, I cannot emphasize enough that if you don’t know what the currency pair is doing, don’t trade it - this is what distinguishes traders from gamblers! You can check currency correlations on www.myfxbook.com/


Tip: When trading pairs involving the U.S dollar do analysis on the U.S Dollar Index (DXY) too!


Conclusions

In this article I covered basic price action, including market structure, support, resistance, trend lines and currency correlations. The next articles will go over indicators, popular chart patterns, candlestick patterns and more. Finally, we’ll combine all of these together in a “trade with me” article. I hope you found this guide to technical analysis useful and if you have any questions you can comment below.


Disclaimer:

The Student Investor is not a registered investment, legal or tax advisor or broker/dealer. All opinions expressed by The Student Investor are from the personal research of the author, and are written for educational purposes only. Although best efforts are made to ensure that all information is accurate and up-to-date, occasionally unintended errors and misprints may occur. Please note that the value of your investment can go up or down, and The Student Investor takes no responsibility for any decisions made by readers.