Price Action Trends: Higher-Highs and Higher-Lows, the Rhythm of Life

Price Action Trends Summary:

This is an educational article published to FOREX.com introducing the topic of price action. In today’s article, we start with chart reading for trends by identifying higher-highs and higher-lows (for up-trends) or lower-lows and lower-highs (for down-trends). In follow-up articles, we’ll expand the discussion to include more strategy around entry and risk management, which we’ve touched on previously in the article, Is your trading strategy just a guessing game?

If you would like to see price action applied to live markets, I host a weekly webinar focusing on the topic that you’re welcome to join: Details for registration.

Trends are an important aspect of market analysis, largely because it’s one of the aspects of chart analysis that can be helpful with forward-looking strategy. Support and resistance are also important as they can help with risk management; but a lot of other analysis is simply idea generation that can produce noise, thereby making the trader’s aim of finding amenable trading opportunities as that much more of a challenge.

Price action strips the indicators from the chart and, instead, lets the market mold the message. If something ‘good’ is getting priced-in, then traders will often reward that market with a fresh high. As longs see trades push into profit, they’re then faced with a decision: Realize profits or let it ride. If they quickly realize profits, that adds supply into the market and if enough traders do that, then price moves down. But - the big test for the trend is what happens after that fresh high, after the pullback, whether buyers return to hold support, and the lows, at a fresh higher-low. If that happens, the market may be showing anticipation of continued strength, and that’s something that can be incorporated into strategy. But trends are important, and that’s what we’re going to start with.

While the future remains uncertain regardless of the point-in-time, trends exist, and there’s often a reason behind them. And as those reasons become more and more prominent, or more well-known, then other traders can act on those trends thereby driving prices to fresh highs or fresh lows. To be sure, no trend lasts forever. But that’s not the point. The point is finding a trend; and trading on the side of that trend may allow a trader to generate a bias that can assist with their trading performance. And as we looked at in the ‘Guessing Game’ article, a trader doesn’t need to be ‘right’ 70 or 80% of the time to allow for profitability, as even a 40% win ratio can allow for a profitable model. The key at that point comes down to managing risk efficiently and trying to ride trends or moves that can bring larger profits when right than losses when wrong.

Trading on the side of the trend can help with directional biases and looking for the trend to continue can allow for larger profit targets than risk outlays. If a trader is attempting to trade an up-trend, then usually they’re looking to buy after a pullback in that trend. This could allow for stops to be placed below support so that if support does hold and remain defended, and the trend remains in order, the trader can see a successful trade and the continuation of that trend can allow for larger profit potential. But – if the trend fails and price breaches support, the trader can look to take a concentrated loss in effort of mitigating the downside for when matters don’t work out.

There are numerous ways to identify a trend, however, and there’s not one ‘right’ way to do it. Previously, we looked at using the 200-day moving average for such and this remains a popular and common way to go about it. In this article, we’re going to take that conversation a step further by looking at how this can be done with price action.

Trend Trading Video

What is Price Action?

Price action is simply focusing on price as opposed to any indicators. When traders are learning technical analysis the price chart can seem a wild and chaotic place to make decisions, and usually indicators come into play to help the new trader to read what the chart is saying.

But really, this isn’t necessary. While it does make matters a bit more objective or easier at the start, it’s important to consider the prospect of lag. By the time the price hits your screen through the chart, there’s already a degree of lag. If you press ‘buy’ or ‘sell,’ by the time that order gets to your broker, price may have moved. This lag is minimal as we’re essentially talking about latency and liquidity but it’s important to mention.

Chart time frames can be important here as standard statistical sampling applies. If following a one or a five-minute chart, there may be too much noise and chaos to allow for cogent analysis. The daily chart, however, can often incorporate enough statistical samples per candle or bar that some relevance can be seen. For this article, we’ll be focusing entirely on the daily chart, and for shorter-term traders, worry not as there’s options to use shorter time frames for entry after the trend has been determined from the daily.

Using an indicator introduces considerable additional lag and that’s somewhat of the design. The very attempt to simplify the chart and make it more objective also makes it more lagging and takes emphasis away from current price. This was something we addressed in the article on the 200-day moving average, as well as the follow-up article in which we looked at how to use moving averages.

Focusing solely on price can seem messier, or noisier given that there’s no lag from an indicator to modulate that candle-to-candle nuance. But, with time, traders can become even more comfortable in their own chart analysis to the point that the lag introduced by an indicator is simply more unwanted noise, and at that point, they have started to become a price action trader.

Two Steps Forward, One Step Back, the Rhythm of Life

If you think about it, almost any trend has gyration along the way. Let’s say you wanted to start working out – or you wanted to start a new diet. You first start with a plan and if you’re like most people, that plan will probably be somewhat aggressive. After all, you want change! And so, you plan for that in the way that you’re looking to incorporate this new thing into your life.

And perhaps you hit the gym and keep the diet clean for a few weeks, which means that you’re getting closer to forming a new habit. But it’s also tiring and somewhat boring as you’ve now been doing this new thing for a few weeks, and it’s far different than the prior ‘you’ that wasn’t doing that before you had gotten started. And this is where you start to slip up.

Maybe you skip the gym for a few days and you let the diet fall by the wayside. Now – you’re at a moment of truth.

Do you continue to slide and go back to your old ways? Or, do you get your ‘stuff’ together, realize that you’ve fallen off track, and get back on the rhythm that you had before your set back? This ultimately is what will determine your path – what you do after a pullback, when conditions aren’t perfect, or ‘when the going gets tough.’ Do you let it fail? Or do you persist and move ahead, forcing yourself to new highs on the way to getting closer to your goals?

Trends in markets are a lot like this, really. Something ‘new’ happens and this causes investors to push prices to fresh highs. Investors that were long already now have a decision to make:  Let the gain ride or realize profits and close the position. If investors remain greedy enough – or, perhaps better said ‘optimistic enough,’ then they’ll probably hold on with the idea that they can gain even more. That lack of selling means that there’s less liquidity at the new high, and if other investors come into the market to act on that ‘new’ thing that drove the initial breakout, well now there’s more buying pressure to allow for even higher-highs. And as more join the trend, allowing for even greater demand, then prices can run higher and higher.

But this is rarely going to be linear, right? Because like our own willpower, market trends will face tests. It’s that same two steps forward, one step back type of logic that’s common in so many other areas of life. But let’s suspend the analogies and go right to the chart.

Higher-Highs and Higher-Lows or Lower-Lows and Lower-Highs

At the root of this logic is the greed/fear continuum that traders face on a near constant basis. When a trade works in our favor, we tend to feel ‘greed’ while a trade going in the other direction tends to invoke fear. More troubling is when we can couple those two emotions together!

Let’s say, for instance, a trader is holding a long position and prices break out to a fresh high. This is usually where that greed will kick in. But then let’s say that prices start to reverse and trade lower. Now, that trader’s greed is put in check, and they start to face the prospect of fear:  The fear that this winner will turn into a loser, the fear that they are responsible for not having realized that gain when they could. And if the trade fails, well, they may feel responsible as they didn’t make the correct decision when they had an unrealized profit. If they hurriedly close the position, that adds supply into the market, which can contribute to a deeper sell-off.

But perhaps more important for the life of that trend is what other market participants are doing after that pullback. Are they excited by whatever initial stimuli had allowed for the breakout in the first place? And now, after a pull back, they have the opportunity to buy that same market at a lower price, and perhaps even with an attractive risk profile if there’s nearby support to use for stop placement.

If more buyers jump in to react to that pullback, driven by the excitement of the initial stimuli driving the breakout, demand can force prices higher again and then we have bullish trend continuation. But, if there’s not enough excitement and, instead, the fear from bulls holding longs brings even more supply into the market, further pressing prices-lower, well then there’s no discernible trend to work with and the bullish bias is no longer as attractive.

The big question – is what happens after the pullback. Do traders return to the market to support the initial move? Or, do they repel with fear? On the below daily chart of USD/JPY, I’ve marked the higher-highs and higher-lows of up-trend (in blue) along with the lower-lows and lower-highs of down-trends (in red). I’ve also added color to the background to help illustrate each market trend or scenario, and on the right side of the chart, you’ll notice a fast pace of recent change that we’ll discuss a little later.

USD/JPY Daily Price Chart: Higher-Highs and Higher-Lows

The Right Side of The Chart

On the very right side of the above chart, you’ll notice a down-trend that started but didn’t really pan out, as prices quickly jumped above the ‘lower-high’ to create a higher-high. This is an example of a trend failing and it’s important to point out up front because this will happen. But that’s the same for any other form of trend analysis, right? The aim here isn’t for perfection, it’s for positioning.

The more attractive element for trend traders is what was happening before that as there were three different well-defined trends. When the trend is up, wait for a higher-low, and then look to join the move. Or, if the trend is down, wait for a bounce, look for the lower-high, and then the door opens to continuation. You’ll notice that the transition to each new trend is a breach of structure from the prior theme. This is when a lower-low showed after a series of higher-highs and higher-lows; or when a higher-high showed after a series of lower-lows and lower-highs. I’ve marked these instances with a green circle below.

USD/JPY Daily Chart: Trend Changes Highlighted in Green

Breaking the Sequence Opens the Door to a Fresh Trend

When a market is bullish and traders are bidding that trend-higher, greed can continue to allow for a continuation of higher-lows and that’s not necessarily driven by greed on the part of the practitioner as much as it is on the greed of other traders in a market.

If the trend that you’ve been tracking and dreaming on is finally pulling back, prior price structure will be fairly clear, along with where price had been supported before. And since you know what that prior support was, you also know that the greed of other market participants may not allow it to come into play, if the trend is to continue. So, the big question then is where the higher-low may show and this is more art than science as it’ll be governed by a host of factors, including whatever is in the backdrop of that market at the time.

It's when that changes that traders should take note of a possible trend change: When, all of the sudden, the same excitement that caused traders to buy higher-highs is now missing when price is testing a higher-low. If there’s no demand on that support test and sellers continue to offer liquidity, then price will break down and now there’s a lower-low to deal with.

This could be a sign of an oncoming sell-off, but the operative time to look at shorts is not always going to be at that first print of a lower-low, but rather, whether price holds at lower-high resistance following that first test of fresh lows. On the below chart, I’ve added a few more annotations: black boxes are identified around the lower-high or lower-low following an initial trend change and I’ve added labels to help illustrate.

USD/JPY Daily Price Chart: Higher-Highs and Lows or Lower-Lows and Highs

Trading Trends

Price action is imperfect like any other form of market analysis. The aim of price action isn’t perfect prediction; instead, it’s a risk-centric type of approach that can allow traders to minimize lag while also looking to limit risk on trades, and that’s probably it’s greatest allure to experienced traders.

The optimal time to look for trend continuation is not on the initial spikes, but rather the pullbacks from those spikes when they hold a fresh lower-high, or a fresh higher-low. This is the indication from bears, who are holding resistance at a lower level than they had previously; or an indication from bulls, who will not allow for price to span back to prior support – that they may be willing to force a continuation of that trend, which could allow for the trader on that side of the trend to move towards profits.

But, as we can see from the right side of that chart, not every trend continues, and this is precisely why risk management is front-and-center with price action. If sellers are unwilling or unable to hold resistance at a lower-high, the continuation potential of that down-trend is questionable and it may not be the best opportunity for bears. And, if not limiting risk and the trader finds themselves on the wrong side of the trend, they can soon be facing a ‘catastrophic trade,’ as we had referenced in the Guessing Game article.

FAQ

Why price action?

Simplicity is a big reason but there’s also the fact that the future remains uncertain regardless of the analytical methods used. More complexity introduced for trend analysis doesn’t necessarily make it any more predictive, and given the necessity of risk management, price action can make the risk-reward of trading setups seem clearer.

And for experienced traders focusing on risk management, price action can offer some attractive asymmetry for trading setups.

Does a trader have to choose only price action? Or can they couple with other types of analysis?

Price action can be a supplement, or it can be the entire approach. It really just depends on how the trader wants to build out their approach, but many traders will use a simple indicator such as the 200-day moving average, and then couple that with price action analysis. With this, the trader can use the moving average to help identify support or possible higher-lows but like with any other indicator added to the chart there’s an added element of possible failure.

What’s the next step after trend identification?

After the trader’s decided that they want to engage with a market and the direction to do so, the next step is investigating the entry and there’s a lot of ways that this can happen. The trader can stick with price action and then look for formations or candlestick patterns pointing in the direction of that trend. Or the trader can use simple support and resistance identification via price action to do something similar, looking for trade setups in the direction of that trend, attempting to sell near resistance for down-trends and buy near support for up-trends. There’s also the option of multiple time frame analysis, such as using a four-hour or perhaps even a one- or two-hour chart for entry in the direction of that trend. For traders that don’t want to use price action for entries, they can also choose to incorporate an indicator for that part of the strategy.

--- written by James Stanley, Senior Strategist