Price Action & Candlestick Patterns
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The final elements involved in the chart study we use for generating these trade ideas is looking at price action and candlestick patterns. Really when it comes down to it, learning to really read and understand price action on your charts, and what it's telling you about the underlying order flow is probably the most important part of the puzzle.
Aside from just learning to identify price structures that suggest certain outcomes or support a certain idea, the actual candlesticks themselves can be used to act as triggers for entry into a trade for actually pulling the trigger and executing on an idea. In exactly the same way that we can use elements such as trend lines and support and resistance or Fibonacci analysis to help us understand market direction and frame price action, patterns and candlesticks offer exactly the same function. Price action trading is all about studying the past and current behaviour of price with a view to identifying recurring patterns which we can look to exploit in the future.
So let's take a look at some of the key structures and candlestick patterns we focus on when generating trade ideas on a daily basis.
Wedges (Falling & Rising)
The first structure we monitor the market for is the wedge; the wedge is a classic reversal pattern and can signal a bullish reversal where we have a falling wedge and a bearish reversal where we have a rising wedge.
See video at 1:14
The falling wedge is a bullish pattern, formed by converging trend lines which show a narrowing range with waning bearish pressure and building bullish pressure. You’ll notice that the upper trend line, the resistance trend line tends to have a steeper gradient than the lower trend line and the reason for this is that buyers are stepping in earlier on each descent.
Each time price sells off again within this structure you can see that buyers are getting in earlier and earlier and hence we get these Sellers are failing to drive price meaningfully lower and this is the basis behind this pattern. It’s used as a bullish reversal, or continuation pattern precisely because of this information. So in the same way that we can use indicators to get information on price movement we can actually gain information just from studying the actual movement of price.
In this scenario, the contracting range shows that momentum is waning and the flatter gradient of the supporting trend line shows that buyers are stepping in earlier and earlier each time as sellers fail to drive price lower, alerting us to the possibility of reversal.
When monitoring the markets for this pattern however, we don’t just look for them to pop up anywhere. We're always looking for confluence and with these patterns our preferred location is to identify them occurring into key support. In terms of mapping the market and building a trade idea, we will start by identifying an area of interest, so just as we looked at with support and resistance and Fibonacci analysis we’ll look for a solid support area whether that be into the low end of a range or on the break and retest of prior resistance that lines up with a key Fibonacci level. We'll identify the area we would like to trade and then we use the presence of a wedge formation at that location as confirmation of our bias.
See video at 3:12
In this example we can see that we have EURUSD and the areas we’ve highlighted was a really good support level at the time. This 1.08 level in EURUSD had several solid touches, before price broke down sharply through the level in a false breakout before reversing sharply and trading back above the level. So you can see that as we traded down to touch the level again price was forming a really clear falling edge structure and this gives us a great example of how you specifically trade falling wedge structures because they can sometimes be a little tricky so you need to have a clear plan with them.
On the face of it, it looks simple. You wait for a breakout of the resistance trend line to enter, playing for a breakout. But you need to be careful, in terms of where you actually enter, to avoid getting sucked in on a false breakout we always try to enter on a candle close beyond the resistance line just to confirm that the pattern has actually broken.
Obviously the caveat to this is that you don’t want to enter on a really large breakout candle because that compromises your risk reward. Once you’ve entered your stop goes below the low of the pattern, because you need to allow for a potential final test of either the broken trend line, or the low of the pattern, and then your target on these patterns is the top of the structure.
The top of the structure represents a key pivot point for price and so often times what you’ll see is that price breaks out of the wedge trades up hits the top of the structure and then reverses, like you can see here, so at the very least you want to be taking some off there or moving your stop up because it can be extremely frustrating playing for a breakout only to see the trade reverse from that level.
So essentially the breakout is really from the wedge break to the top of the structure. Now obviously the size of the structure is important here because if you have quite a tall structure, as we do here, then you have some good room to play for but if you have quite a flat structure obviously the distance to the top of the structure is a lot less and so in those instances it makes more sense to try and hold and see if you catch a full move.
This example also demonstrates another way in which you can look to play falling wedges and that is where you trade a retest of the wedge once price has broken out. So you can see here where price has broke out of the structure, traded up slightly then come back down to retest the breakout zone and this is a dynamic that you’ll see happen quite often so for those who don’t like to trade breakouts this is another way you can look to trade them, and also for those who do trade breakouts it’s something to really consider because if you move to breakeven too soon you can often get shaken out of the trade before price trades to target which you can see is what happened here.
See video at 8:30
The bearish version of this pattern is the rising wedge. This is simply the exact opposite of what we've seen with the falling wedge, this time we have a rising, narrowing range where the contraction of the range shows waning bullish momentum and building bearish momentum.
In this instance because this is a bearish pattern we want to identify this structure into key resistance so again, looking for the high end of a range or alternatively the break and retest of prior support in line with a key fib level. Trade execution and management is exactly the same as it is with the falling wedge but this time we want to aim for the bottom of the structure.
So this is the first key structure we look out for and it really is a great to keep an eye out because where you get this compression in the market shown by these contracting ranges you often then get quite a powerful move and the pattern can tend to catch quite a lot of people by surprise because although the range is contracting price is still pushing in one direction so these are definitely a pattern that we use a lot and you will often find that you get wedges within wedges which can be particularly powerful e/g you will get a big wedge building on the daily timeframe and then within that you will get a smaller wedge building on the H4 or hourly charts and these can be particularly powerful reversal opportunities.
Head & Shoulders Pattern
The next structure we look out for is the classic head and shoulders pattern and this one is a classic for a reason, you will often find a really clear and head and shoulders pattern at many key reversal points, so this is a really great pattern to include in your arsenal.
See video at 10:22
You can now clearly see where this pattern derives its name! The reason why this pattern tends to work so well is because of the underlying order flow dynamic at play, which demonstrates a clear shift in market sentiment. The left shoulder represents an initial test of highs whereby sellers step in to drive price back down, towards the neckline however buyers once again step back in and force price backup, clearing the orders initially eroded at the left shoulder, to form a new high; the head.
Again, however, supply outweighs demand and price is driven back down into the neckline. Buyers step in once more at the neckline support level but this time are only able to take price as high as the initial high (the left shoulder) where supply again outweighs demand to push price down through the neckline, blowing buyers out of the water, confirming the shift in sentiment.
So essentially the Head represents a capitulation to the topside and the neckline represents the key pivot which once broken sees demand outweighed by supply. Again the location of the pattern is key, we don’t look to just trade these patterns at every formation, we look to identify bearish patterns at key resistance levels, to act as confirmation of the anticipated reversal and we look for bullish patterns at key support.
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The basic strategy for trading the pattern is quite simple; sell a break below the neckline of the right shoulder and target the distance between the top of the head and the neckline e.g. if the distance from the top of the head to the neckline is 100 pips then the target on your sell order below the neckline of the right shoulder should be 100 pips. Again with the entry we prefer to use a candle close to avoid false breakouts, or to avoid majority of false breakouts.
So we can see that we sell as price breaks below the neckline, our stop is placed above the right shoulder and our target is clearly marked and equates to the same distance from entry as that between the head and the neckline.
This example shows quite a strong “textbook” Head & Shoulders forming along a horizontal neckline with both left and right shoulder forming around the same level, however what you will often find is that these patterns develop along a different gradient and so you may encounter patterns with either an upward or downward sloping neckline
Now as with the wedge pattern wherever we identify a structure that we use to trade a breakout, we can also trade a retest of the breakout. In this case we trade a retest of the neckline and we'll actually look at an example of this on an inverse head and shoulders formation to give you a look at that structure because then you’ll also get a look at the bullish version of this pattern.
Trading The Retest Of A Broken Neckline
See video at 13:32
So you can see here that we got a really neat inverse head and shoulders pattern form at key support in NZDUSD. See how it is exactly the inverse of the typical head and shoulders pattern. So in this instance we can see that price reversed higher from the right shoulder as anticipated, breaking above the neckline and then we see that price stalled out and traded back down to retest the neckline before reversing higher again.
And actually you’ll see that before we traded to target we actually tested the neckline a further time. This area which previously was an area of strong supply, capping advances, has now shifted to being an area of demand as buyers overtook sellers at this level and so as price retest the level from above further buyers step in to drive price higher.
Again, as with the breakout of the falling wedge we need to really factor this situation into how we trade the pattern because this dynamic, of breaking out only to retest the trend line, is a common occurrence and if you play the breakout and move to breakeven too early you’re really jeopardizing your chances of success because you end up getting shaken out of a lot of winning trades.
Head & Shoulders With Price Action Confirmation
Another way in which we trade head and shoulders patterns actually also brings us on to our final segment which is looking at candlesticks. Generally you will find that head & shoulders patterns form where the right shoulder reverses around the same level that the left shoulder formed.
This won’t always be the case, sometimes you will get patterns with sloping necklines, but where we get a textbook head and shoulders pattern the left shoulder tends to act as resistance and where we identify a left shoulder and head, respecting a neckline we then wait for price to trade back up into the price level that the left shoulder formed and we trade short anticipating the formation of the right shoulder.
The key element to this trade setup and that is that we don't just trade the level. We wait for price action confirmation, and again we use what is our favourite reversal candlestick, a bearish pin bar.
The Pin Bar Candlestick
See video at 15:47
The pin bar candlestick looks like this and it’s defined by its relatively small body and long wick which is referred to as the nose as in Pinocchio’s nose - hence the name pin bar. Essentially the idea is that (in reference to the Pinocchio story) the nose signals that the candle is lying and so if the candle has a bullish body it signals a forthcoming bearish reversal and if the candle has a bearish body it signals a forthcoming bullish reversal.
The key thing with patterns and price action is always location and so going back to trading a pin bar at the potential right shoulder of a head and shoulders formation the thinking is that because we know the head and shoulders pattern is a solid reversal pattern and that often times, especially with a textbook (flat neckline pattern), the right shoulder forms at the same level as the left - where we see price trade up into the level of the left shoulder and we see a classic reversal candlestick such as the pin bar.
This signals to us that we have a case for getting in at this point here instead of waiting for a break of the neckline we can go ahead and enter on the pin bar candle close.
See video at 17:15
Here is an example of this dynamic in play. You can see that price traded up made a left shoulder, traded past it to make a head then sold off and you can see that price was holding at the neckline area and then started to bounce.
So once we see price moving higher we then mark in the area of the left shoulders and monitor as price goes back up there and you can see that we go back up there and as we touch that level price forms a bearish pin bar, so this to me tells us that we are justified in anticipating the formation of a right shoulder here and we can go ahead and get short.
Now obviously as we said this is a more aggressive entry because we’re entering at what we anticipate will be the right shoulder instead of waiting for the breakdown. But what we’re doing is simply using our knowledge of price action and patterns, reading the market structure and assessing the candlesticks to form a bias and it’s precisely these sort of entries which have helped us to be so consistently profitable with our trading signals delivering over 3000 pips in 7 months.
The beauty of a trade like this is that it greatly reduces risk and allows you to trade patterns which have quite a distance between head and neckline.
So this is just one of the ways in which you can employ candlestick reading such as this and if you are interested in learning more about candlestick reading or about chart patterns then you have got to check out the Forex Trading Course.