Improve your trading by analyzing price action, especially velocity and magnitude. As a price action trader, these concepts are crucial for analyzing and making profitable trading decisions in stock, forex or futures markets (or any other market).
Price is the ultimate indicator, it tells the real story. While other technical indicators may help summarize price data, price movement is the basis from which (most of) those indicators are derived. It follows that having advanced price-action-analysis skills will aid your trading. Price action trading is making trading decisions based on price movement itself, without the aid of other technical indicators (although trendlines, marking up your charts and using Fibonacci retracements levels are common among price action traders).
The Importance of Velocity and Magnitude When Analyzing Price Action
Every price wave within a trend can be judged based on velocity and magnitude. Therefore, at every stage of 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 (not taken), or our expectation/target for the trade lowered. For example, in the latter case, if we are day trading and our target is typically $0.15 away from our entry, but velocity and magnitude are slowing
Price Action Trading: The Magnitude of Price Waves
Magnitude, in regards to analyzing price action, 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 than pullbacks.
Short or small price 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.
Figure 1. Analyzing Price Action using Magnitude: GBPYJPY 1 Minute Chart
Magnitude is not measured in absolutes; it is always relative to other price waves. Waves are measured against recent waves, as well as the overall outlook (looking at the bigger picture). In figure 1 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 be 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 there 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 above), 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.
Price Action Trading: The Velocity of Price Waves
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 wave that moves very slowly.
Figure 2 shows the same chart as above, yet we can also use velocity to analyze this chart, in conjunction with magnitude. 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 (for example, taking short positions when strong velocity and magnitude are to the downside).
Figure 2. Analyzing Price Action using Magnitude and Velocity: GBPYJPY 1 Minute Chart
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. Even in extreme cases such as these, velocity and magnitude play a role. Watching the size of the waves, and how fast they move (relative to each other) can provide insight into where the price is most likely to go next.
How to Use This Information When Trading Based on Price Action
Analyzing price action is a constant task. Being able to adjust to new information is critical. This cannot only be down in hindsight, it must be done in real-time. As waves are unfolding talk to yourself, assessing the wave’s velocity and magnitude in this moment. If you only react to it in hindsight, you will always be entering/exiting trades late.
How can you use this in real-time? Here is a trade that I take regularly, and it is almost entirely based on velocity and magnitude. Assume the trend is down, and the last wave down was 20 pips (day trading forex). The price starts to rebound, quickly, and rallies 25 pips before starting to drop again. The rally had bigger magnitude than the last down wave (and possibly more velocity as well). That tells me the price has reversed to the upside (not longer a downtrend). But I don’t do anything yet. I am now biased to buy, but I wait to see how the price reacts when it starts to drop. Assuming the pullback has less velocity than the rally, I will enter a trade on that pullback, expecting upward momentum to eventually kick in again, taking the price higher. Basically, I am taking the information I have and
making assessments on whether I believe the current pullback (which is where I typically take trades, in the direction of the trend) will be of smaller magnitude than the last impulse wave, based on the velocity and magnitude of prior waves and the velocity and magnitude of the price right now. While this strategy is based largely on velocity and magnitude, the method still requires a trade trigger, stop loss and profit target, so you need to incorporate a few more elements to make velocity and magnitude a complete strategy.
Velocity and magnitude are also incorporated into almost every other strategy I use. For example, if the price has plummeted a long way, and then forms a double bottom chart pattern composed of small waves (compared to the drop), I am not likely to use that double bottom pattern as a buy signal. The selling momentum was too strong, and I don’t want to buy into that. BUT, if the price plummets, rebounds, has a small wave to the downside, and then forms a double bottom pattern, that is more enticing as a buy signal. Before the double bottom even occurred the price was already showing signs that the selling momentum was slowing (smaller wave before the double bottom). The same concepts apply to most chart patterns, trend trading, range trading as well as front-running (predicting chart pattern breakout direction).
Traders may wish to develop some guidelines or rules about velocity or magnitude in their trading plan. While 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. A hybrid system is one which has rule-based elements incorporated with more subjective elements such as interpreting velocity and magnitude.
You’ll 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 using that knowledge in real time trading. Therefore, practice, practice, practice. It is always easier to do this in hindsight, and that will be the starting point as you begin to practice using these concepts. Go through historical charts, 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 (see 5 Step Plan for Forex Trading Success).
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–those losing trades will hopefully happen less often for you.
By Cory Mitchell, CMT Follow me on Twitter @corymitc and check out our Facebook page.
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hi Cory hope u doing good.. I wanna develop my trading plan with 4 bar consolidation and velocity and magnitude. i’ve read both of your pdfs…but i can’t seem to come up with a solid plan. Could u give me some tips please. thanks
If you are having trouble deciding exactly which trade signals to take, velocity and magnitude is a good way to add some clarity….but it takes practice.
Since most of my trades are trend trades, and I am taking a trade during the pullback, I use velocity and magnitude to access the trend AND the pullback.
Velocity and magnitude apply to everything. So strong upward waves (relative to the pullbacks) helps confirm an uptrend for example and let us know we are willing to buy on the next pullback if we get a proper setup.
OUr next task is then to watch velocity and magnitude on the pullback. If the price drops sharply and then consolidates (still at a higher low), I typically hold off trading that consolidation because the velocity of the decline before it indicates there is a high probability of more downside. If the price does fall a little more (smaller or weaker wave than the first wave down) and then consolidates right away, then we have some evidence the pullback is slowing down and I am more likely to enter that trade on a consolidation breakout. Here is a stock example (the pattern is the same no matter which market we are trading). https://www.tradingview.com/chart/CFF/nWPucUqf-CFF-TO-Timber-Stocks-Continue-to-March-Higher/ The price had a drop during an uptrend and then I waited for the price to push a bit lower. Ultimately it couldn’t, which indicated the selling had slowed and then I traded the next consolidation break to the upside.
If the pullback is shallow and weak, and has no strong moves, then I watch for any sort of strong breakout from the pullback in the trending direction (assuming it occurs at a higher low, during an uptrend for example). Like this: https://www.tradingview.com/chart/CJT/3pwuwK0Z-CJT-TO-Still-Some-Upside-Life-Left/ Again a stock example, but would apply to forex or trading any other time frame as well.
So we are using velocity and magnitude to help us assess the trend and pullback, and then use that information to help decide which consolidation breakout to trade.
We will never be right all the time…with any method. It is a learning process, and with practice we learn to make smarter decisions based on the information the price movement is providing us.
Cheers,
thank you very much for the reply. Reading your blog/answers is one thing and applying it in live market is different thing. like u say it takes practice. will keep practising it. i find i’ve beenreading/re-reading your articles a lot. besides this blog u write @ investopedia/balance.com and where else? i would like to read all of your articles. could you please give me the links? thanks
Investopedia and TheBalance. There have been some others over the years, but those are the main ones.
great articles, i trade a similar strategy day trading SPY ITM weekly options