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1 Oscillators and Price Action on 30th September 2013, 3:50 pm


Consider the price action sequence in the graph below in which we rely on the RSI to get a sell signal. The downtrend hits an already existing support level and stagnates for a while. Finally demand is exhausted and supply gains ground, leading to a breakout at point 1.
However, during the consolidation phase, the RSI was most of the time below the 50% level (and even went below the oversold level at 30%). Thereafter a breakout occurs followed by a return to the former support area which, once broken, remember, turned into a resistance.
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When price breaks down for the second time at point 2, the RSI is much closer to the 50% territory, having actually exceeded the overbought level of 70%. If the price has not been able to break the resistance level during the overbought condition, then we can conclude that the demand was low comparatively to the supply.
As usual, when price records a breakout, a pullback (or throwback) follows. In this 4H time frame the dimension of the pullback is almost of 200 PIPs and takes 3 days to form. Only then, the bearish trend resumes its course. The pullback at point 3 indicates the best entry, when the RSI turns slightly above the level 50 to revert back down immediately towards negative territory.
The chart below displays the same price action interpreted with the Stochastic. In this particular case, the indicator provides an even more precise reading: in the first two breakouts, the oscillator shows some fatigue, while after the pullback the oscillator returns, full of strength, from overbought territory.
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By means of these two examples, you've seen that breakouts, and especially the pullbacks (or throwbacks), are very reliable prints of low risk trading opportunities.
This emphasizes the importance of the price action to obtain the first evidence of what is happening in the market, and categorizes the indicators as a tool to confirm what is already visible on the chart. Oscillators, in this case, can be used to confirm breakouts because they measure the strength of supply and demand.
When developing a trading method, it's important to think of all the arguments at disposal, whether these are given by trendlines, candle patterns or technical indicators. When confronted with contradictions, you must simply wait for these contradictions to disappear.
Alert Box - If, for instance, the oscillator shows an overbought condition, and price reaches a support level (remember: support means demand), then be careful! It could be a trap, and support may not work. Analytical tools must be used in unison with price action.
Psycho Box - No indicator will reveal completely what the market is doing. But there is something you can do to avoid entering trades based solely on technical indicators: use your judgment. You are not a robot and you will never become one. The better you learn to optimize that judgment through simplicity, practice and record keeping, the better the results will be. Preferably, settle on a strategy (a set of trading tactics) that suits your personality and thinking patterns. But first, start by observing price, and confirm its actions with one or two technical indicators that you understand well.
The use of too many technical indicators is an often underestimated peril when applying technical analysis. When you accumulate to many indicators on a price chart, you lose simplicity. Because technical indicators abound and are so readily at hand through charting platforms, unprepared traders often gravitate to them as the easy solution for their trading. The first experience of knowledge and control can quickly change into a paralysis. This can actually be a major inconvenient in the use of an otherwise useful tool.
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If you apply technical indicators knowing that they are mere representations of price action, but not price action itself, you will focus on making better trades.

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