What is Price Action Trading?
Here's what price action trading is, and how to use it.
Every technical trader (those who make decisions based on price charts, as opposed to fundamentals) trades a slightly different way. Yet the thousands of different strategies that are used can typically be classified into several major categories. There are price action traders, indicator traders and traders who use both price action and indicators. There are also other types of strategies, such as seasonality, order flow or statistical strategies.
Price action trading is one of the simplest forms of trading to learn, and one of the most effective. If you are new to trading, learning price action trading is a great starting point.
What Is Price Action Trading
Price action trading is basing trading decisions on the price movements of an asset. Indicators or other methods of analysis are not used, or given very little weight in the trading decision process.
A price action trader believes that the only true source of information is the price itself. If a stock is going up, that tells the price action trader that people are buying. The trader will then assess, based on how aggressive the buying is, whether it is likely to continue. Price action traders don't typically concern themselves with "why" something is happen.
A favorable entry point is one that allows risk to be controlled, but that also offers a potential profit.
Types of Price Action Strategies
There are many price action strategies. A very common price action strategy is called a breakout. When the price of an asset has been moving with a certain tendency, when it breaks that tendency it alerts traders to a new possible trading opportunity.
For example, assume a stock is trading between $11 and $10 for the last 20 days. Finally, the price moves above $11. This is a change in tendency, and alerts traders that the sideways movement is possibly over, and that a move higher, possibly to $12 (or higher) is starting. Breakouts occur from many different types of patterns, including ranges (discussed above) triangles, head and shoulders and flag patterns.
A breakout doesn't mean the price will continue in the anticipated direction, often it doesn't. This is called a false breakout, and also presents a trading opportunity in the opposite direction of the breakout (see Day Trading False Breakouts).
Breakouts can be small or large. Watching for small consolidations (short periods where the price moves sideways) breakouts during a trend can provide excellent profit potential, as discussed in How to Day Trade Stocks in Two Hours or Less.
There are also price action strategies based on how price bars form on a particular type of chart. For example, when using candlestick charts there candlestick strategies, such as the Engulfing Candle Trend Strategy.
Related to all the above, traders use support and resistance regions that could provide good trading opportunities.
Support and resistance are areas where the price has tended reverse in the past. Such levels may once again be relevant in the future.
Benefits and Drawbacks of Price Action Trading
Once you know a price action strategy there is little research time required. You find an asset with the specific price conditions you need, or you wait for those conditions to develop. Another benefit is that you often get more favorable entries and exits compared to many indicator based methods. The reason is that indicators are based on price, but lag behind it. By simply focusing on price you get the information in real-time, instead of waiting for a lagging indicator to give you information.
A drawback is that price action strategies are typically hard to automate. That means you'll need to sit and watch for patterns to develop and manually trade them yourself.
This isn't a problem for most people, but if you had hopes of creating a trading robot that could trade for you, many price action strategies do not lend themselves well to that.
Price action isn't perfect. Just as you'll have losing trades with other types of trading strategies, you will have losing trades using price action as well. Even though in theory price action sounds great, we can only know what the price has been doing up till we get into a trade. If price was moving higher, and we buy, the price could start to drop shortly after. Such circumstances are unavoidable. The only thing that matters is that you win more than you lose. Learning to do that takes time and practice.
Final Word on Price Action Trading
Price action trading is something all new traders should learn. Learning to read and interpret how a price chart is moving is a trading system on its own, or can help you if you decide to implement other analysis tools such as statistics, indicators or seasonality. There are many price action strategies, but you only need to learn one to start. Become profitable with it before trying to learn more strategies. Price action trading doesn't guarantee profits; it is a great trading style, but takes time and practice to learn...this is true of all trading styles though.