Price Action Definition and Explanation
Price action trading is a method of trading the financial markets using pure price and change in price as a guide to making effective trading decisions.
Price or tape has been around for hundreds of years, many of the great traders from years ago would watch price and price change to determine where the market really wanted to go.
This approach of using price action analysis to gauge market sentiment is still a very popular trading strategy today and when mastered can become a powerful tool in your trading toolkit.
Unlike strict technical analysis which is more concerned with precise chart patterns price action is a more holistic approach to reading price and predicting future price moves.
Price action traders will consider amongst other variables:
- How price has moved to the current position
- Has the price moved quickly?
- How has price responded to support or resistance?
- What did price do from the open?
- How has price responded to other correlated markets?
- How has price moved under bullish or bearish news?
- Has the market set any bull or bear traps?
- Where price is relative to recent events? (ie at new highs, in a weekly range)
- What are the majority of market participants feeling and how are they positioning?
Price action can be used on a short term basis, (often called tape reading) or it can be used on a higher time frame to accurately time day trades or swing trades.
The advantages of trading a price action methodology are that it can be used in any market, under any condition. So you are not just restricted to one asset or one type of market, such as a bull market, bear market or range-bound.
What Markets can I trade with Price Action?
The great thing about price action is the fact that it can be traded in almost any market which freely trades and has natural price discovery:
Popular markets for price action trading include:
- Forex – GBP/USD, EUR/USD, USD/JPY
- Stocks – APPLE, FACEBOOK, TESLA, HSBC, TESCO, BP
- Indices – FTSE 100, DAX 30, DOW 30, NASDAQ 100
- Treasuries – Gilts, Bund, Bobl, US 10yr
- Commodities – Gold, Silver, Crude Oil
Price Action Indicators
Many people believe price action is only to be conducted on a naked chart. Whilst this is true for a lot of good price action traders many will also use indicators as a further guide to trading price.
(However, these indicators are only used to quantify a price move and will only act as additional information rather than being used solely)
A price action trader may be watching a strong market move, anticipating a pullback in price to join the trend. The trader will be fully aware of the type of pullback he is looking for, but may still use a moving average to get a visual representation of how far away price truly is from the moving average and subsequently help him time his entry more accurately.
Similarly, if looking for a mean reversion type setup (fading a move considered too stretched and due for an unwinding) a price action trader could still use an oscillator such as an RSI, CCI or Stochastic to help time a position entry or keep him from pulling the trigger too early on his counter-trend trade.
That being said, pure price action trading is about getting a deep understanding of how the market behaves, what is causing it to move in the way it is, and using price (and the change in price) to determine where the next trade should be.
Price Action Trading Setup Example
Let’s say you are watching the market for a short trade.
You have decided that a level of 5,000 is a resistance level based on your chart analysis and now you will watch how price responds to that level when it touches it:
Price approaches 5,000, breaks through and starts to accept this new high, consolidating above the resistance level
Price breaks through the 5,000 level, but very quickly trades back under around 4,995
Price rallies up to the resistance level but can’t quite touch that 5,000 level. It pauses and hovers just underneath.
Which trading scenario is the most desirable for the price action trader to initiate a short position?
All things being equal it’s Scenario B – why?
Well let’s be well aware we are looking at a hypothetical scenario here and understand there are many variables at play, however, let’s talk through exactly why this would be more desirable from a short traders perspective.
Let’s also note here, that most traders can conduct simple technical analysis on a chart and come up with a resistance level of 5,000. But the edge a price action trader has is to be very aware of how price reacts to that level and it can therefore guide you on your entry. Or even give you a red flag warning allowing you to pass on a trade that looks like a loser.
- Price breaks through 5,000 indicating strength.
- Many textbook traders will buy the breakout.
- This causes a small pop up through the resistance level.
- Then price retraces fairly quickly because buyers are exhausted, they are not willing to pay higher prices.
- The market falls back under 5,000 and has not only trapped breakout buyers but has also run out of buyers.
The price action trader can see this scenario and can attack the market with a short trade with more confidence than someone oblivious to the nuances of price action.
Does every trade work? No of course not!
But the added advantage with a price action approach is that there is often a very obvious place to enter a stop-loss, helping your risk management process considerably.
What is Price Action in Forex?
Price action in forex is similar to many other markets. If you are trading GBP, USD, JPY, AUD or any other pair, the concept is still the same.
A price action trader will watch closely and see how price responds to prior highs, lows, and any scheduled economic news. He will make an assessment of how the price is currently trading and whether or not he wants to join the move in anticipation of an extended trend or whether the market is getting tired and could reverse.