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Momentum is another word for how the price on your charts moves. Momentum analysis, though, is one of the most important skills any trader can learn.
In this article, I will provide an introduction to momentum analysis. If you want to know more about how to trade using momentum analysis and what a professional trading strategy looks like, take a look at our Forex and Futures advanced trading courses.
What is momentum?
First of all, we need to understand what momentum actually means but this is straightforward.
When the price is in a strong or healthy trend, traders say that the momentum is bullish or bearish (in a downtrend).
When we come to the micro level later, we will see that momentum also exists when we just look at individual candlesticks. A long candlestick without wicks (shadows) usually is considered a high momentum candlestick.
Below are three examples:
Left: A trend with strong bullish momentum at first. At the top the momentum ‘faded’ (became weaker).
Middle: A price chart with no momentum. Price is just going up and down without any direction or strength.
Right: A market where the price went from strong bullish momentum to strong bearish momentum.
Following and understanding momentum
To understand and read charts like a pro, let’s follow momentum here a little bit during the trend and reversal.
1: First, we are in a strong uptrend where price trended close to the outer Bollinger Bands®. This is a high momentum phase.
2: Then price entered a regular consolidation after the first trend wave. This is a normal behavior during trends and the price usually moves in those wave-like phases.
3: At the top price then reversed stronger. Here we then saw a strong sequence of three bearish candlesticks. This was the first time in a long time where price showed such strong bearish momentum. This is a significant signal that something is changing.
4: When price breaks the previous low and makes a lower low, the momentum completely turns.
Candlesticks and micro-momentum
As I said above, just comparing how many bullish vs. bearish candlesticks you have and how strong they are, you can gain a deep understanding of price charts. By the way, this is also what indicators like the RSI or the Stochastic do.
Below you see a recent trade of mine. I also share all my setups every weekend with our students. If you want to benefit from my weekly market breakdown and get a list with the best setups, take a look at our trading course: Tradeciety Forex membership
You can see that the downtrend was indicated well in advance. On the left, the price was going up strongly without any bearish interference and the sellers never had any chance to move lower. After the price rose into the blue zone, things changed and now the bearish candles become much stronger and longer.
Then we just wait for all the other signals of my trading strategy and once the trade is ready, the price immediately fell into my take profit target.
As you can see, momentum analysis is a great way of looking at charts and it should be used by all traders, regardless of their style.
We spend a lot of time and focus, analyzing momentum in our Forex price action course and we go into the nitty-gritty to help you understand and trade like a pro.
Questions? Just leave a comment and I’m happy to help you out.
What Is Momentum And How To Trade Momentum In Forex - YouTube
Hunting for signals, chasing the next big win, looking for a cross on your moving averages, trying out new indicators, jumping around timeframes, waiting for the pinbar to finally print, hoping that the gap will close and hedging your way through the week – this is trading. Wrong!
The reason so many traders fail is that they are always trying to be in a trade because they believe that this is the only way to make money.
The truth is, though, that the less you trade, the better your results will be. It may sound strange at first but I have worked with thousands of traders and I see it constantly, once a trader gets into a mindset of trading less, the results will usually improve immediately.
If you often feel stressed, anxious or overwhelmed, you MUST learn to trade from a calm and relaxed perspective. Tune out the noise, adopt a good approach and trade like a sniper. This is the surest way to see better trading results.
If you don’t believe me, just wait until you arrive at the end of this article and you will understand why trading less and knowing when not to trade is the skill the professional and profitable traders have perfected.
“Money is made by sitting, not trading.” – Jesse Livermore1. When you have to think about the trade
The best trades are the ones that jump right at you. After looking at a chart for just a moment you know what to do if you are dealing with a good trade.
Trading is often referred to as a business of “pattern recognition” and the trader who has taken hundreds of trades knows the difference between a high probability setup and one that “just doesn’t look right.”
If you have to pause and ponder about a potential setup, it is usually better to pass on that particular trade.
2. When you don’t know where your stop goes
Even if you have spotted a great setup it does not always mean that you have to jump in the market. If you can’t find a reasonable price level for your stop loss, or you have to set your stop too far away and, therefore, have a reward:risk ratio that is too small, don’t take that trade.
Most amateurs fiddle with their stop until they think that the potential profit is large enough. I can’t stress the importance of identifying a reasonable stop loss level first before you search for a take profit area.
3. If the market does not favor your system
This is something 99% of all trading books miss and it shows a lack of self-awareness in trading. Ask yourself “what is it that my trading system does?” Do you have a trend following system and look for high momentum plays? Do you trade ranges and wait for clearly defined range boundaries without momentum? Or do you fade trends and look for trend exhaustion and losing momentum? Do you need a market with low volatility where price action respects support and resistance levels and gives clear patterns?
If the current market environment does not support the premise of your system, you stay out.
Leave this field empty if you're human: 4. When you want to “catch up”
Did you just close a losing trade and your fingers are already itching to get the next trade? Do you want to increase your position size to make up for that past loss? If you find yourself in such a scenario, take your finger off the mouse and walk away.
Even if you think the setup looks alright, your thinking is probably clouded and you are about to make emotional trading decisions. Move away from your trading platform, get some perspective and after a short break, things usually look very different.
5. When you think that markets are “too high” or “too low”
Do you sometimes use the terms “too high” or “too low” and you believe that just because the price has risen for a long time, it must reverse eventually?
Especially traders who use oscillators and then make trading decisions based on “overbought” or “oversold” conditions often run into such problems. An overbought signal, for example, does not mean that a market will fall. Overbought means that the market is very strong and is likely to continue. We discussed this in our previous article: read about the Stochastic and overbought
6. If price has already moved away from the best entry – don’t chase!
Sometimes, we miss trades or don’t see the setup when it forms on our charts. The worst thing you can do is try to chase price and enter the trade late.
When you chase a trade, your entry will be at a bad spot and your stop and target will be off as well.
You can’t catch all setups and that’s ok. Don’t chase trades. You can always find a new setup, but you can’t get your money back after making a mistake.
7. When you haven’t done your analysis – when a trade is not in your plan
Every trade or scenario should be in your trading plan before it occurs. If it is not in your trading plan, it’s probably better to skip the trade.
Amateur traders don’t write trading plans and endlessly flip through timeframes and markets, trying to hunt signals. We all know where this ends.
Having a trading plan before you sit down at your trading desk should be mandatory for every trader. In our advanced courses, we provide weekly trading plans for our students.
8. When you asked someone else for their opinion
As a trader you have to make trading decisions autonomously because you have to live with the consequences.
When a trader asks for outside confirmation or needs to be spoonfed signals, he/she will not be able to grow as a trader because such traders usually give away all the responsibility. Learning from your own mistakes is critical for success. Furthermore, you must understand the reasoning behind a trade entry or any decision if you want to become a trader.
9. When you focus on a performance goal
We have all been there where we just needed one small winner to break even or hit our arbitrarily set performance goal. But then things usually don’t go as planned, we end up forcing trades and experience a larger setback.
Do not judge your performance on a weekly, or even monthly, basis. You cannot control how many trades you will get and how the price will move. Be open and take the trades as they come without forcing something.
10. When you have personal, job or health-related issues
Trading is a high-performance activity and professional trading requires your full attention. If you can’t focus 100% on your charts and if you are still thinking about the argument with your colleague, or the fight with your spouse, your trading will suffer.
You can always find a new trade, but you can’t get your money back for making mistakes that could have been avoided.
Only trade when you run out of reasons not to trade
This is the only time you should really trade.
When you find a setup that meets all your criteria, when it feels good internally, if you feel good emotionally and mentally, if you are not frustrated about your past loss, when you outlined the trade in your trading plan and when the chart gives you good levels for your stop and profit order, then you can pull the trigger.
Imagine you were only allowed to make 3 trades per week, how would you approach your trading? The “3 trades per week” concept is powerful and cherry-picking trades will transform your equity graph.
Just think about all those trades you took, but you knew somehow that it would have been better to stay out. It is very safe to assume that the majority of traders would have a much better performance if they started trading less.
There is always a next great setup. But you can’t get a refund for a trade you know you should have avoided.
The Donchian channel is a trend-following indicator which has been heavily used by the infamous Turtle traders. The Donchian channel measures the high and the low of a previously defined range – typically of the past 20 days. The screenshot below shows the channel on Apple with a 20-day range where it marks the highs and lows of a 20 day period.
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Typically, a trader would look for a well-defined range and then wait for the price to break out to either one side for a trade entry trigger. But, there is more to the Donchian channels and we will discuss how to increase the quality of the signals and how to structure a trend-following position sizing strategy.
Better entry signals in 2 steps with the Donchian Channel
Step 1 – finding high momentum breakouts
Of course, not all breakouts are going to be successful and there is no way to generate a 100% accurate system, but there are ways to increase the quality of entry signals for the Donchian channel. The first screenshot below shows the AAPL chart and the 20-day Donchian channel. False breakouts have been marked with a red (x) and successful breakouts with a green tick.
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At first glance, it’s apparent that a significant amount of false breakouts exist when momentum is not supporting the move. In the first step, we added the RSI strength and momentum indicator to filter out low-momentum breakouts which are often false breakouts. In the next steps, we show how other tools and techniques can help improve the accuracy of the system.
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Tip: If you are a reversal trader or fade breakouts, combining the Donchian channel and the RSI can be a great asset in your trading arsenal. A lack of momentum or divergences can signal false breakouts if followed by a failed break of the range.
Step 2 – high entry accuracy with a trend filter
In the next step, we add a long-term moving average; in the scenario below we added the 100-period moving average which is an excellent filter tool that helps you separate between long and short scenarios. Whenever price is above the 100-period moving average, you would only look for breakouts to the upside; and when the price is below the 100-period moving average, you only look for short breakouts.
The screenshot below now also includes the 100-period moving average. The amount of signals has been reduced while, at the same time, the quality of the signals has been improved significantly. There are only 3 false signals left and in the next step, we will show how to minimize the impacts of losses by using money management techniques.
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Those are just two examples of how adding trading tools and indicators can help you improve the quality of your trade entries. The approach highlights the importance of combining trading tools and concepts that support your trading style and objective in order to filter out low probability entries.
Position sizing for breakouts and trend-following
Now that you have a better understanding about how to improve the quality of trade signals, we can take a look at position sizing. Especially for breakout and trend-following traders, there is a specific position sizing strategy that can help you improve the quality of your system even further.
“Scaling in” refers to the position sizing strategy of entering a fractional amount of your intended position size first and as price moves in your favor, you add to the winning position, and ideally move your stop loss to protect your profits so far.
There are two major benefits of scaling in:
On a fake breakout, your position will be relatively small because you haven’t yet reached the full position.
Only when the breakout is strong and successful you reach your maximum position size and fully capitalize on winning trades.
The screenshot below shows the AAPL chart again and it illustrates how the impacts of the false signals could have been minimized by applying the scaling in technique. Whereas the successful breakouts often saw long moves and the trader would have been able to scale in completely, the unsuccessful breakout failed after the first entry and the loss would have been only a small amount.
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How these principles can help you become a better trader
While this article is not only meant to show you how to use the Donchian channel indicator, it has another message as well: you have to be conscious of your trading style and build your approach around your goals. As a breakout and trend-following trader, look for momentum and sentiment tools that help you read what is going on and filter out trades with a lower probability. On the other hand, if you fade false-breakouts, look for tools that help you identify low momentum price movements into high-impact price areas.
And take it one step further and look beyond generating entry signals; structure your position sizing and money management around your trading objectives. For every trading style, there are techniques and principles that can improve the quality and robustness of the system; think outside the box and start building your own, powerful method and stop following generic advice.
Do you often change your trading approach because you don’t know what works and what doesn’t? Are you still looking for a way to analyze charts effectively? You are unsure about how to use the right trading tools?
Most traders do not follow a professional approach and just flip through timeframes and constantly change their tools without really knowing what to look for and how to find trades. They hunt for signals and want consistent results without having a consistent approach.
In this article I want to help you make sense of price charts in a clear and structured way. I am introducing 8 ways how you could make sense of any chart. You do not have to use all at once, but pick one, two or three and try to combine them. Don’t jump around but see what makes sense to you and then stick to it.
We have done the hard work for you and if you want to shortcut your learning curve and get our ready-to-use trading strategies, you can join our trading courses here and get immediate access to our video courses and setups:
If you usually trade the 4H or 1H charts, start your analysis on the Daily or Weekly chart to get some perspective. What looks like a strong trend on the 1H chart, can easily be just a range move on the 4H chart. Furthermore, traders who do not look at the higher time-frames often risk overlooking important price areas and support and resistance levels which then create problems for their trades on the lower timeframes.
Furthermore, the way our price charts are zoomed and scaled depending on our screens can have a significant impact. Zooming out and taking a bird’s eye view can often provide a very different picture.
The left Head and Shoulders pattern on the 1H timeframe happened at the resistance level at point (4) on the right Daily timeframe. Taking a higher timeframe perspective, you can often find confluence factors for your trade timing.
2 – Highs and lows
Being aware of highs and lows is crucial for a number of reasons.
First, they are being watched by almost all types of traders whether they are purely technical or trade fundamentals. And even the financial media often refers to major highs and lows.
Second, traders use highs and lows to time their entries, especially when it comes to breakout and trend following trading. Stop placement and target setting is usually also done by considering previous highs and lows.
Furthermore, all technical chart patterns can be described just using highs and lows and, thus, being a trader who can interpret the way highs and lows shape on your charts can help you avoid the template thinking.
3 – Support and resistance levels
Many traders get lost drawing too many support and resistance levels at every possible price level. Instead, just focus on the most important turning points and always keep your charts fresh and only use the most recent price history.
Focus just on the most important and the most obvious levels close to current price and do not obsess about every little reaction. Paralysis by analysis is an issue that many traders face because they draw too many lines.
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4 – Channels and trendlines
Channels and trendlines are similar to support and resistance and they are also the building blocks of many chart patterns such as the triangle or wedges – one we can see below.
Trendlines can be used to analyze trend strength when we look at how strong a trendline rises or falls. When price pulls away from a trendline or fails to move away from it, those can be important tells about the trend strength as well.
A break of a trendline can often foreshadow a new trend direction when the price fails to continue the previous trend direction.
5 – Moving averages
Moving averages are a wonderful tool and they can be used in many different ways.
First, you should identify on which side of the moving average the price is on. When the price is above a moving average it can signal more bullish sentiment and vice versa. Many strategies use moving averages as such a directional filter.
Second, analyze how far price is away from the moving average. The further away price is away from a moving average, the stronger the trend usually.
A break of a moving average or a cross-over are important momentum signals that can foreshadow a change in trend direction and are used by many traders.
Moving averages can act as support and resistance as well. Some markets respond more to different moving averages and being aware of it, can help your analysis.
6 – Volatility
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Understanding volatility is important to make sense of current sentiment and to adapt with your trading approach to the changing market conditions. There are three ways to interpret volatility:
1) Price information: Do you see lots of large candles with relatively long wicks or are the candle bodies and wicks relatively small? The long the candles and the wicks, the higher the volatility.
2) ATR indicator: The ATR indicator analyzes price information. A high ATR means that the past price range was relatively high (large candle bodies and large wicks). A low ATR means that price didn’t move as much during the duration of a candle.
3) Bollinger Bands®. Widening Bollinger Bands show rising volatility, whereas narrow Bollinger Bands show lower volatility. The relation of price and the outer Bands is also important – if price can stay outside the outer Bands, it can signal a strong trend.
Traders generally use volatility to manage their trades and orders. When volatility is high, a wider stop and target are usually used because the market swings more. When the market is calm and volatility is low, traders would then use a narrower stop and target because the price does not move as much.
7 – Momentum and trend strength
Understanding the strength of a price move and a trend is very important to estimate whether the trend is likely to continue, if support and resistance levels are likely to break or if a reversal could be coming soon if momentum is declining. We must understand momentum to make decisions about staying in a trade, getting out or adding to the position.
To interpret momentum, there are three tools that can help you:
1) RSI indicator. The RSI indicator compares bullish and bearish strength. A high RSI signals that past price action was (very) bullish and a low RSI means that bears are in control.
2) The ADX indicator. The ADX is probably among the most commonly used trend strength indicators. An ADX below 25 is signaling a range market. An ADX between 25 and 50 is indicating a trending market and an ADX reading above 50 is signaling a strong trend.
3) The Stochastic indicator. Although people believe that the Stochastic is a range indicator, it also provides information about momentum. If the Stochastic stays above 80 or below 20 for a long time, it can signal strong momentum and a strong trend. Contrary to popular believe the Stochastic does not show overbought or oversold price levels but it is a trend indicator.
8 – Divergences and turning points
Divergences are a powerful concept because they provide information that are often not visible at first glance.
A divergence can signal that price is losing momentum, even though the price is making higher highs and lower lows. When the price moves become weaker and the price has problems continuing the trend direction, the divergence will pick up the clues and signal a potential end or a pause of a trend.
The screenshot below shows that although the price continued the downtrend, the RSI already found that the strength of the move was fading. When the RSI shows 38 during the last low point, compared to 18 during the previous low, the divergence signaled the trend reversal.
Now it is up to you to use this knowledge to make educated trading decisions. As I said in the beginning, try combining two or three concepts and build rules around it to make sense of charts, time trades and improve your edge.
We have done the hard work for you and if you want to shortcut your learning curve and get our ready-to-use trading strategies, you can join our trading courses here and get immediate access to our video courses and setups:
People call themselves ‘traders’ because traders trade, right!? But a more appropriate description of your job would be the one of a ‘risk-taker‘. As a trader you bet your money on something you cannot control, where you have no influence over the outcome and even though you play your best game, you do everything you possibly can and are 100% committed to your plan, you could easily end up losing without being it your fault. In this article, I show you what being a risk-taker means and the mindset you have to acquire in order to trade successfully.
#1 Trading is dealing with the unknown
We touched on this one briefly, but it is important that you understand the full meaning of it. Although you might have a system that you trust based on previous results and you follow all your rules to a T, any setup or any one trade can fail at any time. After you entered a trade based on your criteria, it is out of your hand whether the price will reach your take profit or the stop loss order. Traders often make the mistake of ‘getting married’ to their trades and they believe that if a setup is especially promising it should turn out as a winner. This thinking is dangerous and wrong. You can never know whether your trade will be a winner or a loser in advance – why would you enter the losing trades then anyways!?
As a trader you have to be indifferent towards the outcome. It should not matter whether you win or lose if you have done everything correctly.
Lesson 1: Understand that you cannot control or predict the outcome of a trade. Don’t get married to your trades; you can’t avoid losing trades. Being a trader means that you deal with the unknown every single day.
#2 Risk more when your winrate is high
Sport-betters have always known this: When you bet on a team that is more likely to win, you are willing to risk more because you have a higher chance of making money and when the team of your choice does not stand a high chance of winning, you risk less. Traders are not that smart…Wouldn’t it make sense to risk more when your winrate is 75% than when your trading strategy only has a winrate of 50%? A lower winrate means that you will have more losing trades. Therefore, the greater your risk per trade, the bigger your swings will be in your account balance.
This is especially interesting for traders who trade multiple setups or strategies. Try it out and see how your performance will change if you give more weight to the trades that have a higher winrate and reduce the risk for low-winrate setups. It can smoothen the variance significantly.
Having said that, the reward:risk ratio must make sense as well and if the potential upside is limited, it does not justify the trade – let alone a larger bet.
Lesson 2: Don’t arbitrarily risk a random amount of 2% on any given trade. It’s a myth that risking 2% on any given trade is the way to go. Understand the connection between winrate, position size and the impacts on your account balance. Reduce the risk on low-winrate setups to avoid too much variance.
#3 Losing streaks happen. They are not (always) your fault
You might have a back-tested and forward-tested trading strategy and you can fairly accurately state that your winrate is 65% – or whatever. With this information you can foresee that over your next 1000 trades, you will come close to 650 winning and 350 losing trades. However, your winrate cannot provide any information about the outcome of the next 5, 10 or 20 trades. Having 10 losers over the next 10 trades can happen just as easily as having 10 winning trades in a row.
In the short-term, anything is possible and it’s not in your control.
The data in the table below is based on a trading strategy with a 60% winrate. As you can see, even 6 losing trades in a row will occur every 245 trades. If you take 2 trades per day, you will have a losing streak of 6 trades twice per year. And in the meantime, you will experience several losing streaks of 3, 4 or 5 losing trades in a row.
When you hit a losing streak, ask yourself: Did I follow my rules and did I do everything correctly? Or am I the one that made the mistake and caused the losses?
Losers in a row
Every … trades
Lesson 3: Don’t think that losing-streaks are your mistake. But even more important, don’t lose your head when it happens. Commit to playing your A-game every single trade. Losing streaks will end if you stick to the plan.
#4 Protect your downside
Most traders always focus on the next big trade and ask questions about how to maximize their profits. It does make sense to a degree, but whenever I work with a trader, I try to focus on the defense as well.
I have seen traders make the biggest mindset and performance improvements once they focus more on protecting their capital and making sure losses don’t get out of hand. When you can cut losses effectively, be more selective, adhere to risk management principles and avoid revenge-trading and chasing price, two things will happen: first, your account will develop in a smoother way and the huge swings will stop. Secondly, your mindset will relax and you will become a calmer trader. This second point is where you then see a lot of additional benefits in other areas in your trading. You don’t rush trades, you don’t try to play catch up, you don’t chase, you are selective and you do not stress about growing your account faster.
Mental capital (being in a good emotional state) is more important than monetary capital. Traders who lose their mental capital and then get frustrated, lose the joy and the excitement about trading will either quit or enter the “gambling state” where they just try to hit home-runs and search for the Holy Grail without being serious about their craft.
#5 Leave your emotions outside
If you are into trading to make money, which is the primary reason why we all are into trading, you have to treat it like a job and give it the seriousness it requires.
Good trading has to be repetitive, dull and boring. What a bummer, eh!? But stick with me. By this I mean that if you get excited during your trading sessions, celebrate your winners or cry over your losses, you are not a professional trader, but a hobby gambler. Or, it can also be a sign that your position sizing is way too high.
Trading is an activity of dealing with probabilities where you know that the correct combination of risk:reward ratio and winrate will give you an edge. Your only job is to make sure that you execute your trades 100% according to your plan and don’t get emotionally attached. That is the job description of a trader.
Trading has to be repetitive, boring and dull. Every day you look for the exact same things, your trades should look identical and you must follow a structured approach. It does not mean that it isn’t enjoyable, but the “fun” doesn’t come from doubling your account in a week or a month with inadequate risk management, but it comes from following your plan, doing the things you KNOW are right, conquering yourself and realizing your potential.
Lesson 5: If you are looking for excitement and entertainment, trading is not the place to be. A trader is rational, emotion-less and does the same things over and over again.
The Turtle traders were a legendary group of traders coached by two successful traders, Richard Dennis and William Eckhardt. They selected 10 people (turtles) with little to no prior trading experience and turned them into winning traders by providing them with a set of very precise trading rules.
The building block of the turtle traders’ success was their advanced risk and money management and their position sizing approach. The following 5 principles explain the most important risk and management principles of the turtle traders’ strategy.
Volatility based stop loss orders of the turtle traders
The turtle traders used a volatility based stop loss order, which means that they determined the size of their stop loss based on the average ATR indicator (Average True Range). This also means that for every trade, they used a different stop loss size to react to changing market conditions.
The charts below show why this stop method is so powerful. Both charts show a breakout scenario with very different price dynamics. Whereas the left chart shows very small candlesticks and a low ATR (low volatility), the right chart shows larger candlesticks and a higher ATR value (high volatility). How much sense would it really make to use the same stop loss technique on both breakout trades? Correct, it wouldn’t make any sense. A trader should use a small stop loss for the trade on the left chart and a wider stop loss on the right to account for the different market phases and price behavior.
At the same time, a wider take profit would be used on the right than on the left to capture larger price moves. Adjusting the stop and the target simultaneously will also make sure that the reward:risk ratio stays relatively stable.
Low volatility results in closer stops (click to enlarge)
High volatility results in wider stop (click to enlarge)
A maximum position of 2%
Although the stop loss size (in point distance) changed for every trade, the percentage risked always stayed the same. The maximum allowed risk (position size) on any one trade was 2% of the current total account balance. The table below shows two examples of how the turtle traders would adjust their stop and position size based on volatility.
Stop Loss Price
Risk per trade
Contracts to buy
2% ($ 2,000)
The numbers are for illustration purposes only
Although the risk is identical (2% or $ 2,000), the turtle traders have to buy more contracts during lower volatility because the stop loss is set closer.
Always determine the stop loss distance first. Most amateur traders start by evaluating how many contracts they want to buy and then set their stop loss order so they can achieve a random risk goal. Never start by thinking how many contracts you want to buy/sell before you know your stop loss.
Correlations and risk
If the turtle traders want to enter two trades in different instruments, they had to look at the correlation between the two markets first.
A quick reminder: Correlations describe how “similar” two markets move. A positive correlation means that the two markets move in the same direction and a negative correlation means that they move in opposite directions.
High positive correlation. Two markets move together (click to enlarge)
Negative correlation. Two markets move in opposite directions (click to enlarge)
The two charts above show two completely different scenarios: On the left, you see two price charts with a very high positive correlation (the two graphs almost move identical). On the right, you see two charts with a negative correlation (they move in opposite directions).
A trader who enters two trades in the same direction (two buy or two sell trades) on positively correlated markets increases his risk because it is more likely that the two trades end up the same. A trader who enters two trades in different directions (one buy and one sell trade)in positively correlated instruments will probably (not guaranteed) not have the same result.
(click to enlarge)
When trading positively correlated markets in the same direction, your risk increases. When trading negatively correlated markets in the same direction, you can lower your risk.
The turtle traders did not come up with this strategy, but it has been used by professionals as long as trading exists. It is the irrefutable law of how financial markets work and understanding correlations is of great importance.
Adding to a winner
The turtle traders usually did not enter the full position size on the first entry. Remember that they were allowed to use 2% per trade, but they usually split their order across multiple entries and added to a winner. Their first position would be 0.5% and after the trade has moved into profits, they would add another 0.5%. They would keep adding to their trade until they reached the maximum of 2%. At the same time, they moved their stop loss behind price to protect their position.
The advantages of adding to a winning trade:
You limit your losses. The turtle traders’ strategy was a breakout and trend-following strategy. On a false breakout, when price immediately reversed on them, they would usually only have a very small position and not yet have scaled in. Thus, the loss they take is only a small portion of the 2% maximum risk.
You can catch large winning trades and protect your position. You would only reach your full position size during high momentum breakouts and once you had reached the maximum exposure of 2%, the initial stop loss orders would already have locked in some profits.
You have to minimize your losses and try to preserve capital for those very few instances where you can make a lot in a very short period of time. What you can’t afford to do is throw away your capital on suboptimal trades. – Richard Dennis
Adjusting position size during losing streaks
Dennis and Eckhardt understood that the most important thing during a losing streak is not how fast you can recoup your losses, but the degree to which you can limit your losses. Their rule to limit drawdowns during losing streaks shows this principle:
If your account drops 10%, you then trade as if your account has lost 20%. If you lost $10,000 on a $100,000 account, you then trade as if your account only has left $80,0000.
This means that even though your account is now $90,000 and your 2% would be $1,800, you only trade as if your account is $80,000 with a maximum risk of $1,600. This strategy will greatly reduce the losses once a trader enters a significant losing streak and it takes away a lot of emotional pressure as well.
I am a big believer in chart patterns and there are a few patterns that can produce very reliable signals. However, it’s never about the patterns themselves, but what those chart patterns tell you about the market dynamics and how traders move price.
In this article, I want to explain how to “decode” any chart pattern so that you will be able to understand price movements in a much better way. In the second part, we will take a look at the 4 best chart patterns and how you can use them to make better trading decisions.
And if you find this way of trading interesting, our trading courses also make use of the principles of advanced chart reading and much more.
All chart patterns, whether it’s the Head and Shoulders, triangles, wedges, pennants or the Cup and Handle, are made up of the 3 same components. If you understand how to read those 3 components, you can make much better trading decisions and understand price in a new way.
#1 The foundation: highs and lows
Although it sounds very basic, the analysis of how highs and lows form on your charts build the foundation of any chart pattern analysis. We will get into the nitty gritty soon, but all future chart analysis is based on understanding highs and lows.
It also builds the foundation of the Dow Theory which has been around for decades and is a time-tested trading principle.
Uptrends: Higher highs and higher lows
A trend can only exist if the highs and the lows rise. The rising highs show that the buyers are able to push price higher. The rising lows show that during the correction-phase, the sellers are not able to build a significant opposition and the buyers step in time and again to counter the correction-phase and continue the uptrend.
A trend change
When you see that price fails to make a new high, it can serve as an early warning signal that a change in direction is imminent. Or, when the price barely able to make a new high it can also foreshadow a potential turning point of the buyer and seller balance.
The screenshot below provides a preview and this Head and Shoulder pattern shows that from the left shoulder to the head, the price barely made a new high, indicating that the buyers were not very strong anymore. The right shoulder further confirms it and makes a lower low and signals that the sellers are gaining more strength.
#2 Strength of a trend: length and steepness of trend-waves
The strength of a trend is defined by the individual trend waves that exist between the highs and lows. Here, you should specifically look at the length/size and the steepness of those individual trend waves to get a feeling for trend strength.
Most conventional chart analysis only focuses on the highs and lows themselves, but an important part is understanding what happens between the highs and lows.
In the screenshot below you can see that the first trend-wave (first black arrow) was very steep and long. The second wave was less steep and shorter in duration. The final third trend wave was much shorter and also just barely broke the previous high – we also saw more price wicks which are another rejection and exhaustion signal. Putting all the clues together, the reversal could have been anticipated by understanding the concepts of trend-wave length and steepness.
#3 Strength of trends II: depth of pullbacks
Once you have identified that price is in a trend, the pullbacks within that trend can provide valuable information about what might happen next.
The screenshot below shows an uptrend with many consolidations and retracements in between. However, just before price reversed into a downtrend, the final retracement was much larger in size and duration, showing that something had changed in buyer-seller sentiment and balance.
Whereas a short and shallow retracement means that the ongoing trend is still intact, when retracements become more frequent and larger in size, it can foreshadow a potential trend shift as buyer and seller balance is slowly shifting.
Part 2 – Understanding the 4 best chart patterns
Usually, chart patterns are not that clear-cut and far from the textbook examples that you’ll usually find in trading literature or on other trading websites. Thus, it is even more important to understand how to decode chart patterns to make the right trading decisions.
We will now take a look at the 4 most commonly traded and discussed chart patterns and see how our previous 3 principles apply to each one.
A triangle shows a temporary period of consolidation within a trend or at the beginning of a new trend. During an uptrend, a triangle is formed when the retracements and pullbacks become smaller and smaller; buyers step in earlier each time to push the price back up. Triangles are much more reliable during established trends as they signal accumulation of positions before the next trend continuation.
A Head and Shoulders pattern signals a potential reversal and by decoding the individual parts of this chart pattern you’ll quickly see how this pattern describes sentiment shifts nicely:
From the left shoulder to the head, the price makes a higher high. Often, the left shoulder forms after an ongoing trend and the head is then usually just the last push. Then, the right shoulder fails to make a new high which is the first indication that the trend might be over. The break of the neckline then signals that price is going to make a lower low, confirming the trend reversal.
Being able to interpret highs and lows is all you need when it comes to reading the Head and Shoulders pattern.
Double Top / Double Bottom
Double tops and double bottoms are reversal patterns as well and, similar to the Head and Shoulders pattern, the reasons and underlying dynamics are the same:
The second top, which fails to break the first high, signals that there are not enough buyers to push price higher anymore. Therefore, when you see a double top or double bottom it often signals a shift in price dynamics. If the double top is then followed by a break lower and new lows, the trend shift is confirmed.
Cup and Handle
The Cup and Handle pattern is also just a series of highs and lows; the Cup and Handle formation below shows a slow transition from a downtrend into a new uptrend. First, you see a series of lower lows, followed by a consolidation at the bottom of the Cup and, finally, price starts making higher highs. When then price breaks the top of the Cup, the uptrend is confirmed. A potential Cup and Handle that does not break the previous highs become a double top pattern.
Conclusion: Try to understand what price tells you
As you can see, you can understand and decode all major chart patterns by looking at how highs and lows form, how steep and long trend waves are and how deep retracements are. This knowledge also enables you to estimate the quality of chart patterns and it will help improve your chart reading abilities as well.
Let’s recap what we have learned about the building blocks of chart pattern analysis:
(1) Highs and lows build the foundation of all chart analysis
(2) The first shift in sentiment occurs once price stops making higher highs or lower lows
(3) The length and the steepness of trend-waves define the overall trend strength
(4) The depth of retracement in between trend waves tells you a lot about the balance between buyers and sellers
Trading is all about being able to read market structure, sentiment and the balance between bulls and bears. Understanding if a trend is gaining or losing momentum is important if you are trying to make decisions about whether support and resistance levels are likely to hold or break, if a trend will continue, or if a reversal can be expected anytime soon.
In a different article, we talked about how to understand the direction of a trend; this article explains how to read the trend strength from your charts. The following 6 concepts, tools and indicators can help you make sense of price action and provide insights about market structure.
1) Price action analysisTrend waves – length, steepness, and smoothness
The first point lays the groundwork for all that follows and it describes the basics of price movement. The way price moves during trending waves and pullbacks can tell you a lot. The chart below shows a downtrend with a series of lower lows. At the same time, you can see that the bearish price waves are much smoother and the bullish pullbacks are less smooth.
Secondly, the steepness of the bearish price waves decreases and they become shallower as the trend continues. Steep price waves indicate trend strength whereas shallow price waves signal a lack of strength. Also, the size of the trend-waves is important to understand. The chart below shows that the bearish trend-waves become smaller.
The blue circled area highlights the first period bears faced strong opposition and price wasn’t able to move further down as smooth. This price behavior is in sharp contrast to previous price action. In a strong and healthy downtrend, the bearish trend-waves do occur mainly uninterrupted.
Pullbacks during a trend
The next screenshot highlights the importance of putting the size of pullbacks into context:
The first green shaded area shows the first larger pullback during the ongoing downtrend.
Before that, the pullbacks were relatively small which signaled strong momentum to the downside. Often, strong trends only show sideways ranges instead of real pullbacks.
A large pullback can foreshadow a broken market structure and it provides first indications of losing trend strength.
Finally, price failed to make lower lows altogether which had been foreshadowed by the increasing size of pullbacks against the downtrend.
2) The slope of trendlines
Trendlines are a great trading tool because they provide instant information about the strength of a trend. First, you have to pay attention to the angle of a trendline because the angle shows you exactly how strong the trend is. In an uptrend, a small angle means that the new lows are not moving up as fast. However, once the angle becomes too large, it often signals a trend (Boom) which is not sustainable.
An increase in the angle of trendlines means that price is gaining momentum and price is making higher highs faster. Finally, a break of a trendline signals a broken market structure. A break can either mean a decrease in the momentum of a trend or a complete trend reversal.
The slope of trendlines describe trend strength
An increasing slope in an uptrend shows a trend with rising momentum
A decreasing slope shows fading momentum
The break of a trendline is the final signal of a trend reversal
3) Bulls vs. Bear and microstructures
We already touched on this topic when we talked about pullbacks earlier but there are a few more things that we can use to our advantage when it comes to analyzing the dynamics between bulls and bears during trending phases. There are a few things a trader needs to be aware of when analyzing a trend and tries to estimate the strength:
A trend where candle bodies do not overlap signals strong strength because price keeps going in one direction without pulling back significantly
When candlesticks show no or only small wicks, it also signals a strong and healthy trend
Candlesticks are roughly the same size and are not too large. If you see that suddenly candlesticks are becoming very large, it means that volatility is increasing. This often happens when markets approach a top or a bottom
If you see gaps, especially in the daily timeframe, those gaps don’t close and price keeps trending
4) Rejected reversals
The way failed breakouts and rejected reversals occur on your charts is a big tell as well. Here are the most important patterns and characteristics when it comes to analyzing failed reversals during trends:
Price does not overshoot trendlines or when it does, it never closes beyond a trendline
When a trendline breaks, there is only a sideways move and no immediate reversal
Reversal spikes get immediately rejected and covered
Pullbacks into moving averages are very quick and price does not stay long at a moving average
The ADX measures trend strength and it is non-directional which means that it cannot tell you which direction price is going – it only tells you if the trend is gaining or losing momentum.
The chart below shows a downtrend and the first down-movement shows a lot of strength in the ADX by making a new high and absolute on the ADX. The next two bearish moves were much smaller and not as strong and the ADX confirmed it by showing lower highs. The last move on the far right showed a very choppy and narrow movement and the ADX went dipped at that point, the price had entered a range.
A rising ADX shows gaining trend strength
New highs on the ADX signal a healthy trend
Lower highs on the ADX signal losing strength
A “hook” on the ADX shows a sudden shift in trend strength
A flat or an ADX heading down signals a range
6) Moving averages (MA)The relation of price to the MA and the slope
Moving averages are a great trading tool because they provide a variety of different information at once. First, the slope of a moving average is important. When the price is above the MA and the MA is moving up it signals a strong trend with prices rising faster than the historical averages. The further price can pull away from a moving average, the stronger the current trend is. The longer price can stay on one side of the moving average without touching the moving average, the stronger the trend.
The MA crossover – sentiment shifts
The combination of a smaller and a larger moving average measures sentiment shifts in price. The screenshot below shows a chart with a 50 and a 100 MA. When the small MA crossed above the larger MA it signaled a shift in sentiment to the upside because recent prices were moving above the average of the longer term price structure. Conversely, when the shorter MA crossed the larger MA it signaled a sentiment change to the downside because recent price started trading below the longer-term average.
The space between MAs – momentum information
Finally, the bigger the space between the two MAs, the stronger the trend is becoming because the recent price is pulling away from the long-term average faster. The size of space between the two MAs provides information about momentum. The MACD or the Ichimoku indicators are both based on the differences between short term and long term average price structure.
When the short-term MA crosses above the long-term MA, it signals a bullish trend shift
When the space between the two MA increases, momentum increases as short-term prices pull away fast from the longer-term average price
The RSI is another indicator that measures strength. It is similar to the ADX but the RSI is directional. In a healthy uptrend, the RSI makes new highs and higher lows. In a downtrend, the RSI makes new lows and lower highs. In a range environment, the RSI moves sideways between 30 and 70.
The screenshot below shows that the first uptrend was initiated by an RSI divergence (higher lows on the RSI and lower lows on price – a momentum divergence). During the following uptrend, the RSI made higher highs and higher lows. After the uptrend, price moved down for a while but not with a lot of strength and the RSI stayed mostly between 30 and 70 (dotted arrow). The next uptrend-phase also started after an RSI divergence and the RSI started making higher lows again until, just recently, another divergence signaled the end of the uptrend.
During an uptrend, the RSI makes higher highs and higher lows
A flat RSI ranging between 30 and 70 indicates a lack of momentum
An RSI divergence shows a momentum divergence and it is often a reversal sign
8) Bollinger Bands ®
Bollinger Bands® can be combined with other momentum indicators but they are also a great tool for themselves. The screenshot below shows a healthy uptrend and the Bollinger Bands® showed that as price stayed above the middle Band; price “grinding” higher between the middle and the outer Band is a typical trend signal.
A trend is usually broken once price crosses the middle Band. A price spike outside the outer Band which immediately reverses back into the Bollinger Bands® can often signal a change in trend direction.
In an uptrend, price moves higher between the middle and the outer band
A break of the middle band often signals a trend reversal or the lack of momentum
A price spike through the outer bands and an immediate reversal indicates a sentiment shift
Knowing the strength of a trend is the backbone of any trading method
Understanding trend strength and being able to read the balance between bulls and bears is a very important skill every trader has to develop. And although each of the 6 described tools and concepts can be very helpful, you should pick 1-2 to avoid confusion and indicator redundancy.
The trading tools and concepts described are not a standalone system by themselves, but they should build the backbone of any trading methodology.
Supply and demand is a trading and price action concept that analyses how financial markets move and how buyers and sellers drive the price.
On every price chart, there are certain price points where you can observe a sudden shift between the buyers and the sellers. Those areas are usually characterized by strong and immediate turning points, or an explosive breakout. We as traders call those areas supply and demand zones.
It can pay off to know how to spot such areas because just like the concept or support and resistance, supply and demand areas can add an other layer of confluence to our trading and help us find better trades.
Order absorption – why common trading knowledge is wrong
The scenario below is something we all have seen hundreds of times. It shows the classic price behavior around a support level. Common trading wisdom tells you that with each touch of a price level, the support area becomes stronger. This couldn’t be further from the truth.
What makes the price go down is an imbalance between buyers and sellers and there is more selling activity than buying going on. Each time the price reaches the support level, buyers enter the market and cause a bounce by outnumbering the sellers. Then, the price rises until sellers become interested again, outnumber the buyers and drive the price down. Although this is a very simplistic view, it explains how markets move.
But each time the price makes it to the support level, there will be fewer buyers waiting because, at one point, all buyers who were interested in buying have executed their trades. This is called order absorption. The screenshot shows that price bounced less high with each “touch” and eventually it broke the support level once there were no more buyers left and only the absorbing sellers remained.
When everyone has bought and when there are no buyers left, the support level will break and price falls until it reaches a price level where buyers will get interested again.
Think of order absorption around a price level like a ball that bounces off the floor. Each time the ball hits the ground, some of the energy is absorbed by the floor. Thus, each consecutive bounce will be lower than the previous one until all energy is gone and the ball comes to a standstill.
Identifying high probability supply and demand zones
Now let’s take a look at some charts and see how we can apply our knowledge to find trading opportunities.
The highest probability price levels are the ones with the greatest imbalance between buyers and sellers. What does that mean? Whenever you see a rally and then suddenly, without any prior warning, it reverses on the spot and drops like a stone – those are the areas of major imbalances.
The highest probability price levels are the ones with the greatest imbalance between buyers and sellers.
Think about it from a neutral perspective: What does it tell you about price when you see a rally and then all of a sudden price reverses in one candle and starts a strong sell-off? Exactly. The number of sellers who have entered the market at that price outnumbered buyers that price wasn’t able to withstand it and immediately tumbled. It takes a lot of sell orders to stop a trend and even reverse it.
But this is not only hindsight market analysis; you can use this knowledge to make assumptions about future price movements too. Whenever you see such a supply or demand price area it is –reasonably – safe to assume that not all sellers were able to enter at that price on the first sell-off. We have all seen it before: during a high impact news event price just ran away and we weren’t able to get a fill – this is what happens as those runaway supply and demand zones too.
Furthermore, it is also very likely that, in case of a sudden sell-off, more sellers were waiting to sell just above that level. If price fell from $50.00, it is very likely that other traders were willing to sell at $51 too – who wouldn’t like to sell for a higher price? This is a trading concept called “trading the white space” and although it can be challenging to wrap your head around it when you hear about it the first time, it helps traders understand markets in a new way.
“Trading the white space” means that price picks up unfilled orders and squeezes traders on the wrong side of a market.
How To Use Supply And Demand Zones In Your Trading The Right Way - YouTube
Chart example – supply and demand imbalances
There are three things in particular that we look for when identifying high probability price areas:
1) A strong trending move prior to the reversal
2) The strong reversal itself. Price reverses immediately and does not stay at the level
The chart below shows 6 price points that qualify as high probability price areas. All of those 6 areas show great imbalances between buyers and sellers and a sudden shift in direction. The turning points marked with numbers are initial price imbalances between buyers and sellers. The trading opportunities exist when price moves back into those areas – the areas marked with green checkmarks.
The first point was a major swing high after a rally. Price reversed with just one pinbar and dropped afterward. When it came back to the level the second time, it did not immediately reverse but it sold off eventually. Sometimes the accumulation can take a while, but as long as price does not violate the level, it remains valid.
The second point was a pullback during a downtrend. The bullish pullback was a strong one with 3 large bullish candles. Still, price reversed in a strong fashion and continued its downtrend afterward. The next time price came back it sold off again.
The third point was a price bottom. After a long downtrend, price bounced strong and the next time price came back, it found buying support again. And it goes on like this forever…
Just pull up any price chart and try to find those areas when the trend immediately reversed. The stronger the rejection of the level and the stronger the trending moves before and after the reversal, the higher the likelihood that you will see a new reaction the next time price comes back.
The best supply and demand zones with the greatest imbalance between buyers and sellers are very obvious and they should jump at you when looking at a chart. If you have to think about a setup and wonder if it really qualifies as a high probability area, it probably isn’t one. This is true for all trading methods and types of setups.
The screenshot below shows 4 points where many traders would have ran into problems. But they either lack a strong reversal pattern or do not have a strong enough follow-through after the reversal itself.
A timeless market pattern
You can find this pattern in all markets, asset classes and timeframes because it is the manifestation of the interaction of buyers and sellers. Of course, the pattern won’t work all the time, but it provides enough information about order flow that it enables traders to find high probability price levels.
Especially in the case of Forex majors or stocks with a high market capitalization, it requires a significant imbalance between buyers and sellers to let a market reverse immediately.
In our premium trading course, we learn a lot more about supply and demand trading and how to use those to find better trades with our trading system: Tradeciety premium course