The characteristics of a security’s price movements are described by price action. This movement is frequently examined in light of recent price fluctuations. Price action, to put it simply, is a trading strategy 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.
Because it ignores fundamental analysis factors and focuses more on recent and past price movement, the price action trading strategy is reliant on technical analysis tools.
What tools are used for price action trading?
Because price action trading is based on recent historical data and price movements, all technical analysis tools, such as charts, trend lines, price bands, high and low swings, technical levels (of support, resistance, and consolidation), and so on, are used according to the trader’s preference and strategy fit.
Simple price bars, price bands, break-outs, trend-lines, or complex combinations involving candlesticks, volatility, channels, and other patterns can be observed by the trader.
Price action trades also include psychological and behavioral interpretations and subsequent actions as determined by the trader. For example, if a stock hovering at 580 crosses the psychological level of 600 set by the trader, the trader may assume a further upward move and enter a long position. Others, on the other hand, may hold the opposite viewpoint: once 600 is reached, he or she assumes a price reversal and, as a result, enters a short position.
No two traders will interpret the same price action in the same way because they each have their own interpretation, set of rules, and behavioral understanding of it. A technical analysis scenario (such as the 15 DMA crossing the 50 DMA) will, on the other hand, result in similar behavior and action (long position) from multiple traders.
In essence, price action trading is a systematic trading practice that uses technical analysis tools and recent price history to allow traders to make their own trading decisions within a given scenario, based on their subjective, behavioral, and psychological state.
Who uses price action trading?
Retail traders, speculators, arbitrageurs, and even trading firms that employ traders use price action trading because it is a method of price prediction and speculation. It can be used on a variety of assets, including stocks, bonds, forex, commodities, and derivatives.
Steps used in price action trading:
Most experienced price action traders keep a variety of options for identifying trading patterns, entry and exit levels, stop-losses, and other observations. Having a single strategy for one (or several) stocks may not provide enough trading opportunities. A two-step process is used in the majority of scenarios:
1) Choosing a scenario: For example, a stock price entering a bull/bear phase, a channel range, a breakout, and so on.
2) Identifying trading opportunities within the scenario: Is a stock likely to (a) overshoot or (b) retreat once it is in a bull run? Even in the same identical scenario, this is a completely subjective choice that can differ from one trader to the next.
Listed below are a few examples:
1) A stock, in the opinion of the trader, reaches its high and then retreats to a slightly lower level (scenario met). The trader can then decide whether he or she believes it will form a double top and rise further, or whether it will fall further due to mean reversion.
2) Based on the assumption of low volatility and no breakouts, the trader establishes a floor and ceiling for a particular stock price. If the stock price is within this range (scenario met), the trader can either take positions assuming the set floor/ceiling levels will act as support/resistance levels, or take the alternative view that the stock will breakout in either direction.
3) When a defined breakout scenario is met, there is a trading opportunity in terms of breakout continuation (moving in the same direction) or breakout pull-back (returning to the past level)
As can be seen, technical analysis tools aid price action trading, but the final trading decision is left to the individual trader, giving him or her flexibility rather than enforcing a strict set of rules to follow.
The popularity of price action trading
Instead of long-term investments, price action trading is better suited for short-to-medium-term limited profit trades.
The majority of traders believe the market follows a random pattern and that there is no clear systematic way to define a strategy which will always work. By incorporating the technical analysis tools with the recent price history to recognise trade opportunities based on the trader’s own interpretation, price action trading has a great deal of support in the trading community.
Self-defined strategies provide traders with flexibility, are applicable to multiple asset classes, are simple to use with any trading software, applications, or trading portals, and allow for easy backtesting of any identified strategy on historical data. Most importantly, the traders feel in control because the strategy allows them to choose their own actions rather than being forced to follow a set of rules.
Price action trading has a plethora of theories and strategies that claim high success rates, but traders should be aware of survivorship bias, as only positive stories make the news. Trading has the potential to generate substantial profits. Individual traders are responsible for clearly understanding, testing, selecting, deciding, and acting on what meets their needs for the best possible profit opportunities.