Imagine this situation where you had a gut feeling about a price action signal to be perfect and you went ahead and used it but it exploded right in your face after entering the trade. There is no doubt that such a situation would leave you baffled, furious and desperate to investigate what went wrong here.
I am sure you heard the phrase “missing the woods for the tree” before. Well, the situation that you just encountered is a lot similar to this. You need to consider a crucial component that if left missing from the overall picture can leave you feeling this way even if you had been waiting with patience for these seemingly good price action setups.
Most Crucial Component
Well, the most crucial component that I am trying to bring your attention to is the context or the perspective in which the price action patterns develop in. The ‘context’ is essentially the environment in which the price action has developed and existing market factors, in addition to the price action signal you want to trade.
So it is really of no use to merely look at the individual trees if you are going to miss the overall picture of the woods. In other words, any price action signal makes sense to a trader only if the context in which it developed is also making sense and is every bit as important as the signal itself. If the overall context does not make sense then no matter how great a signal looks to you, it is just meaningless.
Assessing Value of Price Action Signals
Having understood the importance of context for using any signal, the next logical question arising in your mind is, how to assess the value of any these signals in a correct manner.
How do you know which one to choose and which one to reject? It is very important to know the right answer here because it can cost you dearly otherwise.
That being said, let us try to understand how to determine the value of a signal.
Important Factors to Consider
I recommend that you seek answers to few important queries before deciding on the value of a signal.
The first is pertaining to the overall market situation. Determine if the market is trending and is it in a trading range?
The basic rule of thumb here is to use your common sense. No matter how strongly you may feel about a certain price action signal, if it is countering the overall trend then it has higher chance of failure. For instance trying to take a sell signal despite seeing a powerful uptrend in the market is more or less bound to be a cause for heartbreak later on.
If the market is range bound it is recommended that you take the signal that forms quite close to the boundary (either support/ resistance) and tries to false-break through the level, demonstrating that reversal of price to other side of range is coming up soon.
The next factor pertains to the signal itself. Assess it properly to find out how it fits into the overall trend. For example, if you see a pin bar pattern forming, then check if there is any reversal / rejection signal.
One good example is a protuberant pin bar with the tail or “rejection part” of the signal clearly standing above from a key level in the market. Remember that when a pin bar has a protuberant tail it means that it has created a false break trading strategy and this effect definitely adds more power to any signal.
The final factor to consider is whether there are other factors to support the signal. Some factors that are good to consider are the levels of both support and resistance, moving averages and 50% retraces. You must know that it is always good to have as many supporting factors as possible.
A stand-alone price action signal that is devoid of any supporting factors is something like a lone soldier facing an army of enemies. You certainly cannot depend on him to fight the battle and emerge a winner.
When there are many supporting factors that upkeep the signal, then you can be double sure about your decision and the chances of failure get substantially minimized.
On a final note, there are in fact just a few points to be cautious about while using any price action signal. Check if the overall market trend is in conformation with the price action patterns, look out for supporting factors and evaluate if the signal itself blends with the existing trading environment.