Updated: Feb 21
(Listen this article in audio format)
(voiced by - Sharmila R Udupa)
Did you know that most of the technical indicators are derived from the price? Besides, price action trading plays a crucial role in all types of trading? Be it scalping, intraday trading, breakout trading, or positional trading.
This article will cover all the aspects of price action trading, starting from the basic definition to the application part, which is beneficial to forex, commodity, equity, and derivatives traders.
What is Price Action?
'Price Action' means price fluctuations of a script in the given market.
On any trading day, from open to close, the price keeps on changing. This variation is nothing but price action (market action).
What is Price Action Trading?
'Price Action Trading' is a trading technique in which a trader reads the market, and makes subjective trading decisions based on the price movements, rather than relying on technical indicators or any other factors.
In simple words, traders use only 'Price' and 'Volume' to make any trading decisions.
The famous trader John Murphy has mentioned in his book "Technical Analysis of the Financial Markets", that technical analysis is the study of market action using charts, aiming to forecast future price movements.
He also suggests the best way to learn the stock market is using only two components - 1) Price and 2) Volume.
What Does Price Action Mean in Trading?
Removed all of the Moving Average (MA), Bollinger Band (BB), PSAR indicators?
Removed all the underlying indicators like RSI, Stochastics, MACD, ADX?
Do you think you would be able to trade? some traders may ask how to trade in the stock market then?
It might look impossible, but don’t forget most of the indicators derive their existence from one thing – ‘PRICE.’
A fluctuation in the price will also bring variations in those indicators. Isn’t it?
Then which is better to study? The PRICE, or Indicators? one can think for some time.
The three essential components in share market trading are (in the same order):
Price—it advertises all the opportunities.
Time—it regulates all the opportunities.
Volume—it measures the success or failure of all the advertised opportunities.
Volume is essential as 80% of the trading volume is given by 20% of the big players.
Price Action Indicator
As the name suggests, any ‘Indicator’ gives the indication. But they don’t dictate the price. In fact, any changes in the price will cause variations in most of the indicators.
It is widespread to hear many misconceptions about indicators in the stock market community.
For example, many traders say ‘RSI is reached 30, which is an oversold zone, and hence the price will bounce back now’. But the price doesn’t know (or care) whether RSI has reached 30 or not, and it just does what it has to do! If the price shows more fall, then the RSI value will also fall (but relatively slow below 30).
It doesn't matter whether a trader uses a bar chart, line chart, point & figure charts, or Heiken-Ashi chart. It is always better to give top priority to price action. In fact, ‘Price’ is the topmost Price Action Indicator in the world of trading!
Price Action Trading vs Indicator Trading
In the trading world, the debate between 'Price Action Trading' vs 'Indicator Trading' is old as Trading itself!
Below are the 4 important factors which highlight the importance of price action trading over indicator based trading:
Indicators Ignore Human Psychology
Indicators Don't Dictate the Price
Indicators are lagging in Nature
Indicators Overcomplicate Trading
Watch the video to know more.
What does a candlestick chart show?
The price is represented in many forms- line chart, bar chart, or candlestick chart.
But candlesticks charts are the most appealing and powerful representation of the price. Hence we dig a little deeper with candlestick charts.
The candlestick chart reveals open, close, high, and low levels in a user-defined time.
If a user selects a daily chart of a stock, then the above-displayed candles represent a full day's worth of trading.
The low and high price levels indicate the highest price and lowest price made on the trading day
In a bullish candle, buyers have won the battle because the closing price is higher than the opening price.
In a bearish candle, sellers have won the battle because the closing price is lower than the opening price.
It is the primary way to analyze the price using these candlesticks. There are 6 powerful candlestick patterns that often occur in all the markets and in all the timeframes.
Before we look at them, let's first look at where they work best.
Some traders also use chart patterns to plan their trades. Some of the popular patterns are:
Cup and Handle
Double top and Double bottom
Inverse Head and Shoulder
Price Action Forex Trading
As price action trading involves the analysis of price and volume (predominantly price), it can be used in all financial markets. It includes the forex, commodity, bonds, derivatives, and equity market.
However, the forex market has extra advantages as compared to other markets, such as:
It is the largest financial market in the world, so no liquidity issues
It will be open 24 hours a day, five days every week
Forex brokers offer good leverage.
The 6 Most Powerful Candlestick Price Action Patterns
We have millions of candlestick patterns. Studying all of them is foolish because it’s difficult to understand all of them and difficult to implement in the live market.
We need to pick them based on the below parameters:
If any candlestick formation has less impact, then it is not useful.
Similarly, if there is a powerful candlestick formation, but if it doesn’t occur very often, again it’s of no use.
Based on these parameters, I have shortlisted 3 candlestick formations:
Engulfing - Bullish Engulfing and Bearish Engulfing
Harami - Bullish Harami, Bearish Harami
Hammer/Hangman - Hammer comes in an downtrend, whereas, Hangman comes in a uptrend
These candlestick patterns help swing traders, trend traders, and even day traders as well.
Engulfing candles tend to signal a reversal of the current trend/swing in the market. This specific pattern involves two candles with the latter candle ‘engulfing’ the entire body of the candle before it.
The engulfing candle can be bullish or bearish depending on where it forms in relation to the existing trend. Hence, we have two types of Engulfing:
If you look at the above image, the price showed a Bullish Engulfing pattern.
If you look at the above image, the price showed a Bearish Engulfing pattern in Nifty.
Similar to Engulfing we have two harami patterns:
The word ‘Harami’ means a pregnant lady in Japan.
Below are the examples for Bullish Harami and Bearish Harami:
Hammer and Hanging man Patterns
These are the third most powerful patterns.
The below charts are some examples of Hammer and Hangman patterns:
The above images show a Hammer and Hangman pattern at support and resistance levels respectively.
These are the 6 candlestick patterns that are powerful and occur frequently in all the timeframes.
A word of caution - Please don’t use these patterns blindly. You should use these patterns as a confirmation from the price at crucial price levels i.e. support and resistance levels.
Price Action Trading Strategies/System
Two things are very crucial to get mastery in price action trading system:
1. Support & Resistance levels Identification
2. Price Acceptance or Rejection at support-resistance levels
Support and Resistance Levels Identification
There are many ways to arrive at support and resistance levels.
However, drawing trend lines is the simplest and most effective way of identifying support and resistance levels.
A Trend Line is a straight line drawn on a chart by connecting two or more price peaks, which reveals the trend of the script, support, and resistance points, and allows to spot any excellent trade opportunities.
Price Acceptance or Rejection at Support and Resistance Levels
After knowing the support and resistance levels, it's essential to know whether the price will respect that level or not.
In the "Market Profile" world, it's called 'Price Acceptance' and 'Price Rejection.'