Predicting how and when prices of securities will move in the market is a difficult task for traders and investors. While a wide variety of mechanisms are available to traders to make these predictions, knowing which one to use and when can lead to delays in the execution of trades and create unnecessary confusion. The price action trading indicator is a simpler and more efficient tool at the disposal of traders who have to deal with a lot of information. In this method, the trader relies exclusively on price movements rather than basing their strategy on the technical analysis of stocks.
What is a price action trading strategy?
Price action trading in the stock market refers to a technique in which traders track the increase and decrease (or the highs and lows) in the price of a security over a specific timeframe. Several traders, especially those dealing in short-term securities, rely almost exclusively on price action to derive trends and analyse the stock, commodity, or any other asset. This strategy also lays the foundation for more technical analyses, such as moving averages, and enables more informed trading decisions.
How to learn price action trading?
Price action is a tricky trading technique. Relying on only one tool alone to make purchase or selling decisions can seem too good to be true. With multiple variables to consider, a novice trader can easily get overwhelmed and make rash decisions, resulting in massive losses for the client. Price action trading can be understood and learnt if it is broken down into its constituent elements. This can be done through the following steps:
- Gaining a comprehensive understanding of what the price action strategy is and what it entails
- Applying the law of demand and supply to study price movements
- Analysing price swings and trend lines to gauge where and how the market is moving
- Accurately spotting trade entries using price patterns
- Placing stop-losses at the right time to exit the market
- Identifying time periods when profits can be maximised using price action trading
- Employing the concept of “expectancy” to assess probable risks
Price action trading strategies
Traders employ different types of price action trading strategies to enhance profits and expand and diversify their revenue streams. Some of the best price action strategies include the following:
Trend trading
Trend trading strategy is commonly used by new entrants in the market, as it primarily involves studying and tracking the price action trends of a security. Once the trends are spotted and mapped, the trader can decide what position (long or short) needs to be taken to maximise profit.
Pin bar
Also known as the candlestick strategy due to its shape, the pin bar design imitates a candle with a long wick. The wick represents the price range, which in turn indicates a rejection or a reversal. In other words, in a pin bar pattern, the price moves in the direction opposite to the wick, which is used by traders to decide their position.
Inside bar
This price action strategy involves the analysis of two bars, the inside bar and the outside bar (or the mother bar). The former is smaller than the latter and falls between the high and low range of the outer bar. Formed when the market consolidates, veteran traders employ the inside bar strategy to identify turning points in the market.
Trend after a retracement entry
Compared to other price action trading strategies, this one is simpler because the trader has to just follow the existing trend and decide on their position.
Trend after a breakout entry
In this case, traders seek to identify situations where the price moves outside a predetermined support line, which indicates a breakout. Once such a scenario is created, traders can use it as a signal to take a long position. In case the price falls below the support line, then a short position is warranted.
The sequence of highs and lows
Traders use this method to map emerging price action trends. For example, if the price of a stock is trading at the higher end of the “highs” and higher end of the “lows”, it shows an upward trend of the stock.
Head and shoulders reversal
Occurring toward the end of a bullish trend, head and shoulders pattern is characterised by three consecutive peaks. The central peak, which is the head, is higher than the other two, which resemble the shoulders. The head indicates a temporary price peak. Traders use this formation to mark their entry into and exit from the market.
Benefits of using price action strategy
The biggest advantage of price action trading is the simplicity it provides to traders. For a trader who does not wish to perform complex technical analyses, the price action strategy provides an easy and efficient option to enter and exit a market. Moreover, this type of trading is well suited for traders looking to make short to medium-term profits. As this strategy does not require in-depth research of the market, it becomes easier for the trader to conduct on-the-spot price trend analyses and make informed decisions.
Limitations of using price action trading
The foremost limitation of employing the price action trading strategy is the differences in the interpretation of price trends. While one trader may view a certain price movement as bullish, another might perceive it as being bearish. This can lead to widespread speculation and distort the market. Moreover, the assumption that past price trends of a security or any financial asset will continue in the future is itself shaky and fragile. Therefore, traders using price action to decide their position must be fully conscious of their risk appetite and proceed with caution.
Conclusion
A market is a highly volatile space, with diverse players operating at different levels and huge volumes of commodities, securities, and assets being traded at any given point of time. Price action trading enables traders to gain a reasonable amount of understanding of the market trends and mark their positions accordingly. While the merits of this strategy are obvious, its demerits must also be taken into account before it is implemented.
