What is Price action trading? it involves the observation of price movements of a currency pair, future, commodity, etc. on a “naked chart”. Decisions in the marketplace are then made with these observations. Trading decisions are made based on raw price movements.
Economic news/data and global activities provide the basis by which the market moves but these data are represented with a line chart, bar chart, the Japanese candlesticks, etc.
The represented data is then analyzed through recognizable patterns or sequences the market makes.
To fully grasp the disciple of price action trading, the concepts of
- market structure,
- momentum, and
The market structure provides a skeleton for the price to develop over time i.e. highs/ lows that enable us to predict future pricing.But what drives the price to these points? Liquidity does.
This is the most difficult thing to grasp in price action trading.
Liquidity exists beneath lows and above highs. Think of liquidity like a magnet that pulls price towards itself. This is why price takes out previous lows aggressively in a downtrend and previous highs when uptrending.
There are other complex occasions when the price has not gathered enough “momentum” for a move so it has to clear internal liquidity first before going in the intended direction. An example is shown below.
Momentum is a measure of price’s “willingness” to be either bullish or bearish. When momentum is to the upside, the price takes less time to push upwards doing so with large candlesticks (buyers/ bulls are in total control).
In a bearish market, momentum is to the downside meaning sellers/ bears are in total control.
In the example above, notice how price struggles while pushing to the upside. On the contrary, it sells with ease because momentum is to the downside.
When momentum is diminishing, pullbacks start to get deeper.
Another way to realize when momentum is diminishing is with the volume chart.
Volume is always overlooked but it is crucial in price action trading. Any push to either the upside or downside is backed by volume. This is described as “The law of effort”.
This law can be interpreted to mean that price and volume MUST correlate.
When price and volume do not correlate i.e. price bought heavily but the volume chart remained stagnant it indicates that momentum might be shifting.
At the bottom of the chart above, notice how the price was going higher but there was no correlation with volume. This indicates that bullish momentum is diminishing and sellers will take over soon.
Why You Must Learn Price Action Trading?
With the vast options of trading methodologies to choose from, what makes price action better?
#1. Price Action Trading vs. indicators
An indicator interprets price movements and relays them as infographics (visual representation of information). This means that indicators display previous price activity/activities. Indicators that do this are called lagging indicators e.g MACD, stochastic.
There are a few indicators which “predict price”. These are known as leading indicators. A good example is the “Ichimoku cloud” which works really well for swing trading when used “properly”.
Price always tells a detailed story. Price action traders understand price movement by identifying the current market cycle (continuation or retrace), predicting the price’s next move, and reacting to it as it is occurring with various entry techniques.
Also, price action allows your chart to look simple without compromising precision. Charts with indicators on them can be rather messy.
Risk is a chunk of your account you are putting on the line to execute a trade. It is essential to use minimal risk in order to protect your capital and your trading psychology as a whole.
The one thing forex traders have control over is risk. An ideal investment has a high rate of return while minimizing risk.
Price action allows you to do just that. Regardless of your bias, there are points of invalidation that regard your bias as incorrect. Stop losses can be placed accurately at these points of invalidation i.e. minimizing risk.
Over-risking leaves you paranoid checking the charts constantly and this is obviously not a healthy way to trade.
In order to prevent this, a stop loss should be used at all times. Regardless of how good you are, losses are bound to happen. So it is necessary to understand appropriate risk management. A risk of 3% is advisable.
Every price action trader should understand that the market targets liquidity (high and lows) as I said earlier. Take profits should be set at these levels i.e. maximizing returns.
Summary – Price Action Trading
At the end of the day, there is no “holy grail” in the forex market. A lot of mentors try to exploit new traders trying to sell them “the next big thing”.
Loses are incurred with every trading method (though to a different degree). Hence, jumping from one strategy to another does not help.
Instead, refine your trading methodology, persevere, back-test, and demo trade multiple times till you start to notice a series of market scenarios that are highly probable.