Price action is the best way of interpreting assets via charts. It is defined as the movement of an asset plotted over time. Traders rely on price action to spot trends, fractals, and market structures. All three assist us with reaching a correct trading decision.
Patterns drive price action by showing data outliers. Visualizing price data allows us to observe an asset’s behavior and spot repeating occurrences. By doing so, we can classify certain events as patterns and trade according to their expected behavior.
This article guides you through trading price action by learning about:
Before investigating candlestick patterns, let’s refresh our memory on candlestick anatomy. The candlestick body is based on the OHCL format:
Note that candlesticks also have shadows. Shadows represent the price gap between a candlestick’s highest recorded point and its close or open price point. Traders sometimes refer to shadows as wicks, especially if the candlestick leaves a large gap between the shadow and the body.
All candlestick elements matter when searching for patterns. Visualizing OHCL price data allows us to anticipate future price action by comparing an asset’s activity to instances where specific candlestick patterns led to very specific price outcomes.
Candlesticks with wicks to the upside and a close price at or below the open price often imply bearish outcomes. These candlesticks faced sharp rejection and had all their bullish progress erased, leading us to believe that the selling pressure was too strong. An array of candlesticks that make lower highs and lower lows also symbolizes a bearish pattern. They have a greater impact than single candle patterns.
Opposite factors create bullish patterns. When a candlestick appears to have bottomed out (huge wick to the downside) the price might trend bullish. We can say the same for candlesticks that engulf previous red candles by rising and closing above their high.
The infamous Gravestone Doji is a pattern where the open, close, and low of a candle are all at the same level and also have a tall wick to the upside. The pattern signifies a bearish reversal as it has faced a sharp rejection. By spotting it in time, you can sell your assets, close your long position, or open a short position to reap the rewards of the after-effects.
To trade the Gravestone Doji pattern, wait for the candlestick to close at the same price it has opened. Once the pattern is complete, open a short position.
Candlestick patterns do not have a 100% accuracy. It’s also possible for traders to negate the effects of a Gravestone Doji by applying severe buying pressure. This is commonly done at key resistance levels where buyers want to close the candlestick above the level in order to flip it into support.
However, the Gravestone Doji occurs rarely and has high accuracy, especially at longer time frames. In this example, traders should bet that the pattern plays out.
There are more than 35 candlestick patterns out there. Memorizing them helps you anticipate future price action and trade along with their expected behavior. However, candlestick patterns are not the only type of pattern that you’ll spot in your trading journey.
Chart patterns are another way of classifying price action. Sometimes it is smart to refrain from zooming in too far and observing individual candlesticks because a group of candlesticks is perhaps part of a structure.
The price action on your screen might look random to you, but to a professional trader, it is perhaps a triangle, wedge, flag, or pennant. These patterns offer important insight into the asset’s future price action. They tell whether the price trend might continue in the same direction or reverse.
Chart patterns are drawn over an asset’s chart by connecting the lows and highs of candlesticks. They often occur at important resistance and support levels, giving the investor a ‘setup’ at which he can enter a trade. Below is an image depicting common chart patterns.
Chart patterns are divided into two categories based on their expected outcome:
Continuation implies that a bullish/bearish trend shall remain bullish/bearish. The trajectory continues in the same direction following short periods of consolidation or correction.
Reversal implies that the price direction might reverse and head in the opposite direction. A once bullish price action can turn bearish if traders fail to break key resistance levels.
Observe the head and shoulders (H&S) formation for instance. The pattern consists of four elements: left shoulder, head, right shoulder, and neckline.
The neckline is the most important part of this formation. It represents the support level at which prices hold on to during the pattern’s formation. The price might range sideways or trend upwards in the head or shoulders area, but it is at risk of heading downwards around the neckline. If buying pressure is not enough to hold the price in this area, it will break down and reverse the trend.
Let’s say I’m trading Bitcoin and have spotted the head and shoulders pattern on a timeframe like 4H. I can safely say that thousands of traders have already spotted the same pattern and anticipate a reversal if the neckline breaks, just like me. My game plan is to create a setup either by:
In scenario A, my trading thesis is that Bitcoin will go through with the H&S. I open a short on the shoulders or head and place a stop loss above the head. If the price bounces from the neckline and grows higher than the head, it will invalidate my setup. But if the price breaks down, I will take profit at the first support level beneath the neckline.
In scenario B, my trading thesis is that the H&S will not lead to a reversal. My bullish opinion leads me to open a long position at the neckline (strong support) and place a stop loss underneath it. If the pattern fails to hold, the price will bounce from the neckline and head into bullish territory. But if I’m wrong, the stop-loss I’ve placed will trigger right at the start of the breakdown, saving me from further losses.
Prices are fractal.
More than 2000 years have passed since the followers of Hermeticism in Ancient Egypt inscribed the phrase ‘As above, so below’ into the mythic emerald tablet – a concept today known as the Microcosm–macrocosm analogy.
The axiom purports that events and occurrences at smaller scales are also found at higher scales and vice-a-versa. In financial markets, we see this occur in the context of time frames with the help of higher time frames (HTF) and lower time frames (LTF).
Timeframes are like Russian nesting dolls. Three 5M candlesticks make up one 15M candlestick. Four of these nest into an hourly-candle, and 24 such sequential candles nest into a daily candlestick. But how do we make use of this? We can use this information to observe price action at HTFs from the perspective of LTFs.
Have you ever wondered why that peculiar 4H candle gave you the impression that it was about to break a resistance level, only to come crashing down moments later? We see its OHCL, but you can’t really tell what occurred during that time without staring at the chart for all four hours.
Give it another look by dividing the 4H candlestick into sixteen 15M candles. You now gain a clearer picture of how the candle progressed and what made it move upwards and downwards at different times. Maybe a Gravestone Doji pattern forced bulls to capitulate and close their positions? If you exclusively limited yourself to HTF, you wouldn’t have noticed that key piece of information.
We can also see the fractal nature of markets with the concept of eternal recurrence. Since markets rely largely on the psychology of their participants, we can say that traders will more likely than not repeat their actions when facing similar trading environments. As a result, price action may repeat itself in a similar fashion in the future.
History doesn’t repeat itself, but it often rhymes. – Mark Twain
You might have noticed that traders sometimes compare historical iterations of price action with ongoing market activity. In the following image, CT trader IamCryptoWolf compares Bitcoin’s price action from the 2017 bull run to Ethereum’s chart in 2022.
By placing Fibonacci lines on both charts, he predicts that Ethereum might mirror Bitcoin’s drawback from 2017 and hit the 61.8% fib line. This means that ETH would hit $2600 before continuing higher if history repeats.
Looking at fractals as nesting dolls, we can conclude that fractals make price action behave the same across all timeframes. We can find a pattern that starts and ends in the same style at 5M timeframes as it did on 1H timeframes.
The image above shows the same scenario happening twice on the EUR/USD trading pair.
The left chart shows that the price established a support level, tested it, and rallied upwards after an unsuccessful attempt to break down. The price action, shown on a 5M time frame, played out in the span of 10 hours.
The right chart shows the exact same scenario. However, the weekly timeframe shows that it took two years for the price action to play out.
What you learn from this is not to gain tunnel vision by selectively gazing at HTF or LTF. Both scopes matter since you can spot HTF trends ahead of time by looking at LTF and vice-a-versa.
To conclude this guide, I will briefly walk you through market structures.
Market structures represent another form of patterns in price action where prices move according to the state in which an asset is found. The three main market structures are:
Price trends upwards or downwards until it finds a level that market participants accept as accumulation or distribution.
Accumulation marks a period where the asset has found a temporary bottom – a minimal price that everyone deems reasonable. Investors buy the asset during this period as they expect the asset to trend up once everyone finishes accumulating.
Distribution marks a period where the asset has found a temporary top – the highest price at which investors are willing to buy. This is a period where market participants sell in anticipation of a trend downwards.
The period in between accumulation and distribution is the trend itself. Traders often refer to this part as the next ‘leg up’ or ‘leg down. Depending on which direction we’re facing, the asset will either make higher highs and higher lows or lower highs and lower lows until it finds a level that everyone perceives to be the trend’s end.
Knowing how to spot the correct phase is crucial. It allows you to anticipate where the market is headed next and trade accordingly. You can use chart patterns to define the end and beginning of a market cycle. Patterns like H&S and double bottom typically occur during distribution, while you can find double/triple bottoms and inverse head and shoulders (IHS) at accumulation periods.
If you want to learn more about price action and market behavior, we recommend checking out the following articles:
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