By Anne Chapman, TheDynamicTrader.com, @AnneTrader
When learning to trade you will come across numerous methods to help you gauge what price is doing and what it is likely to do next. This could be chart patterns, candlestick formations or numerous indicators either on the chart itself or as a sub chart beneath.
Like Christmas, people can sometimes forget what’s important and often get caught up in the glitz and glamor.
With trading I cannot stress enough that the most important facet is price action.
All indicators are a derivative of price or, on occasion, volume. And if you trade Forex all you have is price. Once you have mastered how to read it you really won’t need multiple indicators any more. You’ll be free to trade with confidence.
So saying, certain patterns and indicators can be really useful in helping you to learn how to read price. But remember – once you have assimilated this knowledge then take it off your chart – you want your charts to be as clean as possible.
DT Tip: If you are new to trading, limit yourself to understanding four to five popular chart patterns, four to five popular candlestick formations, moving averages (especially 200sma on the daily), Fibonacci retracement levels (for trend strength), Donchian channels (for 52 week highs and lows) and Bollinger Bands (for trend identification).
How do chart patterns help me read price action?
A popular chart pattern is a head and shoulders. They crop up quite frequently and are classed as a Reversal Chart Pattern because price tends to reverse after they have formed.
Why?
Well, you can try and follow the rules you’ve learnt or you can think about what it means:
- Price moved up to make a new high (LS)
- Price retraced a little
- Price rose to a higher high (H)
- Price retraced a little
- Price rose again but couldn’t make as high a high as before (RS)
- Price fell
With the left shoulder and the head price was still trending up. But once the right shoulder failed to make a new high clearly the bears were outnumbering the bulls and pulling price down.
So you don’t really have to worry about identifying the pattern, you just need to know that price failed to make a new high which indicates weakness.
Think about other chart patterns and concentrate on what price is telling you rather than how well the pattern fits the textbook picture.
How do candlestick patterns help me read price action?
A popular candlestick pattern is a doji. This is often incorrectly placed in the Reversal Candlestick Pattern category. It is really an indecision pattern. And if you think about why it forms, you will understand the distinction.
- Price opens
- During the bar’s formation price moves up and down quite a bit
- Price closes at, or very close to, the opening price
The features of a doji are long wicks and a very small body. What does this tell us?
It tells us that despite the bulls trying really hard to push price up and the bears trying really hard to pull price down the end result was stalemate.
What it isn’t telling us is that either the bulls or the bears were in control and so price will now go on and definitely reverse.
So, again, you don’t need to remember that a doji is an indecision candle – you just need to understand price action.
Other indicators – the good, the bad, and the ugly
Unfortunately there is not enough room in this article to consider the plusses and minuses of the multitude of indicators out there. Besides, new ones are being created every day!
My main advice would be:
- If it’s simple and you understand it then it’s probably good.
- If it’s complicated and you don’t really understand either how it’s calculated or how to apply it then it’s probably bad.
- And if it takes up too much space on your chart and/or obscures price then it’s ugly and should definitely go!
DT Tip: Technical analysis is a visual game. If you prefer and better understand raw data you are probably more suited to fundamental trading.
New technology means traders can create ever more sophisticated (and complicated) indicators. But the more refined they become the less relevant they are to the markets in general. They are highly likely to work only in certain market conditions. Concentrating on price action, with minimal indicators, helps you understand ANY market condition and trade accordingly.
In summary, it is worth taking the time to learn how to use the most popular indicators. They are popular for a reason – because they have proven to be beneficial to successful traders for many, many years.
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