Overview of Price Action Trading
Every technical trader who makes his decisions based on price charts, as opposed to analyzing the fundamentals, trades in a different way. The thousands of different strategies traders use typically fall into three classifications: price action traders, indicator traders, and traders who use both. There are also more niched strategies, such as seasonality, order flow, or statistical.
Price action trading is one of the simplest forms of trading to learn, and one of the most effective. If you have just started trading, learning price action trading makes a great starting point.
Defining Price Action Trading
Price action trading means basing your trading decisions on the price movements of an asset. You won't use indicators or other methods of analysis, but if you do, you'll give them very little weight in the trading decision process. A price action trader believes that the only true source of information comes from the price itself. If a stock goes up, that tells the price action trader that people are buying. The trader then assesses, based on the aggressiveness of the buying, whether it will likely continue. Price action traders don't typically concern themselves with why something happens.
Using historical charts and real-time price information such as bids, offers, volume, velocity, and magnitude, the price action trader looks for a favorable entry point for their trade. A favorable entry point is one that allows risk to be controlled, but also offers a potential profit.
Types of Strategies
One common price action strategy is called a breakout. When the price of an asset has been moving with a certain tendency, once it breaks that tendency, it alerts traders to a new possible trading opportunity. For example, assume a stock has traded between $11–$10 for the last 20 days, then moves above $11. This change in tendency alerts traders that the sideways movement has possibly ended and that a possible move to $12 (or higher) has begun.
Breakouts occur from many different types of patterns, including ranges, triangles, head and shoulders, and flag patterns. A breakout doesn't mean the price will continue in the anticipated direction, and it often doesn't. This is called a false breakout, and also presents a trading opportunity in the opposite direction of the breakout. Breakouts can be small or large. When watching for small consolidations, or short periods where the price moves sideways, breakouts during a trend can provide excellent profit potential.
Other price action strategies consider how price bars form on a particular type of chart. For example, when using candlestick charts, traders use candlestick strategies, such as the engulfing candle trend strategy. Related to all the above, traders use price support and price resistance regions that could provide good trading opportunities. Support and resistance areas happen where the price has tended to reverse in the past. Such levels may become relevant again in the future.
Benefits and Drawbacks
Once you know a price action strategy, it won't require much research time. Find an asset with the specific price conditions you need, or wait for those conditions to develop. As another benefit, you often get more favorable entries and exits compared to many indicator-based methods. Although indicators use price as their basis, they often lag behind it. By simply focusing on the price, you get the information in real-time instead of waiting for a lagging indicator to give you information.
It's difficult to automate price action strategies, which is a drawback. That means you'll need to 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 process.
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 price action sounds great in theory, you can only know what the price has been doing up until you get into a trade. If the price was moving higher and you buy, the price could start to drop shortly after. You can never avoid such circumstances. The only thing that matters is that you win more than you lose. Learning to do so takes time and practice.
The Bottom Line
All new traders can benefit from learning price action trading. Learning to read and interpret price chart movements becomes a trading system on its own, and it can help if you decide to implement other analysis tools such as statistics, indicators, or seasonality. Many price action strategies exist, 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 makes a great trading style but takes time and practice to learn.