What is Price Action Trading?
It is a technique of stock trading and profiting in stock market. This is a simplistic and minimalistic approach to trading. This approach considers action of price only, that is open, high, low and close of a time period. The time period can be a minute, five minute, thirty or sixty minute, a day, week or it can be a month or a year. Some traders consider volume also for decision making, though it is optional.
Though it appears simple, it is not meant to be easy. It requires a thorough knowledge of psychology of market, its behavioral patterns, pattern formations, volume relations. This method of trading works with all types of financial instruments.
Jesse Lauriston Livermore a speculator from early 19th century made more than $100 million, by his ability of tape reading, which is nothing but making trading decisions based on action of price.
He in the book “How To Trade In Stocks” says “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.”
Price action trading is also based on technical analysis. Here the traders do not use the traditional indicators for analysis. Instead they rely purely on price action and volume. They also use chart patterns, trend lines, break outs and support and resistance. They also consider individual candlestick patterns using one bar or multiple bar for their decision.
Price action traders analyze the price action period by period (bar by bar). A running commentary goes on in the mind of the trader. Based on what is happening he speculates markets immediate next. Every bar or every candlestick gives an hint of its immediate future.
The resulting video or picture that a trader builds up will not only help to predict market direction, but also momentum, that is speed of movement, its duration and intensity. All of this is based on the trader's assessment and prediction of the actions and reactions of other market participants.
In analyzing price action following observations are considered.
Patterns created by price action occur with every bar and the trader watches for multiple patterns to coincide or occur in a particular order, creating a setup which results in a signal to buy or sell. Each individual traders can have widely varying preferences for the type of setup that they focus in their trading.
All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis.”
—Jesse Livermore, How To Trade In Stocks
Based only on price action traders will use setups to determine entries and exits for their trade. Alternatively, the trader might simply exit at a profit target or at a predetermined stop loss point.
After entering the trade, the trader needs to place a protective stop loss order to close the position with minimal loss if the trade goes wrong. The protective trailing stop order will also serve to protect the already accrued profit.
Here is an example of Price Action Trading
A trader does not take action on assumption. But he waits until the action of the price dictates him to take a particular action.
Point A: In the Soy Meal Weekly Candlestick chart above a swing high is made at 390.70. This is a resistance. Then through 2011 the price went sidewards and downwards. At the end of 2011 it started rising. I March-April 2012 the prices crossed the previous swing high.
Point B: After crossing the previous swing high, the prices made two small real bodies. It denoted indecision. The prices could not penetrate down the previous resistance turned support. Ultimately the price broke out of the small consolidation at 397.40. Here first long trade is taken with the initial stop loss order below the consolidation at 385.60.
Point C: The prices are trying to test the support in May 2012 and makes a low of 387.80. The prices breaks above the testing bar at 417.20. Here a second long trade is taken to add to the earlier position.
Point D: Finally prices breaks above the previous swing high at 436.40. Here a third long trade is taken to add to the earlier position. It is followed with the trailing stop loss orders to protect the profit.
Point E: The prices made a high of 554.40 and there is distribution going on in late July, August and first half of September 2012 with swing low of 506.50. Finally the prices broke down at 506.50 where all the three long trades are closed and a short trade initiated.
Point F: The prices falls to the support level and makes low of 394.50 in Jan 2013. When the high of the testing bar is crossed at 412.80 short trade is closed and long trade initiated. A protective stop loss order is place below the low of the previous swing low 387.80 or below 385.60.
Point G: The prices makes a swing high of 445.00 and comes down to test the support. It makes a low of 389.80 in April 2013. When the high of the testing bar is taken out a second long trade is initiated at 403.30. A protective stop loss order is place below the low of the previous swing low 387.80 or below 385.60.
Point H: When the high of the previous high is taken out at 445.00 a third long trade is added to the previous position in May 2013. It is followed with the trailing stop loss orders to protect the profit.
It goes on like this. This is one of the variety of scenarios the market will present to us.
The above chart shows the second half of the previous chart in the above example in daily bars. The change of trend is absolutely obvious. The trades can be simply taken purely on the basis of price action.