Many short-term traders rely exclusively on price action and the formations and trends extrapolated from it to make trading decisions. Technical analysis as a practice is a derivative of price action since it uses past prices in calculations that can then be used to inform trading decisions.
- An Overview of Price Action Trading
Price action trading is a method of day trading where traders make decisions about trades based on price movements rather than on indicators derived from technical analysis.
There are many different strategies available for traders to use. Here is a detailed description of this type of trading, along with some excellent beginner strategies to get you started.
Table Of Content
- Price action generally refers to the changes of a security's price over time.
- Price action trading is a strategy based on the movements of prices rather than indicators or analysis.
- Technical analysis formations and chart patterns are derived from price action.
- There are many different price action strategies you can use, such as candlesticks and breakouts.
- Though many use price action to forecast future prices, prior price action does not guarantee future results.
What Is Price Action Trading?
Some traders make decisions based on the price movements of an asset. This is the premise of price action trading following the movement of prices and trading based on the actions they think are most profitable.
Most price action traders don't use technical indicators, such as moving averages or Bollinger bands, but if you do, you should give them very little weight in the trading decision process. A price action trader believes that the only trustworthy source of information comes from the price itself and its movements.
If a stock price begins climbing, it shows that investors are buying. They then assess the price action based on the aggressiveness of buying; the historical charts; and real-time price information such as bids, offers, volume, velocity, and magnitude.
Price Action Trading Tools
Preferred tools for price action traders are breakouts, candlesticks, and trends. They also use theories such as support and resistance. Traders use these tools and ideas for developing strategies that work with their preferences.
How to Use Price Action
Price action is not generally seen as a trading tool like an indicator, but rather the data source off which all the tools are built. Swing traders and trend traders tend to work most closely with price action, eschewing any fundamental analysis in favor of focusing solely on support and resistance levels to predict breakouts and consolidation.
Even these traders must pay some attention to additional factors beyond the current price, as the volume of trading and the periods being used to establish levels all have an impact on the likelihood of their interpretations being accurate.
Many institutions have begun leveraging algorithms to analyze prior price action and execute trades in certain circumstances. In a 2020 report to Congress, the Securities and Exchange Commission (SEC) noted that the "use of algorithms in trading is pervasive."1 These automated systems are fed price action data and can deduce outcomes and determine potential future price action.
Support and Resistance
Related to all of the above, traders use price support and price resistance regions to identify good trading opportunities. Support and resistance areas occur where the price has tended to reverse in the past. Such levels may become relevant again in the future.4
Price Action Trading Strategies
There are many trading strategies from which to choose. A few of the most popular are:
- Spring at support
- Inside bars after breakout
- The hammer
- The harami
Traders often name their strategies for the visual created by the indicator used on a chart. For instance, "spring at support" refers to a sudden rise in an asset's price after it hit or came close to its support price, or the lowest price the market will support for that asset.
"Inside bars after breakout" refers to the bar in a candlestick pattern between the previous bar's range, after a breakout occurs. "The hammer" is a candlestick that looks like a hammer. It forms into this shape because the open, close, and high are close to each other, while the low is long, simulating a hammer handle. Traders generally view a hammer as a reversal of a trend.
The harami is characterized by an upward or downward trend with a corresponding fall or rise in opening and closing prices. A smaller candle is next to it, with a price movement opposite the trend direction and a smaller gap in the opening and closing prices. Haramis generally signify trend changes
Advantages of Using Price Action Trading.
- 1. Price action analysis factors in all market variables.
The analysis of price movement via price action setups is really the only method you need to build your trading plan around. Often times traders get caught up trying to trade the news combined with their overly complicated multiple indicator method. The beauty of price action analysis is that it gives you a visual representation of the only thing that matters when it comes to news releases; namely traders’ reactions to the news. Price will often go the opposite way of what people may expect based on a certain news release.
- 2. Price action setups are easy to test on demo accounts.
Price action setups occur frequently in the forex market and are easy to spot once you are trained to know exactly what to look for. There is no need to sit and try to figure out what three different indicators are telling you to do. You simply wait for your desired price setup to form and then execute your edge.
- 3. Allows for profitable use of higher time frames.
Another great thing about price action setups is that they usually become stronger and more valid the higher the time frame you trade. This allows you to trade less frequently but with more accuracy. Sitting in front of a computer screen for multiple hours watching a 5 minute chart can be maddening as well as extremely detrimental to your trading account. Many traders get wrapped up with thinking they give themselves some sort of advantage by trading more frequently or on lower time frames.
Once you have a well defined and profitable trading plan built around price action, spending increasing amounts of time looking at your charts and small time frames is only going to hurt you. The reason most people get into trading is because they don’t like spending massive amounts of time at a job they hate.
- 4. Price action trading is the closest thing to what floor traders in the pits use.
We have seen the images of screaming pit traders on the floor of various exchanges in Chicago or New York. Do you think they are using lagging indicators to make their decisions? Thinking about lagging indicators in that perspective actually allows you to see how comical it is to trade using them. Pit traders read tape, meaning they watch the actual price numbers for whatever market they are trading and analyze their movement. Price action analysis is the most analogous method to tape reading that a retail forex trader has at his or her disposal.
It is comical at best that so many people fall into the trap of lagging indicators and trying to predict the market movement resulting from every economic release.
- 5. Price action analysis is a time tested strategy.
Trading based on specific price action setups has been used by professional traders for decades. When you learn to trade using price action analysis you can rest assured that your method is relevant because it teaches you to decipher the core workings of any market; price movement. Many traders get caught up in using different combinations of lagging indicators, these methods often have not been used for long periods of time by many other traders due to their ineffectiveness to adapt to ever-changing market conditions.
- 6. Price action analysis works great in trending or range-bound conditions.
One of the great things about price action analysis is that it provides relevant and profitable signals in both trending and range-bound markets. Many trading methods work well in trending markets but cease to work in trading ranges, or vice versa. An exceptional and flexible trading method will provide consistently profitable signals in any market condition.