How to Understand Forex Signals

By: DailyForex.com

Four days every week, from Monday to Thursday, I publish Forex signals (in fact, they are technical analyses) for the seven most popular USD currency pairs. Once they are published, I am not able to update them, and market conditions may change radically. My aim in publishing these signals is to give the best guidance, ideas, and interpretation as possible to Forex traders once each day as the markets open, focusing on intraday trading (day trading), due to its popularity over longer-term trading methods. In my opinion, it is easier for most people to make money trading daily charts, making buy or sell decisions no more than once per day, but I understand most of my readers are day traders and I try to accommodate their needs.

As the signals are designed to be as useful as possible for as long as possible, the primary tool I use within the signals is the identification of exact prices, or sometimes narrow price ranges at which the market is more likely to turn. These are generally known as “support and resistance”, but you can also think of them as pivotal points. All my signals identify at least one pivotal point, and usually will identify two: a price below the current price (as at the time of writing) which may act as support, and a price above the current price which may act as resistance.

How to Use Forex Signals

Each signal begins with a discussion of the prospect of any open trade that might have been generated by the previous day’s signal in the same currency pair. The piece then goes on to suggest the best times of day in which to open any new trade, and the position size that might be risked on a trade that day. The next section identifies likely support and resistance levels with an accompanying illustrative chart. Following the signal means taking note of these levels and watching during the recommended hours to see if the price reaches any of them.

When the price reaches a resistance level after going up, you wait to identify a bearish turn in the price, which means you think it is going to go down. When the price reaches a support level after going down, you wait to identify a bullish turn in the price, which means you think it is going to go up. The big question is, how to identify such a turn in the price at the point where it has a high probability to become the best point to enter a winning trade?

How to Identify a Price Turn

It is my belief, derived from experience, that the best price turns take at least one hour to play out, and usually more. There is a trade-off between getting in early and achieving a high potential reward to risk ratio, and waiting longer to get a surer turn. For example, let’s say that the price is at 1.0950 and the level at 1.1000 is identified as resistance, and the price then rises to hit the 1.1000 level, forming a strong bearish pin bar reversal candlestick formation on the 5 minutes chart. This might be a great entry and maybe the price will drop strongly and not come back to 1.1000 for the rest of the day, but being so quick to press the trigger carries a higher risk of being wrong. That is why I recommend waiting for at least one hourly candlestick to form before entering a trade. A bearish pin bar reversal candlestick is a stronger indicator on the 1 hour chart than on the 5 minutes chart.

I must admit that even if you are using a slower time frame such as the 1 hour chart, identifying an attractive turn is challenging and is something that takes practice. As a general guideline, what I recommend looking for in identifying a turn is a candlestick formation such as a pin bar, an inside candle, an outside candle, or an engulfing candle rejecting the level quickly and decisively. These tend to be the best trades. Once you have seen one of these formations form quickly, right after the level is first reached, it makes sense to enter a trade as described below.

Entering a Trade Upon a Price Turn

When the candlestick completing the turn has closed, what you do depends upon whether you are entering a long trade where you want the price to go up, or a short trade where you are hoping for the price to go down. For a long trade, it makes sense to place a buy order 1 pip above the turn candlestick’s high, with the stop loss 1 pip below the lowest price that has been reached in the move. For a short trade, it makes sense to place a sell order 1 pip below the turn candlestick’s low, with the stop loss 1 pip above the highest price that has been reached in the move.

For the trade to go ahead, the price must reach the level at which the order is set. Usually the best trades happen quickly. The longer the time elapses before the price is reached, the less attractive the trade looks – it “decays” over time. Therefore, I recommend that if the trade entry has not been triggered within 1 hour of the order being entered (i.e. during the next 1 hour candlestick), it usually makes sense to cancel the trade. Another reason to cancel the trade is if the price reaches the stop loss before the entry is triggered, as this also usually means that the support or resistance level has turned out to be unreliable. To do this properly, it is important to watch the screen from the time of entering the trade until the entry is triggered or until your time limit for entry expires so you can cancel the trade manually.

Examples

I will try to illustrate with a couple of real-life examples.

Last week I identified a resistance level for the USD/CHF currency pair at 0.9761. The price did not hit and it and start to make a turn until after the time I specified as good for trading, but let’s use it as an example anyway. In the chart below, the level 0.9761 is marked in red, and the hourly candles are marked with a down arrow where the level was hit and the price began to turn.

The first thing to note is that it took 3 candles for the price to turn.  In fact, even if you had waited for four candles to print before taking the trade, you still could have made a nice entry. It played out like this: after three strong bullish green candles, the price hit the level and printed a small pin bar candle. You could have entered 1 pip below the low of this candle, but I would have been wary, because the candle was very small, much smaller than any of the bullish candles that printed just before it, and you should beware of using a single small candlestick as a valid reversal sign that the turn has completed. The next candle was more encouraging, as a relatively large outside candle that was also nearly a pin candle. This would have been a better candle to use to place a short entry 1 pip below its low with a stop 1 pip above its high. It would not have been triggered over the next hour, which saw a small inside candle form, which was also a pin candle. This third candle was also encouraging, and from here the price began to fall.

The message I want to get across here is that instead of just waiting for the levels to be reached, seeing a candle form which can be called a pin, inside, outside, or engulfing candlestick, and then entering a trade, is a process that calls for some judgement and discretion. Entering after only a single candlestick can be dangerous unless the turn is very strong and dramatic. In the above example, there were a sequence of three candles that together clearly signaled a turn was probably happening. If you do not feel strongly positive about the first candlestick, usually it pays to wait and see what the next candlestick does.

In the interest of fairness, I present a real-life example of a losing trade. Last Thursday, I thought that the level of 1.1161 could act as good support for the EUR/USD during the London session. The level is marked in blue in the chart below:

The session for the signal began a few candlesticks before the green bullish inside candlestick marked by the upwards arrow in the chart above. The price fell heavily back to 1.1161, and it was encouraging that the large bearish candlestick closed above the level. The next hour printed a bullish inside candlestick. A long (buy) trade could have been entered a pip above that candle, with the stop below the previous candlestick’s low (the swing low) at about 1.1153. This trade would have been triggered quickly, but was ultimately a losing trade. The price struggled and the support put up a fight: note how when the price returned to the level it printed two consecutive pin candles, with the second one looking more convincing. If instead of entering right away you had waited for another candle to print after the bullish inside candle, and placed a buy order above that second candle, you would have been kept out of what turned out to be a losing trade. Of course, some losing trades are an inevitable part of trading.

How to Exit Trades

In my daily signal pieces, I suggest taking enough profit after 20 or 25 pips so that the worst outcome is breaking even. While this can work, as can other set rules for taking profit, there is also an art as to when to exit a profitable trade which depends upon how the chart looks in every individual trade. This is something that the individual must learn, but one tip I would give is that when the trade is going well, don’t get tempted to close it too early just to grab profit. Wait until the trade stops moving in your favor for at least a couple of hours. That should be an effective rule of thumb to use.

Final Tips

If the price breaks above resistance levels, you can use that as a general indicator of an upwards trend, and vice versa if the price breaks below support levels. The more experienced you get, the better you can use this an “indicator” suggesting which direction would be best for day trading, even if no key support or resistance levels are reached.

In trading, it is always a positive thing to have your own view, and not to rely blindly on the tips of someone else. I hope you use my signals as part of your own process of market analysis instead of relying on them exclusively. You might see something I miss, or have your own view that can also be profitable. When you risk real money, it helps to have your own opinion, so you don’t get shaken out of a good trade too early. Although it is possible just to watch for the kind of reversal candlestick formation from key levels as I have described, there is an art to it and every case is different. Compound candlestick formations are usually more powerful than single candlesticks as reversal signals. Sometimes the candlestick formation might be technically correct, but the very best reversals often show a definite change in speed and feel to the price action that occurred just previously.