14 May 2024 - 12min Read

Trading strategies

Price action trading

The price of a financial asset is critical to trading as the price change determines potential profit or loss. Traders who opt to focus simply on price charts must follow a price action strategy that includes analysing price movement to determine when to enter or exit a position.

Understanding price action mechanics and establishing a price action trading system with high probability have the potential to be quite rewarding. In this article, we will venture into price action trading comprehensively.

TABLE OF CONTENTS

Key takeaways

  • Price action, in general, refers to the variations in the price of an asset over time.
  • Different templates may be added to a chart to make price action trends more visible to traders.
  • Price action refers to a form of technical analysis.
  • Although many use price action to help predict future prices, past price action does not guarantee future results.
  • As the name suggests, different price charts are used for technical analysis in price action trading. Line charts, bar charts, and candlesticks charts are some of the most commonly used price charts.
  • Popular forms of price action trading are candlestick patterns, chart patterns and support and resistance.

Understanding price action trading

Price action may be viewed and comprehended using time-series charts. Traders use different chart compositions to increase their ability to recognise and comprehend trends, breakouts, and reversals. Candlestick charts are popular among price action traders because they better visualise price movements by presenting the open, high, low, and close values in the context of sessions. In addition, the shape of the candle also provides valuable information for traders.

When using technical indicators, many technical analysts incorporate price action data in addition to visual patterns on the chart. The idea is to uncover order in what appears to be random price fluctuation. 

For example, an ascending triangle pattern generated by applying trendlines to a price action chart can be used to anticipate a future breakout since the price action shows that bulls have tried a breakout numerous times and gained momentum each time.

Price chart types

Traders have their own preferences as to which chart types they prefer to use in their price action analysis. This is an "each to their own" scenario when it comes to chart types. There is an abundance to choose from, each with its respective pros and cons.

The simple Line Chart is the most basic, simply showing the closing price, used to plot long-term trends. The OHLC and Candlestick charts provide the open, high, low, and closing prices. Japanese Candlesticks are undoubtedly the most popular among traders.

The very basic foundation of price action is built on Japanese Candlestick (the way price is plotted) layouts, formations and patterns.

A new world of understanding supply and demand opens up when we dive deeper into OHLC, Japanese Candlestick, and Point & Figure Charts.

Volume data is added to the chart analysis using VAP and Equivolume charts. These provide market depth in terms of so-called tick volume. This opens up a whole new debate which we will cover in a future article.

Point and figure, Heiken Ashi and Renko charts remove the noise from chart analysis and plot price history. When comparing these chart types to your standard candlestick layout you will realise a night and day difference.

It is not uncommon to see traders utilise a combination of chart types when it comes to price action analysis, very often on different timeframes.

How to read price action?

Price action trading entails analysing trending and pullback waves, also known as impulse and corrective waves. A trend advances when the trending waves are larger than the corrective waves.

Traders look for "swing highs" and "swing lows," or the duration of the trending and pullback waves, to determine the trend's direction. The rules of an uptrend are that the price makes higher swing highs and higher swing lows. During a decline, the opposite is true. On a price chart, trendlines' troughs and peaks hover between support and resistance lines.

How to use price action in trading?

Price movement is not commonly seen as a trading tool, such as an indicator, but rather as the data source upon which all other tools are based. Swing and trend traders are closely associated with price movement, focusing entirely on support and resistance levels to forecast breakouts and consolidation.

However, the timeframe is another factor to consider while studying price action and anticipating a movement. For example, you might not find a move significant on a higher timeframe, while it may seem significant on a shorter time frame.

Price action trading strategies

A price action trading strategy must have three components: why, how, and what. The 'why' is why you want to trade a given market. Price action patterns are useful in this situation. Price action analysis will help you predict whether the market will rise or fall next.

The mechanics of your craft are the 'how.' It is, in essence, how you will trade. This analysis requires you to know your entry, stop-loss, and target price levels. After all, trading is all about probability. Therefore, you must protect yourself and limit losses if the market goes against you.

The outcome of the exchange is the 'what.' Is this a short-term or long-term trade? This boils down to managing the trade to profitability and managing yourself if the outcome is not as desired.

Here are a few major price action strategies that are used in either one form or another in different markets:

Supply and demand price action

Supply zones are evident where sellers enter the market aggressively, causing the price to fall and not recover. Traders keep an eye out for these because sellers may still be around and ready to sell when the price rebounds, causing the price to fall again.

Demand zones are where buyers have actively joined the market. The price rose and has not since returned. If the price returns to that level, traders will monitor to see if buying resumes, causing the price to rise again.

Price action trading patterns

Price action trading patterns are patterns that result either in the trend continuation or reversal.

  1. Trend continuation

Continuation patterns appear throughout a trend. Assume that the trend is upward and that a triangle forms. Because the trend is up, the price has a slightly larger possibility of breaking out of a triangle to the upside. When a pattern appears during a decline, the same logic applies. The technique here is to wait for a trend to build, then for a pattern to form, and then to trade only if the price breaks out of the pattern in the trending direction.

  1. Trend reversal

When the rules of an uptrend or downtrend are broken, price action reversals occur. 

Consider an uptrend with greater swing highs and lows. This is an indicator when it makes a lower swing low. If the price then reaches a lower swing high, it indicates that a reversal is in progress. This is not to say that things cannot reverse, allowing the upswing to restart. The data simply suggests that a reversal is likely. 

Candlestick patterns in price action

Candlesticks are graphical representations of an asset's price trend, open, close, high, and low on a chart. Traders use candlesticks in various ways, both individually and in combinations. Certain candlestick patterns cause a certain reaction with some probability on specific instruments. It also depends on the timeframe you are using.

Price action for scalping

Scalping is a trading method in which gains and losses are taken swiftly, as deals are often completed in a few minutes or less. In forex scalping, this may entail employing a stop loss of 3 to 5 pips and a goal of 5 to 10 pips. In the stock market, it may imply putting a few cents per share at risk in order to make a few cents. Scalping entails fast entering and closing a position in order to profit on minor price changes, for whatever that asset's definition of a small price move is. Many scalpers like to trade on one or five-minute charts.

A scalping technique seeks to trade in the direction of the trend and enter during a pullback when the price begins to move back in the trending direction. To do so, traders seek engulfing patterns, such as when a candle in the trending direction envelops a candle in the retreat direction, to signify an entry. During a retreat, this happens.

Price action for swing trading

Any of the above-mentioned price action strategies can be employed as part of a swing trading strategy. Swing traders often look for trade setups on hourly, 4-hour, and daily charts, while they may employ 15-minute or 5-minute charts to fine-tune their market entrance.

Consider a supply and demand scenario combined with trend trading. 

If you allowed the price to reach the supply zone, it would frequently exceed the previous high. If you want to short the market, you might do it when there is a bearish engulfing pattern or when the price consolidates and then breaks down to the downside. And vice versa. The main goal in swing trading is to enter trending markets (on higher swing lows in an uptrend and on lower swing highs in a downtrend)

Stop losses and profit targets for price action trading

The risk may be managed by putting a stop-loss order on each trade. A stop loss is placed below the most recent swing low when purchasing and entering a long position. You can position an asset above the most recent swing high when shorting it. In both cases, this mitigates the danger of the price falling too low or climbing too high. You might quit Renko charts when the bricks reverse orientation and change colour.

Price action traders should also lock in profits in order to close the position on the anticipated move. This can be accomplished in a variety of ways. A risk-reward ratio is one of the simplest approaches. For example, if you risk $5 per share on a scalp transaction, you should profit $10. That is a risk-reward ratio of 2:1. Scalping ratios of 1.5:1 or 2:1 are frequent. A risk-reward ratio of 3:1 or greater is usual for swing trading, and trend traders typically employ a higher risk-reward ratio.

Other exit strategies include exploiting price action. If you enter a trade because a downtrend has begun, keep it open until the trend reverses. Price action advises when to exit by indicating when the price is turning. Consider departing at demand if you enter at supply. Consider departing near supply if you enter near a demand location.

Limitations of price action

Price action interpretation is quite subjective. It is typical for two traders to get different conclusions while evaluating the same price movement. One trader may detect a negative decline, while another may assume that the price movement indicates a potential near-term turnaround. 

Of course, the selected timeframe greatly impacts what traders observe, as a stock might have several intraday downtrends while maintaining a month-over-month uptrend.

The crucial thing to remember is that trading predictions based on price action on any timeframe are speculative. The more tools you have to corroborate your trade prediction, the better.

In the end, a security's previous price activity is no assurance of future price action. High-probability trades are still speculative trades, meaning traders take on risks to access the possible benefits. Price action does not expressly integrate macroeconomic or non-financial factors affecting security.

Final thoughts

Profitability, like every trading technique or instrument, is determined by how it is used. Many successful traders have demonstrated that trading price movement may be rewarding. However, traders who rely solely on price charts and ignore fundamental elements may miss critical events that significantly influence the price of their securities.

Price action traders use price history to predict the next price, but it takes time to understand price action and identify trends, patterns, and reversals.

People also asked

/

Technical indicators are little flashes of activity on a trading chart that indicate the formation of a trend. Seasoned traders may recognise these signs rapidly and utilise them to find trade opportunities in real time. Price action is solely based on an asset's price changes inside your trading window.
In some ways, technical analysis attempts to bring order to the chaotic trading world. Still, price action allows the trader to take a more conventional gut-based trading strategy by recognising and acting on price action signs.

/

For various reasons, price action traders choose the Forex market. Because it is very liquid, traders may find it simpler to enter and exit positions fast.
The forex market is always on the move. The market's high trading volumes and liquidity make it easier to identify repeating patterns and trends.

/

Price action trading may be profitable; nevertheless, the trader must recognise that it takes a lot of patience to trade the markets successfully. A price action trader will search for specific setups on the charts, which may take some time to develop. Trading before major news events might result in losses.
If a trader wants to adopt a price action strategy, they must have a particular plan for entry and exit points and stick to that plan.

/

Price action trading is not without flaws. No trading method or approach will ever be perfect. On the other hand, price action trading can be very effective, as some experienced traders claim to have higher success rates.

/

Swing traders rely on price movement; if a security's price remains static, it is more difficult to find profitable chances. Price action is helpful for swing traders in general because traders can notice up and down moves and trade appropriately.