Price Action Trading
Price action trading utilizes the movement of a security in your portfolio to take advantage of future price movements. Price action is the foundation for all technical analysis. It can be highly advantageous if done correctly. This article will give an insight into how price action trading works. We will also display some of the common strategies used.
Small traders can actually have the upper hand in trading. Adam Grimes comments on this in his book “The Art and Science of Technical Trading”. Due to their small size, these traders are not bound by time frame or liquidity constraints. Hedge funds or other fiduciary traders are not always able to go after the smaller trades. This is an advantage for small traders. They can leverage price action. This generates profitable trades by entering or exiting the market with relative ease.
Price action trading is when a stock or security is plotted against time. Price action trading involves analyzing chart patterns and trading based on the pattern to earn profits. It is generally depicted in the following ways:
For short-term technical traders, the price is reflected for shorter time intervals. You can quickly spot trading patterns using price action. Price action is used for trading in equities, Forex, commodities, and cryptocurrencies.
A study by Alanzi & McMillan covering the Forex trading market between 2000 and 2018 was compelling. It found that observing candlestick patterns was worth it. Combining this with analysis to identify strong technical signals could have helped achieve returns to the tune of more than 600% over the 19 year period.
Price action forms the basis for technical analysis. Many disciplined traders rely on price action for their Forex strategies. In addition, these traders are dependent on trend and momentum analysis. This relies more on price action.
Those who participate in scalping and swing trading, and who trade on technical and fundamental analysis, are also influenced by price action before seeking a position. Sometimes, technical indicators could be unreliable since these indicators are a derivative of price.
However, price action and price action trading are more reactive. They are often used by retail Forex traders in conjunction with other tools available for technical analysis. Price action trading can also be used by new traders who are just beginning. This is due to it being less complicated than complete fundamental analysis.
A trader needs to observe the price and look out for any pattern created. Similar to other trading tools, price action should likely not be used in isolation. Traders should also look out for volume indicators and other sentiment indicators. These can help contribute to a future security price.
For example, if a stock has witnessed a breakout, it does not guarantee that the price will appreciate further. Any critical developments on the stock, like a big earnings beat or miss, should also be observed. This should compared with the indications suggested by price action.
Sometimes the pattern can be challenging to follow or interpret. The experience of a successful trader can be essential in how successful the trade turns out.
Price action indicates the future price. The keyword here is “indicates.” Like other trading strategies, price action trading does not guarantee that the prediction will always be correct.
Based on price action, a trader can seek a position, but the price could move in an unfavorable direction. What works in favor of price action is that it is a leading indicator. Most technical indicators are lagging in nature. Examples include Relative Strength Indicators (RSI), a stochastic indicator, Moving Average Convergence Divergence (MACD).
To illustrate, suppose the price is constantly trending upward. Immediately you will see the movement reflect in the price. With the 200-day moving average, the upward trend will take some time to reflect in a moving average. This is because it is still under the influence of historical prices. By the time the moving average hints at an uptrend, the trend could have reversed.
It is equally important to learn when to accept a loss and close out a position. This can happen when price action Forex day trading strategy does not work. This is better than holding on to a losing trade for too long. Guaranteed information is not provided by price action. Do your due diligence, aim to be correct on average, not all the time.
Understanding the different patterns based on which price action trading can be carried out is invaluable. While there are many such patterns, one generally specializes in a few and leverages these market trends.
One should also interpret the charts and determine if the price is consolidating or trending in a specific direction. For example, a support level is a price point where buyers are expected to increase the asset’s price. This is often based on strong trend lines or support levels. When a price is expected to fall, it meets a resistance level, where sellers come into play.
Traders can use price or could use the help of candlesticks. Depending on if you are a short-term trader or a long-term one. You will need to decide the time interval.
Every strategy should assess the risk-reward relationship. If the risk is too high and the return is too low, then the strategy should not be pursued. A popular way to assess is the risk-adjusted return. Thus, only those trades that have a high expected risk-adjusted return should be selected. The risk reward ratio can help you in this.
Good traders follow a rule that only 1-2% of your capital is put at risk for any individual trade. This ensures some margin of safety, and that traders do not lose out a large amount in a single position. A few large losses could be enough to wipe out a significant amount in a trading account.
One way to ensure that a trader does not lose large in a single trade, is by establishing a stop loss level. A stop-loss is a sign of a disciplined trader who is willing to accept that the trade did not go as planned.
Such a control mechanism prevents a free fall and limits the loss. The market can be humbling at times. Having proper risk protocols in place can be as valuable as finding high-return strategies.
It is equally important to understand when to exit a trade when it is profitable. A trader can get carried away emotionally and expect the profits to rise further.
The price level at which to exit should be determined while adopting the strategy. A trader should exit once this level is reached. Much like establishing stop-loss levels, profit-taking is essential toward long-run success.
The first step is to analyze the price chart and determine if any pattern is developing. Depending on the type of pattern, a trader must determine what the expected price is going to be.
Once this price is determined, the trader must also select a stop loss level based on the entry point. The next step is to enter into a position. The position size should not lead to a loss of more than 2% of the portfolio.
The trader should monitor the position and also keep track of any macroeconomic developments. Most platforms would have a section dedicated to the latest news. The position should be exited once the target price or stop loss level is reached.
Fundamental trading involves determining if the asset’s current price is overvalued or undervalued. If the market price is lower than the intrinsic value calculated, then you can buy at a discount! A trader would buy this security.
Thus, fundamental trading looks to exploit opportunities in mispricing. On the other hand, price action traders only consider the stock market price without going into the nitty-gritty of the asset’s intrinsic value.
Candlesticks provide more information than simply price. The opening price, closing price, high and low are depicted in each candlestick. Depending on whether the price was higher or lower, the candlestick is colored in green or red.
The figures above show the two types of candlesticks that are plotted. Sometimes the green color is replaced by a blank box, and a black candlestick is used as an alternative to the red one.
OHLC stands for Open, High, Low, and Close. The OHLC bars show the same information as candlesticks but in a different way. Each point on an OHLC chart consists of a vertical line and a horizontal line. The vertical line indicates how volatile the price has been and shows the intraday range. The longer the vertical line, the higher the volatility. The horizontal line extends to the left and to the right of the vertical line. These horizontal lines show the opening and closing prices.
The red line indicates that the closing price was lower than the opening price and for the green line, the closing price is higher.
In a continuation pattern, the trend is expected to remain the same. For example: the price will increase if the trend is upward or decrease if the trend is downward.
When the price crosses an upper trendline in an ascending triangle, the trend is expected to continue further.
As seen above, as soon as the price rises above the upper trend line, there is a breakout. However, it should be observed that leading up to the increase, there is a gradual increase in the level of the lower trendline. When the upper and lower trendline coincide, the breakout point is reached .
Sometimes the market may be in a consolidation phase. It means that there is no significant movement in the price, and the trend is sideways. During such a movement, traders are generally not sure whether to buy or sell. And at some point, there tends to be a breakout, and the action can be in either direction. In the example provided above, a bullish pennant has taken place, and the price increased sharply. With experience you will get better at understanding these.
Similar to an ascending triangle, when the price falls below the lower trendline, it is an indication that the price would drop further. Such a pattern is often interpreted as an option to short the asset or sell it. It has another name: bearish triangle. As the price breaks the lower trendline this is an indication that the momentum is heavily to the downside. Other traders may join in an short, causing the downward momentum to accelerate further. Trading the descending triangle gives the trader the chance to make large profits over a short period of time. There is a risk that the price does not continue on its intial downward spiral though. The more often a price touches resistance levels, the more reliable the pattern.
In a rectangle pattern, there is a period of consolidation, and the price trades sideways. The support and resistance level during a rectangle is flat. Once the consolidation period is over, the price tends to continue on its bearish path. This is considered a continuation pattern as although the momentum pauses for a brief time, it eventually continues on its downward trajectory. As the price moves up and down in between the support levels, it is considered that there is no trend. The rectangle disappears when the price breaks through the lower trendline.
This is similar to a bullish pennant. The only difference is that there is a drop in price after a period of consolidation.
In a reversal trading pattern, there is a break in the trend. For example, if the price is trending upward, a reversal pattern would predict a drop in the price.
In a head and shoulder pattern, there are three peaks. The highest one is the head, with the lower peaks on either side referred to as shoulders. Now for a bullish reversal pattern, the head and shoulders are inverted, and the head has the lowest price point. This pattern is observed after a downtrend and signals a reversal to an uptrend. If you are able to spot this pattern developing you can potentially position yourself ahead of the trend reversal. The head and shoulders pattern is considered one of the most reliable trend reversal patterns. It is a good example of the battle between bullish and bearish traders.
The double bottom can be observed in a downtrend and is shaped like a W. The two bottoms in the figure highlighted above act as a support level, and the price has increased after the support is touched twice. The double bottom is a chart pattern which highlights a momentum reversal due to a change in trend. It can also be described as the battle between bullish and bearish traders, before the bulls gain the upper hand.
A descending wedge pattern is observed when both the trend lines are sloping downward. Since both the trend lines are sloping downward, it can be interpreted as a downtrend, but the price increases after the wedge pattern completes and breaks out to the upside. Essentially this pattern displays a price reversal which is this case was descending before becoming bullish again. As per the ascending wedge, this chart pattern is looked out for by traders seeking a price reversal. This allows traders who are willing to risk this perceived pattern failing in order to position themselves ahead of the breakout.
The pattern formed is like U after a downtrend. After the shape is formed, the price tends to trend upward. A rounding bottom patter is a reversal chart pattern. It starts off as a bearish move, but a slowly developing one. Eventually without necessarily bouncing on any resistance level, it recovers into a bullish move. The time frame for this pattern is not set, but usually takes a while to develop.
First, in a bearish head and shoulders pattern, an uptrend is observed, followed by a head and should pattern. Consequently, there is a drop in the price, indicating a reversal in the uptrend pattern.
The resistance level is touched twice before the price begins to drop after an uptrend in a double top. It can be considered the opposite of the double bottom, so this pattern has an M shape.
In an ascending wedge, the trend lines are sloping upward, and after the pattern is formed, one can expect the price to be bearish. As with the bearish wedge, this pattern displays a price reversal which is this case was appreciating before becoming bearish again. Many traders will look out for this pattern as a sign that a price reversal is about to start. As a result, traders will use this pattern to go short in advance of the downside move so ensuring they capture it to its fullest. As with all technical trading, sometimes the pattern does not necessarily follow through as you expected.
An inverted U pattern is formed after an uptrend, following which the price trends downward.
A trending market is one in which the price continues to follow the trend. If the trend is upward, the price will increase, and if the trend is downward, the price will fall.
A breakout occurs when the price exceeds the resistance level or falls below the support level. A breakout can be traded using the bullish triangle or bearish triangle. One could expect the price to rise or fall sharply.
When the price reaches its support level, the price is expected to increase (bounce). Likewise, the price is set to drop once the resistance level is reached. A trader can buy in the first scenario or sell in the latter scenario. In a trending market, the resistance and support levels keep changing.
For a market trending upward, the support and resistance levels keep increasing. The resistance could subsequently turn into a support level. A trader should look to exit his position, once the support level is breached in a trending market.
In a range-bound market, the price trades within a range. Unlike a trending market, there is no definite direction towards which the price is moving. These can be difficult to identify future price movements in. These tend to react swiftly once a breakout occurs.
A bullish or a bearish pennant is an example of how a trader can use a range bound market. Similarly, there is a definite trend observed in a rectangle after the consolidation phase. A trader can use this to execute a trade.
Unlike a trending market, the bounce is observed in a narrow price range in the case of a range-bound market. Such a strategy can be employed when the price is less volatile and tends to oscillate within a range of prices. Like a trending market, trading a bounce in this market involves selling when the resistance level is reached and buying at the support level.
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Price action trading is straightforward for everyone. Even someone without any prior experience can start within a few weeks. Demo accounts do not require funding. This can give you confidence. Despite being simple, price action trading offers flexibility.
As Larry Pesavento, renowned price action trader, notes, “reliable and repeatable patterns present excellent profit opportunities, but focusing on risk, not potential reward, is the “secret” to pattern recognition trading.” As a result, price action trading can give you an edge in your predictions. It can also help you protect your downside risk in risky trades.
Finding the best price action trading strategies can give you an advantage in your daily decisions. So do your research, find the proper set-up, and execute trades for profit.