Thursday, 9 March 2017

Lesson 4 – Introduction to Forex Trading - Understanding the basics - Part 1

Lesson 4 – Price Action & Supply and Demand


“History repeats itself, first as tragedy, second as farce”
Karl Marx

History Repeats, Repeats, Repeats

The basic premise of technical analysis is that history keeps on repeating itself. Past snapshots into market patterns that start to become identifiable give clues to the way the markets may react in the future. Some chart patterns are more reliable than others in price forecasting, as they can be repetitive. That’s great, because it takes away some of the seeming randomness of the markets. If markets were truly random, than why do the chart patterns so often seem to rest at the same points?

This lesson will teach you how to read the market in the most primary way, via the chart. You will learn about the concepts of supply and demand, support and resistance, candlesticks and trend channels to aid your ability to understand the moves that are happening in Forex; along with order entry types to get you started placing trades.

Concept of Supply and Demand 

The process of supply and demand sets the exchange rate of a currency. Essentially, if supply outweighs demand, then the exchange rate will drop. If demand outweighs supply, then the exchange rate will increase.  This will be covered in greater detail later in the course, but for now, understand this basic concept.

This is no different to your normal goods in the supermarket. If the supermarket baker has made more cakes than he has sold, and they only last a day before they go off, then the price is reduced to sell them off. There was more supply than demand.

The Forex market is therefore made up of lots of orders to buy and sell currencies at specific prices. These orders, along with the flow of supply and demand, create the price action we see on our charts.
Supply and demand can be naturally increased or decreased, or manipulated by central banks changing their own country’s interest rates. The analysis of this is referred to as Fundamental Analysis, and this is an extremely interesting and influential topic.

One simple example of supply and demand was during the financial crash. The US dollar and gold are considered “safe havens” for money (i.e. the US is unlikely to ever go completely bankrupt), so during the financial crash, they were so much in demand that the US dollar’s value rose to record highs.

Orders in the market tend to bunch together around key levels. The reason for this is that speculators, who make up the majority of the trading volume, use key prices to set reference points for entry and exit points in the market.

In general, this means that orders in the market bunch at these levels.

supply demand diagram

An example of this is using relative highs and lows on a chart to place exit orders, i.e. if a price goes above a certain level, an open position will be closed.

When orders congregate around a certain level, they create a large amount of liquidity in a small price range.

Liquidity is simply the term used to refer to how many orders are in the market at certain prices. So lots of orders mean lots of liquidity, and few orders means little liquidity. When there is little to no liquidity, erratic moves in the market are common as price jumps between orders.

Typically, this has the effect of causing what we refer to as Support and Resistance lines or zones.

Support and Resistance 

One of the fundamentals to trading as a speculator is understanding how the market moves.
In theory, the market moves purely by supply and demand, like any product. However, sceptics might suggest that there is a certain amount of psychology involved as well.

The more demand there is for a product, the more its price increases, and the more that is supplied to the market, until it reaches a tipping point when there is so much supply that the price starts to fall again. Currencies are no different, as indicated by the example of US dollars and gold below.

support resistance chart

When considering trading, it is necessary to translate this supply and demand at key prices into support and resistance.

Support is simply a price at which there are a large amount of orders to buy a currency pair- ‘bids’, and resistance is an area where there are a large amount of orders to sell a currency- ‘offers’. Support is the lower line relative to price, and resistance is the higher line relative to price.

As the price moves in its normal flows in a currency pair, the majority of orders will build up around these support and resistance levels. This is primarily due to the fact that orders are driven by large commercial organisations and banks providing liquidity. Therefore, price tends to jump to these key levels.

The chart below shows support and resistance levels on the EURUSD daily chart, and the same levels on a 2hr chart. The process of plotting these levels will be covered later, but for now, the important thing is to notice how the price moved between these levels on two different timeframes.

support resistance chart 1

What this shows is how price gravitates to these levels and jumps between them.

It is important to identify this in order to utilize one of the most basic strategies, what’s known as a breakout strategy. This is based on the premise that when price breaks through a key level, it will often test the next level in that direction.

The 4hr chart below shows an example of this. The circle shows a clean break of a resistance level, while the squares show the price testing the resistance level.

support resistance chart 2

In this chart, the squares show multiple failed breaks of a support level. Therefore, price bounces to test the upper resistance, and in this case also breaks through.

support resistance chart 3

These support and resistance levels are key to trading and they are remarkably easy to work out.

Here’s a routine for plotting them.

First, start with a weekly chart and plot a horizontal line where highs and lows join.
In the example below, the highs and lows on the bold line have been circled as an example.
Then, on the same chart, repeat the same process on the Daily timeframe, keeping your lines from the weekly chart on there.

In the chart below, the bold lines are from the weekly and the thin lines are extra lines that have been added from the Daily chart.

support resistance chart 4

The weekly support and resistance lines will be more important than the daily lines.

support resistance chart 5

Finally, in the chart below, look at how price interacted with these lines on the 4hr chart.

support resistance chart 6

It’s interesting how well these levels hold up, and how they become so important for the market. Using these with your current strategy can significantly increase your profitability. In fact, a large number of profitable and successful traders simply trade from these support and resistance lines.
For instance, if your strategy suggests taking a position and you are close to a key level, wait for the level to break before entering the order. This then gives you confirmation.

Very simply, if there is a rejection of a line, take the trade in the opposite direction; if there is a break in the line, enter in the direction of the break.

If going long, put your stop below the key line (normally around ¼ or 1/3rd of the distance between the support and resistance lines). If going short, put your stop above the key line and aim for the next immediate line. Then keep repeating the process.

Remember, these lines work as they are based on order flows. Highs and lows in candlesticks are created by underlying orders pushing price in one direction and being rebounded. Therefore, joining these together highlights where there has been a large number of orders placed previously.

The large number of rejections suggests a large number of buyers at this level. The key here is to understand that the more these buy orders are eroded, the more likely the level is to give way. One sign to look for is whether to test lower or higher on consecutive candlesticks. If you test lower each time, but push back to current levels, traders are eroding orders and therefore there could be a break in the level. If the lows get gradually higher and the candle closes at similar levels, then buyers are stepping in.

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