What is Price Action?
Okay, to begin with, what is price action? Price action is a particular methodology employed by traders, based on the observation and interpretation of price action, usually through the use of candlestick or bar charts. The price action style of trading is usually characterized by clean charts, without indicators, with the explanation that indicators are themselves interpretations of the historical movements of price, which don’t contain any information or predictive power that isn’t available from the charts themselves. Nonetheless, some traders include basic indicators, such as exponential moving averages or average true range to augment their charts or to provide confluence. The attitude of the price action trader is that the interpretation of price movements can provide an edge, a possibility of being more right than wrong in their predictions about the future behavior of price. This edge is possible from making trades that are informed by the observation of key price levels (demarcated as support and resistance lines), the recognition of common, reliable price action patterns, the use of trading orders with built-in stop loss levels, and a systematic trading strategy.
The basics of reading candles and charts:
Since candlestick and bar charts are the fundamental interface of the price action trader, the most basic unit is the candle or bar itself. Candles sum up the price action over a set period of time: on a 5 minute chart, each candle represents 5 minutes of price behavior, whereas on a daily chart, only one candle is produced per day. The body of the candle constitutes the range between the open price and close price, whereas the wicks or shadows of the candle indicate the high and low over that period of trading. Various color schemes are used to determine whether the price movement represented by the candle is bullish (increasing in price) or bearish (decreasing in price); bullish candles are usually white, blue, or green, whereas bearish candles are usually black or red.
Longer candle bodies demonstrate strong momentum and decisive market behavior in the movement from open to close; longer shadows, however, demonstrate increased volatility, since some prices were reached during the time period but ultimately excluded from the range between open and close.
Smaller candles can indicate the market’s indecision, disinterest, or a balance between bullish and bearish forces
Similarly, a candle that is almost all wick implies that, regardless of the range of prices occurring in the time period, the open and close were extremely close; these candles are referred to by the Japanese term, doji
A doji or small candle with a very long wick in one direction is referred to as a pin bar, which is often interpreted as a sign of potential trend reversal
By contrast, a marabuzo candle has a large body, and almost no wick, implying that price action has been more definitive
There are two important, rudimentary patterns that play out over at least 2 candlesticks:
An outside bar is a bar with a higher high and a lower low than the previous candlestick, often with a body that also encompasses the price range of the previous bar’s body; an alternative variation is the engulfing bar, which simply has a higher open and a higher close, regardless of the candle’s shadows or wicks.
By contrast, an inside bar is a bar, or series of bars, with a high and low encompassed by the preceding candle; in this case, the variation is the harami, a bar or series of bars with an open and close within the range of the bar preceding it
Basic Terms for Price Behavior:
Trend: 2 successively higher tops and bottoms (uptrend) / 2 successively lower tops and bottoms (downtrend)
Other names for a positive trend: run up/bull run/rally
Other names for a negative trend: run down/bear run/decline
Trading range: the market moves up and down within a consistent range without establishing a definitive trend in one direction
Consolidation: the range of price’s movement constricts as the market becomes directionless
Reversal: the market moves in the opposite direction from the previous trend, implying the end of that trend
Retrace: the market moves some amount in the opposite direction from the previous trend before the trend is eventually reinstated
2 Attempts Rule: the idea that if the market attempts to do something twice and fails, the opposite will happen
Support and Resistance
In a trading range, or even within a trend, price action frequently seems influenced by or adherent to levels that have previously been significant turning points in its history; on the price action trader’s charts, these levels are marked as lines offering potential support and resistance to future price action; lines drawn above the current price constitute resistance, while lines drawn below it are support. If either of these levels are broken, the function of the line is reversed, so, for example, if price breaks through a resistance line, that line can now be understood as a support line to future price action.
Support and resistance lines are typically horizontal, but when they are diagonal along a trend they are known as trend lines.
As an example (see video), I marked some significant support and resistance levels on this chart of the euro US dollar pair. This lowest level at about 1.34 is established as the point where the initial trend in mid September is arrested and turns briefly bearish. After the first bullish bear tops out at this level, the two bearish bars thereafter max out as though they are experiencing resistance from the same level before a break-through on September 16th. At this point, the resistance becomes support, and we can see that two months later, in mid November, this support level is tested and holds, as price rises back up for the rest of the month. If you recall the two-attempt rule that I explained, we can see that in action with this highest resistance level at about 1.383. We would draw this line in because it represents the height of the bullish trend extending from the beginning of this chart to late October. We can see that price returns close to this level in the next trend peak in mid December, and then finally tests it with the wick of this candle at the end of the month. Since the level is reached, but price fails to definitively break through, we can expect a reversal based on the two-attempt rule, and that’s exactly what we’ve seen since the end of December.
So, the basic idea behind using support and resistance effectively in a trading range is to buy at the support level and sell at resistance in an uptrend, or to sell at resistance and buy at support in a downtrend; so, we’re not necessarily hoping for a break-out through the established levels, because a break-out means that the market isn’t behaving predictably enough to allow for safe bets on its future performance. Instead, the most conservative or reliable trades are those that occur as the market fluctuates between identifiable support and resistance levels, allowing you, in an uptrend, to buy when a retracement of bearish leg has brought prices down to a support level, and then sell when price returns to the resistance level, or, in a downtrend, to sell when price is maxed out at a reliable resistance level. The reason we are looking to buy in an uptrend and sell in a downtrend is that price action trading is all about playing the odds, so trading with the trend rather than against it is usually a better idea since a trend is statistically more likely to continue than to reverse
So, before we move on to some basic set-ups and stop placement, here are a few more important terms now that we have a sense of support and resistance.
Break-out: the market breaks out of a trading range or a resistance level
Clear-out: the market’s break-out in one direction is quickly followed by its movement in the opposite direction
Throwback: retracement after a break above
Pullback: retracement after a break below
Basic Set-ups and Stop Placement
Most price action traders place buy or sell stop orders with a pre-determined stop loss level, and a take profit or target level. The buy or sell stop sets the level that price much reach for the order to be filled; the stop loss level sets the margin of loss that a trader will accept before closing the position; the take profit level sets the level at which to automatically close a successful position.
Basically, you determine risk based on where you are placing your stop, and then determine your target with regard to this risk level; commonly, traders will aim for at least a 1:3 risk to reward ratio, although scalpers and those who trade on shorter time frames often have to accept smaller ratios.
The buy or sell stop, or entry level, is typically set at a significant support or resistance level so that it will only be filled when price has broken definitively in the desired direction; by setting strategic entry levels in their orders, traders can ensure that they enter trades with the momentum of the market.
Perhaps the most basic set-up is the pinbar, which, if you remember has an open and close within the previous bar, and a wick at least 3 times the length of the candle body, protruding beyond the levels of prior bars.
The long wick and short body implies that traders have made a strong attempt to push price in one direction, but price has returned to earlier levels, often indicating the possibility of a reversal in trend direction.
The basic way to trade a pinbar is to place the stop loss level at the extreme of the wick, and to place your entry level above the body in a bullish scenario, and below the body in a bearish scenario. the target is set relative to the risk level represented by the stop loss, often at a resistance level in a bullish scenario, or at a support level in a bearish scenario.
Another basic strategy is the inside bar, a bar or series of bars contained by the preceding bar; since the shrinking candle size implies consolidation, it can mean that a big move is on the way, either a strong continuation of the current trend, or a reversal. Because the price direction is uncertain, traders often place a orders on both sides of the inside bar, so that a downward movement will trigger a sell, and an upward movement will trigger a buy. A liberal entry point would be set just beyond the high or low of the inside bar; a more conservative entry point would be at the open or close of the preceding mother bar.
Inside bars are more effective to trade on larger time frame charts because they are so common on faster charts.