Basics of trend continuation and reversal signals
This lesson will cover the following
- What is a signal bar
- What do these candles tell us
- Which signals are good and which to avoid
While many technicians wait for different sorts of patterns to form on their charts in order to ensure a higher probability of trading success, in price action trading each candlestick is viewed as a set-up that can be traded because the next candle can initiate a movement in either direction. This is why price action traders are constantly on the hunt for signals (signal bars/candles).
A signal bar is deemed as such in retrospect, after it has closed and we’ve entered a position. As soon as your order is executed, the preceding (set-up) candle becomes a signal candle, while the current candle is an entry candle and the next one is the follow-through candle, which is always better to be in the direction of our position. Even if the market enters a trading range after the entry candle and the follow-through comes a bit later, the odds are still in your favour as long as there is a follow-through.
Others are smart as well
As we’ve already mentioned, each trader interprets market movement differently so you must always keep in mind that no matter how certain you are about what is going to happen, there are many equally smart people who will think the opposite. Each market participant positions themselves around the market and awaits the next candle. If it opens above or below the previous candle, some of the traders will bet in that direction, wagering that a breakout will occur, while other equally bright traders will expect the breakout to fail and will bet against it.
This is why it is of utmost importance for a trader to be able to determine whether there will be more bulls or bears above or below the signal candle. For example, when there is a sell signal candle in a pullback during a downtrend, sellers most likely outnumber buyers so it would be wiser to sell below the candle instead of buying.
The trend is your best friend
We’ve said numerous times throughout the articles in Trading Pedia Forex Academy that novice traders should always bet in the trend’s direction and never go against the market. It is generally easier to profit if you play along, because for example in a bull trend the market spends more time making higher highs than higher lows. A newbie trader should therefore enter the market when the signal candle is a trend candle matching the trend, because the market has already shown buying or selling pressure in that direction, which improves your chances of scoring a winning trade.
If you set that advice aside and decide to trade counter-trend because you presume a trend reversal might occur, you should look for a much stronger trend-reversal signal bar than the one you would need for trading ranges or trend pullbacks. Because trend reversals fail much more often than they succeed, you will need to improve the probability of success as much as you can by waiting for the perfect reversal set-up, including the signal bar. It is advisable that the beginner trader wait for at least a pullback following a decisive trend-line break and enter the counter-position only if the scenario is backed by a strong reversal bar (we will discuss those in the next chapters).
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However, because trends, and especially strong ones, last for much longer than many people would expect, even the most flawless set-up can fail, which is why the most successful market players patiently wait for supportive evidence to build up.
Strong trends require less
Conversely, the perfection of a signal bar becomes less significant when a trader wants to enter a trade in the direction of the trend, especially a strong one. Not only that, but market players very often enter with-trend positions even though the signal bar is against the trend and profit from that, because in general, signal bars during strong trends look poor and only a small number of them are in the trend’s direction.
Because in price action trading scenarios develop swiftly, there is one piece of general advice novice traders should take into consideration. No matter in what direction a trader is about to bet their money, they must be 100% certain in their decision before entering the position. Since market conditions can change within seconds, a novice trader will sometimes face very tough and dynamic decision-making, which may raise doubt. If that trader has not yet become consistently profitable and capable of interpreting signals quickly enough, then it would be better to refrain from entering the market and wait for another entry point.