What Is Price Action and Its Trading Strategies?
Supposed you’re one of the many people who wonder which is the most promising trading strategy a trader would go for? The quick answer is price action trading. Not only is it suitable for intermediate traders, but it works exceptionally well for novice traders too. In fact, it is proven to help traders gain consistent profits over time.
After all, price action is the foundation for all technical analysis, and it’s mostly used to enter and exit the market precisely.
The best part?
This strategy provides a complete arsenal to analyze and trade the markets efficiently. So the idea of this guide is to explain the main concepts about price action so anyone can have the tools to trade the markets like a pro.
What Is Price Action Trading?
Price action is a trading strategy used to analyze the market behavior and identifying the ideal entry, exit opportunities. At its core, price action reflects the imbalances between supply and demand in a market. In another way, a price action trader only believes the price and its movements with little to no use of technical indicators.
Analyzing from a price action’s trader perspective, when buyers have more interest in any given asset, they will be psychologically willing to pay whatever the sellers are offering. Eventually, if the buying interest continues, the prices will tend to go higher, and therefore, creating an uptrend on the chart. In a simpler explanation, the price is parallel to the market’s demand.
Ultimately, the analysis of price charts helps traders to define two things:
- Objective levels to enter a position,
- And, it also provides clear areas to manage risk appropriately.
Additionally, the main purpose of price action trading is to describe the state of the market (trending or sideways markets). Based on this information, the investors can develop a trading strategy to time the market.
The main components of price action are divided into:
- Trending markets (Uptrends and Downtrends)
- Flat markets
Price action applies to all kinds of trading styles, mainly because it can be analyzed in the same way across all time frames. Therefore, long-term or short-term traders can get benefit from this approach.
What Makes Up The Price Action?
Price action comprises four main pillars: candlesticks, bullish trend, bearish trend, and flat market.
Below, we’re going to break down these four concepts and how to use price action effectively.
Candlesticks are a graphical representation that provides information about the open, the high, the low, and the close of any given period. Usually, when the closing price is higher than the open price, the bar is green (bullish). When the close price is lower than the open price, the bar is red (bearish). However, the color depends on the platform configuration.
Generally, a bullish candle is upward while it’s vice versa for the bearish candle’s direction, which is downwards.
The image above indicates two candlesticks, one green where the close is higher than the open and the red one where the close is lower than its open. Usually, big fat candles, in one direction or another, represent significant momentum.
Bullish trends refer to uptrends, where the price is forming consecutive higher lows and higher highs. Above shows an example of the BTCUSD one-hour time frame where a clear uptrend can be identified.
Bearish trends refer to downtrends, where the price is forming consecutive lower lows and lower highs. Below is an example of the BTCUSD 30-minute time frame where a downtrend is illustrated.
Unlike bullish or bearish, a flat market is when the market structure doesn’t follow a path. In other words, a flat market happens when there is no consistency in the location of the lows and highs, and the action tends to be sideways. Usually, this movement is framed between a support and a resistance level.
This 10-minute chart of BTCUSD is an example of a flat market because, as you can see, there is no clear direction. Instead, the movement is sideways and is framed under support and resistance levels.
What Is A Price Action Indicator?
While price action is interpreted as a trading strategy, price action indicator, on the other hand, refers to the study of market movement. You can use this indicator to assess the imbalances between supply and demand. In technical analysis, the candlestick on your price chart is the most powerful price action indicator.
That also referred to as naked trading, which is trading without technical indicators like moving averages, relative strength index, stochastic but mainly relies exclusively on price action. In this case, candlesticks are studied together to provide accurate entry signals.
A good note here is price action analysis needs to be used with other trading concepts like:
- Trend direction
- Support and resistance levels
- The price structure (swing high and swing low)
In case you’re still confused, in the next example, we’ll analyze a 10-minute chart of BTCUSD. From there, we can see that a downtrend is in play (lower highs and lower lows). Additionally, an inside down candlestick (bearish harami) is presented around a resistance level. Those two factors provide confluence for placing a short entry because:
- There is a trend in our favor,
- There is a candlestick signal around a previous resistance,
- And, there is room for a target area around the previous low.
The details of the entry and risk are detailed in the chart below.
Crypto Price Action Trading Strategies
While traders can rely on psychological factors or market sentiments to deduce a trading opportunity, the use of fundamental historical data is inevitable. That’s when the chart patterns come in handy.
To start, here are what you need to know.
The hammer is a candlestick formation that represents strength in the market because it shows that the buyers are strong enough to bring the price from the lows of the bar up to the upper side of the candle.
It is preferable to take this formation in uptrends, especially in corrective movements towards previous support. The ideal entry is above the candle’s high and the stop-loss order at the bottom of the candle.
Here’s an example of the ETHUSD 60-minute chart, where the price is in an uptrend. Additionally, there is corrective price action and a hammer around a support area. Those arguments provided an excellent long entry. The details of the trade (entry and stop-loss) are explained in the chart.
The Shooting Star
The shooting star candlestick represents a weakness in the market because it illustrates that the sellers are strong enough to bring the price from the highs of the bar to the candle’s lower side.
This formation should be taken in downtrends, preferably in corrective action towards previous resistance. The ideal entry is below the candle’s low and the stop-loss order at the top of the candle.
Below is an example of the BTCUSD 2-hour chart. The price broke down a previous consolidation (momentum to the downside). Later on, the price formed a shooting star around the last resistance. This action provides a great example to play the shooting star to the downside. The details of the trade (entry and stop-loss) are explained in the chart below.
The Inside Bar
An inside bar is a representation of price equilibrium in the market. An inside bar is a two-candlestick price formation, where the entire price range of the second candle is contained within the price range of the first candle, also known as— mother candle.
Ideally, inside bars signals should be taken in the direction of the overall trend because it increases the probabilities of success.
In this case, an interesting example is where an inside up candlestick is favoring the trend and around a previous support area. The details of the entry and stop-loss are in the chart are as above.
The outside bar is a two-candlestick price formation that signals a price reversal. The outside bar pattern can be recognized when the second candle takes out the high and the low of the previous candle. Outside bars are powerful reversal trade signals because it shows a shift in momentum.
The outside bars are useful in many trade scenarios. However, they tend to be more effective when anticipating the break of the previous price structure. For example, the BTCUSD daily chart shows the outside up bar takes both sides of the last candle and then goes straight up towards the previous resistance level, which is broken, and the upward momentum continues.
Support and Resistance in Sideways Markets
When the market is in a sideways mode, it is defined under a horizontal formation framed between support and resistance. The use of exhaustion signals around those areas can be powerful signals to enter a market position and depict the price range’s extremities.
The exhaustion signals are some of the formations could be a hammer on support, shooting star at a resistance, inside the bar and outside bars are some of the candlesticks to look for in the limits of the range.
Looking at the daily chart of BTCUSD, there is a trading range where the action of the market is sideways. Notice how exhaustion signals provide good entry points to act on the range’s boundaries around the support and resistance levels.
The first signal was an inside bar to the upside that took place around the support area. Notice how it offered a relatively small risk in comparison to the potential reward (target area).
The second signal was an outside bat to the downside that confirmed the previous resistance. Once again, it provided a clear entry-level, and the risk to reward ratio was acceptable.
Applying The Price Strategy in Swing Trading
Price action pertains to swing trading as much as it’s applicable to short-term trading like scalping and day trading. Typically, the best time frames for swing trading are the 4-hour and daily charts.
A simple and effective way to swing trade using price action is to combine:
- Supply and demand,
- Coupled with trading pullbacks within a trend.
At the very basic, the number one cause behind all price movements results from an imbalance between the supply and demand equations. While there are many ways traders can confirm a supply and demand zone but, the best technique is to double-check it with price action.
In trading, a supply price zone is defined by increased selling pressure, which caused the price to drop. At the same time, a demand prize zone is defined by an area of increased buying pressure, which caused the price to rally.
In summary, swing trading with price action refers to waiting for the price to return to these supply and demand zones. Plus confirming your entry with one of the chart patterns explained throughout this guide.
Let’s consider the supply and demand example in the Bitcoin daily chart above. The overall trend is bullish, which means we look for pullbacks into a demand area and price action for confirmation. To maximize profits and protect the potential gains, you should use a trailing stop-loss order.
How to Spot False Setups?
One of the biggest challenges with price action trading is the false setups. Very often, the chart patterns will fail to produce the expected outcome and can lead to disappointments. In this regard, it’s essential to learn and accept false setups as an everyday occurrence.
The most common fakeout signal is the false break out of support and resistance levels. In normal circumstances, a breakout will lead the price to move in the same direction of the break.
Below is an example of a false breakout of the support zone.
The break of support didn’t cause more follow-through to the downside, and what appeared to be a sure move to the downside turned out to be a false signal.
Here’s another example of a failed chart pattern (bearish outside bar.) Usually, the bearish outside bar signals a trend reversal, and it signals that the bears are in control. However, this time around, the bearish outside bar proved to be a false setup.
The best way to differentiate between a false setup and a simple setup is by measuring the time it takes for a setup to play out. Usually, the higher quality trade setups take a concise period to play out and show you a profit.
Does Price Action Trading Really Work?
Yes, price action trading works because it represents the market dynamics. In other words, it illustrates the sentiment of the market participants. However, reaching a proficiency level requires a lot of screen time to get all the nuances of this approach.
Can These Strategies Be Used in Crypto Market?
By this point, you’ve known that price action trading is versatile. But if you need a solid confirmation to deploy this strategy in crypto, here’s your answer.
Price action is suitable for crypto trading because it is a liquid market and has enough volatility to apply price action concepts.
Given the high participation of institutions and the general public, the imbalances of supply and demand can be easily measured by this trading approach.
To top things off, the wide variety of cryptocurrencies and the ability to go long or short provides the crypto trader flexibility to search for market conditions (trending or sideways markets) that can be analyzed and exploited under a price action trading system.
As good as price action trading, still, we all need a backup plan in case things go sideways.
Price Action in Derivatives Market
Price action trading in the spot market is remarkable and that’s not it. It is in fact widely used in a variety of securities including crypto derivatives contracts like futures and options to speculate and hedge risks. As a price action trader, it’s common to take a deep dive into market sentiments and make a more rational trading decision based on the recent price movements without heavily relying on technical indicators. In addition, since trading options or futures means you’re speculating the price and profiting based on the market reflection, that means, price action works perfectly to help you make strategic decisions.
How to Mitigate Risks of Price Action Trading?
Profits are good, but do you really know how to react when things go against your favor? Just try to imagine your funds being liquidated, are you prepared to cut out our losses when there’s a significant price dip?
If your answer is yes, well, we’re happy for you.
But, if you’re not, here’s precisely what you must know:
First, to mitigate the risk of price action trading, you must ensure that the losing trades only represent a small portion of your account balance. Your position size and risk per trade will determine how much you will lose on each trade. Meanwhile, the winning trades should offset those losses and generate more profits at the end.
Setting a stop-loss order is the most fundamental risk management tool. Try to look for the profit areas that represent several times the amount of risk taken. In other words, look for asymmetrical risk-reward trades.
Putting A Stop Loss
The most common methods to place a stop-loss order include:
- Above and below crucial support and resistance levels
- Above and below pivot points
- Above and below chart patterns
- Moving averages
- Supply and demand zones
- Major swing points
Generally speaking, the place you hide your protective stop-loss order should include critical levels, which, if broken, indicate that you were wrong on the initial trade idea. Think of it this way; if your entry point is at an untested supply zone, you should place your protective stop-loss order above the supply zone and consider taking profit at the following demand zone.
Consider the example in the chart below.
As a general rule, your stop-loss order should also include a buffer to protect yourself from possible whipsaws and false breakouts.
It is reasonably safe to assume that the untested supply and demand zones have a higher probability of holding the price and producing the expected reaction.
One of the benefits of trading price action is that it provides the pillars of a good risk management system. Mainly because it helps spot well-defined entry, risk, and profit target levels, which represents an advantage in front of other trading methodologies.
The Benefits and Drawbacks
This section will outline why you should trade based on price action. We’ll point out some of the advantages and disadvantages of price action trading.
The best advantages of price action trading include:
- The analysis is straightforward compared to analyzing the market based on indicators, which usually leads to analysis paralysis, given the multiple signals from different indicators that sometimes show conflicting signals.
- The price action provides well-defined levels to the entry, the risk, and the profit target; therefore, the trader has objective information to act upon.
The main disadvantages of price action trading include:
Since price action trading analysis mainly depends on the price movement rather than technical analysis, hence, certain risks are accrued.
- Price action trading is a subjective art. For this reason, the same price action chart can tell a completely different story, depending on the experience and skills of each trader.
For example, Bitcoin historical data shows a price pushed over the hovering range of $50,000 mark and has pushed the price even higher in multiple events. But, this situation may be a false breakout that signals for an upcoming reversal.
- Usually, the levels where the stop-loss orders must be placed are common areas (around previous highs and lows) that are easily taken by the crypto whales. In other words, the stop-loss orders can be easily identified and executed around significant swing highs and lows.
Price action is an excellent analysis to define the state of the market. Additionally, the candlestick formations study provides an edge for the crypto investors to find areas of value where trades of high probability can occur.
However, to be proficient at reading prices, the traders must invest their time to study charts. It’s also vital to enough screen time to identify with ease the highest probability price action patterns.