Three-Step Price Action Trading Strategy Explained
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In the world of trading, price action is an important term that denotes the change in the price of a stock, index, commodity or currency. Traders analyse the price action to read the market for an asset and make decisions based on recent price movements.
Price action strategy is one of the simplest trading strategies that involve the subjective analysis of just one factor- price action. Many traders prefer this simple tactic to other complicated ones that analyse fundamental and technical indicators.
Now, let’s learn about the price action trading strategy and its simple 3-step guide that works consistently.
What Is the Price Action Strategy?
As mentioned above, price action describes a security’s price movement with respect to its past price changes. So for trading, you simply need to follow the price action. For instance, if your analysis tells you that the price is about to rise, you will take a long position; otherwise, you will opt for a short position.
In 'pure' or 'naked' price action trading, you will be making trading decisions solely based on the prices on stock charts instead of relying on complex mathematical formulas. You will be looking for easily recognisable patterns in the market to predict future price movements.
Price action traders typically use price bars, price bands, trend lines, breakouts, support and resistance levels and candlestick chart patterns . Experienced traders can spot these signals instantly as they recognise patterns in past performance.
Why Use the Price Action Strategy?
Here are some reasons for the growing popularity of price action trading:
- Price action traders believe that the relationship between a stock's current price and its past prices is more relevant than 'second-hand' values derived from price history. That is why they ignore the additional data that comes from other types of technical analysis.
- The simple and stripped-down approach of price action strategy makes it much simpler and easy to use for most traders. It is also called clean chart trading or raw trading due to the fact that there are no numerous technical indicators crowding the trading charts.
- Some experts state that all variables that influence a company such as news, economic events, company financials, etc., are already factored in its stock price. Therefore, rather than deciphering these variables, traders can make profits by only following the price action.
How to Use the 3-Step Price Action Strategy?
To carry out a price action trade, you will need to identify whether the proper conditions are met first. There are 3 criteria you should check- market activity, momentum and flow. Only when you have confirmation from the proper signals, execute your trade.
The following is a detailed guide on how to execute a 3-step price action trading strategy:
Step 1: Identify an Area with Sufficient Trading Activity
Sufficient trading activity is a must for the price action strategy as it allows you to gauge the sentiment of buyers and sellers. Depending on whether you want to opt for a long or short position, you should look for clear signs of uptrends or downtrends. For uptrends, check if the highs and lows are consistently high and vice versa.
However, you will want to avoid ranging markets completely. If you cannot spot a clear direction or market trend, you will be unable to read the market and profit from it. One great time for spotting clear directions is during the opening hours when you have data from the previous session.
Step 2: Analyse the Momentum
For a successful trade, you will want both trading activity and momentum to back your decision. One way to measure the momentum is to measure the distance between two swing points.
If the distance between swing highs and swing lows keeps increasing as a trend develops, it indicates strong momentum. Conversely, if the distance decreases, it shows a fading momentum. Reading the momentum helps you identify the breakout, breakdown and pullback phases, which helps you execute your price action strategy .
Step 3: Decide the Flow/Territory and Confirm Your Trade
Next, you need to make a decision on the direction your stock is headed. Many traders try to identify signs of clear patterns (head and shoulders, pin bar, inside bar) to pick which trades can be entered. When prices break their predefined levels, they consider the pattern to be valid.
A much simpler but effective solution is to check for resistance and support levels as they provide consistent results. From your observation, you will want an answer to these questions:
- Which party is driving price movements?
- Do the price actions have short or lock wicks?
- Has there been a sign of a recent reversal?
- Are the price movements weak or strong?
- Is the price going through resistance or support levels or consolidating?
Once you have clear answers, you will want to look for signs of confirmation in the market. Waiting for an indicator for your price action strategy to show up on the charts will increase the probability of profits.
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Conclusion
The price action strategy has always been one of the most popular strategies for its simplicity and reliability. While it simplifies the technical analysis by confining your attention to a few variables, you will still need to learn this strategy by heart. For the best results, you should be patient and look for an asset showing high liquidity and volatility. As with any high-risk strategies, having a stop-loss and a proper exit plan is a must.
FAQs
- What should be the exit strategy for price action trading?
As this is a short-term strategy, you should ideally exit as soon as the price hits the very first level of resistance or support. If you see the price action stalling at any point, exit your trades immediately to avoid further losses.
- What is the difference between price action trading and regular technical analysis?
Price action uses only a single variable, i.e., the movement of prices, to spot trading opportunities. On the other hand, regular technical analysis uses a large number of variables and chart patterns to predict future changes.
- What is the main limitation of the price action strategy?
The main limitation of the price action trading strategy is that price action is quite subjective. As such, different traders may come to widely different conclusions when looking at the exact same chart.