Principles of the forex trading beginner strategy
The forex beginner strategy teaches you the basics of reading charts and gets you used to entering trades – it is an entry point into forex trading. You learn by doing and for this reason we have told you what to do, but not why you should do it.
For example, we make use of fractals to make decisions, but we do not tell you why we use fractals or what they really are. In this lesson we explain the principles and the idea behind the forex beginner strategy to give you a broader understanding of how the beginner strategy works
Fractals signal a reversal
Fractals are an indicator and they signal that the market direction could reverse.
When a fractal appears on your chart, it is telling you that a particular type of price action has happened in the market and that a reversal is likely.
When an up fractal forms, it is because the following has happened:
- The price has made two highs – the buyers made two attempts at pushing the price up.
- The price has made a higher high – the buyers made a bigger attempt at pushing the price up.
- The price afterwards made two lower highs – the buyers made two further attempts at pushing the price up, but could not get the price as high as the three earlier attempts.
The following chart shows this price action on a chart:
- Two highs
- Higher high
- Two lower highs
This pattern is common in the markets and when this happens, your trading software puts a fractal above the highest high.
The buyers in this case have attempted to push the price to a higher level no less than five times, however the selling pressure was too great, in which case this signals that the sellers are in control and so it is likely that the price will reverse to the downside.
When a down fractal forms, this is the other way around:
- The price has made two lows – the sellers made two attempts at pushing the price down.
- The price has made further low – the sellers made a bigger attempt at pushing the price down.
- The price has then made two higher lows – the sellers made two further attempts at pushing the price down, but could not get the price as low.
The following chart shows this price action on a chart:
- Two lows
- Lower low
- Two higher lows
The sellers in this case have attempted to push the price to a lower level no less than five times, however the buying pressure was too great, in which case this signals that the buyers are in control and so it is likely that the price will reverse to the upside. When this happens, your trading software puts a fractal below the lowest low.
Trading platforms can jump the gun
Some forex trading software, such as MT4, will print a fractal when the pattern starts to form. It puts the fractal onto the chart at the time of the highest high or lowest low – it does not wait for the pattern to complete, but rather alerts you to the fact that the pattern is currently forming. However, because it is not complete, you have to wait for the last two candles to make sure that the pattern has finished forming and that the fractal does not disappear.
Why do we wait for the price to break the fractal?
Using the example of a down fractal, when it is printed, this means that a reversal could happen. That is, the sellers have attempted to push the price down, but the buying pressure was too strong.
Because of this, there are many traders that open buy positions in the market. This is logical, because the price behaviour has shown that a reversal to the upside is likely. Those traders that are opening buy positions are likely to be placing stop losses on various levels below the fractals and the lows of the candles.
- Fractal indicating a reversal to the upside
- Likely long entry after the fractal has appeared
- Likely stop loss placement below the fractal.
When you buy, your stop loss is actually a sell order – it closes your position by selling the asset that you bought.
If the price was then to break below this level, then these stop losses will be triggered, adding additional selling pressure in the market. Under this selling pressure, the price is likely to fall.
- Down fractal that has been broken by the price
- Under additional selling pressure, the price continues further.
So we wait for the fractal to be broken because the fractal itself provides a strong signal that the market may reverse, but a broken fractal gives an even stronger signal that the market will continue. This is why we use broken fractals to determine the market direction and to enter into the market.
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Pivot points are more than just random lines
Pivot points are price levels that have been calculated from price action that happened the day before. They are used by many traders, including banks and financial institutions to enter and exit the forex markets.
Pivot points are calculated from yesterday's data
To calculate pivot points, you take the average price between the previous day's highest price (H), lowest price (L) and closing price (C):
This gives you an average of the most significant prices from the previous day. If the price is trading above this average, then it stands to reason that there is a higher amount of buying pressure in the market and vice versa if the price is trading lower than the average of these prices.
For this reason, it is said that this price level – the main pivot or daily pivot – is the point at which the market “pivots” around, which is just another way of saying “centred” around. This is where the name pivot point comes from and so you can think of the daily pivot as the centre point of the market.
This means that when the price reaches the pivot point from below, sellers are likely to come in and push the price down and when the price reaches it from above, buyers are likely to come in and push the price back up. Of course, sellers and buyers can push the price below and above the daily pivot point respectively, however, it generally acts as a floor or a ceiling at which the price is likely to stop once the price has reached it.
The additional pivot points, R1, R2, R3 and S1, S2 and S3, and the mid-pivots, labelled as M1, M2 etc, are all calculated from the daily pivot.
The following chart shows the pivot points on a price chart:
Buyers and sellers use pivot points to enter
When the price reaches anyone of these price levels, then traders are likely to sell if the price has reached it from below, or buy if the price has reached from above.
The following chart demonstrates how in an up trend, the price reacts around the pivot point levels, because traders are selling or closing their buy positions. The green shaded areas in the chart show the point at which the price meets the pivot levels.
The pivot level at 1 is stopping the price from going down any further. When the price moves up to the second pivot level, shown as 2, you can see how the price seems to stop and struggle to get higher. This demonstrates that for a time, the sellers were entering the market at this level. When eventually the price moves up again and meets the third pivot level, shown as 3, the price again stops as buyers close their positions and sellers open new positions.
If you know that the majority of traders are using pivot points to make trading decisions, that is, where they are buying and selling, then price is more likely to react around these price levels. Understanding this means that you know two things:
- When the price reaches a pivot point there is a chance that the price will not go any further.
- Other traders are likely to wait until the price reaches that price level before they make trades, which makes it even more likely.
For this reason, they make very good profit targets.
Multiple time frame analysis can enhance results
The forex beginner strategy uses the principle of multiple time frame analysis because of the benefits in reducing the risk as well as maximising the probability of the trade working out.
Increasing the probability
By understanding what is happening over a longer period of time, you can make more accurate decisions when looking for trading opportunities on the smaller time frames.
If there is a long-term trend on a higher time frame, then trading in the direction of that trend on the lower time frame is likely to produce a higher probability of winning trades.
That is the idea behind using multiple time frame analysis in the beginner strategy. When you look at the chart on a 30 minute time frame, you are not just looking at the price action over a thirty minute period, you are observing the price action of at least the last day or so.
This means that you can observe the general direction over the last few hours and then trade in that direction.
Of course it is not easy to always decide which way the market is trending, which is why we make use of the fractals that give a clearer indication when the price breaks through them.
The following two charts show the same time and price action on the 30 minute chart and the 5 minute chart. The green shaded area highlights the exact point in time that we are observing. On the thirty minute time frame, you can observe that the trend is up. This is further confirmed by an up fractal, shown at 1, being broken, shown at 2.
- Up fractal being broken
- Break of the up fractal indicating an upward direction in the trend
This means that if we now take long trades, we are trading in the direction of the trend and so the trades we take have a better chance of working. We can then go to the lower time frame and find more precise entries.
The following chart shows the same period in time on the five minute chart. Following the beginner strategy principles, we now look for a broken down fractal, shown as 1, followed by a broken up fractal 2, at which point we enter.
- Down fractal and the break
- Up fractal and the break, at which point you would enter the long trade
This means that now you can trade in the same direction as the overall trend and maximise the potential for winning trades.
Reducing the risk
When you switch to the five minute time frame, the time period along the bottom stretches over a much smaller time period than it would on the thirty minutes.
You might also notice that the price moves further in a thirty minute period than it does in a five minute period. The candles on a five minute period will therefore be smaller than they would on a thirty minute period.
The beginner strategy instructs you to place a stop loss at the tip of a down fractal in a long trade and the tip of an up fractal in a short trade. Because the candles on a five minute chart will be smaller in comparison to the thirty minute chart (because the price does not move as far on the five minute chart), this means that the stop loss on a five minute chart will be closer to the entry than it would if you made an entry using the 30 minute chart alone and placed a stop loss on the thirty minute chart.
The following two charts demonstrate this. The green shaded area is again the same price action and point in time on both the 30 minute chart and the 5 minute chart. On the 30 minutes chart, if you would have entered using the break of the an up fractal, shown as 1, then the stop loss would be placed at the tip of the last down fractal, shown as 2. As you can see, this is a considerable distance between the entry at 1 and the stop loss at 2, shown by 3 – over 65 pips.
Break of an up fractal
Most recent down fractal where the stop loss would been placed if the trade was taken on the 30 minute chart.
The following five minute chart demonstrates that by waiting for a good time to enter, you can trade in the current direction of the trade, but the entry, shown as 2, is a much shorter distance to the last down fractal, shown as 1, than on the 30 minute chart. The distance between them, shown as 3 is just over 12 pips away, a much lower risk than over 65 pips on the 30 minute chart.
- Most recent down fractal where the stop loss would be placed
- Break of up fractal signalling the long entry
You have reduced the risk of the entry on the lower time frame, however you are trading in the direction of the over all market trend and so you have combined the benefits that both time frames offer.