Price Action Trading Strategy

Price is the most pivotal component of trading in stock markets because it is the movement in prices that decide the fate of the trade, i.e., whether the trade is profitable or a loss-making one. The movement in prices helps decide whether any trade is possible or not and what the correct entry and exit points will be.

But what is price action trading in technical analysis? While using the price action trading strategy, the traders mainly depend on the movement in prices, and they will not be solely dependent on other components of technical analysis. The main characteristic of a price action trading strategy is to deeply follow the price movements of a security and enter the trade when the trader is confident enough about the profitability of the trade.

The logic behind price action

The simple logic of the price action trading strategy is that if the stock price is rising, it means the buying activity is picking up, and there are more buyers than sellers. Once the stocks that are witnessing the surge in buying are identified, the traders will then look for signals from real-time information such as volume, bids, offers and magnitude. However, to confirm his hypothesis, the trader can make use of all other technical tools like price bands, trend lines, support and resistance, etc., or any combination of these that suits his strategy.

Psychology also plays a crucial role in the decisions made by the trader to execute the trades using price action. A trader might set a psychological target of XX price for a further upside, and once the price moves beyond this, he may take a long position in that stock. However, there might be another trader who might be anticipating a downside once the price reaches the XX levels, and he may short his position at that point. Hence, every trader will have a different interpretation of the same situation if he is following the price action strategy.

However, technical analysis will always bring out a similar interpretation from all the chartists.

What does price action trading strategy depict?

The traders look at price action to identify the patterns or signals that can indicate how a particular stock will behave in the near to medium term. They also sometimes confirm their entry and exit levels using the price action. It may be noted that the tools such as moving averages and oscillators are a result of price action that can be projected further to determine the patterns.

There is no specific strategy that works well in all situations. There is no “one size fits all” scenario in the stock markets because the market never follows a fixed pattern, and each trade within the same scrip has to be treated in a unique way. A lot of traders combine the good things of both worlds, i.e., price action and technical analysis, to identify a profitable trade and minimise their risks.

Price action trading strategies

Traders have a choice of price action trading strategies which they can learn and apply while trading. We will glance through price action trading benefits, and risks of price action trading. But few examples of some of the widely used strategies are:

Hammer

A hammer is a kind of candle stick that is in the shape of a ‘hammer’ due to the fact that the open, close and high are very close to each other, but the low is a long way away and is thereby construed as the handle of a hammer. The formation of a hammer is an indication of a reversal of the prevailing trend.

Harami

The harami pattern signifies a change in a trend and is symbolised by an upward trend with a corresponding fall in opening prices or a downward trend with a corresponding rise in closing prices. It is accompanied by a smaller candle next to it with a price that is moving in the opposite direction of the trend.

Spring at support

This is one of the most common strategies used by traders to identify a rising trade. As the name suggests, it signifies a sudden rise in the prices of a security after it has hit its minimum support levels or come very close to it.

Other commonly used price action strategies are price action trend trading, pin bar, inside bar, the sequence of highs and lows, head & shoulders reversal trade, trend following a breakout or a retracement entry, etc.

Advantages of price action

The price action trading strategy provides flexibility and freedom to traders to make their own strategy that is applicable to multiple asset classes. It gives the traders a sense of realization that they are in control of things as the strategy is made by them, and they are not forced to blindly follow a set of rules, as is the case with technical analysis. It is easy to simulate or backtest the strategy on past data, and thus it provides a comfort level to the traders.

Limitations of price action

The biggest limitation is the fact that it is subjective in nature and leads to different interpretations by different traders and, thus, different decisions. Also, predicting the future based on past data analysis may not hold good, and the decision may turn out to be a loss-making one.

Key Takeaways

The price action strategy makes use of price movements of an underlying security to predict future movements. It enables traders to identify trends that might be emerging.

It is different from the technical analysis, which uses moving averages while the price action is focused on the actual price. The traders' gut feeling plays an important role in price action, while technical analysis attempts to find some order in the trading world which otherwise is quite haphazard.

Price action is quite subjective and can result in different interpretations of the same situation by different traders.

Building a trading system based on the study and interpretation of price movements is a good practice, and if it is clubbed with other technical tools, like statistics or indicators, it can turn out to be a potent weapon to make the trading journey a more profitable one.