Price Never Lies
Price action will never lie to us, it is a fact.
Our politicians might, the car salesman might…but price action is reflective of the inherent truth within the market.
If the price is trending up, even when the best indicators tell you that the market is overbought, the most probable future direction for the market is still up (unless price tells us otherwise, for instance price giving us indication of an exhausted trend.) If the price is going down, no indicator in the world will make the price turn around – despite us jumping up and down and swearing at the screen.
Here we have a sideways market (where oscillators are commonly used). The common strategy here would be to go long when the %K line crosses up over the %D line. A short signal will be given when the %K line crosses back down over the %D line.
As we can see, there are many signals given by the oscillator. What is interesting though is that most of them would have failed. If you think long and hard about it, oscillators fail consistently when even a small trend is in place; even within a ranging market there are multiple “mini trends”
There is no way to possibly see how our balance could have ended up if we had traded every single signal, because there are many variables we don’t know like money management applied, stops and targets used, risk-reward applied and more. Nevertheless, our point here is: an overbought/oversold condition won’t make the price turn around and go the other way, the price just moves regardless of the indicator condition.
What are we saying here?
We are not saying indicators do not work, we are saying that sometimes indicators fail to accurately forecast the future direction of price. We must use technical indicators with other technical tools to increase the indicator signal accuracy.
Remember indicators allow us to see certain condition of price, a condition that is sometimes hard to see by judging pure price action. They also tell us what is more likely to happen, rather than what is going to happen.
It is also important to understand that technical indicators are not magic, they are no crystal ball, they are just a simple guide that helps us determine the likelihood of future price movements.
Another drawback of technical indicators is that sometimes indicators get you in a trade late, after the nice price movement has occurred. They also get you out of trades when the price has gone against you leaving you with fewer profits from a trade. On the other hand, signals generated by price get you in and out the market earlier as the sentiment of traders and investors change.
The mistake traders often make is searching for the “holy grail” solely using indicators,
I hope we have illustrated the pitfalls of that single minded approach
I think you may be starting to get what we are driving at here. Although all indicators have their place – the truth of the market lies in, drum roll please… price action!
As you work your way the lessons you will see how to use this in isolation or in conjunction with indicators to put together a very effective trading system. But hold your horses, we have a way to go yet.
What is the best way to determine/forecast price action?
The best way to determine and forecast future price movements is by using and understanding candlestick behavior. Although candlesticks are also an indicator showing the open, high, low and close price in certain period, they are closely related to price action “itself” and price movements.
Candlesticks can tell us more about price than any other indicator:
They tell us how the sentiment of bulls and bears at certain levels is at any given moment.
Important support and resistance levels.
As indicators, candlesticks can tell us what is more likely to happen.
All this information is taken based on actual price movements, since it is what candlesticks intend to do: Measure price movements.
For example, we could use a long term chart to check on the sentiment of bulls/bears so we can make our trade in a shorter timeframe span.
On this 4 hour chart we see first a bearish then a bullish engulfing pattern. In the first case we will only look for short signals and in the second we only look for long signals, as it is more likely that price continues its way up. The same applies for all our other reversal patterns including shooting stars and hammers etc.
It is a good idea to take a look at your longer term charts now to see if you can identify any of these patterns
Candlesticks also help us determine strong support and resistance levels.
On the chart above, the market had a nice run down, but suddenly the bulls were attracted by those “cheap” levels pushing the prices back up. This behavior made a hammer pattern indicated with the red arrow. Then the price went back down to the same levels. This time we knew at which levels bulls feel comfortable buying. So it is likely that price reacts at those levels again making up a strong support level. There was another nice reversal hammer just before the price moved dramatically higher.
As you may have noticed, we always mention “it’s more likely to happen” or “the most likely thing to happen is …” the reason for this is because there are never certainties (apart from death and taxes as we know but let us not dwell on that), there are odds, but we never know what is going to happen until it happens. We will develop this further later on.
Taking trading signals generated by price action increases enormously the odds of being profitable trades, since they are based on price behavior. This takes us to the next section where we combine signals generated by technical indicators and price behavior.