Forex market price action comes with many false signals that can generate huge losses for unprepared traders. The market has periods where prices are range-bound, after which they either break out of the range to continue the previous trend, or they reverse. These are the critical times when traders can easily get whipsawed and accumulate piles of losses.
This step-by-step approach will help you to filter the best trading signals and avoid the bad ones, so let’s get started.
How to filter trading signals
Trade setups that can easily produce false signals either rely on chart patterns or are based on candlestick patterns. For those that rely on candlesticks, the pin bar represents one of the most important signals that can be used to filter good and bad trade entries. Candlesticks are, by their very nature, storytellers of what buyers and sellers are doing. A pin bar, especially a long-tailed one, is an important candlestick that signals what buyers and sellers are doing within the context of the pre-existing trend. So, if you have a pin bar appearing on the charts, it is best to understand what it is saying before taking action. Don’t jump the gun.
So, how can you filter out good and bad trading signals, especially ones that rely on candlesticks? Here are a few tips.
1. False breakout vs true breakout: look out for the pin bar
When a pin bar appears after a sustained long trend, it is a signal that prices are about to reverse. However, many traders are not patient enough to wait for the completion of the pin bar candlestick. When a pin bar first appears after a trend has been ongoing, it starts off with price action in the direction of that trend. But what forms the shadow of the pin bar is the action of traders who are resisting and opposing that trend. If the pin bar starts off pushing through a key level of support or resistance, it can be falsely interpreted as a breakout. This can be seen in the chart below:
On the XAUUSD chart above, we see 4 areas (numbered 1-4) where the candlesticks encountered resistance at a certain price level, and a pin bar has formed, which started off by pushing above this level as if it were breaking above the resistance, only to be firmly resisted by sellers and close below the resistance, causing a price reversal. These sorts of false breakouts happen all the time. A trader must be alert to them.
Here, the golden rule is never to trade an active candlestick as a breakout. Allow it to close to see if it forms a pin bar.
A more conservative approach would be to wait even for the second candlestick to close outside the support or resistance line before we can speak of a clear breakout. Let the price action unfold before you make any trading decisions and end up with a losing trade.
2. Long-tailed pin bars are superior to short-tailed ones
The length of the shadow (tail) on a pin bar speaks volumes about the strength of the rejection of the initial price movement in that candlestick. A longer tail means that the initial move was strong, but the rejection of this move was just as strong, if not stronger. If the pin bar forms at the top, sellers were strong enough to push the price back, which signals that selling pressure is still present and may push the price even lower. On the other hand, if the pin bar forms at the bottom, it signals that buyers were strong enough to push the price back up and we need to be aware that it may continue going up with the underlying momentum.
A pin bar with a long tail carries heavy significance as it serves as a springboard for a possible reversal of the previous trend.
3. Enter with confirmations only
We’ve just mentioned trying to trade once a candlestick breaks a support or resistance. This is not good practice because anything can happen while a candle is still active. In the case of pin bar formations, traders working against the trend can easily push back on any attempted breakout movements and force the candle to close below a resistance or above a support (failed breakout setups).
No matter how long a candlestick seems to have pushed in the direction of the breakout, you can only tell if a true breakout has occurred when that candlestick has closed. Many supposed breakouts end up being “fakeouts”, and traders get sucked into them over and over and again.
Look at this chart of the euro to sek pair. Price action seemed to be on its way to a very strong breakout, only for a magical rejection to occur almost immediately, forcing prices back to where they came from. Buyers were waiting for a price drop and jumped in immediately when they thought the low price didn’t reflect the fundamental value of the instrument. Sellers agreed that the instrument was undervalued / oversold and didn’t push the price lower.Source: "How to filter good and bad price action entry signals"
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