Forex market price action comes with many false signals that can generate huge losses for unprepared traders. The market has periods where prices are range-bound, after which they either break out of the range to continue the previous trend, or they reverse. These are the critical times when traders can easily get whipsawed and accumulate piles of losses.
This step-by-step approach will help you to filter the best trading signals and avoid the bad ones, so let’s get started.
How to filter trading signals
Trade setups that can easily produce false signals either rely on chart patterns or are based on candlestick patterns. For those that rely on candlesticks, the pin bar represents one of the most important signals that can be used to filter good and bad trade entries. Candlesticks are, by their very nature, storytellers of what buyers and sellers are doing. A pin bar, especially a long-tailed one, is an important candlestick that signals what buyers and sellers are doing within the context of the pre-existing trend. So, if you have a pin bar appearing on the charts, it is best to understand what it is saying before taking action. Don’t jump the gun.
So, how can you filter out good and bad trading signals, especially ones that rely on candlesticks? Here are a few tips.
1. False breakout vs true breakout: look out for the pin bar
When a pin bar appears after a sustained long trend, it is a signal that prices are about to reverse. However, many traders are not patient enough to wait for the completion of the pin bar candlestick. When a pin bar first appears after a trend has been ongoing, it starts off with price action in the direction of that trend. But what forms the shadow of the pin bar is the action of traders who are resisting and opposing that trend. If the pin bar starts off pushing through a key level of support or resistance, it can be falsely interpreted as a breakout. This can be seen in the chart below:
On the XAUUSD chart above, we see 4 areas (numbered 1-4) where the candlesticks encountered resistance at a certain price level, and a pin bar has formed, which started off by pushing above this level as if it were breaking above the resistance, only to be firmly resisted by sellers and close below the resistance, causing a price reversal. These sorts of false breakouts happen all the time. A trader must be alert to them.
Here, the golden rule is never to trade an active candlestick as a breakout. Allow it to close to see if it forms a pin bar.
A more conservative approach would be to wait even for the second candlestick to close outside the support or resistance line before we can speak of a clear breakout. Let the price action unfold before you make any trading decisions and end up with a losing trade.
2. Long-tailed pin bars are superior to short-tailed ones
The length of the shadow (tail) on a pin bar speaks volumes about the strength of the rejection of the initial price movement in that candlestick. A longer tail means that the initial move was strong, but the rejection of this move was just as strong, if not stronger. If the pin bar forms at the top, sellers were strong enough to push the price back, which signals that selling pressure is still present and may push the price even lower. On the other hand, if the pin bar forms at the bottom, it signals that buyers were strong enough to push the price back up and we need to be aware that it may continue going up with the underlying momentum.
A pin bar with a long tail carries heavy significance as it serves as a springboard for a possible reversal of the previous trend.
3. Enter with confirmations only
We’ve just mentioned trying to trade once a candlestick breaks a support or resistance. This is not good practice because anything can happen while a candle is still active. In the case of pin bar formations, traders working against the trend can easily push back on any attempted breakout movements and force the candle to close below a resistance or above a support (failed breakout setups).
No matter how long a candlestick seems to have pushed in the direction of the breakout, you can only tell if a true breakout has occurred when that candlestick has closed. Many supposed breakouts end up being “fakeouts”, and traders get sucked into them over and over and again.
Look at this chart of the NEOUSD pair. Price action seemed to be on its way to a very strong breakout, only for a magical rejection to occur almost immediately, forcing prices back to where they came from. Buyers were waiting for a price drop and jumped in immediately when they thought the low price didn’t reflect the fundamental value of the instrument. Sellers agreed that the instrument was undervalued / oversold and didn’t push the price lower.
4. Long-tailed pin bars after a sustained trend are good reversal signals
The occurrence of long-tailed pin bars after a sustained trend is usually indicative of a possible reversal in price action. However, such reversals need some other kind of confirmation. In the chart below, the candlestick following the pin bar closed below the low of the bullish candlestick preceding the pin bar. The story being told by this setup is that sellers are now dominant in the market, and this is an indication of a possible short trade. In this example, you can place your Stop Loss just above the high of the pin bar.
5. Try to enter breakout trades after a pullback
A breakout of a key price level reverses the function of that level. So, a broken support becomes a resistance and a broken resistance becomes a support. In many cases, price action tries to return to where it came from following a breakout. This is called a pullback, and if you look closely at your chart, you will notice that pullbacks happen over and over again after a breakout of a support or resistance line.
In order to get the best risk-to-reward ratio (i.e. Take Profit: Stop Loss), trade on pullbacks to broken key price levels. This enables the trade to be set with a tight Stop Loss and a generous Take Profit target.
This chart of the USDCAD pair shows the initial support line which was broken, with 4 subsequent pullback attempts. Eventually, a pin bar formed at the 4th pullback, showing that sellers forced prices down when buyers were trying to breach the support-turned-resistance line. This is our confirmation signal that a sell opportunity may be around the corner. It was from here that prices moved on in a downside continuation. Setups like this produce astounding results for traders who have the patience and tact to make the right entry.
6. Don’t trade signals that appear when prices are choppy
Choppy price movements are characterised by whipsaws on price charts; when buyers and sellers are fighting for control of the market with no clear winner. Any pin bars or signals that form at these points when the price is range-bound or consolidating are not good entry signals. They are best avoided.
Experienced traders can identify choppy markets at the blink of an eye, but beginners may have difficulty doing so and can use technical indicators such as the Average Directional Movement Index (ADX) to get a clear indication of whether or not the market is trending. Basically, an ADX reading of below 25 indicates a ranging market, while a reading above 25 indicates a trending market. The ADX indicator is already built in to the MetaTrader platform, and you can add it to the charts by going to Insert -> Indicators -> Trend -> Average Directional Movement Index.
7. If a setup is good, trade it
Using filters ensures that you have a checklist on which to base your trade entries. Those who hesitate to pull the trigger when a setup is screaming for it are usually those without a defined entry checklist. Build up a checklist, and if a setup satisfies all points in the checklist, execute the trade.
The ultimate goal of trading is, aside from making a profit, to avoid emotional trading. If all parts of a trade setup are in line with your trading plan, there is no reason not to enter the market. Trading is a probability game and we need to make a series of trades to eventually end in profit; as we can’t tell for sure if any single trade will be a winner or loser. If you haven’t read my article about trading profit targets, you should do so now to learn how you can make a larger number of high-quality trades go in your favour.
8. Look for confluence zones
Confluence zones form when two or more support or resistance levels form at the same price level. Confluence zones are great to trade on, as they can be used to accurately predict future price action more often than not. The confluence of support and resistance zones can form on the basis of various technical tools, such as channels, traditional swing highs and lows, Fibonacci retracements, trend lines, or chart patterns. If the confluence zone is accompanied with a confirming candlestick pattern, such as a long-tailed pin bar or a long engulfing candlestick, it offers a rewarding basis on which to enter the market. The following chart shows a confluence zone that formed on overlapping support levels of a trend line and a horizontal support zone. Notice how the price respected the confluence zone. This offers the possibility of placing tight Stop Losses with high potential rewards.
9. Trade like an institutional investor
Institutional investors don’t stare at charts all day or chase pips all over the place every single minute of the day. They wait for setups that satisfy their entry checklists. These setups do not come up too often, but when they do, they are usually high-probability profit trades. This requires patience and a keen eye for detail. If the market doesn’t give any trading opportunities, professional traders will stand aside and not try to chase the market. Once they see a promising trade setup, they may decide to enter and leave the position open for days, even weeks if it proves to be a winner. The moral to learn here is that patience is key to trading. The market will always do what it wants and there’s nothing we can do to stop it.
This article explained how to filter good and bad price action signals based on pin bars and support and resistance zones. However, note that other candlestick patterns can also be used to filter entry points, but pin bars are easy to spot and offer high-probability trade setups. Remember that the length of the upper or lower shadow of the pin bar carries a lot of significance; the longer the shadow, the more significant the pin bar is.
Pullbacks are especially rewarding to trade on. There are traders that base their entire trading strategy on pullbacks as they offer tight Stop Losses and generous profit targets, i.e. high risk-to-reward ratios. Pullbacks are also one of my favourite setups on which to enter a trade.
Trading choppy markets, on the other hand, may not be a good idea. Traders get regularly whipsawed during those market conditions and end up with a pile of losses. A safer bet would be to wait for a clear trend and price action that offers more profitable trades.