How to read charts. Technical Market Analysis
Hey there, Protraders!
Many people, especially at the beginning of their adventure with trading wonder what will happen next, what price will do in an hour or by the end of the day. When we start looking for methods to predict future price movements, we will find plenty of different analyzing techniques rather quickly. Many people think that to make a good trade, they need to learn how to make good analysis. It's well known fact that investment banks got probably most professional analysis in the world and what comes next are their financial reports with outstanding trading profits.
First thing we will probably walk on is Technical Analysis or Price Action. Both these methods focus on a historical price behavior and try to extend it to the future - as history tends to repeat itself. It seems totally understandable, as to know where we are going we need to know where did we start and which way we're moving. For example, if price bounced at a support level and formed upward candle, and next one is upward as well, we can anticipate that heading that way price will eventually hit the nearest resistance.
On the other hand, some Technical Analysis opponents speak up here saying that you cannot drive a car observing reverse mirror only. Or if you'll sit at a bus stop tracking colors of bypassing cars, you will find it very difficult to predict next car basing on colors of preceding cars. Does three green cars in a row would signal that fourth or fifth will also be green?
But such approach assuming that markets are totally random is very extreme and most probably unable to defend it in argument.
Beginner traders often look at charts and think, i.e.: "It went down a lot, so I think it will rise up now", or "Now it looks like it will drop". It's simply reading a charts but without the skill of reading. It's like you would take book written in Chinese and looking at writing you would try to guess if the book is good or boring.
But let's start from the beginning
On a chart each candle has its meaning. Well, maybe not each and every candle, but most of them. From each candle and each set of candles you can acquire some information. Taking any piece of chart, couple subsequent candles, into consideration, we may find information about what market is doing right now. How? Each candle can be described by 6 basic parameters: (1) open, (2) close, (3) high, (4) low, (5) time, (6) range. Out of these values we derive other measures such as: wick length, body length, ratio of a wick compared to body, candle's dynamics - range compared to time, etc. Each timeframe, each candle, looks like it really looks not without a reason, and not by accident. Candle with a big range and small body may mean that market was undecided at that time, while long candle with big body will prove strong supply or demand on a market during certain time period. If counter wick is short or absent at all, it may mean that market was basically one way and no one was going to fade the move or take profits of it at that point in time. Will such situation last in close future? If market was undecided or bold, how long would such state persist? Why buyers are buying and sellers are selling? Well, an answer to this question will probably come to us from the "big picture". Long supply candle in an uptrend may mean temporary profit taking, i.e. on a weak data release. But eventually probability favors trend continuation, and traders love to buy such dips. On other occasion strong candle breaking out of consolidation may mean that market decided to pick direction, and we should not buy such dip, obviously.
Context and current situation
If we place two moving averages, slow one - showing tendency in a longer term price movement - and fast one - which follows price with low latency - then we will receive example of a context (big picture) and current situation (small picture). Therefore, in certain trend (slower moving average) we can identify retracements, impulses and periods of consolidation (faster moving average) which might be a potential supply/demand area.
Why context is so important?
When we begin to learn various types and methods of analysis and we focus on them so much, that we may lose attachment to basics. We start to use trend lines, indicators, channels, supports and resistances, etc. which proved to be good signals with assumption that these signals will pay well no matter what. We assume logical consequence - if A then B. We read on forums or in books about patterns that should result in reversal or bounce or at least they give good chance of that. However in practice we will fail on these signals very often while theoretically signal was perfect. After we test such approach of focusing on single signals, we start to discover, that proper signal is not the only thing that matters but also context in which it occurs is important as well. And now, context is a confusing thing here. Pinbar in any position is not any specific clue about future price action. But Pinbar on a support or resistance level may suggest some certain market reaction. But even here we will find it difficult to trade, as support and resistance levels tend to be broken.
Context or prevailing trend (technical and fundamental) will tell us the way of interpreting such signals we are finding on charts. Well known rule says, that trader should not sell in an uptrend nor buy in a downtrend.Signals that stay in opposition to the trend most often are ignored by market or tied with potentially great risk and small reward - it's a reversal of what we should chase in our trading. Trend is all about breaking S/R levels on its way even if these levels are able to hold price for a while.
Specialization will be the key
Many traders found their specialization in certain ways of analyzing and interpreting charts. They focus on waves, candles, patterns, indicators. After some time certain schemes on a chart become clear to traders what allows them to read charts more effectively. For example, they see higher trend and signals warning of possible retracement. Trader starts to notice continuation or reversal signals which help him to determine whether it's better to stay in position or run out with profits.
We can read from the chart using couple most basic terms and patterns like: impulse/momentum, retracement, wicks, reversal patterns like double bottom or double top, supply or demand zones, candlestick formations, movement range correlation (harmonic patterns or trend lines, channels, etc.) and many more. Prevailing trend shows us the tendency among traders on a given instrument. And trend always tends to continue, so we should properly treat signals we find regarding if they are in line with the trend or opposite. We may count waves, use moving averages, highs/lows positioning or one of many other techniques to determine dominating context for our trading signals. Therefore trader does not need dozens of signals to generate profits - usually trend accompanied by 2-3 good entry signals should be enough.