Price action is a particular methodology employed by traders, based on the observation and interpretation of price action, usually through the use of candlestick or bar charts. The price action style of trading is usually characterized by clean charts, without indicators, with the explanation that indicators are themselves interpretations of the historical movements of price, which don't contain any information or predictive power that isn't available from the charts themselves. Nonetheless, some traders include basic indicators, such as exponential moving averages or average true range to augment their charts or to provide confluence. The attitude of the price action trader is that the interpretation of price movements can provide an edge, a possibility of being more right than wrong in their predictions about the future behavior of price. This edge is possible from making trades that are informed by the observation of key price levels (demarcated as support and resistance lines), the recognition of common, reliable price action patterns, the use of trading orders with built-in stop loss levels, and a systematic trading strategy.
Since candlestick and bar charts are the fundamental interface of the
price action trader, the most basic unit is the candle or bar itself.
Candles sum up the price action over a set period of time: on a 5 minute
chart, each candle represents 5 minutes of price behavior, whereas on a
daily chart, only one candle is produced per day. The body of the
candle constitutes the range between the open price and close price,
whereas the wicks or shadows of the candle indicate the high and low
over that period of trading. Various color schemes are used to determine
whether the price movement represented by the candle is bullish
(increasing in price) or bearish (decreasing in price); bullish candles
are usually white, blue, or green, whereas bearish candles are usually
black or red.
Longer candle bodies demonstrate strong momentum and decisive market
behavior in the movement from open to close; longer shadows, however,
demonstrate increased volatility, since some prices were reached during
the time period but ultimately excluded from the range between open and
close.
Smaller candles can indicate the market's indecision, disinterest, or a balance between bullish and bearish forces
Similarly, a candle that is almost all wick implies that, regardless of
the range of prices occurring in the time period, the open and close
were extremely close; these candles are referred to by the Japanese
term, doji
A doji or small candle with a very long wick in one direction is
referred to as a pin bar, which is often interpreted as a sign of
potential trend reversal
By contrast, a marabuzo candle has a large body, and almost no wick, implying that price action has been more definitive
There are two important, rudimentary patterns that play out over at least 2 candlesticks:
- An outside bar is a bar with a higher high and a lower low than the previous candlestick, often with a body that also encompasses the price range of the previous bar's body; an alternative variation is the engulfing bar, which simply has a higher open and a higher close, regardless of the candle's shadows or wicks.
- By contrast, an inside bar is a bar, or series of bars, with a high and low encompassed by the preceding candle; in this case, the variation is the harami, a bar or series of bars with an open and close within the range of the bar preceding it
Basic Terms for Price Behavior:
- Trend: 2 successively higher tops and bottoms (uptrend) / 2 successively lower tops and bottoms (downtrend). Other names for a positive trend: run up/bull run/rally. Other names for a negative trend: run down/bear run/decline
- Trading range: the market moves up and down within a consistent range without establishing a definitive trend in one direction
- Consolidation: the range of price's movement constricts as the market becomes directionless
- Reversal: the market moves in the opposite direction from the previous trend, implying the end of that trend
- Retrace: the market moves some amount in the opposite direction from the previous trend before the trend is eventually reinstated
- 2 Attempts Rule: the idea that if the market attempts to do something twice and fails, the opposite will happen
Basic Set-ups and Stop Placement
Most price action traders place buy or sell stop orders with a
pre-determined stop loss level, and a take profit or target level. The
buy or sell stop sets the level that price much reach for the order to
be filled; the stop loss level sets the margin of loss that a trader
will accept before closing the position; the take profit level sets the
level at which to automatically close a successful position.
Basically, you determine risk based on where you are placing your stop,
and then determine your target with regard to this risk level; commonly,
traders will aim for at least a 1:3 risk to reward ratio, although
scalpers and those who trade on shorter time frames often have to accept
smaller ratios.
The buy or sell stop, or entry level, is typically set at a significant
support or resistance level so that it will only be filled when price
has broken definitively in the desired direction; by setting strategic
entry levels in their orders, traders can ensure that they enter trades
with the momentum of the market.
Perhaps the most basic set-up is the pinbar, which, if you remember has
an open and close within the previous bar, and a wick at least 3 times
the length of the candle body, protruding beyond the levels of prior
bars.
The long wick and short body implies that traders have made a strong
attempt to push price in one direction, but price has returned to
earlier levels, often indicating the possibility of a reversal in trend
direction.
The basic way to trade a pinbar is to place the stop loss level at the
extreme of the wick, and to place your entry level above the body in a
bullish scenario, and below the body in a bearish scenario. the target
is set relative to the risk level represented by the stop loss, often at
a resistance level in a bullish scenario, or at a support level in a
bearish scenario.
Another basic strategy is the inside bar, a bar or series of bars
contained by the preceding bar; since the shrinking candle size implies
consolidation, it can mean that a big move is on the way, either a
strong continuation of the current trend, or a reversal. Because the
price direction is uncertain, traders often place a orders on both sides
of the inside bar, so that a downward movement will trigger a sell, and
an upward movement will trigger a buy. A liberal entry point would be
set just beyond the high or low of the inside bar; a more conservative
entry point would be at the open or close of the preceding mother bar.
