Price Action Trading: A Comprehensive Guide
Key Takeaways
Price action is subjective.
Price action should be combined with other technical tools.
Price action doesn't guarantee future results.
What is price action trading
Price action trading is a systematic trading strategy that involves analyzing price movements to make trading decisions. It uses recent price history and technical tools that can help traders make subjective decisions based on their own behavioral assumptions and psychological state.
Some traders don't rely solely on technical indicators, and they don't assume that the price will rise just because logic says it should. Instead, they use a probability-based, adaptive mindset, thinking "If the price does this, then I will do X?
Here's an example. A trader is watching a stock's price and notices it has repeatedly bounced off a price level of $100 over the past few weeks. This is identified as a support level because the price seems to "support" the stock from falling below this point.
The trader can wait for the price to approach the $100 level again and this time, he'll look for a bullish price action signal to indicate that the price may rise from this support level again. One common signal is a bullish pin bar (a candlestick pattern with a long lower wick), which suggests that buyers are stepping in to push the price up.
Once the price hits the $100 support level and a bullish pin bar forms, they can enter a market order just above the high of the pin bar. Assuming the order executes and they are long the stock, they can then open a stop loss order just below the support level, e.g $98, to limit the downside risk if the price breaks below support.
They can also set an order at a price level where they expect resistance, e.g. $110, based on previous price action patterns or use a trailing stop to lock in gains as the price rises.
The trader can monitor the stock's price movement and if it moves up as expected, they can either let it hit the profit target and set a stop loss below the support level or manually close the trade when satisfied with the gains. If the price moves against them and hits the stop loss, the trade automatically closes, possibly minimizing losses.
Potential pros and cons of price action trading
Potential pros
Price action trading can be relatively easy to use and can be applied across markets and timeframes.
Can be used with most any trading software, applications, and portals.
Can easily backtest strategies on past data.
Price action indicators can help traders analyze price charts and anticipate potential price moves.
Potential cons
Can be highly subjective, leading to different interpretations among traders.
Requires traders to have experience and dedicate time to analysis and decision-making.
Can't be fully automated because it relies on traders' ability to accurately interpret candlestick patterns.
Price action vs. technical analysis
Technical analysis and price action are both trading strategies that can use price data to help forecast future prices; however, they have differences.
Technical analysis: Uses a variety of technical indicators and oscillators to forecast price direction by studying past market data, primarily price, and volume. Technical analysis can include many technical studies, such as indicators and chart patterns and it can be more complex due to the use of many indicators and tools.
Price action in trading: Focuses on the patterns formed by the price itself, such as price levels and indicated support and resistance levels. Price action analysis tends to be simpler and more intuitive, focusing on understanding basic price movements and patterns with traders potentially having more flexibility to adapt to changing market conditions because they are not tied to specific indicators, and instead may take trading positions according to subjective analysis, behavioral assumptions, and psychological state.
History of price action trading
Price action trading has deep roots, beginning in 17th century Japan when rice farmers used it for candlestick patterns. In the early 1900s, Richard Wyckoff developed a trading methodology based on price action and volume, which focused on market phases and volume patterns. His principles continue to influence price action trading.
Today, there has been a trend towards simplifying trading strategies and from this, price action trading has gained in popularity for its focus on pure price movement rather than a heavy reliance on indicators. Other factors such as educational resources, including the rise of online trading communities, educational platforms, and social media has made price action trading more accessible, enabling traders to share strategies, insights, and real-time analysis globally.
And while often used by individual traders, institutional traders and hedge funds often integrate price action with algorithmic and high-frequency trading strategies. These methods use sophisticated algorithms to analyze price movements and execute trades at high speeds.
How to read a price action chart
When reading a price action trading chart, it can help traders understand how to trade using price action. Traders can consider the following factors:
Identify the direction of the price and volume.
Look for patterns by analyzing the shape, structure, and relationships between candles, including their highs, lows, and closing prices. For example, on most trading platforms, a candle with a higher closing price than its opening price is green (a bullish candle), while a candle with a lower closing price is red (a bearish candle).
Monitor the length of the trending and pullback waves to identify the direction of the trend. During an uptrend, prices make higher swing highs and lows; the opposite is true during a downtrend.
Watch for confluence in an area instead of trying to pinpoint exact levels. When support and resistance levels become too obvious, it's called a "crowded" trade, which can lead to fakeouts and overreactions.
Common indicators of price action
What is price action in trading? Price action trading focuses on interpreting the movement of price itself rather than relying heavily on technical indicators. However, traders often use tools and concepts to complement their analysis. Here are some common ones:
Support and resistance levels: Horizontal lines drawn at levels where the price has historically had difficulty moving above (resistance) or below (support). By identifying these levels, it can help traders recognize potential reversal or breakout points.
Trendlines: Diagonal lines drawn on a chart to connect higher lows in an uptrend or lower highs in a downtrend. These can help traders visualize the direction of the market and potential points of trend reversal or continuation.
Moving averages: While not a primary tool in price action trading, moving averages can help confirm trends and identify dynamic support/resistance levels.
Simple Moving Average (SMA): An average of prices over a specified period, which smooths out price data to identify trends.
Exponential Moving Average (EMA): A moving average that gives more weight to recent prices, making it more responsive to new information.
Candlestick patterns: Specific formations of candlesticks on a chart, such as pin bars, doji, engulfing patterns, and hammers. These patterns provide insights into potential market reversals or continuations based on the price's behavior over a specific period.
Price patterns
Chart Patterns: Common patterns like head and shoulders, double tops/bottoms, triangles, and flags.
Usage: These patterns help traders identify potential trend reversals or continuation setups based on historical price action.
Volume: The number of shares or contracts traded in a security or market. Volume can help evaluate the strength of a price move; increasing volume often supports the validity of a trend or breakout.
Average true range (ATR): A measure of market volatility that calculates the average range between the high and low prices over a specific period. ATR can help traders gauge market volatility and set appropriate stop-loss and take-profit levels.
Fibonacci retracement levels: Horizontal lines that indicate potential support and resistance levels based on Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 76.4%). Traders can use these levels to forecast potential reversal points during retracements within a trend.
Pivot points: Calculated levels used to identify potential support and resistance levels based on the previous period's high, low, and close prices. Pivot points can help traders set entry and exit levels and identify potential turning points in the market.
Price channels: These are parallel lines that outline the high and low boundaries of price movement over a period. Channels can help traders identify the range within which the price is moving and potential breakout points.
Common indicators to combine with price action
Price action trading can be combined with many indicators, including technical, momentum, and other ones:
Technical indicators
Relative strength index (RSI): Measures the magnitude of recent price changes
Moving average convergence divergence (MACD): Can help traders identify potential trend reversals and market momentum
Moving averages: A trend-following indicator that smooths out price fluctuations over time
Bollinger bands: A set of three lines that represent volatility, or the range in prices that a security has historically traded within
On-balance volume: A volume-based indicator that measures buying and selling pressure by keeping a running total of positive and negative volume
Momentum indicators
Stochastic oscillator: Compares the closing price with the trading range of a specific period of time to help spot potential trend reversals
Average directional index (ADX): Evaluates a trend's strength, but its reading doesn't move according to the direction of price action
In addition to the momentum indicators above, other ones can include Fibonacci levels and exponential moving average (EMA).
Combine with Price Action
Price action trading is a technical analysis method that uses a security's price movements to make trading decisions. It's based on the idea that price movements reflect market psychology, sentiment, and available information. While price action trading presents opportunities for potential profits, it's important for traders to thoroughly understand, test, and choose the approaches that align with their individual goals.
FAQs about price action trading
Do professional traders use price action?
Yes, price action trading is a common way for professional traders to analyze and trade financial markets. Many short-term traders rely on it to help them make trading decisions. They often combine price action with other methods, such as fundamental analysis or technical indicators, to create well-rounded trading strategies.
What is price action in options trading?
In options trading, "price action" refers to the analysis and interpretation of the movement in the price of an underlying asset (such as a stock) and how these movements can impact the value of options contracts. It also involves examining historical price movements, chart patterns, and trading volumes to make decisions about buying or selling options.
What is price action in day trading?
Price action in day trading refers to the practice of making trading decisions based on an asset's price movements within a single trading day. Day traders analyze these price movements to identify patterns, trends, and key potential support and resistance levels without relying on external indicators like moving averages or oscillators. This approach can allow traders to react swiftly to market changes and execute trades based on real-time data.