Price actiondescribes the characteristics of a security’s price movements. This movement is often analyzed with respect to price changes in the recent past. In simple terms, price action trading is a technique that allows a trader to read the market and make subjective trading decisions based on recent and actual price movements, rather than relying solely on technical indicators.
Since it ignores thefundamental analysisfactors and focuses more on recent and past price movement, price action trading strategy depends ontechnical analysistools.
Key Takeaways
- Many day traders focus on price action trading strategies to quickly generate a profit over a short time frame.
- Traders using a price action trading strategy take positions according to their subjective and technical analysis.
- Several tools and software platforms can be used to trade price action.
Tools Used for Price Action Trading
Since price action trading relates to recent historical data and past price movements, all technical indicators, such as charts, trend lines, price bands, high and low swings, technical levels (of support, resistance and consolidation), and so on are taken into account as per the trader’s choice and strategy fit.
The tools and patterns observed by the trader can be simple price bars, price bands, break-outs, and trend lines, or they may be complex combinations involving candlesticks, volatility, and channels.
The price action trader's psychological and behavioral interpretations, and their subsequent actions, also make up an important aspect of price action trades.
For example, suppose a trader has personally set a level of 600 for a stock. If a stock that has been hovering near 580 crosses the set level of 600, then the trader assumes a further upward move and takes a long position.
Other traders may have an opposite view—once the stock hits 600, they assume a price reversal and hence take a short position.
No two traders will interpret a particular price action in the same way. Each trader has their own interpretation, self-defined rules, and understanding of behavior. Contrast that with a technical analysis scenario which will yield similar behavior and action from multiple traders, such as a stock with a 15-day moving average(DMA)crossing over 50 DMA, resulting in traders taking a long position.
In essence, price action trading is a systematic trading strategy, aided by technical analysis tools and recent price history, where traders are free to make their own decisions within a given scenario. Price action traders take trading positions according to their subjective analysis, behavioral assumptions, and psychological state.
Who Uses Price Action Trading?
Since price action trading is an approach to price predictions and speculation, it is used by retail traders,speculators,arbitrageursand even trading firms that employ traders. Price action trading can be used with awide range of securities, including equities, bonds, forex, commodities, and derivatives.
Price Action Trading Steps
Most experienced traders following price action trading keep multiple options for recognizing trading patterns, entry and exit levels, stop-losses, and related observations. Having just one strategy for a stock may not offer sufficient trading opportunities. Most trades involve a two-step process:
- Identifying a scenario: Traders identify a scenario, such as a stock price entering a bull phase or a bear phase.
- Identifying trading opportunities within the scenario: For example, once a stock is in a bull run, is it likely to either overshoot or retreat. Guessing which path the stock price will take is a subjective choice that will vary from one trader to the other, even given the same identical scenario.
Here are a few examples. Suppose a stock reaches its high (in the trader’s view) and then retreats to a slightly lower level. With this scenario met, the trader can then decidewhether they think the stock will form adouble topto go higher, or whether it will drop further following amean reversion.
The trader sets a floor and ceiling for a particular stock price based on the assumption of low volatility and no breakouts. If the stock price lies in this range, a scenario is met. The trader can take positions assuming the set floor and ceiling will act as support and resistance levels, or they can take an alternate view that the stock will break out in either direction.
When a definedbreakoutscenario is met, trading opportunity exists in terms of breakout continuation (going further in the same direction) or breakout pull-back (returning to the past level).
Price action trading is closely assisted by technical analysis tools, but the final trading call is dependent on the individual trader. This offers flexibility instead of enforcing a strict set of rules to be followed.
The Popularity of Price Action Trading
Price action trading is better suited for short- to medium-term, limited-profit trades instead of long-term investments.
Most traders believe that the market follows a random pattern and that there is no clear, systematic way to define a strategy that will always work. By combining technical analysis tools with recent price history to identify trade opportunities based on the trader’s own interpretation, price action trading has gained a lot of support in the trading community.
Advantages of price action trading include:
- Flexibility
- Applicability to multiple asset classes
- Easy use with any trading software, applications, and trading portals
- The possibility of easybacktestingof any identified strategy on past data
Most importantly, the trader feels in charge, as the strategy allows them to decide on their actions instead of blindly following a set of rules.
What Does Price Action Mean?
Price action refers to the pattern or character of how the price of a security behaves, typically in the short run. Price action can be analyzed when it is plotted graphically over time, often in the form of a line chart or candlestick chart.
What Does Price Action Tell You?
Technical analysts look to price action on charts to look for patterns or indicators that can help predict how a security will behave in the future and to time entry and exit points of trades. Technical tools such as moving averages and oscillators are derived from price action and projected into the future to inform traders.
What Are Some Limitations of Using Price Action?
Price action is often subjective, and different traders may interpret the same chart or price history differently, leading to different decisions. Another limitation of price action trading is that past price action is not always a valid predictor of future outcomes. As a result, technical traders should employ a range of tools to confirm indicators and be prepared to exit trades quickly if their predictions prove incorrect.
The Bottom Line
A lot of theories and strategies are available on price action trading, many of which claim high success rates. However, traders should be aware ofsurvivorship bias, as only success stories make news. Although price action trading does have the potential for making handsome profits, it is up to the individual trader to clearly understand, test, select, decide, and act on what meets their requirements for the best possible profit opportunities.
If you're interested in day trading, Investopedia's Become a Day Trader Course provides a comprehensive review of the subject from an experienced Wall Street trader. You'll learn proven trading strategies, risk management techniques, and much more in over five hours of on-demand video, exercises, and interactive content.
