Price action trading is a trading strategy that helps traders make decisions based on price movements. Price action trading focuses on actual price movement rather than relying on technical indicators.
As a new trader, you might have heard countless trading suggestions from fellow traders: follow the price, identify patterns in your charts, keep up with the trend, and a successful trade is not far away. Not bad recommendations! But what can be bad is incomplete information.
Patterns, prices, or trends. They all are part of one form of trading known as price action trading. But what is it? How to perform price action trading? What are the pros and cons of price action trading? We address all your questions at this price.
What is Price Action? – The Definition
The price action is the basic movement of the price of financial assets. The price movement happens during trading hours. Therefore the price action is very much related to time. Even for those assets which are traded 24 hours a day, the price movement is judged across time.
The price of an asset primarily depends on supply and demand. The relation between the two varies. There is always a tug of war going on between supply and demand. The supply-demand curve is a fast-moving curve that determines the asset price. When supply is more the price falls. On the other hand, the price goes up when demand is high.
The price action trading system tries to identify the probable direction of future price movement. In this system, price movement is the primary objective. The market depth, the resistance and support and patterns evolving through price movements are identified.
Traders doing price action trading do not need to do all the fundamental and technical analyses for asset trading. A close focus on the price action and interpretation is all that is necessary to do this kind of trading. It is a frill-free, simple way of trading assets.
What is Price Action Trading?
Shown above is a typical chart on price action trading. This is a EURUSD candlestick chart. The price movement gave rise to some typical patterns that are helpful for a trader. The chart above shows how the support and resistance, breakout, and trend channels are helping to find trades.
Before going into trading details we need to understand what kind of charts are being used nowadays in stock trading. All kinds of charts have some unique characteristics of their own. A person interested in doing price action trades needs to understand these charts’ basics.
3 Types of Price Charts Used in Price Action
There are three kinds of basic price charts that are in use today. The line chart, the bar chart and the candlestick chart. The price actions of stocks and trading can be done in all of them in their own ways.
1. Candlestick chart
Shown above is a candlestick chart. This chart is made up of candle-like columns known as candlesticks. Each candlestick represents the OHLC (Open, High, Low, Close) prices of a period. The pattern formation helps the trader to identify and interpret accordingly. After identification of price action, the trader decides the next course of action. Shown here is the formation of the Head and Shoulder pattern. Many other patterns are helpful for the price action traders.
Read more: Important Candlestick Patterns
2. Bar chart
A bar chart is a different kind of chart. It consists of bars that represent the OHLC pattern through a bar as shown in the diagram.
These bars form a chart as shown above. People using these charts can also find price action patterns.
3. Line chart
These are simple curves following the price movements. This is a continuous line. No gaps or discontinuity can be seen in this type of chart. Price gaps or jumps are shown through straight lines. Pattern formations can be seen easily in this kind of chart.
The most popular of these three types of charts are candlestick charts. Price action traders mostly follow these charts. All charting platforms provide all these three kinds of charts.
What is the Use of Price Action Trading?
Before learning how to do price action trading, there are some things you should know. Why is this form of trading gaining prominence among traders? What makes it different from other strategies? And most importantly, how is it helpful to traders?
Price Action Trading is based on one notion: “History repeats itself. “
Traders of this discipline believe that price is the sole indicator of trading, and it goes up and down, following a pattern that repeats itself. The purpose of price action trading is to keep track of the price movements and identify those patterns. Then, select entry and exit points for your trades.
Since price action traders trade solely based on price, you don’t need to involve fundamental analysis in your trading, which makes the work of traders easy.
Now, you might ask, how do we identify those trends and patterns? What skills do I need to acquire to become a price action trader? The answer to both of these questions lies in the charts. A good price action trader should be good at reading charts, identifying patterns, and what those patterns suggest.
6 Important Price Action Trading Strategies
Price action trading is a form of trading that is done purely based on price movements. In this type of technical analysis, you keep track of the price movements, i.e., high, open, close and low prices to identify hidden price patterns. It gives you a clear indication of what the market is doing instead of what you think it might do.
As stated earlier, Price Action traders need to be proficient at reading charts. Since charts are loaded with information, we need to specify what exactly to look for. Concerning price action trading, we generally trade with price movements.
The traders here use clatter-free charts. Clean and pure price action charts are preferred. Therefore most of the common technical indicators are generally not preferred by the traders.
Traders watch for trends, patterns, blocks and waves to identify phases of price action. In addition, they monitor the swing high and swing low ranges for trends and support resistance, unlike other technical analyses where many indicators are used to interpret price movements.
This chart above shows pure price movements, on which lines have been drawn to identify the different phases of price movements. Trends, support and resistance, patterns are drawn on charts to interpret price action.
1. Support and resistance levels
The primary indicator that is used in price action trading is the use of support and resistance levels. The support and resistance levels are those price levels where either price makes upward moves whenever came down to that level or price comes down whenever price reaches a certain level.
We generally use two kinds of support and resistance level.
Normal Support & Resistance
The normal support and resistance levels are found by adjoining the previous swing highs and lows. The support lines are found by drawing a straight line joining previous swing lows in the price chart.
Similarly, when we join the previous swing highs in the chart, we get the resistance lines. Instead of lines, many prefer using zones. Because support and resistance areas work as zones than as linear price points.
In the chart below we can see supply and demand areas are mentioned. In support zones, the demand increases because the price seems cheap to the buyers. So this area is the support zone.
Price moves up and in some areas, it faces resistance because the supply becomes more. At these prices, the stocks become costly apparently. So traders tend to take a profit. Thus these areas become the resistance zones.
Price action traders follow price action at these zones. There are times when price breaks out from the resistance zones or breaks down from the support zones. At such times a continuation of the existing trend can be seen. Otherwise, the support and resistance areas become the areas for price reversals.
Fibonacci Support & Resistance
The Fibonacci support and resistance areas are computed by using Fibonacci ratios to interpret price action and retracement patterns. The Fibonacci lines are drawn from swing low to swing high in an uptrend and vice versa in a downtrend. Assuming the swing low is 0% and the swing high is 100%, parallel lines are drawn at 23.6%, 38.2%, 50%, 61.8% and 100%. These lines are drawn to foresee the price retracement levels. Just the opposite is done in a downtrend extending from 0% to 100% on the downside taking in the swing high to swing low.
The price action traders use the Fibonacci lines to find support and resistance levels. Usually, in an uptrend, the price retracement is limited to 38.2% zones. Therefore when the retracement or pullback is more than that, the trader becomes cautious about trend reversals or loss of momentum. The loss of momentum indicates the commencement of a rangebound period. The same stands for the downtrend also.
Read more: Fibonacci retracements
From these, the breakout and reversal zones can also be identified. Thus with the help of the support and resistance levels, a price action traders can trade in the stock market.
Channels develop when highs and lows move in a range. This is true for the trading phase. Channels can also be drawn in a downtrend or an uptrend. When the swing highs and swing lows can be connected through straight lines that are parallel to each other, we get a channel.
A price action trader can find the trending phases and trading phases by drawing channels on a chart. Price action traders draw these channels on price charts. For this most of the charts adds drawing facilities for price action traders. A trader can pick parallel lines from drawing tools provided by the chart and can easily draw channels on the chart.
This is how a price action trader draws a channel. We can see there is a section showing tools with the charting platform. Just picking the parallel lines from the tool a price action trader can draw the channels.
For a price action trader, the channels show trends and trends reversal. The trader can sell the stock when the price reaches the upper band in a downtrend and exit from that when the price reaches the lower band. Similarly, during the uptrend, the buyer buys the stock when the stock reaches or crosses the lower band and will exit when the stock reaches the upper band. This buying and selling can be repeated as long as the price moves with the channels.
The channels are very effective because price always moves in a wavy pattern even in a downtrend or uptrend. So, channels provide multiple trading opportunities.
A trader can even do scalping trades using channels. For a price action trader, the channel is a very useful tool.
To a price action trader, a Triangle is a chart pattern that is formed by two converging trend lines. It is a continuation pattern, or if it fails to validate, it may form the starting point of a price reversal. Triangle patterns are of three types, Ascending, Descending and Symmetrical.
A triangle can only be formed if there are at least five touch points found in the chart. The diagram above shows that. A triangle found in a trend indicates a continuation of the trend.
An ascending triangle is found in an uptrend. It indicates a continuation of the uptrend. Similarly, descending triangles can be formed in a downtrend.
Trading a triangle is typical for a price action trader. All triangle formations need a different types of trading tactics with different stop losses and targets. But, all in all, triangle trading is favoured by price action traders.
4. Bullish Flags
As the name suggests, this pattern is also a continuation pattern like the triangles. It has two parts. Pole and the flag itself. The linear upward move of price resembles the Pole and a rectangular price movement resembles the Flag. This pattern signifies that the bullish move will continue.
Wedge is a pattern that can be found both in bull and bear markets. In a bullish market, we can see rising wedges and in a bear market, we can see falling wedges. Wedges are formed by two converging trend lines taking price movement over 10 to 50 trading periods. The Wedges indicate imminent potential price reversal.
The Wedge patterns are accompanied by declining volumes which further ascertains the potency of price reversal. The declining volume is found both in the case of rising and falling wedges.
There are many other patterns found in price action. Traders need to have close look at the formation of these patterns. Many of the following patterns are formed in candlestick charts, where we have the OHLC bars or candles. We may not find them in line charts. As we all know, candlestick charts are price charts themselves that are loaded with information. Candlesticks combinations signify different price action strategies.
The study of candlesticks and their interpretation is a different technique that a price action trader may or may not use. We have not delved into the candlestick patterns here. That can be found in candlestick pattern studies and trading strategies.
Head and shoulder
The Head and Shoulder pattern is a typical bearish pattern. It consists of three consecutive rising price movement formations, all arranged in a specific manner. The middle portion, which represents the Head represents the highest part of the pattern. The left shoulder or price rise is higher than the right shoulder. There is a neckline which is the support zone through which the price breaks down to start the downtrend.
Inverse Head and Shoulder pattern
The Inverse Head and Shoulder is a typical bullish signal. The price action seen here is just the opposite of the price action in the Head and Shoulder pattern. The neckline represents the resistance zone, through which the price breaks out to start a bull run.
Triple top and Double top
The triple top and the Double top formation occurs when the price faces a strong resistance zone and can not break through after repeated bullish moves. In such cases, the price goes back and starts a bearish trend.
Shown below is the chart of double top formation. After the formation of the first double top, the support line was not broken. So the price action trader doesn’t trade. But after the second double top formation, the support line was broken. So the trader sells/shorts the stock and keeps position because the earlier support line has become the resistance. The resistance is the stop-loss price.
Similar is the case in Triple top. Here, as shown below, the price tests a particular area thrice and fails to break. So the triple top formation has occurred.
Both the Double and Triple top areas are price reversal zones. A price action trader makes note of this and trades accordingly.
The triple and double bottom formations are just the opposite of double and triple tops. These formations indicate a bullish price reversal.
The double bottom formation is similar to the triple bottom and is opposite to the double top in behaviour and formation. It is indicative of a bullish price reversal.
Climactic exhaustion reversal
This pattern is typically a behavioral pattern. These are BAB (Breakaway Bars) which are more than two standard deviations larger than the average length of a normal bar or candle.
These are found at the end of a trend. This large bar indicates that, in the case of a bull market, the presence of the last of the bulls. After the bulls become exhausted and only the bears remain. These indicate exhaustion of the trend. The opposite happens in the case of a bear trend. The large bar indicates the exhaustion of the bear trend.
Using Trend in Price Action Trading
The price of an asset follows a direction, and a trend is simply a prolonged direction that the price of an asset follows. So when you trade with trends, you note down in which direction the price is moving and stick to it as long as it doesn’t reverse.
In general, we can have three types of trends. Uptrend, Downtrend and Range bound phases.
In an uptrend, the price of an asset grows continuously. This trend is also known as a bullish trend. An uptrend is the right opportunity to buy an asset.
A downtrend is the opposite of an uptrend. Here, the price of an asset continuously decreases. It is the right opportunity to sell an asset.
In a sideways trend, the market neither reaches any highest nor lowest point. It is also known as a trading range.
Both short-term and long-term traders can use trend trading. As a trend forms, you can use a trendline – a line that you can draw on the charts – on the lows and highs of the price to predict the direction of the market.
Support and resistance lines are commonly used for this purpose. There are other ways you can perform trend trading. The use of multiple technical indicators is one such method. Some of the best indicators for price action trading are given below.
As we have seen earlier, price action traders prefer trend channel trading. Simple two parallel trend lines joining high and low price points in the chart produce a trend channel.
Similar to trends, we can find three types of channels. Ascending channels for an uptrend, Descending channels for downtrend and Horizontal channels for rangebound phases.
In an uptrend, the price action trader sells the stock when the price reaches the upper band and buys the stock when it reaches the lower band. It is a trading strategy for aggressive price action traders. But for normal traders using a price action trading strategy, buy the stock when the bullish trend is confirmed and sell the stock when the price breaks down from the channel. In an uptrend, the upper band is the resistance line and the lower band is the support line. The traders come out of position when the support line breaks.
The descending channels can be drawn in a bear market or during bearish trends only. The price goes down in a wavy form, bound by two downtrend lines. The trader sells the stock when the trend is confirmed and exits the trade when the resistance line, i.e. the upper trend line is broken through by price movement. The chart immediately below shows the trading pattern for an aggressive price action trader.
The Horizontal channel can be formed only in rangebound markets. At this phase, the market moves with a range and doesn’t go out of it unless the range is decidedly broken. Shown below is a chart, where the price is moving within a range-bound by two horizontally parallel straight lines.
Throughout the year, we find rangebound trading most of the days. The upper trend line becomes the resistance line and the lower one becomes the support line. The stock price tends to move between these two lines. The trader sells the stock when the price comes down after touching the upper line and buys the stock when the price starts rising after touching the lower line.
Trend channel line overshoot
It is a typical price movement when the price moves along the trend but shoots out of the channel. This price behavior compels the trader to redraw the channel defining a new range moving along the same trend. This is an important movement that involves all the players jumping for the trade who were sitting by the side-line. This movement makes the situation ripe for the price reversal. Big players wait for such opportunities to bring the price down after trapping all the retailers at the top.
The following chart shows how the overshoot traps the market players before the reversal. It is a bearish trend channel overshoot. Similar but opposite events occur during bullish trend channel overshoot.
Trend line break
A trend line break is a specific price movement that breaks out or breaks down through the trend line drawn by the trader on the chart. Trend lines work as support or resistance lines or zones.
When the price breaks away from the trend the line trader should exit the already entered trade and/ or wait for a new price trend to emerge.
Gap refers to the gap in continuation of price or large space between two consecutive price data points. A gap or price gap occurs when a price jumps from one price to another leaving a space between two prices. Trading the Gap is unique. It requires special trading techniques.
Gap or price gap can occur anytime, in any trend. A price action trader studies the nature of the gap before trading the gap. Gaps can be traded with specific stop-loss and risk/ reward ratios.
Read more about Gaps in Price Charts
Reversal bars are found in candlestick charts which indicate a potential price reversal. In the chart below, we can see a single bar that indicates a price reversal. Price action traders
We can have both a bullish reversal bar at the end of a bear trend and a bearish reversal bar at the end of a bullish trend.
When the price action goes beyond a predefined range of price, the price breakout occurs. This usually happens when the price breaks through the support or resistance line or a trend channel.
These are significant price moves that may start a new trend or a continuation of the trend from the price congestion period. Or this may cause a price reversal as we have seen in the case of Trend Channel Line Overshoot.
A break-out failure occurs when the price breakout could not be validated in the price action of the following consecutive periods.
In such cases, the price returns to the previous zones from which the price breakout originally occurred.
Often after a breakout, the price comes back near or close to the support or resistance zone, from which the breakout happened. This pull back against the direction of the breakout trend is called breakout pullback, It is also called Traders’ Remorse after which the price returns to the breakout direction.
A valid breakout never breaks the support or resistance zones decidedly. It returns to its original path in the direction of the breakout, after breakout pullback. Otherwise, it becomes a breakout failure.
Spike and channel
A spike is a sudden surge in price found to set up a new trend. After the spike, the price moves in the direction of the trend through a tight channel because price action slows down. It is typical price action. Usually, a spike is found during the opening of the day. Sometimes a Gap accompanies this formation. The Gap occurs just before the spike. This is known as Gap Spike and Channel.
In the chart below we can see a Gap before the Spike. After that price comes down in a tight channel. This formation is shown here to start a bearish trend. After the price moves out of the channel, the trader exits the trade.
Shaved bar entry
A shaved bar has one wick missing. For a bullish candle, the lower wick is missing and in a bearish candle, the upper wick is missing. If the shaved bar appears within a strong trend, it indicates that the trend is going to continue and there’s no let-up. The appearance of a shaved bar strengthens the trend.
Bull trend bar
The bull trend bars appear in a bullish trend. It usually leads to a final price increase.
Bear trend bar
The bear trend bars are found in bear trends. Similar to the bull trend bars, these bars also lead to final price breakdown.
The range bar is similar to a Doji in a candlestick pattern. It has a small body and the price closes at or near the opening price. The price action traders interpret as the price is moving in a tight range.
Advantages of Price Action Trading:
There are a few benefits that the price action traders enjoy.
1. Say no to indicators.
Many new traders, especially rookies, believe that successful trading strategies require more indicators. This methodology is wrong. With price action trading, you can build successful trading strategies with minimum or no use of indicators.
Also, price action strategies are simple to implement and do not require any research. You can use this trading method for various trading instruments, including stocks, bonds, derivatives, commodities, foreign exchange, etc.
2. Build your successful trading frameworks
With price action trading, you can also build successful frameworks for trading, which can help you trade in different market conditions. You can develop a plan for when to buy and sell and hold your market positions. Frameworks are built using various patterns (candlestick and other patterns) formed on the charts or drawing lines on the chart.
3. No fundamental analysis
Another benefit is that you don’t need to keep track of essential news since the impact of news is instantly reflected in the price, and your trade is purely on the price movements.
Limitations of Price Action Trading
1. It requires time
Price action trading requires too much data and time to validate trading strategies. There are cases when selected strategies fail to bring results. You also have to manually chart out price action patterns since they can’t be automated, which may take time.
2. Price Action trading is subjective.
With trading, what may work for you may not work for other traders. The case is the same with price action trading. Two traders might have their ways of dealing with trends and charts. Different thought processes may turn you skeptical of this trading method. To avoid this, follow a framework that will help you when to buy, sell, hold, or stay away from the market.
Price has been one of the top strategies of traders for centuries. When you perform price action trading, you ignore everything and make trading decisions as per the price. Your job is to analyze how charts are moving right now and determine future price movements purely based on that. As a price action trader, you can trade either with the help of trends or patterns or both.
Trends help you identify the direction the price is moving, while patterns help you identify repetitions among price movements. Both the techniques are solid and can help trades make profitable trading decisions. However, please don’t use it as a shortcut to trading. Price Action trading has its flaws, and there is risk in trading. Have a solid risk management strategy to avoid losses and implement price action trading with a proper framework.