In this second article, we will cover slightly more advanced topics on understanding price action: how confluence can increase confidence, how some indicators may be useful to gain perspective, and how we can use multiple time frames for fine tuning entries. If you missed part 1 of this two-part article, read it first and understand just What is Price Action?
In the first article on price action trading, we have shown how price movement is determined by investors' decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. We, as chartists, have chosen to study the visual representation of actual exchanges made, which is reflected in the current market price of the asset traded. By doing so, we are avoiding as many abstractions as possible because we are only interpreting what we see play out. We have also seen how Japanese Candlesticks can help up us understand the current psychology playing out in any given moment. In particular, there are certain price action patterns in the form of candlesticks that give us strong cues (doji, bullish engulfing, bearish engulfing, etc.).
We also know that looking for certain behavior traits at key levels is a much more logical way to use price action (i.e. looking for candle patterns at supports and resistances or at swing points). What we started to describe in the first article is commonly referred to confluence. We have seen how price action patterns that form at swing highs / lows or at support / resistance can give additional robustness to the setup.
Why can confluence give us confidence to pull the trigger? Because at evident levels on the chart, other traders may enter (or exit for that matter) and it's important to us because it takes active participation (high volume) to take prices on their merry way. We have a higher probability of getting onboard with a decent number of large orders that will (hopefully) give the market a little boost in the desired direction.
There’s another tool that we can use to add confluence to a level: Fibonacci Retracements. Before applying them to our charts, we need to understand what they are and how they are created.
Leonardo Pisano (from Pisa) was the son of Guglielmo Bonaccio and lived between 1170 and 1250 AD, calling himself Fibonacci (or son of Bonaccio). He was a distinguished mathematician and was famous for introducing the decimal system of numbers into Europe (Hindu-Arabic numbering system) which replaced the Roman Numeral system. When he was studying mathematics, he used the Hindu-Arabic (0-9) symbols instead of Roman symbols which didn't have 0's and lacked place value. In fact, when using the Roman Numeral system, an abacus was usually required. There is no doubt that Fibonacci saw the superiority of using Hindu-Arabic system over the Roman Numerals. He shows how to use our current numbering system in his book Liber abaci.
The following problem was written in his book called Liber Abaci:
A certain man put a pair of rabbits in a place surrounded on all sides by a wall. How many pairs of rabbits can be produced from that pair in a year if it is supposed that every month each pair begets a new pair, which from the second month on becomes productive?
It was this problem that led Fibonacci to the introduction of the Fibonacci Numbers and the Fibonacci Sequence which is what he remains famous for to this day. The sequence is 1, 1, 2, 3, 5, 8, 13, 21, 34, 55... This sequence, shows that each number is the sum of the two preceding numbers.
0+1 =1 1+1=2 2+1=3 3+2=5 5+3=8 …..
It is a sequence that is seen and used in many different areas of mathematics and science. The sequence is an example of a recursive sequence. The Fibonacci Sequence defines the curvature of naturally occurring spirals, such as snail shells and even the pattern of seeds in flowering plants. The Fibonacci sequence was actually given the name by a French mathematician Edouard Lucas in the 1870's.
If you divide each integer by the one before it (8/5), the average over a large sample comes out to 1.618 while dividing the number prior to the number after it (5/8) you get 0.618. The growth rate for the series is 1.618. Interestingly enough, 0.618^2 is 0.382 and funny enough 0.618 + 0.382 = 1.
So applying Fibonacci to Financial Markets would mean that the chartist believes that the natural growth rate of price moves is 1.618. And for particularly aggressive moves, 1.618^2 which is 2.618. For slower growth rates, we would use 1.382. So we now have the following fundamental ratios for Fibonacci:
When you step back and look at these levels as they’re applied to a chart, they end up representing roughly 1/3, ½ and 2/3 of the most recent “leg” (distance from a swing high to a swing low).
The objective of Fibonacci is to identify a probable future support level, and probable future price projections. You are trying to isolate a particular “leg” on the chart and from such leg calculate the retracement areas and the extension targets.
Fibonacci applied to an upward swing on EURUSD Daily
Fibonacci applied to a downwards leg on EURUSD
Also, try to apply Fibonacci on non-discretional price points like weekly high-low swings, monthly high-low swings or any really evident price swings. The more obvious the swing high and swing low are, the more likely other participants are using them as a reference as well and therefore the more likely it is to be effective.
The main issue about Fibonacci retracements is that they can be applied discretionally. And traders often abuse this discretion and start to apply Fibonacci levels to every tiny, 20-pip price swing they see on the chart. How can you fight this urge? By remembering that the large players do not even look at sub-hourly time frames often, and that they are concentrated on the larger price swings. So if you want to position yourself with the savvy players in the market, you must try to emulate what they do and stick your Fibonacci retracements and projections on larger swings.
As with all other methods of analysis, the Fibonacci relationship is not 100% reliable. It is interesting, though, how often it predicts significant turning points. The only certain fact is that this mysterious ratio is found repeatedly in nature. It was pervasive in the paintings of the Renaissance period, defining proportions and perspective. It was also found in the architecture of Ancient Greek temples, much before Fibonacci was born. You can read more about the natural representations of the Golden Ratio on Wikipedia (http://en.wikipedia.org/wiki/Golden_ratio)
But, as beautiful as this may be in nature, there might be a better reason for the efficacy of Fibonacci levels in the marketplace. As noted, much of the power of Fibonacci levels comes in the form of other major players who use those Fibonacci levels to make their trading decisions. The power of these 1/3, ½, and 2/3 areas can also be explained by those who average their positions. For example, let’s imagine a dealer at a Tier 1 bank creating liquidity.
Let's say the EURUSD is at 1.3000 and the dealer is required to offer (sell) €100million to his counterparty. Then price moves 100 pips against the dealer—in this example, up to 1.3100—and his counterparty is in the black.
The dealer, which is still within his risk limits, sells €200million to average his position. Price rises another 100 pips and at 1.3200 the dealer now sells another €400million. At this point, the counterparty may want to cash in part or all of the position and profit. The dealer, however, needs some sort of retracement in price to unwind his position. His average position is
[ (€100m * 1.3000 + €200m * 1.3100 + €400m * 1.3200)/€700m] = 1.3150
As it turns out, 1.3150 is approximately 1/3 of the range between 1.3000 and 1.3200. That level which is around 1/3 the distance of the rally so far becomes a pullback point where, after price falls to that level, the dealer can then square off (which would causing buying pressure in the pair, helping turn that price area into a support level).
Of course, parabolic averaging can certainly be very dangerous, but dealers do average their position to some extent if they’re confident that the market is more likely to stay in a range. Also, bear in mind that dealers do not deploy their total risk into a few positions. They have deep pockets and manage them wisely.
Usually the way to apply the Fibonacci retracement/extension is to go from the low to the high of a leg up (or from the high to the low of a leg down) and look to buy into the retracement for a move higher (or sell into the retracement if in a leg down). But what if the retracement zone doesn’t harbor orders and price moves through it?
Fibonacci traders have created another way of using the price extensions, in case price blows through areas where it should have found support/resistance:
Price targets to the upside, after the downwards fib failed to offer resistance.
Never forget that Fibonacci is only a tool and its effectiveness will depend on the trader using it. It's an indicator of possible zones of resistance and support, and possible targets that can give you good risk:reward ratios if used properly. But the fact that you draw in certain magic lines on your chart does not mean that the market will obey them. If you can line up Fibonacci with a structural support or resistance, then naturally your odds will increase, but as with any other indicator, you must specialize and know what it can do for you – and what it cannot do for you.
Bottom Line: Fibonacci is a hybrid indicator that has a very sound construction plan in it. It also creates static support and resistance lines, and for that reason is very commonly used by many market professionals. The right ways to use it, and not become a slave of it, is to focus on the higher time frames and most evident price swings. Try to use it the same way each time, so that you specialize in a non-discretional way. Otherwise it may be difficult to know when to expect the zones to hold, or not.
Let's say that we get a great price action setup with confluence, and we want to trade it. Take the example below:
We have a classic daily pin bar setup that has a wick pushing beyond a prior swing point, and then closing back below it. Price subsequently moved lower as we would expect but that's not the point. The point is another: if you took the setup, playing the break of the pin bar, you would have entered, needing almost a 100 pip stop loss. This may be fine, but let’s examine a few ways to reduce your stop loss, allowing you to enter into the same trade with a larger position (and potentially make more money).
Yes: Fibonacci can come in handy for something else rather than confluence. It can help find a value entry on a lower time frame, that can enhance the reward:risk profile of our trade. Below, we have a 1H chart of the same pin-bar entry as the chart above.
Sure, we don't always have the luxury of getting these tight entries...
... but sometimes they really come in handy...
Technical Indicators can also give us a hand in pinpointing good setups. As an example, we'll use the Stochastic Oscillator – which is quite common and therefore used by various sources. The Stochastic Oscillator as defined in Technical Analysis has nothing to do with stochastic processes as known in statistics and econometrics. The stochastic oscillator was developed by George C. Lane in the late 1950s, and is a so-called “momentum” indicator that shows the location of the close relative to the high-low range over a set number of periods. Again, there is no “magic” look-back period to use with your Stochastic Oscillator. 14 periods is the default look-back period – maybe due to some study of the lunar cycle or something similar.
What a stochastic oscillator looks like on a chart. It answers the question: where is price now compared to the high/low range of the look-back period.
Apparently, Lane believed that his Stochastic Oscillator "doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price."
So now you may ask: what is momentum? The rate of acceleration of a security's price or volume. The idea of momentum in securities is that their price is more likely to keep moving in the same direction than to change directions. As such, we should primarily be focused on bullish and bearish divergences in the Stochastic Oscillator. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. Because the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels.
Stochastic oscillator divergences: price diverging from the oscillator
The chart above shows – from left to right – a bearish divergence and then a bullish divergence. What the divergence is telling you is this: price moved slower when making the second high (in the bearish case) when compared to the first high. Price “lost momentum” as they say. To Lane, this meant that price really didn't have enough intent to push higher. Reverse the information for the bearish divergence.
Please note this: the fact that the Stochastic Oscillator is above 80 or below 20 does NOT mean that the market is going to change direction. When the market is trending, prices can keep rising and push the oscillator above 80 or below 20 for extended periods of time.
The best way to use the Stochastic, in our view, is to help time entries within an evident trend or range.
The chart above shows possible timing solutions that can help a trader identify potential entries, in line with a clear trend.
So again, taking a smaller time-frame view of the EURUSD Daily pin-bar example from before, we could have also gotten confirmation from our indicator of choice:
Now that we've seen how price moves, what to look for and where to look for it, we need to address one of the points that makes trading so difficult. The examples that we've given are obviously good representations of what to look for. But maybe one detail has slipped past you. Spot the difference between the setups below. Would you have taken all three? Would you have taken just one?
Not all setups are the same. Just because a support or resistance is rejected, or a swing high or low is faded, it does not mean we can jump into the market. We need to pay attention to these details. We need to create a clear expectation of how much space is available for price to develop. Look to the left of your chart to see how much space the move may have. Avoid trading in the middle of a lot of “noise” or “chop”. This is one of the most difficult concepts to master in trading, but if you are able to filter out your trades with this criteria, it will save you a large number of losses.
To sum up: price action is probably the most robust method of interpreting market moves and market psychology that there is. As long as markets will be populated by humans, there will be repetitive behavior traits that we can learn to exploit. Certain candle formations can show us what the market thinks of a certain level. If that level has also seen a face-off between buyers and sellers once before (a support or resistance) you're adding confluence to what you're seeing. If you can smack a Fib retracement into the same zone, you're onto something! All you have to do is look for “space” and verify your risk:reward. Maybe shift down a timeframe or two to get a tighter entry off a fib retracement or a stochastic divergence. It's nothing more difficult than that. These are excellent ingredients of top tier price action trades. All you have to do is step into the kitchen and start cooking!