Posted on: 19 Nov, 2018
In this article, I am going to dissect the very critical component of how to choose the right battle to fight in the forex market. This article should be your Go-To to help you pick the areas of significance where decisions will be made, creating launching pads to move into new territories and advance ground.
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If you’ve been reading my tutorials, you know that the closest thing I’ve ever encountered that may resemble the holy grail in trading comes down to the power of win rate, risk-reward, risk management, and selecting the right broker with a range of services to render tailored to your needs, period.
The way I see perfection in trading is, therefore, nothing more than picking the right battles, at the right time (win rate), position yourself to gain the most ground in each victory that you claim (risk-reward), while calculating with precision the number of troops to deploy in each battle (risk management).
In this article, my focus will be on one how to choose the right battles to fight in the forex market. Ultimately, this write-up and the video exercise that will follow is intended to be your Go-To guide to help you select areas of significance where decisions will be made. It is precisely at these areas where we will find ourselves at thr right junctures to engage in trades. As an analogy, these areas should be seen as launching pads to move into new territories and advance ground.
The reason lies in the ability we all have as traders to easily eyeball where these levels are located in the chart. This makes such levels the most universal form of reference for participants to use. It also makes the selection of these vicinities objective in nature as the market can easily agree on their location.
As a result, they act as a magnet to attract and repel prices due to the liquidity that resides near-by. Since every participant can spot the whereabouts, it is precisely at these junctures where the larger share of stop placements will be found, which creates pools of liquidity, hence areas of interest worth fighting for.
Entering trades around areas of highly concentrated liquidity is absolutely essential for large institutions. These titans of the market have a pressing need to transact large sums of capital to the tune of hundreds of millions if not billions of dollars on behalf of their clients or for purely speculative purposes.
If large sums of capital were to be transacted around thin volume activity areas, as an analogy, large players would be shooting themselves on the foot by getting poor entries.
Why is that? Because of the lack of counterparties to fill in their orders. The absence of liquidity would, therefore, lead to average entry prices that are far from ideal as they'd be driving prices against themselves. That’s why major players are especially active around areas of high volume activity or liquidity.
Why do you think we hear the term manipulation or stop loss hunting so often? Because liquidity is the oxygen of every large player, it’s essential to have them involved at the size of trades they intend to. There is no better place for large players to get involved than in the areas this article will teach you to identify.
Trend lines can be more subjective to be determined, which is the primary reason why I personally wouldn’t add as much weight compared to key static or horizontal levels as a standalone indication. That said, they certainly can still serve us very well for several reasons.
First of all, it’s a great tool to visually represent the type of trend at play and its dynamics. Are we trading with a very steep trendline? Is the trend developing with a less pronounced angle trendline? The angles of the trendline hold valuable information that one can use to their advantage to gauge market directions.
However, nothing comes close to the power a trendline has when combined with a level of horizontal support or resistance, as that communicates that a lot more eyes will be paying attention to the level. It also creates the phenomenon of confluence, in other words, the overlapping or cluster of different key levels around the same area.
Whether it is drawing horizontal levels or trendlines, you must start this process by squeezing your charts, so that you can visually identify the maximum number of interactions a particular area has exhibited in the past. I recommend about 5-10 years in the weekly, 1 year on the daily, and 1 to 2 weeks on the hourly chart.
Drawing the right levels of horizontal support and resistance and trend lines is definitely more an art rather than an exact science. It takes screen time and training your eye. Anyway you slice it though, it all starts from the very foundation of the ability to get enough data points of reference. By zooming out the chart, you can develop a much-needed eagle-view of a chart’s history.
The higher the time frame, the more relevant the area identified becomes. You must think about the top-down order of timeframes as dissecting the anatomy of a chart by studying the structure of its parts. As we move up in time frames, each candle contains a greater amount of information.
What this translates into is that by identifying areas of high interest on higher time frames, it will invariably represent the opportunity by major players to find very large pockets of liquidity. These areas will allow them to fill in their orders at the best average prices before a resolution, which will involve a markup or markdown phase.
To limit the risk of suffering analysis paralysis, which is nothing else than an overdose of information, I’d personally wouldn’t suggest cross-checking more than 3 time frames.
I personally use the weekly and the daily to make a well-informed judgement of the context at play, while the hourly and at times the 15 minutes are the time frames where I will concentrate most of my time and resources to find the trades in line with the direction dictated by the site in control on the higher time frames.
To make a distinction about the levels of relevance based on the timeframes they refer to, I recommend using different colors. I personally use the red color for the weekly (left chart), the blue for the daily (middle chart) and the black for the hourly (right chart). This applies to both the levels of horizontal support/resistance as well as trend lines.
Let’s briefly dive into this concept. For a level to be considered a horizontal support or resistance, the number of times it must be tested does not necessarily need to be a minimum of 2. It’s also dependable on the type of market conditions (trend, counter-trend, range).
If trading with an existing trend, the creation of a unique point (swing high/low) from which a strong departure is seen, that by itself constitutes sufficient evidence that the next time the level is tested, it may hold relevance. As you will find out by reading this guide, the number of tests a level has is just one factor to account for.
There is much more to it that will determine the quality of a static support and resistance, so for now, I command you to keep moving along.
Bottom line: The number of tests for a level to become static support or resistance doesn’t need to be a minimum of 2 unless we are talking about trend lines. In the case of trendlines, this rule of 2 does apply as otherwise, we could never have the second anchoring point to keep the line dynamically adjusting.
Let me put a debate to bed. We tend to see the camp of traders endorsing the drawing of horizontal levels taking the candle closes as a reference. Then we find the camp that tends to select the tails to draw levels of support/resistance from.
There is no right or wrong. What matter here is to understand the concept of liquidity, as that will allow us to approach charts from the right perspective.
If you think the market will concentrate pockets of significant liquidity at the horizontal levels represented by the close of the candles, you are right. If you think about the tail and beyond as a level rich in liquidity, you are also right as that’s where stops tend to be placed. You must account for both while understanding market auctions.
When you analyze a chart, what you see in front of you is nothing more than the representation of an auction process for that particular time frame.
You could think of any market as an auction to sell a Picasso painting. The peculiarity is that participants are free to determine the fair value of the painting up and down up until the close of the candle, at which point we will be in a better position to make a judgment call on the value perception about the Picasso for that particular day.
If we were looking at the daily, the close of the candle at 5 pm N.Y. time would, therefore, represent the price at which the market has agreed to transact the Picasso for. The tail also offers valuable information, as it would tell us at what price level the market decided to reject the price and said enough is enough.
My preference is to draw levels of support or resistance not based on market closes or the tails, but by identifying what levels have had the highest number of interactions.
Remember, part of the success in picking the right battles is to identify the number of times a level has acted as a turning point in the past by assessing the number of interactions, that’s what we want to identify.
The more times an area is tested, if other boxes are also ticked, the more relevance it holds. It doesn’t matter if the area is drawn through the close or the tail of the candle, both hold weight, what is more important is the number of times the market has interacted with this level in the past.
With regards to trend lines, since it serves the secondary purpose of either finding confluence or as a mere visual representation of the trend, I am more inclined to draw the trendlines off the tails. I’ve never invested the time to get into the route of drawing trend lines through the candle closes as that would be, in my opinion, a less accurate way of representing the market dynamics, which should factor in highs/lows achieved.
Also note, I personally validate trend lines if they are in line with the dominant cycle. What this means is that the number of interactions is not what I base my decision on to draw a trend line, but whether or not it’s conducive with the new lows or high in line with underlying cycle in the time frame being studied. As long as the market continues to respect a down cycle, a descending trendline can be applied, up until the moment we transition into a range. Same applies for an up-cycle/uptrend.
It’s also worth noting that the 3rd touch of a trendline tends to hold more relevance. Personally, whenever the context is right and I find a horizontal level of interest that happens to intersect with the 3rd touch of a trend line, more often than note, I know this level represents an opportunity to find trades based on the confluence found.
How the price departs from a specific price point will determine to a certain degree the quality of the static horizontal level.
The more impulsivity or velocity away from a level, the more pronounced the imbalance of supply or demand it is. That’s a universal principle of supply and demand that all market participants will immediately agree on, which would then create points of reference, hence opportunities on a retest.
However, that’s just half the equation. The impulsive departure is one aspect that adds credence to the level, the second determiner involves asking yourself how much ground did the market manage to advance after the creation of this static horizontal level? Did we break into new structure lows or highs? Did we simply retest those levels?
In the example below, the price took off with extreme velocity and made it all the way back down to retest the previous swing low, which is what I call a ++ level. Have a look at the second chart below where I classify the type of moves away from a level and how they may be graded.
Similarly, if a level that used to be support now turns resistance or vice versa, how can we grade it?
The answer lies on the same concepts, that is, the velocity of the breakout and its extension. The first test of the backside of a level tends to be the most powerful as it’s that first pass that still occurs within the context of a developing trend and supportive market structure. The more times the level is tested, the more dubious the market structure becomes and the more we exhaust the liquidity at that level. Find an example below.
Here is a trick for you. Above, I suggested using different colors based on timeframes, right?
You could take it even further by drawing lines of support and resistance depending on the quality of the level. If it’s a +++ or high quality, you could use a thick line, if it’s still solid but fails to break into new highs/lows (++), a dash line could be used as reference, while a dotted line could be the line you draw if the level happens to be low quality (+).
The more recent the formation of the horizontal level, the more relevant it holds.
A level in the hourly chart that was formed 10 days ago may not hold as much relevance as one that just occurred in the last 24 or 48h. The main reason has to do with the re-allocation of liquidity based on new market structures or the exhaustion of it due to multiple tests. The markets are constantly evolving by adapting to new information.
Remember, it’s important to take a holistic approach by accounting for both the recent activity as the heavyweight barometer, but at the same time, understanding how many times in the past this level has also acted as a turning point, even if that hinges in the first premise, that is, the ability of the level to still being respected in recent times.
Whenever you encounter a situation in which within a relatively small range you have the potential to select several horizontal lines, I suggest not to draw multiple levels as illustrated below. You want to stay away from adding complexity or in this case, a messy chart with an excessive number of lines.
Instead, as a rule of thumb, whenever you notice a cluster of levels with minimal separation among them, select the level that is further away from the price. Alternatively, the one that has acted more reliably as a key support or resistance based on the number of interactions. Check the second chart below.
This concept is absolutely critical for you to understand. The best trades you will even find off areas of high interest occur in line with the dominant market structure. Therefore, you must constantly ask yourself if the retest of a good quality area of support happens to occur in the right context.
We should interpret the term context as to whether or not the market structure is favorable for a potential rejection of the level or does the current cycle heightens the risk of the level failing to hold. Find below an example where the resistance is highly graded yet the market structure is no longer in our favor.
I wrote extensively about engaging at areas of high value with the structure in favor. You can find my article on How to trade off liquidity levels following a structure breakout. If you also want to find out all there is to know about my approach to read market structures, then make sure you read this tutorial on How to read market structures in Forex.
As important as it is to validate and grade a level of support and resistance where we know liquidity will be found, it’s also cardinal that we come up with some rules to invalidate the level. To determine that, we will apply the concept of acceptance and rejection above or below the level.
There are two ways to go about it. The rule that I personally apply to dim a support or resistance broken comprises consecutive price closes past the level (minimum 2 candles in the hourly, 1 enough if daily or higher). If you are looking for even further evidence, you could find it by seeing that the market is now treating the former resistance as new support or vice versa. That should be the ultimate clue. I will be using the same chart example above to help you understand this concept.
After you've gone through your daily study levels, it's time to start asking yourself the important question. How many eyes will be on this level today? Does it represent only a level of horizontal support on the hourly, with few retests and having achieved very little? In that case, the weight and lack of confluence would be worrisome, suggesting that the amount of liquidity may be easily absorbed by the side with the upper hand riding the trend.
What if the area price is about to interact with represents a daily level, it also happens to intersect with an hourly trendline, and it's at a round number? While far from a guarantee that the level will hold, right here you have a great example of what confluence should be about. In its simplest form, it's the overlapping of critical levels around the same area, which would undoubtedly increase the liquidity and therefore the interest of the market to engage in business activities.
All the prep that you have conducted by identifying and grading each and every level of interest in the chart, from higher down to lower time frames, serves the ultimate purpose of you knowing what fights you want to get involved in. Because you know this is an area of liquidity that acts as a magnet to attract and repel prices, which puts you in a good position to ride a move if you happen to pick the right move. Now, it all comes down to choosing what’s going to be your style when entering at these critical levels.
I highly recommend that when you conduct your chart studies, you keep an easy-to-read reminder of all the key points we touched on this article.
Just as in aviation must go through a preflight checklist of the tasks that should be performed by pilots and aircrew prior to takeoff, as a trader, this same routine to analyze high areas of interest should come extremely handy to make sure you never skip any step in the process.
The checklist should be short, very concise, such as the example below:
- Zoom out
- Identify levels
- Recent info
- Credence level
By absorbing all the points above, the next logical step is to go through a chart analysis, so that you can start practicing the art of identifying these high areas of interest. I will reiterate that the more you practice this routine, the better you’ll get at identifying the areas that are worth fighting to get the most risk-reward potential.
I will begin by presenting the end result of what the EUR/USD chart would look like based on all the criteria that I have introduced in this tutorial. Since it will probably be a lot to take, I’ve also taken the time to make a Youtube video where I walk you, step by step, how I selected all the levels.
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