Benefit from analyzing price action, especially velocity and magnitude. In my opinion these concepts are the most important when it comes to analyzing price action in stocks, forex or futures trading (or any other market). Price is the ultimate indicator, it tells the real story. While other technical indicators may help interpret price data, price is the basis from which (most of) those indicators are derived. It follows that having advanced price-action-analysis skills will aid your trading. Use to confirm or filter out trade signals via price or other indicators.
Velocity and Magnitude: Why They’re Important
Every price wave within a trend can be judged based on velocity and magnitude. That means throughout the trend assessments can be made about the probability of trades in regards to that trend.
If a trend is strong based on velocity and magnitude we know that we want to take the next valid trade signal (based on our trading plan) that will get us into that trend. If velocity and magnitude are significantly weakening then the trend may be ending and therefore the next trade signal may be filtered out, or our expectation/target for the trade lowered.
Analyzing Price Action: Magnitude
Magnitude in regards to analyzing price action simply refers to the length of price waves, relative to other price waves of consequence. If the price runs for a long way in one direction without a significant pullback, then that run has strong or large magnitude. During a trend we want to see the impulse waves (waves in the direction of the trend) have large magnitude relative to the pullbacks.
Short waves have little or weak magnitude. The price is not moving aggressively in one direction. During a trend, pullbacks should have weak magnitude relative to the impulse waves of the trend.
Magnitude is not measured in absolutes, it always relative. Waves are measured against recent waves, as well as the overall outlook. In the attached chart the trend is down because the impulse waves are larger than the smaller pullbacks. Toward the middle of the chart there are some stronger pullbacks, relative to recent down waves. While this may deter us from taking a short position for a period of time, looking at the overall outlook the pullback is not big enough to rival the major down waves.
Here are some basic guidelines for analyzing price action with magnitude:
- The trend is confirmed by waves of large magnitude in the trending direction.
- A reversal has begun, or deeper pullback is underway, when a wave of large magnitude (relative) occurs against the prior trend.
- A trend may is losing momentum if small waves start to occur in the trending direction. The trend isn’t over yet, it is just potentially weakening (it’s possible to have several slow waves in the direction of the trend, only to be followed by another strong wave renewing the strength of the trend–this is why we don’t assume the trend is over just because their are small waves in the trending direction).
- Pullbacks of small magnitude, relative to the impulse waves of the trend, confirm the trend.
Compare a pullback to other pullbacks, impulse waves and the overall trend. Do the same for impulse waves; comparing them to other recent impulse waves, recent pullbacks and the overall trend.
It can also help to view another time frame as well. If trading off a 1-minute chart like, it may help to view a 5 minute chart as well. This will provide a slightly broader perspective, and you may notice some relative strengths or weaknesses in waves that you hadn’t noticed on the shorter time frame chart.
Analyzing Price Action: Velocity
Velocity is how fast price covers distance, and is used in conjunction with magnitude.
A very fast price move which covers a significant distance (relative) shows greater conviction than a move that moves very slowly.
The attached chart shows how to use velocity and magnitude in conjunction with one another. Moves down are not only larger than pullbacks, but they occur faster than the pullbacks–the impulse waves down cover more distance in a quicker amount of time.
Having magnitude and velocity on the side of the market you are trading is ideal (ie. taking short positions when strong velocity and magnitude are to the downside).
Velocity is most applicable when combined with magnitude. A short burst of velocity isn’t particularly important, since it could just be one or two big orders being filled in the market. A move of large magnitude which also has velocity shows a lot of power and conviction, and may either confirm the trend (if in the trending direction) or indicate a reversal (if moving against the trend).
Extremely large moves with substantial velocity (both relative to recent price action) usually indicate some sort of news announcement or some unusual event. In such cases, technical analysis is generally useless, and it is recommended traders steps aside until valid signals based on more stable market conditions emerge.
Analyzing Price Action – How to Use This Information
Analyzing price action is a constant task. Being able to adjust to new information is critical.
Traders may wish to develop some guidelines or rules about velocity or magnitude in their trading plan. While the these concepts are relatively simple to understand in theory, I consider them advanced trading techniques because they have the potential to turn a rule-based system (which most new traders use) into a hybrid trading system–one which has rule-based elements incorporated with more subjective elements such as interpreting velocity and magnitude.
Subjective or hybrid type systems are harder to test. Basically you need to hone your price analysis skills in a demo account, and only when you see–over many trades–that using this information provides you with an edge should you attempt to implement this knowledge using real money.
Agreeing that something works, or can aid your trading, is very different than actually being able to do it, and use that knowledge in real time trading. Therefore, practice, practice, practice. It is always easier to do this in hindsight, yet this will be the starting point as you begin to practice using these concepts. Go through historical charts and analyze velocity and magnitude and how it impacted the trend, as well as potential trades you may have taken. Then proceed to trade using this information in a demo account, marking up charts in real-time, noting changes in velocity and magnitude, and how those changes affect the price waves that follow.
Realize that velocity and magnitude are constantly in flux. We must look at an overall picture of what is occurring as well as note details about each wave. This is the study of current price waves relative to recent price waves. There is still an element of uncertainty. Everything can look great and we will still lose trades. By analyzing price action based velocity and magnitude–and being able to effectively act on the information we interpret and alter our expectations/targets–hopefully those losing trades will happen slightly less often for you.
Cory Mitchell, CMT