Premium and discount is a basic principle that can be used when purchasing something on the market ranging from consumer goods, all the way to exchange-traded securities or even Forex!
The basic idea is you can purchase a product, good, service, or even stock on the stock exchange at a premium (over the fair value of the thing you’re buying) or at a discount (buying something that is on sale).
The Basics of Premium & Discount
As illustrated in the chart above, premium and discount can be applied to anything that is traded or sold in a free market, from fuel to milk, or even bushels of wheat!
When marking up premium and discount on a candlestick chart, you have the choice of marking up any leg of price action or range on the chart in front of you in order to determine the premium and discount of that particular range. From there what most traders do is look to use premium and discount as a confluence in their trading, looking to sell in premium, and buy in discount.
Why You’re Probably Using Premium & Discount Wrong
The truth is, most traders either rely too heavily on this tool to make educated trading decisions, or they use it in market conditions that don’t make sense to use the tool in. The most common problem with premium and discount is that on lower time frames (15-minute and below), this tool becomes less effective unless price is completely rangebound.
On top of that, some traders may use this concept of premium and discount as a crutch instead of conducting an in-depth analysis of the market using structure, supply and demand zones, and liquidity to get a sense of market direction in a more reliable and consistent way.
Common Mistakes Traders Make With Premium & Discount
Let’s cover the most common pitfalls that traders face when using premium and discount. While we think premium and discount is a great tool to use as a confluence, being overly reliant on it can cause you to both take losses as well miss good quality trade setups just because they aren’t in premium or discount.
Relying On Premium & Discount As Your Only Confluence
Much like using fibonacci retracements, relying too heavily on premium and discount can actually hurt your trading, because the truth is that price isn’t always going to fall because it’s in premium, or rise because it’s in discount the way you’ve marked it up. Price tends to trend and respect premium and discount in the longer term rather than in the short to medium term.
Using Premium & Discount In Volatile Trending Markets
The second most common pitfall that traders fall into is using premium and discount in markets that are extremely volatile and are trending heavily in one direction. You may have noticed this even on the higher time frames when price starts going “parabolic”, meaning that it’s moving in one direction with so much momentum that it’s not going to come back into premium or discount before continuing the same way.
How To Properly Use Premium & Discount In Your Trading
Using Premium & Discount In Trading Ranges
Premium and Discount is best used in trading ranges where price is consolidating because this helps us avoid taking low probability trades in the middle of the range where price is likely to take us out as liquidity.
While we’re not saying to avoid trading in the middle of a long-term consolidation outright, it’s better to concentrate on playing longs from discount and shorts from premium of the overall range. This will allow us to capitalise on rangey price action that most retail traders would otherwise stay out of.
Why Using Premium & Discount In Rangey Price Action Is Best
If you recall, earlier in this article we mentioned how most traders use the premium and discount concept and tool in the wrong market conditions, often using them in large ranges where price just doesn’t return to premium or discount because of a huge imbalance between buyers and sellers in the market!
We’ve found that the best place to use the P&D tool is simply in any mid-high timeframe range that has developed on the chart in the form of consolidation because it will help you avoid taking entries in the middle of the range where they’re least likely to play out.
Aside from looking to take shorts from the premium of the range and looking to take longs from the discount, there is one other way this tool can be used, but it should only be used as a confluence, and not used in isolation. It shouldn’t stop you from taking certain trades, nor should it validate a trade on its own.
How To Use Premium & Discount When Picking Entry Levels
We’re talking about using the premium and discount tool to pick entry levels, much like you would use Fibonacci retracements to predict where price may pull back to and react off of in a continuation play.
In this particular example, you can see how price will sometimes retrace to 50% of the structure’s leg, and sometimes it will retrace as far as 70% or more. This in and of itself shows that premium and discount can be extremely subjective and current prices are all relative.
That being said, we can use this as a soft confluence for picking zones that have all of the following characteristics:
- Are further in premium in a bearish market / further in discount in a bullish market.
- Have a larger overall profit potential assuming that the trend continues.
- Reduces our chances of being swept out as liquidity.
- Stops us from chasing low probability zones that aren’t in premium or discount.
- Keeps us from trading the middle of a range or consolidation.
So if we only look for zones at or above 50-70% of the previous leg whether we are in a bullish market looking for deeper demand levels to long from, or a bearish market as shown above, looking for higher supply levels to short from, we can effectively use this tool as a filter for staying out of low probability zones that are likely to fail altogether.
Premium & Discount In Conclusion
While premium and discount is a powerful concept and tool that traders like to use, it’s one that we don’t often see traders in Phantom Trading use for a couple of reasons. Firstly, it’s extremely subjective in the way that people mark out their ranges, and secondly, it can be very unreliable in situations where price is pro-trend and it’s running in one direction with high volatility.
Knowing this, we only suggest using the premium and discount tool when we’re in a clear consolidation or range over a long period of time in order to help us stay out of low probability points of interest and thus low probability trade setups.
We hope this article has helped you understand the nature of this concept and has given you some insight into how we use the tool in certain market conditions and situations where it works best!
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Robert Castillo
@coldwaterfx
FX Trader & Analyst
Writer & Editor
Rob is a funded trader from Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading, he enjoys making music, boxing, and riding motorcycles.
