If you’ve read some of my other articles on this site you would have probably realized I’m a big fan of trading pin bars.
There easy enough to understand for a beginning trader and tend to offer a great risk reward ratio on most of the trades taken.
Today though, I want to talk in-depth about the reasons why pin bars actually work.
Because its one thing being able to identify a pin bar and another thing entirely understanding why they work the way they do.
Why Do Pin Bars Work ?
It’s easy to see this bar looks very bullish, if you was watching this candle develop on your charts you may have an urge to place a trade, you’re not alone in feeling this urge.
Thousand and thousands of other traders also feel compelled to trade this movement, but unlike you or me, these traders have yet to realize that trading these moves usually result in losing trades.
These people are reactive traders.
I’ve talked about reactive traders before.
Reactive traders are key in to understanding how pin bars result in successful trades, when people see candles like the one above it entices them into taking positions in the direction of the candle their seeing, in the example above this would be buy trades.
You may have felt this urge before, you see the market suddenly start moving up and you have this feeling inside that you know its going to continue moving higher, the bigger the up or down candle is the greater the urge becomes.
This situation presents opportunity for the professional trader.
They know these movements cause a lot of people to buy or sell, they also know if they place trades in the opposite direction then they can make a lot of money.
And if you’ve read my article on zero sum games you’ll know that having an idea of when and where traders are going to lose money is integral in your understanding of how the forex market works as well as how money is made and lost within the market.
What professional traders do is sell into the reactive traders who are buying because they think the markets going up, this selling pushes the market down resulting in this….
….a bearish pin bar
If you were a trader who had brought when this candle looked bullish by now you would start to feel a little bit under pressure in regards to what the market may do next.
Your trade has gone from being at a profit to being at a loss, if the market goes down any lower you will start to consider whether its a good idea staying in the trade.
Everyone who places a trade has a threshold of how much money there willing to lose, whilst many traders decide beforehand how much there willing to lose ( in the form of a stop order ) there will be many more who haven’t bothered to put one in. These traders will only exit their trades when their loss becomes so big that they cannot withstand the pain of losing any more money.
So What Does That Mean ?
When they finally decide to close their trade they will have to use the opposite order of what they used to place the trade.
To close a buy trade the trader must use a sell order, to close a sell trade a trader must use a buy order.
In the example above we have a trader who is at a loss on his trade with no stop in place to limit his potential loss, for this trader to be able to close their trade they will have to use a sell order. You must keep in mind that this is not an isolated trader in this situation, thousand of traders brought when the market looked bullish and most of them wont have placed a stop, the weird thing is most of these traders will all close their trades at the same time.
Although they will most likely all have differing levels of money in their account, their pain threshold will all be relatively similar because of their reactive tendencies.
Lots of sell orders suddenly hitting the market will push the market lower, making the professional trader who sold against the reactive traders a handsome profit.
Remember no one can make a profit without someone else making a loss.
Here’s a real world example.
First we get the bearish pin bar at the top of an up-move, to begin with this pin would have looked like the big bullish candle found four candles before it, so when it comes to placing a trade on this pin I wont be placing it due to this pin being found at a support or resistance level, but instead because I know a lot of people went long in the market when the candle was forming.
So I know that if the market was to move lower from here, at some point the traders who have brought on this pin are likely to close their trade.
If you look I’ve marked an X below the candle after the pin, this is where the professional traders start taking profits.
The only way they can take some profits off a sell trade they’ve placed is if they buy, to be able to buy they need sell orders, where do these sell orders come from ?
All the people who were buying back when the pin was forming.
By the time the market has dropped down to here nearly all of these traders will have closed their trades resulting in the market being dominated by sell orders, this gives the professional trader the opportunity to take profits on his trade.
This article was meant as a brief introduction into some of the more advanced concepts of which I have knowledge on when it comes to trading the markets, if you’re a beginning trader then its best not to worry about these concepts just yet.
Understanding how people trade is a big part of some of my other trading strategies. Lots of opportunities in the market come from knowing when and where lots of traders are likely to lose money, if we know where these people are going to lose money it means we can take it from them, if you’re a beginning trader then understandably some of the concepts I’ve discussed in this article maybe a little bit over your head, in a few weeks I’ll be releasing an article which will hopefully explain these concept in more detail as well as some of the techniques and strategies I use based on these concepts.