What is price action?
March 4, 2021 2021-06-05 13:18What is price action?
As its name suggests, price action trading is quite literally the process of trading according to the ‘action’ of the price. But what does this process involve exactly?
Price action refers to the various ‘moves’, ‘changes’ and ‘shifts’ in price over different time frames. It’s a process where you can identify how these changes in price build into trends, or differing price patterns (with continuation or reversal patterns).
Based on this, you’d then trade with the relevant price action.
How does price action trading work?
Price action trading works by first deciding on the time frame you want to use in your technical analysis. You might opt for day trading (see our lesson on day trading), or position trading, swing trading or scalping. It just depends on your preference but price action analysis can be incorporated into each one. Our trading strategies blog also covers a number of useful points for you to consider. <<insert links to relevant lessons>>
Basically, price action trading works by:
- Identifying the dominant price action in your time frame
- Pinpointing the trend or the pattern that’s currently most dominant on that time frame
- Trading in the direction dictated by the trend or the price pattern signal
Once you’ve decided on your trading time frame, it’s time for you to identify which price action trading strategy (or strategies) you’re going to follow.
We’ll look at some of the more popular strategies below.
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Price action trading is important as it’s a fairly easy introduction to trading a strategy. By using fairly simple trend, continuation and reversal rules, in turn, it’s possible to follow some simple rules that you can build into your trading plan.
By refining these rules, you can hopefully build and develop a more significant and profitable trading strategy.
Price action is a primary indicator when it comes to technical analysis and so if you’re just starting out then understanding how it works is definitely important to your education. Below are two bullet points that you should always come back to when you execute your strategy and ensure you’re following.
- Primary indicators to create your view
- Secondary indicators to confirm your view
What are the best price action trading strategies?
There are many types of price action strategy for you to consider, but we’re going to concentrate on some of the more popular. These include:
- Hammer trading strategy
- Shooting star trading strategy
- Inside bar trading strategy
- Forex price action scalping strategy
- False breakout trading strategy
- Pin bar trading strategy
Hammer trading strategy
The Hammer trading strategy is based on a Japanese candlestick pattern. You’d recognise this as a bullish signal that concludes a very short-term downtrend. It can be used in any time frame.
Once the signal is produced, you’d anticipate higher prices — for the next 2–3 candlestick bars at least.
As you can see in the image above, the market is in a downward trend. The Hammer candlestick pattern is produced in a downtrend with a small body and long lower shadow (or tail). You’ll see the body at the very upper end of the candlestick pattern.
On the next candlestick, if the price moves above the high of the Hammer candlestick, this sends a positive buy signal. You’d then enter a long position.
Following this, you’d look to set the stop-loss below the low of the Hammer candlestick.
We’d suggest looking for at least a 2:1 reward-to-risk ratio (so, you’d set your target to make twice the profit as the potential loss).
Ideally you would combine this with another strategy to identify the best target zone to take your profit.
Shooting star trading strategy
The Shooting Star trading strategy is basically the inverse of the Hammer trading strategy. It’s a Japanese candlestick pattern that you’d see as a bearish signal to conclude a very short-term uptrend.
The Shooting Star trading strategy can be applied to any time frame. After the signal is generated, the expectation would be for lower prices for the next 2–3 candlesticks at least.
As you’ll see in the image, the market here is in an up-trend. The Shooting Star candlestick pattern is formed in an up-trend such as this with a small body and long upper wick, or shadow. You’ll notice that the body is at the lower part of the candlestick pattern.
If, on the next candlestick, the price moves below the low of the Shooting Star candlestick, this produces a negative sell signal and you’d then enter a short position. The stop would be placed above the high of the Shooting Star candlestick.
Again, we’d suggest aiming for at least a 2:1 reward-to-risk ratio (you’d place your take-profit target so as to make double the profit as the possible loss).
Using timeframes for shooting star and hammer strategies
A great example of how to utilise these strategies are when you use different time frames. If you see either candlestick formation on a daily chart and you get a buy or sell signal by the next candle taking out either the low or the high.
You can then drill down into a smaller time frame, an hourly for instance, and look for the same set up (hammer or shooting star) in the direction of the daily chart.
If you get that signal, you’ll be able to use a tighter stop loss and have a larger target. Use the stop loss of the hourly time frame and the target of the daily.
Pin bar trading strategy
The Pin Bar trading strategy is very similar to the Hammer and Shooting Star trading strategies above. In fact, Hammer and Shooting Star candlestick patterns are both examples of Pin Bars.
By using a Pin Bar trading strategy, you’d use similar tactics as you would for the Hammer and Shooting Star trading strategies, but with some refinements.
You might look to enter trades, not just on a break above or below the highs or lows of the Hammer and Shooting Star candlestick patterns. You could also look to enter trades on retracements back into the pin bars.
Examples of this would be:
- To sell on a rebound to the Shooting Star-type Pin Bar. This would be at the 50% retracement of the top to the bottom of the range of the Shooting Star type Pin Bar
- To buy on a setback on the Hammer-type Pin Bar at the 50% retracement of the top to the bottom of the range of the Pin Bar
And in the same vain as the previous strategies, you can use different timeframes to help boost your risk to reward ratio (where you place your stop loss versus where you place your target).
Inside bar trading strategy
The Inside Bar trading strategy is best used on daily chart time frames.
An Inside Bar is simply a bar or candlestick that’s contained within the prior bar. So, for a daily chart, this would mean that the trading day was confined by the previous session’s trading range. This is a reflection of consolidation and indecision.
At its most basic, the Inside Bar trading strategy would involve you:
- Buying or selling a breakout from the bar preceding the inside pattern range
- Placing a stop above the peak preceding bar range, if the breakout is lower
- Placing a stop below the low of the preceding bar range, if the breakout is higher
Again, we’d suggest aiming for at least a 2:1 reward to risk ratio. So place your take-profit target to achieve twice the profit as the possible loss.
A development of this strategy would be to only take breakouts in the direction of the prevailing trend. This would mean that if there was a current downtrend, you’d only go short on a bearish breakout, not on a bullish break. Similarly, if the trend was higher, you’d only take the long trades on a bullish breakout.
Forex price action scalping strategy
We’ve already looked at a number of scalping trading strategies in our previous lesson ‘What is Scalping?’. However, forex price action scalping is mainly a way of looking for trend continuation patterns on very short time frames (1–5 minute charts).
As a forex trading scalper, you’d look to follow these steps:
- Identify the very short-term trend —defined by Dow Theory, trend lines or very short-term moving averages
- When the price action goes into a consolidation mode, or a pause in the trend, look for a continuation pattern. This pattern would come in the form of a flag, triangle or pennant
- Look to trade on a breakout from the pattern, in the direction of the prior, underlying, very short-term trend
False breakout trading strategy
A false breakout trading strategy is when the market signals a breakout from a price pattern or a reversal of a trend. It then rejects this breakout or reversal, by reversing the signal.
As this is a ‘fake’ breakout, these are sometimes referred to as ‘fakeouts’ or ‘fake breaks’. You can see more on these in our lesson ‘What Are Trend Lines and Breakouts In Trading?’.
Trading with breakouts can be profitable, but it’s worth being aware that, sometimes, the breakout is not sustained. In this case, the price reverts back to the original trend or the original range. This gives you an opportunity if you’re a false breakout trader, or you have it in your strategy armoury.
When using a false breakout trading strategy, you’d use a filter to identify if a breakout had been confirmed and would be sustainable. This would be a price or time filter, or a combination of the two.
Then, if the price action doesn’t confirm the breakout, you’d then take the opposing view and enter a position in the opposite direction of the initial breakout.
An example might be if on a 15 minute timeframe, you see a bullish candle close above a resistance line. The next candle immediately reverses and you have the exact same size candle next to the breakout but in the wrong colour, red. On a 30 minute timeframe, this would look like a shooting star type of candle and it’d be the price actions telling you that it’s a ‘fake break’.
Watching price action
The above strategies are a great entry into using price action but there is another element to price action and it’s really watching the price move.
This is very subjective and discretionary and we wouldn’t recommend beginners look into this but experienced traders will be able to notice changes in the fluctuations of price.
Depending on the volatility, you’ll see the price move quickly and slowly. This can give you an indication about the selling or buying pressure of the market.
- Short sharp movements. For instance, if the price goes down 2 pips in 1 second but then goes back to the original price in 3 seconds, you can see that the selling pressure is higher.
Price action trading summary
Price action trading works by identifying the current trends and potential patterns in stocks, and on any given time frame. By using fairly simple trading patterns, signals and rules, you can use these to develop, test and follow a basic trading strategy.
The key takeaways from this lesson are:
- Price action trading can be a relatively easy entry into developing your first trading system
- It can be applied to many time frames, which allows you the flexibility to trade on the time frame that suits you best and fits with your lifestyle
In our next lesson ‘What is Algorithmic Trading?’, we’ll take an in-depth look at algorithmic traders and the relevant methods of trading you can use for this trading style.
