Price Action Trading Strategy
Price action is simply the study of price movement in the market. Various fundamental and technical analysis tools derive their values from price, so why not study, analyse and learn from the price itself? This is what price action traders attempt to do. They believe that everything they need to know about any particular market is displayed in the price. This is what differentiates price action from other forms of technical analysis where the use of mathematical indicators is prevalent.
The two most important elements to consider when trading price action are both the price and the time variables that are displayed clearly on a ‘clean’ chart. It is referred to as a clean or naked chart because there are no indicators to cloud the view of the price action trader. The price displayed on a price chart at any given time represents the collective beliefs, knowledge and action of market participants.
If prices are moving up, it implies buyers are in control; whereas, in declining markets, it means that sellers are running the show. In a sideways market, there is no consensus between buyers and sellers. Price action traders also do not track fundamental events because they believe that the information will be captured by the prevailing prices. For them, price movement is the ultimate signal provider. Price action is incredibly popular and is applied by all types of traders, from retail investors to floor traders and even institutions. Price action is a powerful way of analysing markets, but it has its critics.
Critics believe that price action is very subjective in nature because different traders can have different views at the same time in the same market. For instance, if the price of an underlying asset is approaching a particular important resistance level, one trader may buy the asset in anticipation that the price will hit that level, whereas a second trader may wait to see whether prices will bounce off the level or breach it.
Granted, both traders may be right, but the lack of clarity in how to trade opportunities in the market makes it look like a play on herd mentality. Proponents of Random Walk Theory also believe that there is no way of predicting what prices in the financial markets will do in the future because they are fundamentally chaotic by nature. But this is a critique of all analysis types. Random Walk theorists usually invest in deeply diversified portfolios to protect themselves from the ‘random’ nature of price movements in the market.
Price Action Trading System
Price action trading is simplistic, and most systems usually have a two-step process for identifying and taking advantage of trading opportunities in the market. The steps are as follows:
- Identify the Prevailing Market Conditions: As mentioned above, a market can either be in an uptrend, downtrend or moving sideways. By observing asset prices, traders should quickly be able to tell what phase of price action the market is in at that moment.
- Identify the Trading Opportunity: After identifying the prevailing market condition, a trader then proceeds to establish whether there is an actionable trading opportunity.
For instance, in an uptrend, the price action should tell the trader whether prices will continue extending higher, or whether a retracement is expected. An example of a price action trade is when the gold price has been trending higher and is approaching $2,000. If it successfully breaks that level, then $2,000 will now be the new support area. A long position will now be entered after a pullback fails to break below $2,000.
If an earlier support level was $1,980, the price action trader would place a stop loss level below that price, which is exactly where the uptrend will be deemed invalid. The exit on the trade can be triggered when the trader satisfies their risk/reward ratio, or when the market does not make higher highs and higher lows.
Price Action Indicators
The only relevant trade elements for a price action trader are price and time. This makes a price chart the most important trading tool for a price action trader. On almost every platform, candlestick charts are the most popular due to the detailed information they give traders on asset prices as well as their graphical appeal. A typical candlestick will display the high, low, opening and closing prices (HLOC) of an asset over a specified period. On most platforms, a candle with a higher closing price than an opening price is green in colour (bullish candle), whereas a candle with a lower closing price than its opening price is red (bearish).
This detailed price information can tell a price action trader a lot about the collective action of market participants. The positioning of HLOC price points determines the size and shape of the candle as well as the information it provides to a price action trader. For this reason, some candle types provide bullish signals such as hammer; bearish signals such as hanging man; and neutral signals such as Doji. You can learn more about the different types of candlesticks in our comprehensive candlestick patterns guide.
As time goes, multiple candlesticks are printed on a chart. This gives price action traders more price information as candlestick patterns form on the chart. Candlestick patterns allow traders to track the ebb and flow of market waves, and if understood and interpreted efficiently, they can help pick out lucrative price action opportunities in the market.
Reading candlesticks and chart patterns is why price action traders trade with clean charts. Numerous chart patterns give traders three primary signals: continuation, reversal or neutral.
- Continuation patterns, such as directional wedges and flags, form in trending markets and signal that the dominant trend will continue;
- Reversal patterns, such as head and shoulders as well as double bottoms, signal that the momentum of the prevailing trend is fading and a reversal is to about to happen;
- whereas Neutral patterns, such as symmetrical triangles, can form in any market and while they signal that a big move is about to happen, they do not provide a directional cue.
When it comes to candlesticks and chart patterns, reading and analysing the information they provide is more important than actually memorising their formation. Follow the candlesticks to determine the price pathway in the market. Learn how to read price chart patterns effectively in our comprehensive chart patterns guide. In addition to candles and candlestick patterns, price action traders can also use Trendlines to pick the most optimal price points in the market for entry and exits.
Price Action Trading Strategies
Price action strategies involve reading the psychology of market participants by watching price changes in the market. Here are some of the most reliable price action setups in the market:
Long Wick Candles
A candle in the market is depicted by a body and wick(s). The body is the distance between the opening and closing prices, while the wicks represent the extremes (the high and low achieved). Long wick candles are a favourite for price action traders. For instance, a candle with a long upper wick shows that in that period, buyers attempted to push prices higher by some distance, but sellers resisted the attempt and even managed to return prices close to the opening price. With this information, a price action trader can back the sellers again in the succeeding period or can wait for confirmation. Either way, long wick candles are a must-watch for price action traders.
Inside Bar After Breakouts
When breakouts occur, the challenge for traders is if it is a genuine one or a fake one. An inside bar breakout pattern is when one or more candles trade within the highs and lows of the large breakout candle, hence the name ‘inside’. The psychology for the setup is that market participants are unwilling to give back any breakout gains and are ready to defend and back the new trend going forward.
Trendline trading involves the use of lines to establish the optimal points to enter trades in trending markets. In an uptrend, a trendline is drawn from a particular swing low to a subsequent one and then projected into the future. Retracements to the trendline represent an ideal price point to join the uptrend. Horizontal trendlines can be used in ranging markets to map out support and resistance areas.