Markets generally move in one of three ways, either up, down or sideways, and of these three it is the last where they spend most of their time. Many forex traders are mistakenly told that the currency markets are strongly trending markets. Whilst this may have been true several years ago, this is certainly not the case now, for many reasons. Partly, it is as a result of the financial crisis of 2007 and the associated ramifications globally, and partly also as a result of changes in the way currency markets are now increasingly manipulated by a variety of forces.
As a direct consequence, any currency pair will tend to spend around 70% of the time moving sideways in a narrow trading range, and 30% of the remaining time trending in one direction or another. This of course occurs in all timeframes, so on a 5 minute chart for example, an extended period of sideways price action might last a few hours, whilst on an hourly chart, this might last for a few days. Many forex traders become frustrated, assuming incorrectly, that a currency pair which is moving sideways is a trading opportunity lost. Nothing could be further from the truth. It is in fact a trading opportunity in waiting. Let me explain why with a simple example in Fig 6.14.
Fig 6.14 - AUD/JPY 1 hour chart
As you can see, we are looking at an hourly chart here for the AUD/JPY, covering a period of approximately two days in total. As I said earlier, congestion phases can last for extended periods!
Let’s take a look at this chart, which is an excellent example to explain the principles of price behavior in these congestion phases, and why they are so important. If we start at the left hand side of the chart, the pair were mildly bearish, moving gradually lower, but note the volume, it is falling, so we know that this phase is unlikely to last long. We then see a series of three ‘up candles’, with increasing volume, but on the third candle in the sequence, there is a deep upper wick, suggesting weakness. After all, if the market were strong, with this level of volume, then the close should have been somewhere near the high of the session. It is not, and has closed at the mid-point, so clearly there is selling now coming onto the market. The following candle ends marginally lower, but with a wick to the downside, suggesting buying support at this point, and signaling that this is probably a minor reversal in the longer term bullish
trend.
The pair then continue higher for the next four candles, but note the price action. The price spreads are narrowing, suggesting a market that is running out of energy, and indeed this is confirmed by the volume which is falling, not rising, as the spreads narrow. The volume is in agreement with the price action, in other words narrow price spreads, with average to low volume. But the volume is falling away in the move higher, so clearly the market is weak, and unlikely to continue higher, just yet. At this point we then start to move into our congestion phase, and note the volumes throughout - they are extremely low. Buying and selling activity has died away completely as the pair wait for a catalyst to bring it back to life. The volumes are now simply reflecting the price spreads, with low volume associated with narrow spreads, which is as we expect. Remember, this is in agreement. A narrow spread candle should have low volume. High volume would be an anomaly, and an alarm signal.
As the market moves in this congestion phases, it creates two price levels on the chart. One above, which we call resistance, and is shown by the red line, and the other we call support, which is shown by the yellow line. However, there are several questions here, not least, is why we call then support and resistance, and why congestion phases are so important. Therefore let me try to explain.
The reason any congestion phase is important on any chart, whatever the time frame, is simply that this is where trends are spawned and then develop, before finally breaking out into the next phase of price action. The next phase of price action may be a continuation of the current trend, or a reversal to a new trend and a consequent change in direction. It doesn’t matter. You can think of a congestion phase as the source of a great river, where salmon return year after year to breed and spawn. Once they are large enough they then return to the sea to start their long journey around the world. This is why I always refer to these congestion phases in terms of salmon and their spawning grounds, as I believe this makes the point using a real world analogy. When the market is moving sideways, it is waiting, building its strength, and preparing to launch the next phase of the price action, and the next trend.
This is why these phases of price action are so important. We know that the market is going to breakout from this price region, it is just a question of when, not if. As forex traders, all we have to do is to wait and be patient, which is often the hardest part. When we see a market in price congestion, as in Fig 6.14, this is good news. Now all we need to do is wait for the signal of a breakout, which
will, of course, be instantly apparent from our volume price analysis.
In creating these ‘channels’ of price action, the two lines of support and resistance are also created, and again we need to understand why these are so important, and here the clue is in the name we give to these price levels, ‘support and resistance’.
In the above example, the pair has been moving higher, before entering our congestion phase, so any attempt to move higher at this stage of the price action, is considered resistance. In other words the market is ‘resistant’ to any move higher at this point. Equally, any move lower in the congestion phase is finding ‘support’, in other words the price action at this level is finding a ‘platform’ which is helping it to bounce back higher again. The two levels are rather like the first electronic games of ping pong, with two paddles on the screen, one left and one right, and the ping pong being bounced back and forth by the two players.
Finally of course, the catalyst arrives, which I think in this case from memory was an item of fundamental news, which drove the pair higher, breaking out from this extended phase of price congestion with the wide spread up candle on the right hand side of the screen. Our first question at this stage is simply, ‘is this a valid breakout ?’ And the answer here is a resounding ‘yes’.
Why?
Because the associated volume is ultra high and in agreement with the price action, so a valid breakout is in progress. The market has ‘broken out’ from the congestion phase, and the ‘new’ trend is underway, only in this case it is simply a continuation of the current longer term bullish trend. The currency pair has risen, paused into the congestion phase, and then with the catalyst of fundamental news, has broken out into the next leg up. But for how much longer? Well as you can see the volume is starting to fall away, as we move higher, so perhaps another phase of congestion is in prospect. We would now be watching and waiting.
There are several points which are key from the above and these are as follows:
When a market breaks out from congestion, what was resistance becomes support, and what was support becomes resistance
confirmed by VPA
Support and resistance create natural barriers for placing stop loss orders Support and resistance levels are not solid bars, but are more like rubber bands, and as always with technical analysis, this is an art and not a science!
Let’s take these one at a time.
The analogy that I always use to explain the concept of how resistance becomes support, and conversely how support becomes resistance, is to use a house as an example. Imagine that you are standing in front of a house which has two or three floors, and the front wall has been removed completely. What would you see?
If you have ever seen a toy doll’s house, then it would look much the same, with a cross section of each floor and ceiling now exposed. Imagine now you are standing on the ground floor, and want to move up to the first floor. Above you is the ceiling, and if you cut a hole in the ceiling, and then climbed through, you would now be standing on the first floor. But what was the ceiling when you were on the ground floor, has now become the floor on the first floor. If you repeated this exercise and cut a hole in the first floor ceiling, and then climbed through to the second floor, once again what was the ceiling at the first floor level, has now become the floor at the second level where you are now standing.
This concept is very familiar to us, and rarely one we ever think of when we are in a building with several floors, but as we climb the stairs, what was the ceiling below is now the floor above. Equally, when we go downstairs, what was the floor above, has now become the ceiling from below! This is the principle of support and resistance which is at work on our price charts, and which is so important once the ceilings and floors (price levels) are breached.
Returning to our example in Fig 6.14, whilst the market was in its congestion phase, the red line was the resistance level, and the yellow line was the support level. However, as soon as the market broke out through the resistance level, the yellow line, immediately becomes a potential support level. In other words, going back to our house analogy, the market has moved upstairs to the first floor and the price resistance ceiling, has now become the price support floor for a further move higher. In other words, this area of price resistance, which has now become support, is acting as a springboard, a platform if you like, to
help the market move higher.
The reverse is also true. Had the market broken to the downside on this occasion, then the floor of support, the yellow line, would then have become a resistance area. In other words the floor has now become the ceiling as we move downstairs. It is these areas of dense price action which create the ‘natural’ areas of price support and resistance. These then come into play, either immediately as the market breaks away, or later when the market returns to these areas in the future.
Which leads us to the second point. When a market breaks away from one of these areas of price congestion, we know that this is an excellent trading opportunity, provided it has been validated with volume. Why?
Because these are the regions where trends are born and created. They are the regions where the market is pausing, waiting and preparing, building up strength or waiting for a catalyst, often an item of fundamental news. This is why they are so important. They are the launch pad for future price action. Not only do they offer excellent trading opportunities, but also provide the added protection of a natural price barrier above or below, which leads me on to the next point.
These price levels are defined by the market. They are not our levels, but the market’s levels, and so as the market moves away from these regions, we have some natural barriers of price protection in place. In our example in Fig 6.14, the AUD/JPY broke higher, and on this occasion moved firmly higher on strong volume. However, what you will often see is the market move away, and then reverse back to test the ‘new support’ level (the old resistance level), before bouncing off, and moving away again. This is why these price regions are so important as they help define how and where to place any stop loss orders, to protect our position in the market. I will be explaining this type of order later in the book, but for now, just recognize the importance of these regions. They define the areas at which we can place our money management orders, and in this example we would place these somewhere below the yellow line. In other words, the market has set this price level for us, by the associated price action.
And finally to the last point.
Having read the above description, where we have talked about floors and ceilings, which are solid structures, the last thing I want you to think is that
support and resistance levels on a chart are just the same in that sense. They are not, and you should think of them more as rubber bands. They have some ‘give’ in them, both when applied to any price action and also in any subsequent price action when the market breaks away. This is why you always have to be careful and wait for a clear break, and not simply the point at which the price action has just cleared either above or below one of the areas.
There are really two points here in one. The first is this. When drawing these levels on a chart, or applying the line to connect these points together, we do have to allow ourselves a degree of ‘poetic license’. In other words, technical analysis is an art and not a science, so joining up price points precisely is not what is required. What we are looking for is the general price levels only, not three or more precise points. A ‘best fit’ approach to placing the lines is fine, and don’t worry if some of the historic price action is slightly above or below the line. That’s the first point.
The second which follows on, is that we have to wait for a clear break from the price congestion, before entering the market. Here it is generally a case of waiting for the first candle to complete, in whatever your timeframe, and then make a judgment based on the price action and associated volume.
In Fig 6.14, the currency pair has broken firmly higher, and once the candle has completed, we can then assess the associated volume. Here we have a strong move higher, the price action is now well clear of the congestion, and we have excellent volume, so it is a valid move higher.
This is the analysis that we carry out every time we see a congestion phase and subsequent breakout. The first point is how far the market has moved away, and the second is the associated volume. If the close of the breakout candle is well above (or below) the associated resistance or support levels, and we have good supporting volume validating the price action, then it’s time to make our move!
If you are a novice trader I would urge you to embrace this approach. I consider myself to have been immensely fortunate in my own trading career, having been introduced to volume and price analysis from the beginning. To me, it just made sense, and has done so ever since. It is a method I use in all the markets I trade, not just spot forex, but in futures and stocks. It is, I believe, the right approach, the only method that applies common sense and logic to the analysis, using two leading indicators. It will take you a little time to learn to become confident and proficient, but like riding a bicycle, once learnt it is never
forgotten.
I hope this chapter has helped you gain some insight into the methodology of trading using VPA, and also convinced you of its merits and power! As I mentioned at the start, if you would like to learn more, please study my volume book, which explains some of the more advanced concepts, and builds on what we have covered here.
In the next chapter I want to move on to explain the mechanics of the trading process, how we make money, and how the trading process works.