Price Action Trading

April 12, 2013 03:46 AM

Essentially, price action trading is based on the concept of behavioral analysis – the idea that since markets are made up of human participants, the price alone should be considered the most important indicator of market movement. As such, price action traders make trading decisions based on price alone and therefore ignore other factors such as fundamentals or lagging technical indicators like moving averages.  The concept is often referred to among floor traders as ‘reading the tape’ and is one of the oldest and most popular methods around for analyzing markets.

A price action trader will often base trading decisions on certain patterns that they will have applied to the market and will often use volume to support the analysis. The most important price action patterns are shown here:

Trend lines

Trend lines are possibly the first thing a price action trader will look at when analyzing a market since they clearly show where the market has been in the past and is likely to go in the future. In theory, a trend line can be drawn to connect any two points however to be of any worth trend lines usually need to connect at least two historical lows or highs. Once in place, trend lines show clear support and resistance levels in a market and once broken, they signal a change in direction for the security.

Since they are drawn by hand, trend lines can be subjective to the trader. Nevertheless, they do provide the building blocks of trading by price alone.

Example: Trend lines should be drawn to connect a low (or high) and at least one other higher low (or lower high). The trend line here shows strong support, a break of the line would be bearish.

Price action traders often rely on important levels of support and resistance in the market with which to base their trading decisions. Typically, strong levels of support and resistance come from calculations made from a security’s price history, (for example pivot points or Camarilla levels), strong levels in the market, such as yesterday’s high or the previous month’s low, or even significant ‘double 00’ levels such as 1500 or 1.30.

Once a trader knows the key levels of support and resistance in the market, she can use the levels as entry points, take profit levels or stop loss levels depending on the overall direction of the market.

Pin bars

Most price action traders will use what are known as candlestick charts since they convey the most amount of information about a market’s recent movements. Candlesticks show the open, high, close and low of a market and therefore can give traders some clue as to the likely direction of a market. Pin bars for example, occur when a market moves in one direction, but then rejects the move and moves back strongly in the opposite direction. They are therefore very similar to a ‘doji’ or ‘hanging man’ candlestick and often indicate a possible reversal.

Break-outs

A break-out occurs when the price of a security moves beyond predetermined support or resistance levels and usually indicates a strong bullish or bearish move in the respective direction. Often, the breakout will occur after a period of consolidation in the market or when a security trades within a relatively clear trading range or channel. Price action traders will also be aware of break-out pull backs, where the market often retraces a certain amount after a break-out occurs, and break-out failures, which can often occur when the break-out is not supported by large volume.

Reversals

Reversal patterns are a common feature of markets and typically occur when a market has moved in a direction for such an amount of time that the move has become exhausted and threatens to move back in the opposite direction sharply. They differ from mere retracements by the fact that they last longer and offer more potential to profit. They also come in many forms. Head and shoulders patterns, double tops, double bottoms and rising and falling wedges are all examples of reversal patterns.

Example: The 5 min chart below shows an example of a possible double top formation. A trader would only go short if the market moved back below the neck line.

Bilateral triangles

Bilateral patterns are often identified by triangle patterns that fit over the chart and indicate that a period of consolidation for the market is likely coming to an end. The triangles can be ascending, descending or symmetrical, however, the common feature is that they are usually coming together to form a converging apex point. At some point the market will need to break either to the up-side or down-side and when it does, it’s a strong signal that the market has found its next long term direction.

Example: The chart below shows two converging trend lines to form an apex point. The break of this upper line shows a strong signal to go long.

Gaps

Many price action traders perceive ‘gaps’ in the market as important indicators of market strength or weakness. Indeed, gaps are usually the result of lots of traders moving to just one side of the trade and therefore indicate a major turn in market sentiment, especially when accompanied by high volume. They nearly always offer strong clues to the next direction of the market.

Volume

Most price action traders will make volume a key consideration when analyzing a market on price alone, since it is volume that determines whether a move is simply a technical reaction or is actually supported by a large number of market participants. It’s for this reason that traders will often talk about the market, ‘spiking up’ on ‘heavy’ volume.

Volume, essentially describes the number of financial transactions that change hands on a given day, so it goes without saying that if a lot of people come together to trade at one time and the result is a clear bullish or bearish move, it’s a clear signal to trade in the same direction. As every trader knows, trading against the crowd can be a very dangerous strategy. In reality, many traders will combine price action analysis with other methods.


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