Art and Science of Price Action – Part 2

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thIn today’s entry we will examine a candlestick pattern that I find the most potent and the easiest to spot.  This pattern clearly communicates specific order flow (buy and sell orders) characteristics that we can use to make informed and hopefully profitable trading decisions.  Keep in mind however, that just blindly trading this whenever you see it will end up hurting your confidence as well as your bank account.

The pattern that we will be examining is called the pin bar, short for Pinocchio bar.  This pattern shows a strong rejection, or movement away, from a price level.  Think of price rejection as throwing a tennis ball (current price) against a wall (future price level).  As the ball is moving towards the wall it has a lot of energy (orders) moving it one direction.  Once it hits the wall that energy is not strong enough to move it beyond the wall. Instead, the energy is reversed and the ball heads back towards you.

CandlestickBasicsChartCosmetically, all pin bars should have a very long shadow with a small body.  This long shadow (often called a tail) is showing the rejection we talked about with the tennis ball, that price was moving strongly in one direction but was pushed back since it did not have enough orders for it to continue on. The nose, which is the opposite shadow, should be very small or non-existent in the best case scenario.  The only way that price could change direction so sharply is that there are many opposing orders, enough to outnumber the original direction, or energy, of the order flow in the candle.

As an example, take a look at the bearish (black) pin bar.  Lets say that the opening price was $4, the close was $3, the low is $2 and the high was $8.  When the period started, the candle was at a price of $4.  Over the course of that period, price was able to move all the way up to $8.  This price moved as high as $8 because there were buy orders that outnumbered the sell orders and pushed price higher.  Once it hit the $8 price point, the sellers jumped in with strength and outnumbered the buy orders.  They were able to push the price all the way down to $3 showing their dominance.  Once this candle closes, we can step back and say “Wow, the sellers really ended up taking control.”  It is therefore reasonable, but NOT a certainty, to expect that price will continue to fall since the order flow is showing seller strength.

With this in mind, we should NOT be selling after a bullish pin bar nor buying after a bearish pin bar.  Why? Because the candle just communicated that we would be fighting the current order flow.  If a bearish pin bar shows that sellers are showing dominance, we would be foolish to try and buy against it.  If a bullish pin bar shows that buyers are showing dominance, we would be hurting the probability of our trade to succeed if we sell against it.  I would suggest looking at some charts now and hunting down some pin bars.  Where did they occur? How large were they? What did price do after they formed?

Summary:

  • Pin bars should have a long tail, a very small nose if any, and a small body
  • Pin bars show that the momentum of order flow is shifting in the opposite direction. Bullish pin bars show a change of dominance from sellers to buyers.  Vice versa for a bearish pin bar.
  • Remember that pin bars are not going to automatically lead you to endless winning trades, but they start to tip the odds in your favor
  • Do not buy after a bearish pin bar. Do not sell after a bullish pin bar.  This alone will keep you out of losing trades.

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