What is price action trading? — A complete trading guide

Price action trading falls into the category of technical analysis. It is a way of analysing the market by looking at a “clean” chart, meaning no indicators are added to the charts. 

However, some traders might decide on one indicator to provide additional information, such as the Fibonacci retracement or Stochastic Oscillator. Others might use specific tools, such as a trend line to markup support and resistance levels, trendlines, or chart patterns.

Traders use this trading method to analyse a financial instrument’s past price performance to try and predict future price movements by identifying certain chart and candlestick patterns. 

They believe the market isn’t random, and particular chart and candlestick patterns tend to repeat themselves, using these patterns to try and predict the future price movement of the financial instrument they might be trading.

Traders could use different timeframes when analysing the market and looking for potential entry and exit points. They might not see a possible entry point on an hourly chart; however, they could see one when they move to a 15-minute timeframe.

As mentioned, price action traders rarely consider the fundamental analysis aspect when evaluating a financial instrument. They believe all the information they need is already present on the chart.

This trading method is primarily popular among scalpers, day traders, and swing traders.

Trading with price action is mainly done on a candlestick chart. However, some traders might prefer to use other charts, such as a line chart, a bar chart, a Heiking Ashi chart, or a Renko chart.

Most traders, however, generally stick to candlestick charts because of the information the candlesticks provide. They are also essential when looking for candlestick patterns and/or chart patterns.

The way to read price action starts with the candlesticks before moving to the market’s trend direction.

Candlesticks illustrate an instrument’s price movement over time. Each candle provides information about the price movement in a single unit of time.

If you were looking at a daily chart, each candle represents one day’s price movement, whereas if you were looking at an hourly chart, each candle represents one hour of price movement.

A candlestick has three parts: the body, wicks, and colour, each indicating an aspect of the price movement.

The candlestick’s body represents an instrument's opening and closing prices during a specific trading interval. These points determine the direction in which the price moved during that interval. 

The candlestick is bullish if the close is above the open, whereas if it is below the open, it is bearish.

Next are the wicks (shadows), representing the highest and lowest points price reached during that specific trading interval. 

A candlestick could have two wicks showing the highest and lowest points price reached for that interval. Or, it could have one wick, showing either the highest or the lowest point depending on the direction of the wick, which means either the opening or closing of the price was the highest or lowest point price reached for that interval.

It could also have no wicks, which means the price's opening and closing were the highest and lowest points it reached during an interval.

Lastly, we move on to the colour of the candlestick. It represents the direction in which prices moved during that specific trading interval. When the closed candlestick is white or green, the prices rose (bullish). When it’s black or red, it means the price decreased (bearish).

As these candlesticks move along the chart, they could move in one of three directions: upwards (uptrend), downwards (downtrend), or sideways (ranging).

Identifying an uptrend involves examining whether prices make consecutive higher swing highs and higher swing lows. In a downtrend, the opposite will happen; prices will make consecutive lower swing highs and lower swing lows.

When the market is trending sideways, there won’t be identifiable swing highs or lows. Instead, the highs and lows will be more or less the same throughout.

Traders could also use trendlines to assist in identifying whether a market is moving in a downtrend, uptrend, or sideways trend, which we'll look at in more detail in the next section.

Price action trading strategies are also known as price action signals. These signals assist traders in identifying possible indications about the direction of the market and potential entry points for a position.

Before entering a trade, you might want to consider three components of a price action strategy: the why, how, and what.

The “why” refers to the reason you might want to trade a specific market and the reason behind entering a particular trade. Combining some of the strategies with your original price action analysis might be able to assist in predicting whether the market will rise or fall.

The “how” refers to the mechanics of your trading, in other words, how you will conduct your trading. In other words, because the markets are unpredictable and trading is based on probabilities, the “how” will involve identifying where you might want to enter a trade and where to place your stop-loss and take profit order. 

Placing a strategic stop-loss could protect you from substantial losses if the market moves against you.

The “what” refers to the outcome of the trade. Was it a short-term or long-term trade? Was it a losing or winning trade? And what steps you might’ve taken to manage the trade and your emotions before exiting the trade.

Below is a detailed breakdown of some popular price action strategies you could use when analysing the market.

Support and resistance trading

Support and resistance levels show how supply and demand play out in the market.

These levels form once the market has become range-bound, meaning the price fails to break above previous swing highs while also failing to break below previous swing lows. Instead, prices will likely bounce off these levels and reverse.

Support levels are formed from swing lows, where the price retests the previous swing low, failing to break past those swing lows and instead reverses towards the upside. 

Conversely, resistance levels are formed from swing highs, where the price retests the previous swing high, failing to break past those swing highs and instead reverses towards the downside.

When analysing support and resistance levels, traders could wait for the price to reach a resistance level, and once the price has retested that level, they could open a short (sell) position with a stop-loss placed slightly above resistance and a take-profit order at support.

Similarly, they could wait for the price to reach a support level, and once the price has retested that level, they could open a long (buy) position with a stop-loss placed slightly below support and a take-profit order at resistance.

If the price were to break out of a resistance level, come back down and retest that level, it would become future support. The same goes for support; if the price were to break out of a support level, that would become future resistance if the price rose and retested that level.

To confirm whether a support and resistance level is reliable, you could draw trendlines at the highs and lows where the price is retested.

Trend retracement trading

As previously mentioned, when the market is trending, it could either trend upward, down, or sideways. In the above section, we covered the sideways (ranging) trend. In this section, we will cover an uptrend and a downtrend.

When the market is in an uptrend, the price will make consecutive higher swing highs and higher swing lows, and when the market is in a downtrend, the price will make consecutive lower swing highs and lower swing lows.

A trader could draw a rising trendline by connecting at least two to three consecutive higher swing lows to confirm an uptrend. This trendline could be seen as a support level, which traders could also use to look for potential entry points. 

When the price moves towards this support level and retests it, traders could open a long (buy) position, placing a stop-loss order at the previous swing low and a take-profit order at the previous swing high.

A trader could also draw a trendline by connecting at least two to three consecutive lower lows to confirm a downtrend. This trendline could be seen as a resistance level, which traders could also use to look for potential entry points.

When the price moves towards this resistance level and retests it, traders could open a short (sell) position, placing a stop-loss at the previous swing high and a take profit at the previous swing low.

There are two types of patterns traders could use when analysing the market: price action, chart patterns, and candlestick patterns.

First, we will cover the various aspects of chart patterns before moving to candlestick patterns.

Chart patterns in price action

Chart patterns became synonymous with price action because technical traders believe the market isn’t random and certain patterns tend to repeat themselves.

Chart patterns form due to a struggle between buyers (bulls) and sellers (bears) or a change in supply and demand.

These patterns could assist traders in making more informed decisions on where the market could move. The result of the pattern will generally dictate which direction the trend will move, either upwards or downwards, depending on the pattern formation. 

However, traders might want to look out for a false breakout. This is a false signal, trapping traders into thinking the market will move in their desired direction, only to reverse shortly afterwards. These false breakouts can appear as a bull trap or a bear trap.

Different chart patterns move in different directions depending on the prevailing trend at the time. In contrast, the formation of these patterns will differ depending on the situation between buyers (bulls) and sellers (bears).

Each outcome will vary depending on certain factors, such as whether the market is experiencing high or low volatility.

Lastly, there are many different chart patterns to choose from; however, each will fall into one of three categories: continuation, reversal, and bilateral.

• Continuation patterns: These patterns indicate that the market is likely to continue with the current trend once the pattern's result has been reached.
• Reversal patterns: These patterns indicate the market is likely to reverse from its current trend following the result of the pattern.
• Bilateral patterns: These types of patterns are a little trickier because they indicate indecision in the market, meaning the pattern result could either show a continuation of the trend or a reversal.

For the purpose of this article, we’ll only be covering continuation and reversal patterns in more detail below.

Trend continuation patterns

Trend continuation chart patterns generally indicate that the market will continue its current trend. 

These patterns form because buyers are taking a break from finding lower prices to buy while the market is in an uptrend. Conversely, when these patterns form while the market is in a downtrend, it indicates sellers are taking a break from finding higher prices to sell.

It can be challenging to predict what will happen as the pattern starts forming, so it might be best to wait for the pattern’s result before deciding to enter a position.

As previously mentioned, traders can choose from many different chart patterns. Two popular continuation patterns are channels and flags.

Channels are formed when prices move between two parallel trendlines, with the top trendline acting as resistance and the bottom trendline acting as support. They can also occur in bull markets and bear markets.

This pattern forms because buyers take a break when the market is in an uptrend, and sellers take a break when the market is in a downtrend.

The way to identify this pattern is when the price moves sideways with a slight slant to the upside when the market is in an uptrend. The pattern formation will be the same for a down trending market, except with a slight slant to the downside.

The way to trade this pattern could be for traders to wait for the price to break out of either support or resistance, depending on the dominant market trend, before placing a long (buy) or short (sell) order.

When it comes to flag patterns, the formation is also identified by two parallel trendlines; however, in this instance, the price will either slope downward when the market is in an uptrend or upward when the market is in a downtrend.

When the market is in an uptrend, the pattern is created, with buyers taking a break and sellers starting to come in, pushing the price lower. At some point, buyers will start to come in again, causing the price to break out of the top trendline (resistance) and the market to continue with the overall uptrend. 

Conversely, when the market is in a downtrend, the pattern is formed due to sellers taking a break and buyers coming in, pushing the price higher. At some point, sellers will start to come in again, causing the price to break out of the bottom trendline (support) and the market to continue with the overall downtrend.

Trend reversal patterns

Reversal patterns emerge when market sentiment shifts. These patterns generally indicate that the dominant players, whether bears or bulls, have run out of steam.

If the market is in an uptrend accompanied by bullish excitement, where buyers feel the price will continue to rise, the market can always stall when it reaches a certain point. 

When it gets to that point, sellers could start coming in, causing a “tug of war” between buyers and sellers where the sellers ultimately take over, pushing the price lower, resulting in a reversal.

The same can be said for when the market is in a downtrend and stalls at a certain point when buyers start coming in, pushing the price higher and reversing upwards.

Reversals at these market peaks are also known as distribution patterns, where the financial instrument has more selling pressure than buying pressure. 

On the other hand, reversals occurring at market bottoms are known as accumulation patterns, in which a financial instrument experiences more buying pressure than selling pressure.

One of the more popular reversal chart patterns used by traders is double tops and bottoms. A double-top pattern shows an instrument’s price trying to break out above the previous high point at a resistance level but failing, resulting in a possible reversal.

The two high points in price are almost identical in height.

The retracement from the first high can be seen as a support level known as the neck. Traders could wait for the price to come down from the second high, and when it breaks the support level, it could confirm that the price will likely reverse into a downtrend.

A double bottom is the opposite of a double top, where the price fails to break the previous low point at a support level, resulting in a reversal.

The two low points in price are almost identical in depth.

The retracement from the first low can be seen as a resistance level known as the neck, like the support level in a double top.

With a double bottom, traders could wait for the price to move up from the second low point. When it breaks above resistance, it could confirm that the price will likely reverse towards an uptrend.

Another popular reversal pattern traders use is a head-and-shoulders pattern, which could appear during a market uptrend. Its formation is identified by its three peaks. 

The first peak refers to the first shoulder, the second, higher peak refers to the head, and the third peak, which is more or less the same height as the first peak, refers to the second shoulder.

During the formation of this pattern, the two retracements will generally retest the same support level, known as the neckline.

For a trader to confirm the reversal with this pattern, they could wait for the price to move back down from the third peak towards the support level; if it breaks out below the support level, that could be confirmation the price has reversed and will likely continue the new downtrend.

There is also the inverted head and shoulders pattern, which could appear during a market downtrend. 

This pattern's formation will resemble a regular head-and-shoulders pattern; however, it will be upside down. Also, the neckline will be situated at a resistance level instead of support.

With the inverted head and shoulders pattern, traders could wait for the price to rise from the third peak, moving towards the resistance level and waiting for a breakout above resistance. When that happens, it could be confirmed that the price has reversed and will likely continue with the new uptrend.

During the formation of either of these head and shoulder patterns, the volume will likely decrease, rebounding once the price breaks out of the neckline.

Candlestick patterns in price action

Before identifying and assessing whether a candlestick pattern is reliable, a trader might want to wait for the current candle to close first. Once the candlestick has closed, they could examine the high, low, open, and close points together with the colour.

Waiting for the candle to close first before identifying a potential pattern might be essential because, depending on the timeframe a trader uses, the price can move between a bullish (green or white) and a bearish (red or black) candle during the specific time interval.

There are many different candlestick patterns traders could use. However, they all fall into one of three categories: bullish, bearish, or continuation patterns.

In the following few sections, we’ll look at two bullish candlestick patterns, two bearish candlestick patterns, and one continuation pattern.

Hammer 

The first candlestick pattern is the hammer, characterised by a small body, a long lower wick, and little to no upper wick. For a candlestick to be considered a hammer, the wick must be at least two to three times the length of the body.

This pattern is formed due to exhaustion when the market is in a downtrend and signals a possible bullish reversal is likely to follow. Sellers drove the price to a new low during the trading interval but couldn’t maintain it. Instead, buyers came in, pushing the price higher, which caused the price to close just below or just above the opening price.

If the candle closes just below the opening price, the colour will be red or black. However, if it closes just above the opening price, the colour will be green or white.

Generally, the candle’s colour isn’t as important as the pattern itself; however, if it is green or white, it can be seen as a stronger signal.

Bullish engulfing bar

A bullish engulfing candlestick pattern is a combination of two different candles, with the first being a red or black bear candle following the downtrend and the second being a green or white bull candle. 

The formation of the bear candle isn’t of much importance; what is essential, though, is the next green or white bull candle that follows, which completely engulfs the previous bear candle.

When this happens, it indicates that buyers came in strong and overwhelmed the sellers. The candle starts at the closing price of the previous candle but eventually rises past the prior candle’s high before closing.

As the price concludes at or near the top of the bull candle, barely declining, there should be little to no apparent upper or lower wick.

Shooting star

A shooting star’s formation looks like an upside-down hammer pattern and becomes significant when the market is in an uptrend. Instead of the candle body being at the top, with this pattern, it appears at the bottom, with a long upper wick.

Much like the hammer, the wick of a shooting star should be two to three times the length of the body to be considered a shooting star.

This pattern is usually formed when the price experiences exhaustion while in an uptrend. Buyers push the price higher. However, sellers come in, overwhelming the buyers and pushing the price lower, causing the candle to close near the opening price point.

This pattern could signal a possible bearish reversal is likely to follow.

Again, the candle’s colour isn’t critical; it has more to do with the pattern itself. However, if the candle is red or black, it could be seen as a stronger signal.

Bearish engulfing bar

A bearish engulfing pattern is the opposite of a bullish engulfing. It is also a combination of two different candles, the first being a green or white bull candle followed by a red or black bear candle, which is significant when the market is in an uptrend.

Again, the formation of the bull candle isn’t very important. However, the next bear candle is essential, as it completely engulfs the previous bull candle. 

When this happens, the candle opens at the previous candle’s closing price when sellers start coming in, overwhelming buyers and causing the price to fall below the prior candle’s low point before it closes.

As with the bullish engulfing candle, when the price concludes at or near the bottom of the bear candle, barely rising, there should be little to no apparent wicks on either end.

Doji

The last candlestick we’re looking at is a continuation pattern. A doji candlestick pattern is easy to identify because it resembles a big plus sign with a small to non-existent body. The open and closing points in price are almost the same.

The wicks on either end could vary as the vital part of this pattern is the small to non-existent body. This pattern forms because buyers and sellers struggle, with no one coming out on top.

The doji candlestick pattern indicates indecision in the market, and as a result, the current trend might continue after this pattern is formed.

Most price action traders might choose not to use indicators as they prefer a ‘clean’ looking chart when analysing the market. However, others might add at least one indicator onto their charts if it helps them in their analysis and decision-making process. 

Two popular indicators most traders decide on are the Stochastic Oscillator and Fibonacci retracement.

Stochastic Oscillator

The Stochastic Oscillator is a momentum indicator that traders could use to try and identify areas where price could be seen as overbought or oversold.

The indicator works by taking the most recent closing price and comparing it to the previous trading range over a period of 14 days.

This indicator could also be considered a leading indicator because market momentum tends to change ahead of volume or price. It is generally used in ranging markets, which we covered in the support and resistance trading section when prices fail to break the previous highs or lows at a dedicated support or resistance level before reversing in the opposite direction.

When this indicator is placed on a chart, a trader can see two moving lines: the first is the indicator line, which is generally presented as a solid white line. The second is the signal line, which is usually presented as a solid red line, as seen in the picture below.

These two lines move between two horizontal lines; the first horizontal line is marked at the 80 level, and the second at the 20 level.

Apart from finding overbought and oversold areas, traders could also combine this indicator with their analysis to identify possible reversals. It works by identifying the crossover between the indicator and signal line at areas of interest.

A trader could look at the indicator line crossing below the signal line at the 80-level mark for a possible indication of a potential reversal towards the downside. Whereas for a possible indication of a potential reversal towards the upside, a trader could look at the indicator line crossing above the signal line at the 20-level mark.

Traders could incorporate certain candlestick patterns to further confirm the reversal and find possible entry points at these crossovers.

Fibonacci retracement

This tool works by having traders find the highest and lowest points of interest on their charts and then draw the Fibonacci retracement by connecting these high and low points. 

If the market is in an uptrend, they could connect the highest point, moving towards the lowest point. And for a downtrend, connect the lowest point, moving towards the highest point.

When the retracement is placed on the chart, a trader will be able to see six lines: the top is marked at 100%, the bottom at 0%, and the middle at 50%. The remaining lines are marked at 61.8%, 38.2%, and 23.6%.

The 61.8%, 50%, 38.2%, and 23.6% follow the premise of the Fibonacci golden ratio, which identifies these levels as areas of interest and possible entry points. These levels could also be used as potential support and resistance levels.

In theory, if the price, whether in a downtrend or uptrend, retraces back towards one of these levels, it could be used as a possible entry for a trader to either open a long (buy) position or a short (sell) position.

When opening a long (buy) position, a trader could place their take profit at or above the 100% level, with a stop-loss below the level price retraced from. When opening a short (sell) position, they could place their take profit at the 0% level with a stop-loss at or above the level price retraced from.

It might be essential to remember that these take-profit and stop-loss targets will differ between traders according to their specific risk-reward ratio.

Price action trading could be quite subjective, as two traders might have different conclusions while analysing the same financial instrument. One trader might speculate the price will continue to decline, while another might assume the price is about to reverse.

There is also the timeframe aspect, which could influence a trader’s decision-making process. Some price action traders might only use one timeframe when analysing the price movement of a financial instrument. 

Doing so could potentially influence their decision-making because they won’t be able to see the big picture; a financial instrument might be on a downtrend in the 4-hour timeframe while it maintains a strong uptrend on the weekly.

As previously mentioned, price action traders solely focus on the price movements of the instrument they’re looking to trade; however, it could sometimes be challenging to predict valid outcomes when only past price movements are analysed. 

This is why some traders might incorporate at least one indicator to provide additional information on possible entry and exit points.