Price Action Trading II

Price Action Components

Trend Channel

A trend or price channel can be created by plotting a pair of trend channel lines on either side of the market - the first trend channel line is the trend line, plus a parallel return line on the other side. Edwards and Magee's return line is also known as the trend channel line (singular), confusingly, when only one is mentioned.

Trend channels are traded by waiting for break-out failures, i.e. banking on the trend channel continuing, in which case at that bar's close, the entry stop is placed one tick away towards the centre of the channel above/below the break-out bar. Trading with the break-out only has a good probability of profit when the break-out bar is above average size, and an entry is taken only on confirmation of the break-out. The confirmation would be given when a pull-back from the break-out is over without the pull-back having retraced to the return line, so invalidating the plotted channel lines.

Shaved bar entry

When a shaved bar appears in a strong trend, it demonstrates that the buying or the selling pressure was constant throughout with no let-up and it can be taken as a strong signal that the trend will continue.

A Brooks-style entry using a stop order one tick above or below the bar will require swift action from the trader and any delay will result in slippage especially on short time-frames.

Microtrend line

If a trend line is plotted on the lower lows or the higher highs of a trend over a longer trend, a microtrend line is plotted when all or almost all of the highs or lows line up in a short multi-bar period. Just as break-outs from a normal trend are prone to fail as noted above, microtrend lines drawn on a chart are frequently broken by subsequent price action and these break-outs frequently fail too. Such a failure is traded by placing an entry stop order 1 tick above or below the previous bar, which would result in a with-trend position if hit, providing a low risk scalp with a target on the opposite side of the trend channel.

Microtrend lines are often used on retraces in the main trend or pull-backs and provide an obvious signal point where the market can break through to signal the end of the microtrend. The bar that breaks out of a bearish microtrend line in a main bull trend for example is the signal bar and the entry buy stop order should be placed 1 tick above the bar. If the market works its way above that break-out bar, it is a good sign that the break-out of the microtrend line has not failed and that the main bull trend has resumed.

Continuing this example, a more aggressive bullish trader would place a buy stop entry above the high of the current bar in the microtrend line and move it down to the high of each consecutive new bar, in the assumption that any microtrend line break-out will not fail.

Spike and channel

This is a type of trend characterised as difficult to identify and more difficult to trade by Brooks. The spike is the beginning of the trend where the market moves strongly in the direction of the new trend, often at the open of the day on an intraday chart, and then slows down forming a tight trend channel that moves slowly but surely in the same direction.

After the trend channel is broken, it is common to see the market return to the level of the start of the channel and then to remain in a trading range between that level and the end of the channel.

A "gap spike and channel" is the term for a spike and channel trend that begins with a gap in the chart (a vertical gap with between one bar's close and the next bar's open).

The spike and channel is seen in stock charts and stock indices, and is rarely reported in forex markets.

Pull-back

A pull-back is a move where the market interrupts the prevailing trend, or retraces from a breakout, but does not retrace beyond the start of the trend or the beginning of the breakout. A pull-back which does carry on further to the beginning of the trend or the breakout would instead become a reversal or a breakout failure.

In a long trend, a pull-back oftens last for long enough to form legs like a normal trend and to behave in other ways like a trend too. Like a normal trend, a long pull-back often has 2 legs. Price action traders expect the market to adhere to the two attempts rule and will be waiting for the market to try to make a second swing in the pull-back, with the hope that it fails and therefore turns around to try the opposite - i.e. the trend resumes.

One price action technique for following a pull-back with the aim of entering with-trend at the end of the pull-back is to count the new higher highs in the pull-back of a bull trend, or the new lower lows in the pull-back of a bear, i.e. in a bull trend, the pull-back will be composed of bars where the highs are successively lower and lower until the pattern is broken by a bar that puts in a high higher than the previous bar's high, termed an H1 (High 1). L1s (Low 1) are the mirror image in bear trend pull-backs.

If the H1 doesn't result in the end of the pull-back and a resumption of the bull trend, then the market creates a further sequence of bars going lower, with lower highs each time until another bar occurs with a high that's higher than the previous high. This is the H2. And so on until the trend resumes, or until the pull-back has become a reversal or trading range.

H1s and L1s are considered reliable entry signals when the pull-back is a microtrend line break, and the H1 or L1 represents the break-out's failure.

Otherwise if the market adheres to the two attempts rule, then the safest entry back into the trend will be the H2 or L2. The two-legged pull-back has formed and that is the most common pull-back, at least in the stock market indices.

In a sideways market trading range, both highs and lows can be counted but this is reported to be an error-prone approach except for the most practiced traders.

On the other hand, in a strong trend, the pull-backs are liable to be weak and consequently the count of Hs and Ls will be difficult. In a bull trend pull-back, two swings down may appear but the H1s and H2s cannot be identified. The price action trader looks instead for a bear trend bar to form in the trend, and when followed by a bar with a lower high but a bullish close, takes this as the first leg of a pull-back and is thus already looking for the appearance of the H2 signal bar. The fact that it is technically neither an H1 nor an H2 is ignored in the light of the trend strength. This price action reflects what is occurring in the shorter time-frame and is sub-optimal but pragmatic when entry signals into the strong trend are otherwise not appearing. The same in reverse applies in bear trends.

Counting the Hs and Ls is straightforward price action trading of pull-backs, relying for further signs of strength or weakness from the occurrence of all or any price action signals, e.g. the action around the moving average, double tops or bottoms, ii or iii patterns, outside bars, reversal bars, microtrend line breaks, or at its simplest, the size of bull or bear trend bars in amongst the other action. The price action trader picks and chooses which signals to specialise in and how to combine them.

The simple entry technique involves placing the entry order 1 tick above the H or 1 tick below the L and waiting for it to be executed as the next bar develops. If so, this is the entry bar, and the H or L was the signal bar, and the protective stop is placed 1 tick under an H or 1 tick above an L.

Breakout

A breakout is a bar in which the market moves beyond a predefined significant price - predefined by the price action trader, either physically or only mentally, according to their own price action methodology, e.g. if the trader believes a bull trend exists, then a line connecting the lowest lows of the bars on the chart during this trend would be the line that the trader watches, waiting to see if the market breaks out beyond it. The real plot or the mental line on the chart is generally comes from one of the classic chart patterns. A breakout often leads to a setup and a resulting trade signal.

The breakout is supposed to herald the end of the preceding chart pattern, e.g. a bull breakout in a bear trend could signal the end of the bear trend.

Breakout pull-back

After a breakout extends further in the breakout direction for a bar or two or three, the market will often retrace in the opposite direction in a pull-back, i.e. the market pulls back against the direction of the breakout. A viable breakout will not pull-back past the former point of Support or Resistance that was broken through.

Breakout failure

A breakout might not lead to the end of the preceding market behaviour, and what starts as a pull-back can develop into a breakout failure, i.e. the market could return into its old pattern.

Brooks observes that a breakout is likely to fail on quiet range days on the very next bar, when the breakout bar is unusually big.

"Five tick failed breakouts" are a phenomenon that is a great example of price action trading. Five tick failed breakouts are characteristic of the stock index futures markets. Many speculators trade for a profit of just four ticks, a trade which requires the market to move 6 ticks in the trader's direction for the entry and exit orders to be filled. These traders will place protective stop orders to exit on failure at the opposite end of the breakout bar. So if the market breaks out by five ticks and does not hit their profit targets, then the price action trader will see this as a five tick failed breakout and will enter in the opposite direction at the opposite end of the breakout bar to take advantage of the stop orders from the losing traders' exit orders.

Failed breakout failure

In the particular situation where a price action trader has observed a breakout, watched it fail and then decided to trade in the hope of profiting from the failure, there is the danger for the trader that the market will turn again and carry on in the direction of the breakout, leading to losses for the trader. This is known as a failed failure and is traded by taking the loss and reversing the position. It is not just breakouts where failures fail, other failed setups can at the last moment come good and be 'failed failures'.

Reversal bar

A reversal bar signals a reversal of the current trend. On seeing a signal bar, a trader would take it as a sign that the market direction is about to turn.

An ideal bullish reversal bar should close considerably above its open, with a relatively large lower tail (30% to 50% of the bar height) and a small or absent upper tail, and having only average or below average overlap with the prior bar, and having a lower low than the prior bars in the trend.

A bearish reversal bar would be the opposite.

Reversals are considered to be stronger signals if their extreme point is even further up or down than the current trend would have achieved if it continued as before, e.g. a bullish reversal would have a low that is below the approximate line formed by the lows of the preceding bear trend. This is an 'overshoot'.

Reversal bars as a signal are also considered to be stronger when they occur at the same price level as previous trend reversals.

A bear trend reverses at a bull reversal bar.

The price action interpretation of a bull reversal bar is so: it indicates that the selling pressure in the market has passed its climax and that now the buyers have come into the market strongly and taken over, dictating price which rises up steeply from the low as the sudden relative paucity of sellers causes the buyers' bids to spring upwards. This movement is exacerbated by the short term traders / scalpers who sold at the bottom and now have to buy back if they want to cover their losses.

Trend line break

When a market has been trending significantly, a trader can usually draw a trend line on the opposite side of the market where the retraces reach, and any retrace back across the existing trend line is a 'trend line break' and is a sign of weakness, a clue that the market might soon reverse its trend or at least halt the trend's progress for a period.

Trend channel line overshoot

A trend channel line overshoot refers to the price shooting clear out of the observable trend channel further in the direction of the trend. An overshoot does not have to be a reversal bar, since it can occur during a with-trend bar. On occasion it may not result in a reversal at all, it will just force the price action trader to adjust the trend channel definition.

In the stock indices, the common retrace of the market after a trend channel line overshoot is put down to profit taking and traders reversing their positions. More traders will wait for some reversal price action. The extra surge that causes an overshoot is the action of the last traders panicking to enter the trend along with increased activity from institutional players who are driving the market and want to see an overshoot as a clear signal that all the previously non-participating players have been dragged in. This is identified by the overshoot bar being a climactic exhaustion bar on high volume. It leaves nobody left to carry on the trend and sets up the price action for a reversal.

Climactic exhaustion reversal

A strong trend characterised by multiple with-trend bars and almost continuous higher highs or lower lows over a double-digit number of bars is often ended abruptly by a climactic exhaustion bar. It is likely that a two-legged retrace occurs after this, extending for the same length of time or more as the final leg of the climactic rally or sell-off.

Double top and double bottom

When the market reaches an extreme price in the trader's view, it often pulls back from the price only to return to that price level again. In the situation where that price level holds and the market retreats again, the two reversals at that level are known as a double top bear flag or a double bottom bull flag, or simply double top / double bottom and indicate that the retrace will continue.

Brooks also reports that a pull-back is common after a double top or bottom, returning 50% to 95% back to the level of the double top / bottom. This is similar to the classic head and shoulders pattern.

A price action trader will trade this pattern, e.g. a double bottom, by placing a buy stop order 1 tick above the bar that created the second 'bottom'. If the order is filled, then the trader sets a protective stop order 1 tick below the same bar.

Double top twin and double bottom twin

Consecutive bars with relatively large bodies, small tails and the same high price formed at the highest point of a chart are interpreted as double top twins. The opposite is so for double bottom twins. These patterns appear on as shorter time scale as a double top or a double bottom. Since signals on shorter time scales are per se quicker and therefore on average weaker, price action traders will take a position against the signal when it is seen to fail.

In other words, double top twins and double bottom twins are with-trend signals, when the underlying short time frame double tops or double bottoms (reversal signals) fail. The price action trader predicts that other traders trading on the shorter time scale will trade the simple double top or double bottom, and if the market moves against them, the price action trader will take a position against them, placing an entry stop order 1 tick above the top or below the bottom, with the aim of benefitting from the exacerbated market movement caused by those trapped traders bailing out.

Opposite twin (down-up or up-down twin)

This is two consecutive trend bars in opposite directions with similar sized bodies and similar sized tails. It is a reversal signal when it appears in a trend. It is equivalent to a single reversal bar if viewed on a time scale twice as long.

For the strongest signal, the bars would be shaved at the point of reversal, e.g. a down-up in a bear trend with two trend bars with shaved bottoms would be considered stronger than bars with tails.

 

 An Up-Down Pattern.

Wedge

A wedge pattern is like a trend, but the trend channel lines that the trader plots are converging and predict a breakout. A wedge pattern after a trend is commonly considered to be a good reversal signal.

Trading range

Once a trader has identified a trading range, i.e. the lack of a trend and a ceiling to the market's upward movement and a floor to any downward move, then the trader will use the ceiling and floor levels as barriers that the market can break through, with the expectation that the break-outs will fail and the market will reverse.

One break-out above the previous highest high or ceiling of a trading range is termed a higher high. Since trading ranges are difficult to trade, the price action trader will often wait after seeing the first higher high and on the appearance of a second break-out followed by its failure, this will be taken as a high probability bearish trade, with the middle of the range as the profit target. This is favoured firstly because the middle of the trading range will tend to act as a magnet for price action, secondly because the higher high is a few points higher and therefore offers a few points more profit if successful, and thirdly due to the supposition that two consecutive failures of the market to head in one direction will result in a tradable move in the opposite.

Chop aka churn and barb wire

When the market is restricted within a tight trading range and the bar size as a percentage of the trading range is large, price action signals may still appear with the same frequency as under normal market conditions but their reliability or predictive powers are severely diminished. Brooks identifies one particular pattern that betrays chop, called "barb wire". It consists of a series of bars that overlap heavily containing trading range bars.

Barb wire and other forms of chop demonstrate that neither the buyers nor the sellers are in control or able to exert greater pressure. A price action trader that wants to generate profit in choppy conditions would use a range trading strategy. Trades are executed at the support or resistance lines of the range while profit targets are set before price is set to hit the opposite side.

Especially after the appearance of barb wire, breakout bars are expected to fail and traders will place entry orders just above or below the opposite end of the breakout bar from the direction in which it broke out.

Price Action Trading I

The concept of price action trading embodies the analysis of basic price movement as a methodology for financial speculation, as used by many retail traders and often institutionally where algorithmic trading is not employed. Since it ignores the fundamental factors of a security and looks primarily at the security's price history — although sometimes it considers values derived from that price history — it is a form of technical analysis. What differentiates it from most forms of technical analysis is that its main focus is the relation of a security's current price to its past prices as opposed to values derived from that price history. This past history includes swing highs and swing lows, trend lines, and support and resistance levels.

At its most simplistic, it attempts to describe the human thought processes invoked by experienced, non-disciplinary traders as they observe and trade their markets. Price action is simply how prices change - the action of price. It is readily observed in markets where liquidity and price volatility are highest, but anything that is bought or sold freely in a market will per se demonstrate price action. Price action trading can be included under the umbrella of technical analysis but is covered here in a separate article because it incorporates the behavioural analysis of market participants as a crowd from evidence displayed in price action - a type of analysis whose academic coverage isn't focused in any one area, rather is widely described and commented on in the literature on trading, speculation, gambling and competition generally. It includes a large part of the methodology employed by floor traders and tape readers. It can also optionally include analysis of volume and level 2 quotes.

The trader observes the relative size, shape, position, growth (when watching the current real-time price) and volume (optionally) of the bars on an OHLC bar or candlestick chart, starting as simple as a single bar, most often combined with chart formations found in broader technical analysis such as moving averages, trend lines or trading ranges. The use of price action analysis for financial speculation doesn't exclude the simultaneous use of other techniques of analysis, and on the other hand, a minimalist price action trader can rely completely on the behavioural interpretation of price action to build a trading strategy.

The various authors who write about price action, e.g. Brooks, Duddella, give names to the price action chart formations and behavioural patterns they observe, which may or may not be unique to that author and known under other names by other authors (more investigation into other authors to be done here). These patterns can often only be described subjectively and the idealized formation or pattern can in reality appear with great variation.

This article attempts to outline most major candlestick bars, patterns, chart formations, behavioural observations and trade setups that are used in price action trading. It covers the way that they are interpreted by price action traders, whether they signal likely future market direction, and how the trader would place orders correspondingly to profit from that (and where protective exit orders would be placed to minimise losses when wrong). Since price action traders combine bars, patterns, formations, behaviours and setups together with other bars, patterns, formations etc. to create further setups, many of the descriptions here will refer to other descriptions in the article. The layout of descriptions here is linear, but there is no one perfect sequence - they appear here loosely in the sequence: behavioural observations, trends, reversals and trading ranges. This editing approach reflects the nature of price action, sub-optimal as it might appear.

Credibility

There is no evidence that these explanations are correct even if the price action trader who makes such statements is profitable and appears to be correct. Since the disappearance of most pit-based financial exchanges, the financial markets have become anonymous, buyers do not meet sellers, and so the feasibility of verifying any proposed explanation for the other market participants' actions during the occurrence of a particular price action pattern is tiny. Also, price action analysis can be subject to survivorship bias for failed traders do not gain visibility. Hence, for these reasons, the explanations should only be viewed as subjective rationalisations and may quite possibly be wrong, but at any point in time they offer the only available logical analysis with which the price action trader can work.

The implementation of price action analysis is difficult, requiring the gaining of experience under live market conditions. There is every reason to assume that the percentage of price action speculators who fail, give up or lose their trading capital will be similar to the percentage failure rate across all fields of speculation. According to widespread folklore / urban myth, this is 90%, although analysis of data from US forex brokers' regulatory disclosures since 2010 puts the figure for failed accounts at around 75% and suggests this is typical.

Some sceptical authors dismiss the financial success of individuals using technical analysis such as price action and state that the occurrence of individuals who appear to be able to profit in the markets can be attributed solely to the Survivorship bias.

Analytical Process

A price action trader's analysis may start with classical technical analysis, e.g. Edwards and Magee patterns including trend lines, break-outs, and pull-backs, which are broken down further and supplemented with extra bar-by-bar analysis, sometimes including volume. This observed price action gives the trader clues about the current and likely future behaviour of other market participants. The trader can explain why a particular pattern is predictive, in terms of bulls (buyers in the market), bears (sellers), the crowd mentality of other traders, change in volume and other factors. A good knowledge of the market's make-up is required. The resulting picture that a trader builds up will not only seek to predict market direction, but also speed of movement, duration and intensity, all of which is based on the trader's assessment and prediction of the actions and reactions of other market participants.

Price action patterns occur with every bar and the trader watches for multiple patterns to coincide or occur in a particular order, creating a 'set-up'/'setup' which results in a signal to buy or sell. Individual traders can have widely varying preferences for the type of setup that they concentrate on in their trading.

 An candlestick chart of the Euro against the USD, 

marked up by a price action trader.

This annotated chart shows the typical frequency, syntax and terminology for price action patterns implemented by a trader.

One published price action trader is capable of giving a name and a rational explanation for the observed market movement for every single bar on a bar chart, regularly publishing such charts with descriptions and explanations covering 50 or 100 bars. This trader freely admits that his explanations may be wrong, however the explanations serve a purpose, allowing the trader to build a mental scenario around the current 'price action' as it unfolds, and for experienced traders, this is often attributed as the reason for their profitable trading.

Implementation of trades

The price action trader will use setups to determine entries and exits for positions. Each setup has its optimal entry point. Some traders also use price action signals to exit, simply entering at one setup and then exiting the whole position on the appearance of a negative setup. Alternatively, the trader might simply exit instead at a profit target of a specific cash amount or at a predetermined level of loss. This style of exit is often based on the previous support and resistance levels of the chart. A more experienced trader will have their own well-defined entry and exit criteria, built from experience.

An experienced price action trader will be well trained at spotting multiple bars, patterns, formations and setups during real-time market observation. The trader will have a subjective opinion on the strength of each of these and how strong a setup they can build them into. A simple setup on its own is rarely enough to signal a trade. There should be several favourable bars, patterns, formations and setups in combination, along with a clear absence of opposing signals.

At that point when the trader is satisfied that the price action signals are strong enough, the trader will still wait for the appropriate entry point or exit point at which the signal is considered 'triggered'. During real-time trading, signals can be observed frequently while still building, and they are not considered triggered until the bar on the chart closes at the end of the chart's given period.

Entering a trade based on signals that have not triggered is known as entering early and is considered to be higher risk since the possibility still exists that the market will not behave as predicted and will act so as to not trigger any signal.

After entering the trade, the trader needs to place a protective stop order to close the position with minimal loss if the trade goes wrong. The protective stop order will also serve to prevent losses in the event of a disastrously timed internet connection loss for online traders.

After the style of Brooks, the price action trader will place the initial stop order 1 tick below the bar that gave the entry signal (if going long - or 1 tick above if going short) and if the market moves as expected, moves the stop order up to one tick below the entry bar, once the entry bar has closed and with further favourable movement, will seek to move the stop order up further to the same level as the entry, i.e. break-even.

Brooks also warns against using a signal from the previous trading session when there is a gap past the position where the trader would have had the entry stop order on the opening of the new session. The worse entry point would alter the risk/reward relationship for the trade, so is not worth pursuing.

Behavioural observation

A price action trader generally sets great store in human fallibility and the tendency for traders in the market to behave as a crowd. For instance, a trader who is bullish about a certain stock might observe that this stock is moving in a range from $20 to $30, but the traders expects the stock to rise to at least $50. Many traders would simply buy the stock, but then every time that it fell to the low of its trading range, would become disheartened and lose faith in their prediction and sell. A price action trader would wait until the stock hit $31.

That is a simple example from Livermore from the 1920s. In a modern day market, the price action trader would first be alerted to the stock once the price has broken out to $31, but knowing the counter-intuitiveness of the market and having picked up other signals from the price action, would expect the stock to pull-back from there and would only buy when the pull-back finished and the stock moved up again. Support, Resistance, and Fibonacci levels are all important areas where human behavior may affect price action. "Psychological levels", such as levels ending in .00, are a very common order trigger location. Several strategies use these levels as a means to plot out where to secure profit or place a Stop Loss. These levels are purely the result of human behavior as they interpret said levels to be important.

Two attempts rule

One key observation of price action traders is that the market often revisits price levels where it reversed or consolidated. If the market reverses at a certain level, then on returning to that level, the trader expects the market to either carry on past the reversal point or to reverse again. The trader takes no action until the market has done one or the other.

It is considered to bring higher probability trade entries, once this point has passed and the market is either continuing or reversing again. The traders do not take the first opportunity but rather wait for a second entry to make their trade. For instance the second attempt by bears to force the market down to new lows represents, if it fails, a double bottom and the point at which many bears will abandon their bearish opinions and start buying, joining the bulls and generating a strong move upwards.

Also as an example, after a break-out of a trading range or a trend line, the market may return to the level of the break-out and then instead of rejoining the trading range or the trend, will reverse and continue the break-out. This is also known as 'confirmation'.

Trapped traders

"Trapped traders" is a common price action term referring to traders who have entered the market on weak signals, or before signals were triggered, or without waiting for confirmation and who find themselves in losing positions because the market turns against them. Any price action pattern that the traders used for a signal to enter the market is considered 'failed' and that failure becomes a signal in itself to price action traders, e.g. failed breakout, failed trend line break, failed reversal. It is assumed that the trapped traders will be forced to exit the market and if in sufficient numbers, this will cause the market to accelerate away from them, thus providing an opportunity for the more patient traders to benefit from their duress. “Trapped traders” is therefore used to describe traders in a position that will be stopped out if price action hits their stop loss limit. The term is closely linked to the idea of a “trap” which Brooks defines as: "An entry that immediately reverses to the opposite direction before a scalper’s profit target is reached, trapping traders in their new position, ultimately forcing them to cover at a loss. It can also scare traders out of a good trade." 

Since many traders place protective stop orders to exit from positions that go wrong, all the stop orders placed by trapped traders will provide the orders that boost the market in the direction that the more patient traders bet on. The phrase "the stops were run" refers to the execution of these stop orders. Since 2009, the use of the term “trapped traders” has grown in popularity and is now a generic term used by price actions traders and applied in different markets – stocks, futures, forex, commodities, etc. All trapped trader strategies are essentially variations of Brooks pioneering work.

Trend and range definition

The concept of a trend is one of the primary concepts in technical analysis. A trend is either up or down and for the complete neophyte observing a market, an upwards trend can be described simply as a period of time over which the price has moved up. An upwards trend is also known as a bull trend, or a rally. A bear trend or downwards trend or sell-off (or crash) is where the market moves downwards. The definition is as simple as the analysis is varied and complex. The assumption is of serial correlation, i.e. once in a trend, the market is likely to continue in that direction.

 A 'bear' trend where the market is continually falling, 

interrupted by only weak rises.

On any particular time frame, whether it's a yearly chart or a 1-minute chart, the price action trader will almost without exception first check to see whether the market is trending up or down or whether it's confined to a trading range.

A range is not so easily defined, but is in most cases what exists when there is no discernible trend. It is defined by its floor and its ceiling, which are always subject to debate. A range can also be referred to as a horizontal channel.

A trading range where the market turns around at the ceiling and the floor 

to stay within an explicit price band.

OHLC bar or candlestick

Brief explanation of bar and candlestick terminology:

• Open: first price of a bar (which covers the period of time of the chosen time frame)
• Close: the last price of the bar
• High: the highest price
• Low: the lowest price
• Body: the part of the candlestick between the open and the close
• Tail (upper or lower): the parts of the candlestick not between the open and the close

Range bar

A range bar is a bar with no body, i.e. the open and the close are at the same price and therefore there has been no net change over the time period. This is also known in Japanese Candlestick terminology as a Doji. Japanese Candlesticks show demand with more precision and only a Doji is a Doji, whereas a price action trader might consider a bar with a small body to be a range bar. It is termed 'range bar' because the price during the period of the bar moved between a floor (the low) and a ceiling (the high) and ended more or less where it began. If one expanded the time frame and looked at the price movement during that bar, it would appear as a range.

Trend bar

There are bull trend bars and bear trend bars - bars with bodies - where the market has actually ended the bar with a net change from the beginning of the bar.

Bull trend bar

In a bull trend bar, the price has trended from the open up to the close. To be pedantic, it is possible that the price moved up and down several times between the high and the low during the course of the bar, before finishing 'up' for the bar, in which case the assumption would be wrong, but this is a very seldom occurrence.

Bear trend bar

The bear trend bar is the opposite.

Trend bars are often referred to for short as bull bars or bear bars.

With-trend bar

A trend bar with movement in the same direction as the chart's trend is known as 'with trend', i.e. a bull trend bar in a bull market is a "with trend bull" bar. In a downwards market, a bear trend bar is a "with trend bear" bar.

Countertrend bar

A trend bar in the opposite direction to the prevailing trend is a "countertrend" bull or bear bar.

BAB

There are also what are known as BAB - Breakaway Bars- which are bars that are more than two standard deviations larger than the average.

Climactic exhaustion bar

This is a with-trend BAB whose unusually large body signals that in a bull trend the last buyers have entered the market and therefore if there are now only sellers, the market will reverse. The opposite holds for a bear trend.

Shaved bar

A shaved bar is a trend bar that is all body and has no tails. A partially shaved bar has a shaved top (no upper tail) or a shaved bottom (no lower tail).

Inside bar

An "inside bar" is a bar which is smaller and within the high to low range of the prior bar, i.e. the high is lower than the previous bar's high, and the low is higher than the previous bar's low. Its relative position can be at the top, the middle or the bottom of the prior bar.

There is no universal definition imposing a rule that the highs of the inside bar and the prior bar cannot be the same, equally for the lows. If both the highs and the lows are the same, it is harder to define it as an inside bar, yet reasons exist why it might be interpreted so. This imprecision is typical when trying to describe the ever-fluctuating character of market prices.

Outside bar

An outside bar is larger than the prior bar and totally overlaps it. Its high is higher than the previous high, and its low is lower than the previous low. The same imprecision in its definition as for inside bars (above) is often seen in interpretations of this type of bar.

An outside bar's interpretation is based on the concept that market participants were undecided or inactive on the prior bar but subsequently during the course of the outside bar demonstrated new commitment, driving the price up or down as seen. Again the explanation may seem simple but in combination with other price action, it builds up into a story that gives experienced traders an 'edge' (a better than even chance of correctly predicting market direction).

The context in which they appear is all-important in their interpretation.

If the outside bar's close is close to the centre, this makes it similar to a trading range bar, because neither the bulls nor the bears despite their aggression were able to dominate.

The outside bar after the maximum price (marked with an arrow) 

is a failure to restart the trend and a signal for a sizable retrace.

Primarily price action traders will avoid or ignore outside bars, especially in the middle of trading ranges in which position they are considered meaningless.

When an outside bar appears in a retrace of a strong trend, rather than acting as a range bar, it does show strong trending tendencies. For instance, a bear outside bar in the retrace of a bull trend is a good signal that the retrace will continue further. This is explained by the way the outside bar forms, since it begins building in real time as a potential bull bar that is extending above the previous bar, which would encourage many traders to enter a bullish trade to profit from a continuation of the old bull trend. When the market reverses and the potential for a bull bar disappears, it leaves the bullish traders trapped in a bad trade.

If the price action traders have other reasons to be bearish in addition to this action, they will be waiting for this situation and will take the opportunity to make money going short where the trapped bulls have their protective stops positioned. If the reversal in the outside bar was quick, then many bearish traders will be as surprised as the bulls and the result will provide extra impetus to the market as they all seek to sell after the outside bar has closed. The same sort of situation also holds true in reverse for retracements of bear trends.

ioi pattern

The inside - and outside - inside pattern when occurring at asto higher high or lower low is a setup for countertrend breakouts. It is closely related to the ii pattern, and contrastingly, it is also similar to barb wire if the inside bars have a relatively large body size, thus making it one of the more difficult price action patterns to practice.

Small bar

As with all price action formations, small bars must be viewed in context. A quiet trading period, e.g. on a US holiday, may have many small bars appearing but they will be meaningless, however small bars that build after a period of large bars are much more open to interpretation. In general, small bars are a display of the lack of enthusiasm from either side of the market. A small bar can also just represent a pause in buying or selling activity as either side waits to see if the opposing market forces come back into play. Alternatively small bars may represent a lack of conviction on the part of those driving the market in one direction, therefore signalling a reversal.

As such, small bars can be interpreted to mean opposite things to opposing traders, but small bars are taken less as signals on their own, rather as a part of a larger setup involving any number of other price action observations. For instance in some situations a small bar can be interpreted as a pause, an opportunity to enter with the market direction, and in other situations a pause can be seen as a sign of weakness and so a clue that a reversal is likely.

One instance where small bars are taken as signals is in a trend where they appear in a pull-back. They signal the end of the pull-back and hence an opportunity to enter a trade with the trend.

ii and iii patterns

An 'ii' is an inside pattern - 2 consecutive inside bars. An 'iii' is 3 in a row. Most often these are small bars.

Price action traders who are unsure of market direction but sure of further movement - an opinion gleaned from other price action - would place an entry to buy above an ii or an iii and simultaneously an entry to sell below it, and would look for the market to break out of the price range of the pattern. Whichever order is executed, the other order then becomes the protective stop order that would get the trader out of the trade with a small loss if the market doesn't act as predicted.

A typical setup using the ii pattern is outlined by Brooks. An ii after a sustained trend that has suffered a trend line break is likely to signal a strong reversal if the market breaks out against the trend. The small inside bars are attributed to the buying and the selling pressure equalling out. The entry stop order would be placed one tick on the countertrend side of the first bar of the ii and the protective stop would be placed one tick beyond the first bar on the opposite side.

 An iii formation - 3 consecutive inside bars.

Trend

Classically a trend is defined visually by plotting a trend line on the opposite side of the market from the trend's direction, or by a pair of trend channel lines - a trend line plus a parallel return line on the other side - on the chart. These sloping lines reflect the direction of the trend and connect the highest highs or the lowest lows of the trend. In its idealised form, a trend will consist of trending higher highs or lower lows and in a rally, the higher highs alternate with higher lows as the market moves up, and in a sell-off the sequence of lower highs (forming the trendline) alternating with lower lows forms as the market falls. A swing in a rally is a period of gain ending at a higher high (aka swing high), followed by a pull-back ending at a higher low (higher than the start of the swing). The opposite applies in sell-offs, each swing having a swing low at the lowest point.

When the market breaks the trend line, the trend from the end of the last swing until the break is known as an 'intermediate trend line' or a 'leg'. A leg up in a trend is followed by a leg down, which completes a swing. Frequently price action traders will look for two or three swings in a standard trend.

With-trend legs contain 'pushes', a large with-trend bar or series of large with-trend bars. A trend need not have any pushes but it is usual.

A trend is established once the market has formed three or four consecutive legs, e.g. for a bull trend, higher highs and higher lows. The higher highs, higher lows, lower highs and lower lows can only be identified after the next bar has closed. Identifying it before the close of the bar risks that the market will act contrary to expectations, move beyond the price of the potential higher/lower bar and leave the trader aware only that the supposed turning point was an illusion.

A more risk-seeking trader would view the trend as established even after only one swing high or swing low.

At the start of what a trader is hoping is a bull trend, after the first higher low, a trend line can be drawn from the low at the start of the trend to the higher low and then extended. When the market moves across this trend line, it has generated a trend line break for the trader, who is given several considerations from this point on. If the market moved with a particular rhythm to and fro from the trend line with regularity, the trader will give the trend line added weight. Any significant trend line that sees a significant trend line break represents a shift in the balance of the market and is interpreted as the first sign that the countertrend traders are able to assert some control.

If the trend line break fails and the trend resumes, then the bars causing the trend line break now form a new point on a new trend line, one that will have a lower gradient, indicating a slowdown in the rally / sell-off. The alternative scenario on resumption of the trend is that it picks up strength and requires a new trend line, in this instance with a steeper gradient, which is worth mentioning for sake of completeness and to note that it is not a situation that presents new opportunities, just higher rewards on existing ones for the with-trend trader.

In the case that the trend line break actually appears to be the end of this trend, it's expected that the market will revisit this break-out level and the strength of the break will give the trader a good guess at the likelihood of the market turning around again when it returns to this level. If the trend line was broken by a strong move, it is considered likely that it killed the trend and the retrace to this level is a second opportunity to enter a countertrend position.

However in trending markets, trend line breaks fail more often than not and set up with-trend entries. The psychology of the average trader tends to inhibit with-trend entries because the trader must "buy high", which is counter to the clichee for profitable trading "buy high, sell low". The allure of counter-trend trading and the impulse of human nature to want to fade the market in a good trend is very discernible to the price action trader, who would seek to take advantage by entering on failures, or at least when trying to enter counter-trend, would wait for that second entry opportunity at confirmation of the break-out once the market revisits this point, fails to get back into the trend and heads counter-trend again.

In-between trend line break-outs or swing highs and swing lows, price action traders watch for signs of strength in potential trends that are developing, which in the stock market index futures are with-trend gaps, discernible swings, large counter-trend bars (counter-intuitively), an absence of significant trend channel line overshoots, a lack of climax bars, few profitable counter-trend trades, small pull-backs, sideways corrections after trend line breaks, no consecutive sequence of closes on the wrong side of the moving average, shaved with-trend bars.

In the stock market indices, large trend days tend to display few signs of emotional trading with an absence of large bars and overshoots and this is put down to the effect of large institutions putting considerable quantities of their orders onto algorithm programs.

Many of the strongest trends start in the middle of the day after a reversal or a break-out from a trading range. The pull-backs are weak and offer little chance for price action traders to enter with-trend. Price action traders or in fact any traders can enter the market in what appears to be a run-away rally or sell-off, but price action trading involves waiting for an entry point with reduced risk - pull-backs, or better, pull-backs that turn into failed trend line break-outs. The risk is that the 'run-away' trend doesn't continue, but becomes a blow-off climactic reversal where the last traders to enter in desperation end up in losing positions on the market's reversal. As stated the market often only offers seemingly weak-looking entries during strong phases but price action traders will take these rather than make indiscriminate entries. Without practice and experience enough to recognise the weaker signals, traders will wait, even if it turns out that they miss a large move.

Bollinger Bands

Bollinger Bands is a technical analysis tool invented by John Bollinger in the 1980s as well as a term trademarked by him in 2011. Having evolved from the concept of trading bands, Bollinger Bands and the related indicators %b and bandwidth can be used to measure the "highness" or "lowness" of the price relative to previous trades. Bollinger Bands are a volatility indicator similar to the Keltner channel.

Bollinger Bands consist of:

• an N-period moving average (MA)
• an upper band at K times an N-period standard deviation above the moving average (MA + Kσ)
• a lower band at K times an N-period standard deviation below the moving average (MA − Kσ)

Typical values for N and K are 20 and 2, respectively. The default choice for the average is a simple moving average, but other types of averages can be employed as needed. Exponential moving averages is a common second choice.^{[note 1]} Usually the same period is used for both the middle band and the calculation of standard deviation.

Purpose

The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.

Indicators derived from Bollinger Bands

In Spring, 2010, John Bollinger introduced three new indicators based on Bollinger Bands. They are BBImpulse, which measures price change as a function of the bands; percent bandwidth (%b), which normalizes the width of the bands over time; and bandwidth delta, which quantifies the changing width of the bands.

%b (pronounced "percent b") is derived from the formula for Stochastics and shows where price is in relation to the bands. %b equals 1 at the upper band and 0 at the lower band. Writing upperBB for the upper Bollinger Band, lowerBB for the lower Bollinger Band, and last for the last (price) value:

    %b = (last − lowerBB) / (upperBB − lowerBB)

Bandwidth tells how wide the Bollinger Bands are on a normalized basis. Writing the same symbols as before, and middleBB for the moving average, or middle Bollinger Band:

    Bandwidth = (upperBB − lowerBB) / middleBB

Using the default parameters of a 20-period look back and plus/minus two standard deviations, bandwidth is equal to four times the 20-period coefficient of variation.

Uses for %b include system building and pattern recognition. Uses for bandwidth include identification of opportunities arising from relative extremes in volatility and trend identification.

Interpretation

The use of Bollinger Bands varies widely among traders. Some traders buy when price touches the lower Bollinger Band and exit when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper Bollinger Band or sell when price falls below the lower Bollinger Band. Moreover, the use of Bollinger Bands is not confined to stock traders; options traders, most notably implied volatility traders, often sell options when Bollinger Bands are historically far apart or buy options when the Bollinger Bands are historically close together, in both instances, expecting volatility to revert towards the average historical volatility level for the stock.

When the bands lie close together, a period of low volatility is indicated. Conversely, as the bands expand, an increase in price action/market volatility is indicated. When the bands have only a slight slope and track approximately parallel for an extended time, the price will generally be found to oscillate between the bands as though in a channel.

Traders are often inclined to use Bollinger Bands with other indicators to confirm price action. In particular, the use of oscillator-like Bollinger Bands will often be coupled with a non-oscillator indicator-like chart patterns or a trendline. If these indicators confirm the recommendation of the Bollinger Bands, the trader will have greater conviction that the bands are predicting correct price action in relation to market volatility.

Effectiveness

Various studies of the effectiveness of the Bollinger Band strategy have been performed with mixed results. In 2007 Lento et al. published an analysis using a variety of formats (different moving average timescales, and standard deviation ranges) and markets (e.g., Dow Jones and Forex). Analysis of the trades, spanning a decade from 1995 onwards, found no evidence of consistent performance over the standard "buy and hold" approach. The authors did, however, find that a simple reversal of the strategy ("contrarian Bollinger Band") produced positive returns in a variety of markets.

Similar results were found in another study, which concluded that Bollinger Band trading strategies may be effective in the Chinese marketplace, stating: "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving-average crossover rule, the channel breakout rule, and the Bollinger Band trading rule, after accounting for transaction costs of 0.50 percent." (By "the contrarian version", they mean buying when the conventional rule mandates selling, and vice versa.) A recent study examined the application of Bollinger Band trading strategies combined with the ADX for Equity Market indices with similar results.

A paper from 2008 uses Bollinger Bands in forecasting the yield curve.

Companies like Forbes suggest that the use of Bollinger Bands is a simple and often an effective strategy but stop-loss orders should be used to mitigate losses from market pressure.

Statistical properties

Security price returns have no known statistical distribution, normal or otherwise; they are known to have fat tails, compared to a normal distribution. The sample size typically used, 20, is too small for conclusions derived from statistical techniques like the central limit theorem to be reliable. Such techniques usually require the sample to be independent and identically distributed, which is not the case for a time series like security prices. Just the opposite is true; it is well recognized by practitioners that such price series are very commonly serially correlated—that is, each price will be closely related to its ancestor "most of the time". Adjusting for serial correlation is the purpose of moving standard deviations, which use deviations from the moving average, but the possibility remains of high order price autocorrelation not accounted for by simple differencing from the moving average.

For such reasons, it is incorrect to assume that the long-term percentage of the data that will be observed in the future outside the Bollinger Bands range will always be constrained to a certain amount. Instead of finding about 95% of the data inside the bands, as would be the expectation with the default parameters if the data were normally distributed, studies have found that only about 88% of security prices (85%-90%) remain within the bands. For an individual security, one can always find factors for which certain percentages of data are contained by the factor defined bands for a certain period of time. Practitioners may also use related measures such as the Keltner channels, or the related Stoller average range channels, which base their band widths on different measures of price volatility, such as the difference between daily high and low prices, rather than on standard deviation.

Bollinger bands outside of finance

In a paper published in 2006 by the Society of Photo-Optical Engineers, "Novel method for patterned fabric inspection using Bollinger bands", Henry Y. T. Ngan and Grantham K. H. Pang present a method of using Bollinger bands to detect defects (anomalies) in patterned fabrics. From the abstract: "In this paper, the upper band and lower band of Bollinger Bands, which are sensitive to any subtle change in the input data, have been developed for use to indicate the defective areas in patterned fabric."

The International Civil Aviation Organization is using Bollinger bands to measure the accident rate as a safety indicator to measure efficiency of global safety initiatives. %b and bandwidth are also used in this analysis.

Foreign Exchange Market - Forex

The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. In terms of volume of trading, it is by far the largest market in the world. The main participants in this market are the larger international banks. Financial centres around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.

The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market”, although a few insurance companies and other kinds of financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

• its huge trading volume representing the largest asset class in the world leading to high liquidity;
• its geographical dispersion;
• its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
• the variety of factors that affect exchange rates;
• the low margins of relative profit compared with other markets of fixed income; and
• the use of leverage to enhance profit and loss margins and with respect to account size.

 As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks.

According to the Bank for International Settlements, the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3 trillion in April 2007. Foreign exchange swaps were the most actively traded instruments in April 2013, at $2.2 trillion per day, followed by spot trading at $2.0 trillion. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows:

• $1.490 trillion in spot transactions
• $475 billion in outright forwards
• $1.765 trillion in foreign exchange swaps
• $43 billion currency swaps
• $207 billion in options and other products

History

Ancient

Currency trading and exchange first occurred in ancient times. Money-changing people, people helping others to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybistẻs") used city-stalls, at feast times the temples Court of the Gentiles instead. Money-changers were also in more recent ancient times silver-smiths and/or gold-smiths.

During the 4th century, the Byzantine government kept a monopoly on the exchange of currency.

Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences of exchange of coinage within Egypt.

Currency and exchange was also a vital and crucial element of trade during the ancient world so that people could buy and sell items like food, pottery and raw materials. If a Greek coin held more gold than an Egyptian coin due to its size or content, then a merchant could barter fewer Greek gold coins for more Egyptian ones, or for more material goods. This is why, at some point in their history, most world currencies in circulation today had a value fixed to a specific quantity of a recognized standard like silver and gold.

Medieval and later

During the 15th century, the Medici family were required to open banks at foreign locations in order to exchange currencies to act on behalf of textile merchants. To facilitate trade the bank created the nostro (from Italian translated – "ours") account book which contained two columned entries showing amounts of foreign and local currencies, information pertaining to the keeping of an account with a foreign bank. During the 17th (or 18th ) century, Amsterdam maintained an active forex market. During 1704 foreign exchange took place between agents acting in the interests of the nations of England and Holland.

Early modern

Alex. Brown & Sons traded foreign currencies exchange sometime about 1850 and was a leading participant in this within U.S.A. During 1880, J.M. do Espírito Santo de Silva (Banco Espírito Santo) applied for and was given permission to begin to engage in a foreign exchange trading business.

The year 1880 is considered by at least one source to be the beginning of modern foreign exchange, significant for the fact of the beginning of the gold standard during the year.

Prior to the first world war there was a much more limited control of international trade. Motivated by the outset of war, countries abandoned the gold standard monetary system.

Modern to post-modern

From 1899 to 1913, holdings of countries' foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between 1903 and 1913.

At the time of the closing of the year 1913, nearly half of the world's foreign exchange was conducted using the Pound sterling. The number of foreign banks operating within the boundaries of London increased in the years from 1860 to 1913 from 3 to 71. In 1902 there were altogether two London foreign exchange brokers. During the earliest years of the 20th century, trade was most active in Paris, New York and Berlin, while Britain remained largely uninvolved in trade until 1914. Between 1919 and 1922, the employment of foreign exchange brokers within London increased to 17, in 1924 there were 40 firms operating for the purposes of exchange. During the 1920s the occurrence of trade in London resembled more the modern manifestation, by 1928 forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors, in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930's London.

During the 1920s, the Kleinwort family were known to be the leaders of the foreign exchange market; while Japheth, Montagu & Co., and Seligman still warrant recognition as significant FX traders.

After WWII

After WWII, the Bretton Woods Accord was signed allowing currencies to fluctuate within a range of 1% to the currencies par. In Japan the law was changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of Tokyo was to become, because of this, the centre of foreign exchange by September of that year. Between 1954 and 1959 Japanese law was made to allow the inclusion of many more Occidental currencies in Japanese forex.

U.S. President Richard Nixon is credited with ending the Bretton Woods Accord and fixed rates of exchange, eventually bringing about a free-floating currency system. After the ceasing of the enactment of the "Bretton Woods Accord" during 1971, the Smithsonian Agreement allowed trading to range to 2%. During 1961–62, the amount of foreign operations by the U.S. Federal Reserve was relatively low. Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organisations relied instead on reserves of currency. During 1970 to 1973 the amount of trades occurring in the market increased three-fold. At some time (according to Gandolfo during February–March 1973) some of the markets' were "split", so a two tier currency market was subsequently introduced, with dual currency rates. This was abolished during March 1974.

Reuters introduced during June 1973 computer monitors, replacing the telephones and telex used previously for trading quotes.

Markets close

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float the forex markets were forced to close sometime during 1972 and March 1973. The very largest of all purchases of dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure given as 2.75 billion in total by The Statesman: Volume 18 1974), this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks (during February and, or, March 1973. Giersch, Paqué, & Schmieding state closed after purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened ... March 1 " that is a large purchase occurred after the close).

After 1973

The year 1973 marks the point to which nation-state, banking trade and controlled foreign exchange ended and complete floating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source), although another states the first time a currency pair were given as an option for U.S.A. traders to purchase was during 1982, with additional currencies available by the next year.

On 1 January 1981, as part of changes beginning during 1978, the People's Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading. Sometime during 1981, the South Korean government ended forex controls and allowed free trade to occur for the first time. During 1988 the countries government accepted the IMF quota for international trade.

Intervention by European banks especially the Bundesbank influenced the forex market, on February the 27th 1985 particularly. The greatest proportion of all trades world-wide during 1987 were within the United Kingdom, slightly over one quarter, with the U.S. of America the nation with the second most places involved in trading.

During 1991 the republic of Iran changed international agreements with some countries from oil-barter to foreign exchange.

Market size and liquidity

The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998). Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other derivatives.

In April 2010, trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the United States accounted for 17.9% and Japan accounted for 6.2%.

In April 2013, for the first time, Singapore surpassed Japan in average daily foreign-exchange trading volume with $383 billion per day. So the rank became: the United Kingdom (41%), the United States (19%), Singapore (5.7)%, Japan (5.6%) and Hong Kong (4.1%).

Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.

Most developed countries permit the trading of derivative products (like futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies. Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is estimated to account for up to 10% of spot turnover, or $150 billion per day (see below: Retail foreign exchange traders).

Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day.

Market participants

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0 to 1 pip to 1–2 pips for a currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 39% of all transactions. From there, smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”. Central banks also participate in the foreign exchange market to align currencies to their economic needs.

Commercial companies

An important part of the foreign exchange market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short-term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational corporations (MNCs) can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

Foreign exchange fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator.

The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism collapse, and in more recent times in Asia.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions conducted are speculative. This means the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Since 1996, Hedge funds have gained a reputation for aggressive currency speculation. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management and, hence, can generate large trades.

Retail foreign exchange traders

Individual retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange trading, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association, have in the past been subjected to periodic foreign exchange fraud. To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.

Money transfer/remittance companies and bureaux de changeMoney transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange

Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange companies.

Trading characteristics

There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are quite close due to arbitrage. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. Major trading exchanges include Electronic Broking Services (EBS) and Thomson Reuters Dealing, while major banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.

The main trading centers are New York City and London, though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the Euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the 2013 Triennial Survey, the most heavily traded bilateral currency pairs were:

• EURUSD: 24.1%
• USDJPY: 18.3%
• GBPUSD (also called cable): 8.8%

and the US currency was involved in 87.0% of transactions, followed by the euro (33.4%), the yen (23.0%), and sterling (11.8%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

Determinants of exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):

1. International parity conditions: Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions (e.g., free flow of goods, services and capital) which seldom hold true in the real world.
2. Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during the 1980s and most part of the 1990s in face of soaring US current account deficit.
3. Asset market model: views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days), algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors

These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.

• Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
• Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
• Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
• Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
• Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
• Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

• Flights to quality: Unsettling international events can lead to a "flight-to-quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The US dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.
• Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.
• "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
• Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
• Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract, and interest is not included in the agreed-upon transaction. Spot trading is one of the most common types of Forex Trading. Often, a forex broker will charge a small fee to the client to roll-over the expiring transaction into a new identical transaction for a continuum of the trade. This roll-over fee is known as the "Swap" fee.

Forward

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Swap

The most common type of forward transaction is the foreign exchange swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed.

Futures

Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. Thus the currency futures contracts are similar to forward contracts in terms of their obligation, but differ from forward contracts in the way they are traded. They are commonly used by MNCs to hedge their currency positions. In addition they are traded by speculators who hope to capitalize on their expectations of exchange rate movements.

Option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors. Also to be considered is the rise in foreign exchange autotrading; algorithmic, or automated, trading has increased from 2% in 2004 up to 45% in 2010.

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Mahathir Mohamad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.

Risk aversion

 Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.

In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US dollar. Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across the world fell while the US dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA.

Carry trade

Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate. A large difference in rates can be highly profitable for the trader, especially if high leverage is used. However, with all levered investments this is a double edged sword, and large exchange rate price fluctuations can suddenly swing trades into huge losses.

Forex signals

Forex trade alerts, often referred to as "forex signals", are trade strategies provided by either experienced traders or market analysts. These signals which are often charged a premium fee for can then be copied or replicated by a trader to his own live account. Forex signal products are packaged as either alerts delivered to a user's inbox or SMS, or can be installed to a trader's trading platforms. Algorithmic trading, whereby foreign exchange users can programme (or buy ready made software) to place trades on their behalf, according to pre-determined rules has become very popular in recent years. This means that users can set their 'Algos' to trade on their behalf, thus reducing the need to sit and monitor the markets continuously, plus it can remove the element of human emotion around executing a trade.