Price action trading is a method of trading where traders are more focused on price movements, rather than indicators derived from technical analysis, to make trading decisions. Price action traders think that everything they need to know about any particular market is displayed in the price. As a result, they analyze how the price moves across a certain period of time and try to find potential entry and exit points to take advantage of further price movements.
Most adepts of price action trading ignore fundamental factors of an asset and don’t use technical indicators such as moving averages and Relative Strength Index (RSI). Quite often, they use “clear” charts with no indicators to “not cloud” the price action analysis. In some cases, price action traders still use indicators, but they typically give them very little weight in the trading decision process.
The Idea Behind Price Action Trading
Although price action is often included under the umbrella of technical analysis, it can be also incorporated into behavioral analysis. Many price action traders believe that prices are determined by people’s psychology.
For example, from the price action traders’ perspective, the fundamental factors can be limited to how much impact they have on people’s perception of the asset. If the news can’t change people’s perception, then people may not “react” to this news, and as a result, prices may not change significantly. Because of that, price action traders don’t typically analyze how fundamental factors may affect the asset itself, but rather want to understand how people feel about these factors.
In addition, price action trading relies significantly on the so-called three premises of technical analysis, which are also predominantly based on human psychology and include the following statements.
Market action discounts anything
For price action traders, market action equals price action. This means that they believe that anything that can affect the price — fundamentally, psychologically, or otherwise — is actually reflected in the market price. Such a statement is based on an efficient market hypothesis which claims that any changes in market sentiment are rapidly included in prices.
Prices move in trends
People’s perception of an asset may lead to multiple conclusions, and the price may change depending on what intersubjective narrative dominates the market. But people’s perceptions may not change drastically, allowing price movement to form a trend. Technicians believe that a trend is more likely to continue by inertia than reverse, if there is no force to change the market’s sentiment. This corollary is an adaptation of Newton’s first law of motion.
History repeats itself
This premise claims that human psychology tends not to change, meaning people may act the same way in similar situations. Similar situations mean patterns that have worked well in the past are assumed to continue to work well in the future. Thus, price action traders try to identify chart patterns to anticipate the direction the price may move. In addition, such a statement can convince price action traders that the key to understanding the future price lies in the study of past performance.
Price Action Trading Instruments
First of all, it is important to keep in mind that price action trading is a quite subjective endeavor. Each trader can interpret price movement differently and form their own strategy based on this perception. If you think that you spot a certain pattern or “important level” and plan to trade accordingly, then that doesn’t mean that other traders also see it and will do the same actions.
This means patterns can be self-replicating. The more traders believe in the formation of a certain pattern, the higher the possibility that traders may act following this pattern or make counter-trend actions.
Despite the different perceptions of price movement, the main instruments for price action analysis remain the same.
Candlesticks
Candlesticks are graphic representations of price actions on a chart. Traders analyze their size, shape, and position, trying to understand what may lead to their formation. Quite often, traders analyze them in combinations to spot potential patterns that may hint at further price movement and trade accordingly. Let’s take a look at the following example.
Looking at the chart above, some price action traders may spot candlestick patterns such as Shooting Star (1), Hammer (2), and Three Inside Down (3), that indicate potential trend reversal. Once they spot these patterns, they may open positions in the opposite direction to take advantage of anticipated price reversal.
However, the formation of the candlestick patterns does not guarantee that they will confirm or work out as the trader anticipated. Instead of remembering how the candlestick pattern looks, try to understand the potential reasons for its formation. For example, long tails in a Shooting Star and a Hammer formation may indicate that the price reached levels with higher pressure from bears and bulls respectively.
Trends
An asset can continue to follow the trend, moving up and down. Price action traders try to spot moments when the trend can potentially begin and end, to “ride on it” until it shows signs of reversing. One of the potential signs of a trend reversal can be volume, which can be used to analyze price momentum.
Support and Resistance
Support and resistance areas occur where the price has tended to reverse in the past. But prices do not act as support and resistance alone. The structure and path taken to reach certain levels form support and resistance. After a breakout, support levels tend to become resistance levels, and vice versa. In the example below, the level first acted as support (1) and then as resistance (2, 3).
In some cases, support and resistance can be found near “psychological levels”. These levels often end in .00 and other locations where traders like to place orders. Psychological levels are purely the result of human behavior as they interpret these levels to be important.
Breakout
The breakout of support/resistance/psychological levels may push some traders to make trading decisions. In addition, a breakout may confirm the formation of certain patterns, including triangles, double bottom, and flags.
A breakout can become an alert for traders that bulls or bears have accumulated enough momentum to move the price forward. Traders may enter the market after a breakout, anticipating that momentum will maintain for a certain period of time. However, it often doesn’t, and the price may quickly return to previous levels.
For example, the first possible option shows that the price retraced in the opposite direction after the breakout. Such a breakout pull-back may happen to test whether it’s a valid or false breakout. Since bulls managed to sustain the price above the breakout point, it helped them increase pressure on the market and bounce off the support level.
In the second possible option, bears pushed the price below the support level and had enough momentum to make a breakout without a pull-back.
Benefits and Drawbacks of Price Action Trading
Price action is considered to be one of the most popular methods of trading and here are some benefits that explain why:
- Less research time is needed. Price action instruments and strategies are often used by intraday traders. When you have a high frequency of trades, you have less time for comprehensive analysis. Mastering price action analysis can help traders make trading decisions with minimum inputs.
- Flexible strategies. Basing trading decisions on price action allows traders to trade in real time, in consonance with market movements. It helps them quickly adapt strategy when market sentiment changes.
- Minimizing analysis paralysis. Signals produced by price action instruments can be quite easy to detect. Clear charts may help them avoid analysis paralysis, when traders overuse indicators, confuse themselves, and make uncertain decisions.
However, like any other trading strategy, price action trading has certain drawbacks and may not suit all traders:
- Requires significant focus and patience. Being a price action trader means waiting until the price comes to a certain level to enter the trade. Furthermore, patterns often need confirmation to become valid signals, meaning traders need to be patient to avoid hasty trading decisions. While waiting for an asset to reach certain levels, traders may miss other potential trading opportunities.
- Can be difficult to automate. Since price action traders barely use indicators and other dynamic methods to identify major levels, they may face issues with automating their strategies.
- Subjective way of analysis. Looking at the price chart, every trader makes different conclusions about current market conditions. Without enough experience, price action traders can make a lot of mistakes or have a poor base for trading decisions.
Closing thoughts
Price action trading empowers traders to potentially take advantage of price movements just by looking at the price chart. It may save time to make trading decisions and help them quickly respond to changes in the market. But when focusing only on price charts, traders may miss key fundamental events that may have a major impact on the price of the asset.
Price action analysis is often considered a subjective rationalization of current market movements. Because of that, it may quickly become wrong and requires traders to reassess their inputs from time to time. If you want to start trading based on price action, keep in mind that such an approach relies heavily on the trader’s experience and ability to read price movements, despite the relative simplicity of price action instruments.
Disclaimer: For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
