Introduction
Previous day highs and lows are known to be in the minds of traders, and are often used as reference points when making trading decisions. While there is a good chance that price may bounce at these levels, it doesn’t always do so, and can easily continue through and beyond them. How can one qualify and filter entries, and help identify those most likely to hold? Let’s have a look.
The strategy
I always find myself getting excited when price approaches the previous day’s high or low. After numerous slaps by Mr. Market, I began to look a little deeper at what price was doing at these levels in an attempt to put the odds slightly more in my favour. I was able to define a handful of steps, which when followed with discipline, increased the likelihood of a successful outcome. The following points, which we’ll cover in detail in this thread, are all worth considering when qualifying and filtering entries for this particular trading strategy.
[ul]
[li]The anatomy of the move up/down to the previous day’s high/low
[/li][li]The anatomy of price action at the high/low
[/li][li]The time of day
[/li][li]Moving Average Convergence Divergence (MACD)
[/li][/ul]
Let’s have a closer look these points together with an example.
The anatomy of the move up/down to the previous day’s high/low
This is probably one of the most important parts of this trading strategy, why? Price is approaching “key” levels all the time, on every time-frame, at all times of the day. So why is this so important? Have you ever gotten a good deal on a purchase? Yes of course, we all have. What is the psychology behind a good deal? How do you feel just before you take advantage of a good deal? Generally, one may feel excitement, happiness, or any other positive emotion or combination thereof, and make a decision to purchase with much less resistance, had it been a bad or even ordinary deal. When price is low, people buy, when price is high, people sell. what role does this play in the markets? When price quickly moves e.g. down, causing an imbalance in price, we can expect this great deal not to last, as others will also feel the same positive emotions, and take advantage of the smoking deal. Even when we’re convinced that a good deal is indeed as good as we think, we’ll still look for some kind of confirmation to support our decision. Previous levels, highs and lows, provide us with the confirmation that we’re getting a good deal. If we are able to find a historical level such as yesterday’s high/low that validates the legitimacy of the good deal (either to buy or sell), we’ll act with confidence when buying/selling. Others will be referencing price in relation to the same confirmation levels, also for validation purposes. In other words, providing that there are no impending news releases, others are looking to trade at the same levels.
The following commented screen-shot shows an unbalanced move down to the previous day’s low on the hourly chart:
The anatomy of price action at the high/low
When price approaches the previous day’s high/low on e.g. the hourly chart, I will move down to a five minute chart, as this time-frame really helps one to understand what’s happening around these key levels, and offers greater detail, detail that simply isn’t visible on greater time-frames. As an example, when price is moving on or around the previous day’s low, it will often form a dealing range (period of consolidation) at or close to (below or above) this level. Before I do anything, I wait for price to show me a directional bias. This bias is often presented in the form of a new dealing range, either above or below the previous. In the screen-shot presented below, the buying bias is initiated when price breaks above the trading range on the previous day’s low, signified by the dark grey rectangle. The strong move up once price moves above, is a sign of buying in contrast to the decline in selling, which will often cause price to drift, as illustrated just after the first move down to the previous day’s low.
The time of day
Time of day is crucial. Volume data isn’t available in Forex as it is in other markets, so the only way to tell when the market is most liquid is by looking at the clock. Typically, the Forex market is most liquid when London is busy. When London closes, Asia has already gone home, which means that liquidity is on the decline. With two of the three (Asia, Europe, North America) markets closed, liquidity is low and decreasing, which typically results in price pulling back into the day’s range. While anything can happen at any time, generally speaking, when London goes home, things tend to slow down. Knowing this, if price approaches a key level (e.g. yesterday’s high/low), price will tend not to make new highs/lows. How does this affect our decision making with regards to this specific trade? Again, when price approaches e.g. yesterday’s low and price is negatively imbalanced, there may not be enough liquidity (power) in the market to push the price lower. While this, like anything else, is no golden rule, it does provide an additional element of confirmation, which, when combined with the previously mentioned, puts the odds slightly more in our favour. This is illustrated on the first screen-shot, and is marked London close.
Moving Average Convergence Divergence (MACD)
While trading MACD independently, stand-alone, will empty your account at the drop of a hat, when combined with other technical studies such at those mentioned above, it can be a useful method by which to provide confirmation. How the MACD is used when trading price imbalances is illustrated via the two screen-shots provided above. In short, when price is going in one direction and approaching a key level, and the MACD is moving in the opposite direction, the move may slow down, correct, turn around.
Conclusion
Price imbalances, negative and positive, can be observed and traded at any significant historically respected level when combined with other technical studies, as illustrated above. More significant levels of support and resistance in the form of e.g. swing-points on greater periods, previous month/week/day high/low and Fibonacci retracements and extensions and pivots can all considered when trading this strategy.
Time of day is very important, and should be considered prior to taking on a new position. When London is roaring, nothing will stand in its way.
It is my experience that previous day highs and lows as presented above, provide some nice trading opportunities, and they tend to develop once or twice a week. While this may not sound like much, these setups, with a 20-30 pip risk, will in most cases hand you 100 pips or so if properly managed and carefully picked.
Thank you.