Price action is a form of technical analysis that focuses on the past prices that have traded in the market.
If you master it well, you will make it your favorite indicator because it will never tell you a lie.
And this is true, except for new traders, or experienced traders who haven’t mastered it.
The study of this approach involves reading past prices to come up with a plan for the future.
Most successful forex traders end up finding and using this approach when running their traders.
However, this comes after a number of failed attempts and disappointments.
The reason as to why this strategy doesn’t lie is that it doesn’t tell traders what WILL happen, but it tells them what HAS happened.
Forex is a very volatile market, and as a trader, you will never be certain about what will happen in the future.
Forex is a game of probabilities and any indicator or indication of what may happen in the future is simply a possibility.
And again, it can be a remote possibility because most of the technical indicators used by forex traders are derived from the underlying price behavior.
This means that regardless of the trading strategy that you choose to use, the most important concepts to the trader are the risk, trade, and money management.
But after using those concepts, the trader can try to get the probabilities on their side as much as they can through analysis, and this is where you need this trading strategy.
It provides traders with a cleaner way of looking at past prices without the obfuscation of a mathematical formula that may obscure what has happened in the recent past.
In this article, I will be helping you to master price action trading.
What is Price Action Trading?
This type of trading strategy involves reading price charts and anticipating the future price movements without using technical indicators.
So, the trader uses a bare price chart to make his trading decisions rather than technical indicators.
If you take a closer look at the tools mentioned above, they are directly applied to the price chart itself.
The reason is that traders who use this trading strategy believe that price is the ultimate guide to forecasting future price movements.
For the trader to make informed trading decisions, they must first understand the current market structure.
The market will never go up or down without a reason.
Most traders make the mistake of entering trades without paying attention to the underlying market structure.
So, before you can use this trading strategy to enter the market, first identify the current market structure and then use price-action trading techniques to enter the market.
How to Identify the Current Market Structure
This should be your first step when using this type of trading strategy.
It is after you have identified the current market structure that you can be able to make informed trading decisions.
Here are the steps that you need to follow so as to identify the underlying market structure…
Step 1: Zones of Supply and Demand (Key Support and Resistance Levels)
First, you need to identify then mark the key technical levels on your price chart.
These key technical levels are normally referred to as the key support and resistance levels and they hold a huge number of buy and sell orders.
Due to this, we can describe them as zones of increased demand and supply.
The best way to identify the key support and resistance levels is by using longer timeframes like daily or weekly timeframes.
Just identify swing highs and swing lows that have been respected many times in the past and mark them using horizontal lines.
Those horizontal lines will mark the key support and resistance levels at which the price is most likely to retrace.
Consider the chart given below…
The above chart shows the key support and resistance levels on a chart.
All these levels have been shown using black lines running horizontally across the chart.
The lines have also been marked respectively.
For the case of the resistance lines, there are cases when the price tries to make bullish moves past them but the bullish move fails.
The price reverses and begins to move in a bearish direction.
This means that these two lines are acting as resistance levels.
For the case of the support lines, there are cases when the price tries to make a bearish move below them.
However, the price reverses and begins to make a bullish move.
This means that the two lines are acting as support lines.
So, the best way to identify support and resistance levels in a price chart is by reading the swings.
When a swing low is creating support, a swing occurs at a point where demand overruns supply.
When a swing high is creating resistance, a swing high is formed at a point where supply overruns demand.
A trader can use these higher swing highs and higher swing lows to define an uptrend.
Each of the swing highs will offer a point of support which traders can use to buy into the uptrend cheaply.
Consider the chart given below…
The above chart shows the price in an uptrend and how the higher swing lows define support.
The support is the black running upwards on the chart.
Many are the times that the price tries to reverse and make a bearish move.
However, this doesn’t continue past the support line.
This can be said to be a consolidation period, and it is formed as a result of traders trying to take out their profits from the trade.
On the other hand, when the market is in a downtrend, lower swing-highs define the resistance.
These are also formed as a result of traders trying to take out their profits from the trade.
Consider the chart given below…
The above chart shows how lower swing highs form the resistance when the price is in a downtrend.
The resistance is the black line running downwards on the chart.
There are times when the price attempts to break out through the resistance in a bullish direction.
However, this doesn’t happen, but the price instead reverses and makes a bearish move.
So, the black line is acting as a resistance level.
Once you have identified swings with support and resistance inflections, you can begin looking to buy trends cheaply, at or near the support line.
You can also begin looking to sell expensively when the prices are at or near the resistance.
Other than the horizontal support and resistance levels, there also exist other types of key technical levels that you should know as a trader.
- Psychological support and resistance levels- These levels are usually formed around round-number exchange rates, like 1.00, 1.10, 1.20, etc.
Most forex traders have the habit of placing their buy and sell trades around round numbers.
That is the reason as to why the price can either respect the levels or break them with a very high trading momentum.
- Fibonacci retracement levels- The Fibonacci retracement levels help traders to identify potential levels at which the price may retrace and pick up its underlying trend.
When it’s applied on higher timeframes, important Fibonacci levels like the 61.8% retracement level can become key technical levels that can host a large number of pending orders.
- Pivot points– Pivot points may also be important technical levels at which the price may face support or resistance.
Most Forex traders follow daily pivot points as well as their support and resistance levels when trading.
- Dynamic support and resistance levels- The key technical levels must not be static. They can be dynamic too.
Traders use moving averages to identify dynamic key technical levels that rise to around 50-day EMA, 100-day EMA, 200-day EMA, or even around Fibonacci EMA levels like the 144-day EMA.
- Confluent zones of support and resistance- There are zones at which important technical levels intersect, and this acts as an emphasis on the importance of those levels even more.
A good example is a rising trendline which can provide support for a currency pair exactly at the price level where a horizontal support lies.
This will create a confluence support zone of the rising trendline and the horizontal support.
Step 2: Market Direction- Trends
After identifying and marking the key technical levels on your chart, you should analyze the current market direction, which is the current trend.
Most price action traders choose to trade only in the direction of the overall trend.
The reason behind this is that such trade setups have high chances of recording a success.
The market can move either of three directions, up, down, or sideways. When a market moves up, it’s in an uptrend, and it forms higher highs and higher lows on the chart.
The higher lows are formed when price corrections occur during the uptrend.
The higher lows are simply short-term price movements in the opposite direction of the currently established trend.
They result from profit taking activities of the traders who have joined the current uptrend.
After the price has dropped, new buyers jump into the market since they will see the current market price as relatively undervalued.
That is how higher lows are formed when the market is in an uptrend.
When the market forms lower lows and lower highs, it is said to be in a downtrend.
The lower highs are formed when a price correction occurs during the downtrend.
Again, the price correction is simply a short term price movement in a direction that is opposite to the direction of the current trend.
As the price moves downwards, traders may decide to take their profits, and this will result into the formation of lower highs.
When a market does not show higher highs and higher lows during an uptrend and lower lows and lower highs during a downtrend, but it’s making a sideways movement without an obvious direction, it is said to be ranging.
When this occurs, the price seems to be moving between two horizontal lines, which are the boundaries for the range.
The upper boundary line of the range normally acts as the resistance, while the lower boundary line of the range acts as the support for the range.
During this time, it is difficult for a trader to tell the direction that the market will take after the range.
When the market is ranging, traders will buy when the price reaches the lower range boundaries and sell when the price reaches the upper range boundaries.
After identifying the current direction of the market, you can use a trend-following price action technique only by placing trades in the direction of the overall trend.
Now, let me give you a tip…
You can use the ADX (Average Directional Movement Index) indicator to identify the current direction of the market.
The ADX indicator is used to measure the strength of a trend.
An ADX reading of below 25 is an indication of a ranging market.
An ADX reading of between 25 and 50 is an indication of a trending market.
An ADX reading of between 50 and 75 is an indication of a strong trend in the market, and an ADX reading of above 75 is an indication of a very strong trend in the market.
However, it will be good for you to note that the ADX indicator is not different from other technical indicators, so it will simply be lagging the underlying behavior of the forex pair price.
So, the ADX indicator is not more important than analyzing the price itself.
Step 3: Market Psychology (Chart and Candlestick Patterns)
Now, you have identified the key technical levels on your chart and determined the direction of the market.
You only need one more ingredient to help you get a bigger picture of the market and understand the current market structure better.
This is the psychology of the market participants, which is shown by the charts and candlestick patterns.
The market psychology will help you gain valuable insights into what the market participants are thinking about.
This will help you to place a buy order at exactly when the buyers overpower the sellers and take over control of the market, or place a sell order when the sellers overpower the buyers and take over control of the market.
Price action traders normally use charts and candlestick patterns to analyze the current market psychology.
Chart patterns are formations within the price that give traders a lot of information as far as the battle between buyers and sellers is concerned.
Traders use chart patterns to predict future price movements based on the outcome of the battle between buyers and sellers.
Since chart patterns have been used successfully by traders in the past, technical analysts and traders believe that these patterns should also work well in the past and the future.
There are two major types of chart patterns in Forex…
These are the reversal and the continuation chart patterns.
Examples of reversal chart patterns include head and shoulders, rising wedges during uptrends, inverse head and shoulders, falling wedges during downtrends, triple tops and bottoms, double tops and bottoms, and triangles.
Examples of continuation chart patterns include rectangles, falling wedges during uptrends, rising wedges during downtrends, flags, pennants, and triangle.
Although chart patterns are formed by dozens or even hundreds of candlesticks, the candlestick patterns are formed by a single candlestick or by up to a few candlesticks.
Candlestick patterns are normally used to confirm a price action trade setup, hence, traders should not rely only on candlestick patterns when making trading decisions.
The patterns give traders valuable insights into the battle between the buyers and the sellers, which is represented by the size of the candle body and its upper and lower wicks/shadows.
Just like the chart patterns, the candlestick patterns can also be classified into reversal patterns and continuation patterns.
Examples of reversal candlestick patterns include hammer, three inside up, hanging man, three inside down, engulfing pattern, and star patterns (morning and evening star patterns).
Examples of continuation candlestick patterns include marubozu, three crows, and three soldiers.
Chart patterns and candlestick patterns give traders a lot of insights about the psychology of the market participants, the buyers and the sellers.
Are the market participants thinking bearish or bullish on the forex pair?
If the forex pair creates a reversal chart pattern, like the head and shoulder pattern with a lower high as its right shoulder, there are high chances that the sellers will have an upper hand in the near future.
If the forex pair forms a continuation chart pattern like the rectangle pattern, it acts as an indication that the market is in a consolidation phase before a continuation occurs in the direction of the previous trend.
As a trader, ensure that you understand the chart and candlestick patterns. This will give you a real edge in trading.
Price Action Analysis Methods
After identifying the current market structure, you need to analyze the price behavior in order to become a good trader.
The following methods will help you achieve this…
Method 1: Grade Trends by Focusing on Swings
As a trader, see the trend as your friend.
The reason is that the future price movements are unpredictable.
However, there must be a reason behind every trend.
And for you to become a successful trader, you must flow with the trend.
If you choose to trade as pessimistically as you can, and assume that each individual trade is equivalent to flipping a coin, then you will have 50/50 chances of the price moving up or down.
If that bias continues, and you keep on trading in the direction of that bias, then you can begin moving your probability or chances of success better that a 50/50 split.
The move can be as small as 51/49, 52/48, etc., but the logic remains the same.
If what has happened continues to happen, you will stand better chances of recording success.
If you add strong money management strategies to it, you will have a complete trading strategy.
Traders can use the price alone to gauge trends.
As we stated earlier, uptrends will be characterized by higher highs and higher lows.
Consider the following chart…
The above chart shows the formation of higher highs and higher lows during an uptrend.
The uptrend has been shown by the green arrow running upwards and marked as Uptrend.
During the uptrend, higher highs were formed as shown by the bullish candles (green).
Also, the consolidation periods led to the formation of higher lows as shown by the bearish candles (red).
Remember that the consolidation periods result from the profit-taking activities of the traders who have joined the trend.
The downtrends on the other hand are characterized by lower lows and lower highs.
Consider the chart given below…
The above chart shows the formation of lower lows and lower highs during a downtrend.
The downtrend has been shown by the red arrow running downwards on the chart.
The lower highs have been shown using black lines and pointed to by black lines marked as Lower Highs.
The lower highs were formed as a result of price consolidations in the market.
Before you enter a trade, it will be good for you to ask yourself whether it is good for you to buy just because the price is moving high or to sell just because the price is moving down.
The answer is no.
The reason is that you should try to get the possible chances of success in the market from the information available to you.
Method 2: Use Price Action Formations to enter into Positions
After identifying the trend and the swings displayed in the marketplace, you can begin to look for formations and decide on how and when to enter into positions.
There are different types of formations that can develop from the price behavior.
It’s up to you to identify the formation that has been created and trade wisely.
Consider the chart given below…
The above chart shows the formation of three bearish engulfing candles.
The three have been shown using three black arrows running vertically downwards.
A closer look at the chart shows that each of the three bearish engulfing candles completely engulfs its previous bullish candle.
After the formation of each bearish candle, a strong bearish move begun.
The bearish move continued running for some time before it came to an end.
This is an indication that anytime that you spot a bearish engulfing pattern in the market, there is an impending bearish move.
This is a signal that you should exit your long position if you had entered one.
After exiting your long position, you can enter a short position.
This way, you will benefit from the subsequent bearish move that occurs in the market.
Consider the chart given below…
The above chart shows the formation of bullish engulfing chart patterns in the market.
The 5 instances at which the bullish engulfing patterns are formed have been pointed to by black arrows.
A closer look into the chart reveals that each engulfing candle is characterized by a bullish candle that completely engulfs its previous bearish candle.
Again, after the formation of each bullish engulfing pattern, the market entered into a very strong bullish move.
This means that anytime you spot a bullish engulfing pattern in the market, it is a signal that there is an impending bullish move in the market.
If you were in a short position, it’s time for you to exit it and enter a long position.
A trader who entered a long position after spotting the bullish engulfing pattern benefited from the subsequent increase in the price of the forex pair.
So, anytime that you spot a bullish engulfing pattern, short the currency pair.
Staying in the trade may make you incur a loss.
Consider the following chart…
The above chart shows the formation of hammer and inverted hammer candles on the price chart of a forex pair.
The first two candles pointed by black arrows are the hammer candles, while the candle pointed to by a red arrow is the inverted hammer candle.
The formation of the first hammer candle marked the end of the preceding bearish move.
Instead of the bearish move continuing, it ended immediately.
This means that the formation of the hammer candle was a signal that the bearish trend has reached its end and a new bullish move should begin.
A hammer candle means that the sellers are pushing the market to a new low.
However, the sellers aren’t strong enough to stay at the low, hence, they decide to bail on their positions.
This makes the market to rally back up, causing buyers to also step into the market.
So, when you spot the formation of a hammer candle after a bearish trend, just know that the market is about to reverse into a bullish trend.
So, if you were in a short position, it is an ideal time for you to exit and enter a long position.
A second hammer candle was formed immediately.
This hammer candle was an indication that the bullish move will run for some time.
So, this was sending the signal that you should remain in your long position if you had entered one.
If you had not entered a long position, it is also not too late for you to enter into one.
After the formation of this candle, the price kept on moving in a bullish direction.
The inverted hammer candle has also been shown, and it’s a bearish candle (shown in red color).
This candle is preceded by a bullish trend.
After the formation of this candle, the market changed from a bullish trend into a bearish trend.
So, the formation of the inverted hammer candle was an indication that the bullish trend is coming to an end and that a new bearish trend is starting.
So, anytime you see an inverted hammer pattern on your chart, it’s time for you to exit your long position and enter a short position.
If you continue staying in your long position, you may incur a loss since the price is more likely to make a reversal.
This is what you’ve learned in this article…
- Price action trading is one of the best trading strategies among forex traders.
- It involves making trading decisions solely based on price charts rather than using technical indicators.
- The trader analyzes the past price behavior of a forex pair.
- The trader can then use the insights gained from that analysis to anticipate the future movement of the forex pair price.
- This can help the trader to make sound decisions when planning to enter or exit a particular trade.
- The key to this trading strategy is getting a bigger picture of the market.
- There are a number of elements that can help you get a bigger picture of the market.
- When the price is in an uptrend, it is characterized by higher highs and higher lows.
- During this time, the higher lows are formed as a result of consolidations in the market.
- The level at which the higher lows bounce back forms the support level.
- When the price is in a downtrend, it is characterized by lower lows and lower highs.
- The lower highs are formed as a result of consolidations within the market.
- The level at which the lower highs bounce back forms the resistance level.
- After identifying the trends and market swings in the marketplace, you can look for price formations to help you determine the positions at which you should enter into trade.
- Examples of such price formations include the hammer and engulfing candles.
- These will help you know when it is the right time for you to enter a trade as well as when it is the right time for you to exit a trade.