Price Action: How to Trade Reversals
Trading on key levels is one of the basic principles of Price Action trading in the financial markets. There are two main ways to trade on levels: on the breakout and on the reversal. How to distinguish a correct signal to enter the market from a false one, how to set stop-losses and take-profits and what other nuances should be considered when trading in this style?
🔷 Specifics of trading from levels
Key price levels are present in any financial market, including Forex. Often, these horizontal lines act as either support or resistance to further price movement, which is why traders are so interested in them. These key lines are formed due to the large accumulation of buy and sell orders. When the price reaches such a congestion, the current strength of the trend, as a rule, is not enough to close all these orders and move the price further.
Therefore, if the movement does not get support, the price will turn in the opposite direction. If there are new volumes that are able to break through a great accumulation of orders, it is likely to happen that the trend strength is enough for the further movement, i.e. a strong breakout level will occur. Of course, events do not always develop only according to these scenarios, but these are the two most likely variants. There are big players at the market whose orders influence the price due to big volumes. Because of this, experienced traders only need to correctly identify such levels and signals that the price is most likely to reverse. The classic level is an area based on the opening or closing candlestick prices (not the high/low), which the chart has already touched before. That is, if the chart, having risen to a certain level, rolled back and then approached that level again, the price value at the extreme point will be that level.
🔷 Entering the market
The main condition for entering the trade at the reversal from the level, it is necessary to make sure that it is exactly the reversal. If the price is just approaching the key level, it is too early to open a trade. The trader must form a reversal pattern of Price Action in order to be sure that the position opening is correct.
It may be the following patterns:
1. A Pinbar (a candlestick with a long shadow, level breakout and a small body);
2. Engulfing (the next candlestick is directed in the opposite direction, its body and shadows are bigger than those of the previous candlestick);
3. Tweezer top/bottom pattern (alternation of bullish and bearish candlesticks with the same lows and highs);
Once the pattern is formed, a trade can be opened.
For example, the screenshot above shows a pin bar with a large upper shadow breaking through the resistance level, then rolls back down and the candle closes in bearish status. At the opening of the next candle you can enter the sell trade.
🔷 Setting Stop Losses and Take Profits
Stop Loss should be set in such a way that a random movement against the direction of the trade, such as a level retest with a false breakout, does not knock the trader out of the market. It is impossible to set a specific value (e.g. 10 pips) for this trading style, the stop should be set based on the chart and "tails" of the candles in the visible proximity.
As for take profit, there are no strict rules for its setting. You can use the standard technique, multiplying the value of the stop-loss by 3 or 4 and set a TP on the resulting distance. This is correct from the money management point of view. However, in each situation there may be conditions for greater profits than the standard stop-loss. For example, you can focus on the next key level in the direction of the trade. However, unlike a stop, a TP should be set so that the price is guaranteed to hit it when approaching the key level.
🔷 Important points
1. It is worth paying attention to the strength of the level and the likelihood that it will break or hold. There is a common misconception that the more price reversals from a level, the more likely it is that the level will remain intact. In fact, if the price keeps testing a certain level over and over again without going into the opposite trend, it means that it is likely to be broken. In practice this means that it is better to skip the third and the next attempts of a level bounce, trading on the second one only.
2. One should not draw a distinction between a classic reversal from a level and a retest of the level after it has been broken, when, for example, support becomes resistance. Such a retest is an even stronger signal than a simple reversal. The probability of a successful trade is even higher if we obtain a clear signal for reversal after an unsuccessful attempt to break through the level in the opposite direction.
3. The probability of a reversal or breakout of the level can be assessed based upon the movement towards the key level. If the previous candlesticks were small and differently directed, but the price has still reached the level, a breakout is quite probable. If the trend was strong and confident and the level was reached in just a few candles, but was not broken through, most likely, it won't be broken through. This phenomenon can be explained by the fact that market makers are trying to mislead small traders, playing on visual triggers. Seeing a strong movement, the trader unconsciously waits for a breakout and as a result suffers losses giving his money to the market maker.
According to this logic, the conclusion can be made that if a big candle has reached a level, stopped in it, and closed without breaking through it, a breakout will probably never happen. But if a powerful candle has broken through the level, passed some more points (or tens of points), and closed on the other side, the breakout can be considered to have taken place.
4. When opening a trade, attention should be paid to the extrems of the nearest candlesticks. If the maximums (when testing the resistance) are approximately equal, or differ by 1-2 points, this supports the signal for the reversal and the pullback. The same is true for candlestick minimums when testing support.
🔵 Conclusion
All other things being equal, a reversal of the level is more probable than its breakthrough. Such statistics gives a trader the reason to count on more signals and following the strategy rules will ensure profitable trading. However, one should keep in mind that trading from levels is a tactic that requires a trader's experience to be able to make decisions according to the situation. Despite the presence of rules, there is no clear algorithm that would regulate the actions in any situation.
And due to this, a trader who uses the analysis of levels in his trading system, can count on the success of his trade. Most trading systems, allowing to open trades on an automatic basis, very quickly lose their validity, as well as trading robots based on these algorithms. The market is constantly changing, and only the ability to adjust to these changes and make decisions depending on the situation provides professional traders with a stable and high income.
🔷 Specifics of trading from levels
Key price levels are present in any financial market, including Forex. Often, these horizontal lines act as either support or resistance to further price movement, which is why traders are so interested in them. These key lines are formed due to the large accumulation of buy and sell orders. When the price reaches such a congestion, the current strength of the trend, as a rule, is not enough to close all these orders and move the price further.
Therefore, if the movement does not get support, the price will turn in the opposite direction. If there are new volumes that are able to break through a great accumulation of orders, it is likely to happen that the trend strength is enough for the further movement, i.e. a strong breakout level will occur. Of course, events do not always develop only according to these scenarios, but these are the two most likely variants. There are big players at the market whose orders influence the price due to big volumes. Because of this, experienced traders only need to correctly identify such levels and signals that the price is most likely to reverse. The classic level is an area based on the opening or closing candlestick prices (not the high/low), which the chart has already touched before. That is, if the chart, having risen to a certain level, rolled back and then approached that level again, the price value at the extreme point will be that level.
🔷 Entering the market
The main condition for entering the trade at the reversal from the level, it is necessary to make sure that it is exactly the reversal. If the price is just approaching the key level, it is too early to open a trade. The trader must form a reversal pattern of Price Action in order to be sure that the position opening is correct.
It may be the following patterns:
1. A Pinbar (a candlestick with a long shadow, level breakout and a small body);
2. Engulfing (the next candlestick is directed in the opposite direction, its body and shadows are bigger than those of the previous candlestick);
3. Tweezer top/bottom pattern (alternation of bullish and bearish candlesticks with the same lows and highs);
Once the pattern is formed, a trade can be opened.
For example, the screenshot above shows a pin bar with a large upper shadow breaking through the resistance level, then rolls back down and the candle closes in bearish status. At the opening of the next candle you can enter the sell trade.
🔷 Setting Stop Losses and Take Profits
Stop Loss should be set in such a way that a random movement against the direction of the trade, such as a level retest with a false breakout, does not knock the trader out of the market. It is impossible to set a specific value (e.g. 10 pips) for this trading style, the stop should be set based on the chart and "tails" of the candles in the visible proximity.
As for take profit, there are no strict rules for its setting. You can use the standard technique, multiplying the value of the stop-loss by 3 or 4 and set a TP on the resulting distance. This is correct from the money management point of view. However, in each situation there may be conditions for greater profits than the standard stop-loss. For example, you can focus on the next key level in the direction of the trade. However, unlike a stop, a TP should be set so that the price is guaranteed to hit it when approaching the key level.
🔷 Important points
1. It is worth paying attention to the strength of the level and the likelihood that it will break or hold. There is a common misconception that the more price reversals from a level, the more likely it is that the level will remain intact. In fact, if the price keeps testing a certain level over and over again without going into the opposite trend, it means that it is likely to be broken. In practice this means that it is better to skip the third and the next attempts of a level bounce, trading on the second one only.
2. One should not draw a distinction between a classic reversal from a level and a retest of the level after it has been broken, when, for example, support becomes resistance. Such a retest is an even stronger signal than a simple reversal. The probability of a successful trade is even higher if we obtain a clear signal for reversal after an unsuccessful attempt to break through the level in the opposite direction.
3. The probability of a reversal or breakout of the level can be assessed based upon the movement towards the key level. If the previous candlesticks were small and differently directed, but the price has still reached the level, a breakout is quite probable. If the trend was strong and confident and the level was reached in just a few candles, but was not broken through, most likely, it won't be broken through. This phenomenon can be explained by the fact that market makers are trying to mislead small traders, playing on visual triggers. Seeing a strong movement, the trader unconsciously waits for a breakout and as a result suffers losses giving his money to the market maker.
According to this logic, the conclusion can be made that if a big candle has reached a level, stopped in it, and closed without breaking through it, a breakout will probably never happen. But if a powerful candle has broken through the level, passed some more points (or tens of points), and closed on the other side, the breakout can be considered to have taken place.
4. When opening a trade, attention should be paid to the extrems of the nearest candlesticks. If the maximums (when testing the resistance) are approximately equal, or differ by 1-2 points, this supports the signal for the reversal and the pullback. The same is true for candlestick minimums when testing support.
🔵 Conclusion
All other things being equal, a reversal of the level is more probable than its breakthrough. Such statistics gives a trader the reason to count on more signals and following the strategy rules will ensure profitable trading. However, one should keep in mind that trading from levels is a tactic that requires a trader's experience to be able to make decisions according to the situation. Despite the presence of rules, there is no clear algorithm that would regulate the actions in any situation.
And due to this, a trader who uses the analysis of levels in his trading system, can count on the success of his trade. Most trading systems, allowing to open trades on an automatic basis, very quickly lose their validity, as well as trading robots based on these algorithms. The market is constantly changing, and only the ability to adjust to these changes and make decisions depending on the situation provides professional traders with a stable and high income.
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🔻FREE Telegram channel🔻
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