What is price action trading?
Traders who opt to focus exclusively on price are required to develop a price action strategy that will focus on analysing trending waves to adjudge when to enter or exit a position.
Delving deeper into the mechanics of price action and designing a highly operative price action trading strategy has the potential to make the trade an effective one. Here, we uncover the techniques and indicators that will contribute to developing this operative strategy.
How to interpret price action
Trading on price action primarily includes analysing trending waves and pullback waves, also referred as impulse and corrective waves. A trend gets momentum when the underlying trending waves are superior to corrective waves.
Traders typically watch “swing highs” and “swing lows” closely, and the length of the trending and pullback waves, in a bid to identify the course of the trend.
During an uptrend, the rules are that the price tend to make higher swing highs in price, and higher swing lows. The reverse is true during a downtrend. The troughs and peaks of trendlines float between lines of support and resistance on a price chart.
The following Amazon (AMZN) candlestick chart has lines overlaid to validate the major up and down waves and help in highlighting the downtrend and reversal to uptrend.
Price waves can also form patterns, including ranges (equal size waves up and down), triangles (price waves getting smaller and smaller), and expanding ranges (higher swing highs and lower swing lows).
Trends and patterns constitute the basic foundational elements of price action trading. Moreover, traders watch for supply and demand levels and candlestick patterns.
Price action in forex
Price action trading works in a similar pattern across all markets, even forex trading. However, there are a few exceptions to take a note of:
For instance, currencies trade 24 hours per day, yet some forex pairs are less likely to show movement when their respective markets are not open, even in case a price action signal develops.
Therefore, this article elucidates examples across all markets to decode how price action trading works, be it for the forex, share, index or commodity markets.
How to trade supply and demand with price action
Supply areas are realized where sellers have entered the market aggressively, resulting in drop in the prices, and it has not returned. Traders watch closely for these because, when the price returns, sellers may still be present and ready to sell again, pushing the price back down.
Demand areas occur wherein buyers have entered the market aggressively. The price soared and has not returned. If the price returns to that level, traders will be keenly watching to see whether the buying picks up again, pushing the price back up.
Price action trading patterns
In technical analysis ecosystem, conversions between falling and rising trends are often indicated by price patterns. A price pattern is an identifiable configuration of movements in the price of a security that is recognized leveraging a series of curves and/or trendlines.
Technical analysts have extensively utilized price patterns to decode current market movements and predict future market movements.
Price action continuation patterns
Continuation patterns occur during a trend. Let us assume the trend is up, and a triangle form. Because of the uptrend, the price has a slightly higher chance of breaking out to the upside because the trend is up. Similar concept is applicable amid a downtrend when a pattern forms.
The strategy in this case is to wait for a trend to develop, and then wait for a pattern which forms, and then only trade in case the price breaks out of the pattern in the trending direction.
Here is an example using silver.
Price action reversals
Price action reversals occur when the rules of an uptrend or downtrend are violated. Once one of these basic rules is violated, the trend is in trouble. If both rules are violated, the trend will reverse based on the waves being viewed.
Let us consider an uptrend that is making higher swing highs and lows. When it makes a lower swing low, this is a warning sign. If the price then makes a lower swing high as well, this means that a reversal is underway.
In case we consider an uptrend that is making higher swing highs and lows. When it makes a lower swing low, this is a warning sign. If the price then makes a lower swing high as well, this means that a reversal is underway.
However, this does not imply that things cannot go back the other way, allowing the uptrend to resume. The evidence simply indicates that a reversal is likely to happen. The below Tesla [TSLA] chart shows a price action reversal from uptrend to downtrend, and then back to an uptrend.
Advanced price action strategies
Price action defines the comprehensive characteristics or traits or way of course across the price movements of a security.
Simply put, price action refers to a trading technique that permits a trader to read between the lines and interpret the market movements to devise subjective trading decisions dependent on the latest and actual price movements, rather than banking solely on technical indicators.
Price rejection trading strategy
Price rejection is when the price tries to move through an important level, but then reverses direction because there is not enough force to maintain the trading momentum.
Rejections often result in hard and fast moves in the opposite direction. Here is what to watch out for:
Price approaching a key price area (supply, demand, or pattern breakout area).
Price nears the area or even breaks through it marginally.
The price momentum fails, and price moves in the other direction.
The candle typically has a long tail.
Price moves back the other way, providing an entry opportunity.
For example, the EUR/USD supply and demand chart above provides several examples of a price rejection. In all these instances, the candles had long tails, which indicate the last failed attempts to breakout.
Renko price action strategy
Renko charts form bricks, where each new brick appears once the price has moved a specified amount. Bricks only occur at 45-degree angles, and they stay the same colour until a reversal occurs. A reversal is when the price moves two-bricks in the opposite direction.
Renko charts typically work well in trending markets. If the Renko chart stays the same colour and the trend continues, traders must stick with the trade.
But in case it reverses, then it might be the time to exit the position.
Notably, the Tesla chart we previously looked at, has been recreated below, using Renko blocks. They would have kept the trader in for the entire rally starting in March.
Price action scalping strategy
Scalping is a trading strategy wherein profits and losses are taken quickly, as trades typically last a few minutes or less.
In forex scalping, this may mean using a 3 to 5 pip stop loss and a 5 to 10 pip target. In the share market, it may mean risking a few cents a share in or order to make a few cents.
Scalping includes entering and exiting a position quickly to tap the advantage of small price movements, depending on whatever a small price move is considered for the asset in focus. Many scalpers usually utilize 1-minute charts.
A scalping strategy is aimed to trade in the trend direction and enter during a pullback when the price starts moving back in the trending direction. To execute this, traders watch out for engulfing patterns to signal an entry, for instance, when a candle in the trending direction envelops a candle in the pullback direction. This typically occurs amid a pullback.
In the chart below, the arrows indicate the engulfing patterns that signal potential trade entry points on the Alcoa [AA] 1-minute chart.
Although this is one instance of a scalping strategy, all the previously discussed strategies and concepts can be utilized for price action.
Price Action Strategy for Swing Trading
Any of the price action strategies discussed above can be tapped in as part of a swing trading strategy. Swing traders generally use hourly, 4-hour, and daily charts to find trade setups. However, they may utilize 15-minute or 5-minute charts to fine-tune their market entries.
Let us take a look at a supply and demand example, combined with trading with the trend. The USD/CAD chart below displays an overall downtrend on this 4-hour chart.
As you can infer, the price rallies, puts in a swing high, declines and then enters a short-term downtrend, before rallying back to the prior high. As long as the trend is down, and the price has entered a supply area, this is an opportunity for potential short trade.
If you were to allow the price to enter the supply area, it might often exceed the prior high. If you are hoping to short the stock, you might enter the order when there is a bearish engulfing pattern, or the price consolidates and then breaks the consolidation to the downside. The arrow marks the breakout of the consolidation, to the downside in this instance.
Stop losses and profit targets for price action trading
Placing a stop loss on each trade helps you to control risk. When buying and taking a long position, a stop loss goes below the recent swing low. When shorting an asset, you must consider placing it above the recent swing high. In both the cases, this minimizes the risk of the price sinking too low or rising too high.
While referring to Renko charts, exit when the bricks reverse direction and change colour.
Price action traders essentially look to lock in profits. This can be done in various ways. One of the simplest methods is to utilize a risk-reward ratio. For example, if risking 5 cents per share on a scalp trade, exit at a 10 cents profit. That is a 2:1 risk-reward ratio. For scalping, 1.5:1 or 2:1 ratio is common. For swing trading, 3:1 or higher is common, but traders can regulate for themselves their desired risk-reward ratio.
Other exit methods are using price action itself. If you enter a trade because a downtrend has started, stay in the trade until the trend reverses. Price action provides the indicator when to exit by providing signals that the price is turning. If entering at a supply area, you must consider exiting at demand. In case you are entering near a demand area, you must consider exiting near supply.
The best indicators for price action trading
Many price action traders do not employ indicators, but a few may in case it helps them to better identify entry point, stop loss, and target levels. Also, the technical indicators may provide a sense check to confirm what a trader is seeing in the price action.
Fibonacci retracements for support and resistance
The Fibonacci retracement is drawn on a chart from a low to a high (in case of an uptrend), or a high to low (in case of a downtrend). It indicates areas wherein the price could pull back to. The levels are 23.6%, 38.2%, 50%, 61.8% and 100%. Amid a strong trend, pullbacks are usually low, often only reaching the 38.2% level. While, in most trends, pullbacks exceeding the 50% and 61.8% levels are typical.
The following chart shows a modest uptrend in crude oil. The last wave up is utilized to draw the retracement tool. The 100% goes at the bottom of the move and the 0% at the top as the price is rising. You can reverse this method if price is falling.
Expect a pullback beyond 50%. Then, wait for a trade signal as discussed priorly. There is a strong move to the upside after the price drops below the 61.8% level. This is a potential buy signal. Read more about how to trade with Fibonacci retracements.
Relative strength index (RSI) for momentum
The relative strength index measures where the price lies in terms of its 14-period price range. When the RSI is above 70%, the price is in the upper realm of where it has traded in the last 14 periods. When it is below 30%, the price is in the lower realm of where it has traded in the last 14 periods.
Traders often wait for the price to move out of these areas during trends to help confirm trades. During an uptrend, traders will look to buy when the RSI moves below 30 and rallies above. During a downtrend, traders will look to short when the RSI moves above 70 and drops below. Other price action signals are typically used to confirm these signals.
Let us take a look at the same crude oil chart as above, but this time an RSI is additional. The RSI dropped below 30 and then rallied back above, simultaneously while the price action and the Fibonacci retracement also signalled an entry.
Stochastic oscillator for identifying trend reversals
A stochastic can be employed to help spot turning points and confirm to price action signals. It is utilized in a similar manner as the RSI. There are two lines on the stochastic indicator: the stochastic and the signal line. The signal line is a moving average of the stochastic, so it moves more slowly.
A trader who is interested in trading a price action signal can closely watch for the stochastic to move through the signal line. If planning for a long trade, they must wait for the price action signal and for the stochastic to move above the signal line. The stochastic offers similar information as the RSI on the crude oil chart.
Price action trading indicators - a word of caution
Indicators might aid or help price action signals, but usually, the price action signal will come first. Awaiting confirmation from these lagging indicators might mean entering a trade later and missing out on profit, therefore, confirmation comes at a cost. Timing is important.
Price action trading system
You can gain more knowledge in price action via our Trading Smart Series, where all the above technical indicators are available. You can leverage our technical tools, comprising drawing and price projection tools, and our customizable charts on the platform.
You can learn more to develop these price analysis skills by registering for a free demo account and trading with virtual funds, and when you are ready, you can switch it to a live account to trade with real funds.
It is prudent to focus on one strategy at a time and aim to learn it inside out.
Is price action trading profitable?
The price of any asset classes is one of the deciding indicators of success — after all, price movements within the financial markets result in profits or losses. Traders who emphasize solely on the price of an asset to make the trading decisions are leveraging a “price action” strategy, which forms an important part of technical analysis.
Profitability, like any trading strategy or tool, is dependent on how it is employed. It has been witnessed by many successful investors and traders that price action trading can be profitable.
However, traders that consider focussing on price charts solely and not fundamental factors, including crucial financial announcements and economic indicators, might miss key events that significantly influence the price of the concerned security.
All profits and losses in trading are based on price. Price action traders focus on historical and current patterns in a bid to rake in profits as per the prices may head next.
Although there have been many profitable price action traders, but it takes time to learn price action strategies, and spot trends, patterns, and reversals.
Disclaimer: Past performance is not a reliable indicator of future results.
The material (whether or not it states any opinions) is for general information purposes only and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Century Financial or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
Century Financial does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and Century Financial shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.