An Introduction to Price Action Trading Strategies

Price action describes the characteristics of a security’s price movements. This movement is often analyzed with respect to price changes in the recent past. In simple terms, price action trading is a technique that allows a trader to read the market and make subjective trading decisions based on recent and actual price movements, rather than relying solely on technical indicators.

Since it ignores the fundamental analysis factors and focuses more on recent and past price movement, price action trading strategy depends on technical analysis tools.

Tools Used for Price Action Trading

Since price action trading relates to recent historical data and past price movements, all technical indicators, such as charts, trend lines, price bands, high and low swings, technical levels (of support, resistance and consolidation), and so on are taken into account as per the trader’s choice and strategy fit.

The tools and patterns observed by the trader can be simple price bars, price bands, break-outs, and trend lines, or they may be complex combinations involving candlesticks, volatility, and channels.

The price action trader's psychological and behavioral interpretations, and their subsequent actions, also make up an important aspect of price action trades.

For example, suppose a trader has personally set a level of 600 for a stock. If a stock that has been hovering near 580 crosses the set level of 600, then the trader assumes a further upward move and takes a long position.

Other traders may have an opposite view—once the stock hits 600, they assume a price reversal and hence take a short position.

No two traders will interpret a particular price action in the same way. Each trader has their own interpretation, self-defined rules, and understanding of behavior. Contrast that with a technical analysis scenario which will yield similar behavior and action from multiple traders, such as a stock with a 15-day moving average (DMA) crossing over 50 DMA, resulting in traders taking a long position.

In essence, price action trading is a systematic trading strategy, aided by technical analysis tools and recent price history, where traders are free to make their own decisions within a given scenario. Price action traders take trading positions according to their subjective analysis, behavioral assumptions, and psychological state.

Who Uses Price Action Trading?

Since price action trading is an approach to price predictions and speculation, it is used by retail traders, speculators, arbitrageurs and even trading firms that employ traders. Price action trading can be used with a wide range of securities, including equities, bonds, forex, commodities, and derivatives.

Price Action Trading Steps

Most experienced traders following price action trading keep multiple options for recognizing trading patterns, entry and exit levels, stop-losses, and related observations. Having just one strategy for a stock may not offer sufficient trading opportunities. Most trades involve a two-step process:

1. Identifying a scenario: Traders identify a scenario, such as a stock price entering a bull phase or a bear phase.
2. Identifying trading opportunities within the scenario: For example, once a stock is in a bull run, is it likely to either overshoot or retreat. Guessing which path the stock price will take is a subjective choice that will vary from one trader to the other, even given the same identical scenario.

Here are a few examples. Suppose a stock reaches its high (in the trader’s view) and then retreats to a slightly lower level. With this scenario met, the trader can then decide whether they think the stock will form a double top to go higher, or whether it will drop further following a mean reversion.

The trader sets a floor and ceiling for a particular stock price based on the assumption of low volatility and no breakouts. If the stock price lies in this range, a scenario is met. The trader can take positions assuming the set floor and ceiling will act as support and resistance levels, or they can take an alternate view that the stock will break out in either direction.

When a defined breakout scenario is met, trading opportunity exists in terms of breakout continuation (going further in the same direction) or breakout pull-back (returning to the past level).

Price action trading is closely assisted by technical analysis tools, but the final trading call is dependent on the individual trader. This offers flexibility instead of enforcing a strict set of rules to be followed.

The Popularity of Price Action Trading

Price action trading is better suited for short- to medium-term, limited-profit trades instead of long-term investments.

Most traders believe that the market follows a random pattern and that there is no clear, systematic way to define a strategy that will always work. By combining technical analysis tools with recent price history to identify trade opportunities based on the trader’s own interpretation, price action trading has gained a lot of support in the trading community.

Advantages of price action trading include:

• Flexibility
• Applicability to multiple asset classes
• Easy use with any trading software, applications, and trading portals
• The possibility of easy backtesting of any identified strategy on past data

Most importantly, the trader feels in charge, as the strategy allows them to decide on their actions instead of blindly following a set of rules.

The Bottom Line

A lot of theories and strategies are available on price action trading, many of which claim high success rates. However, traders should be aware of survivorship bias, as only success stories make news. Although price action trading does have the potential for making handsome profits, it is up to the individual trader to clearly understand, test, select, decide, and act on what meets their requirements for the best possible profit opportunities.