What Is Price Action Trading Strategy: A Step-By-Step Guide

In the modern market, most traders try to foresee the price movements of various financial assets, to choose their investment strategies carefully and, as a result, gain higher profits. The Price Action Trading strategy (PAT) is an efficient market tool that combines data of past price changes with actual and more recent information. Thus, PAT does not take into consideration the fundamental analysis factors. Traders can take advantage of the price action technique and understand the upcoming trends and fluctuations of an asset’s price.

In this article, we will define what Price Action Trading (PAT) strategy is and explain the trading tools that PAT embodies and how they can be applied. Moreover, we will provide a brief guide on how to read the price action as well as which indicators and techniques it includes.

What Is Price Action Trading?

An important part of technical analysis is considered to be the Price Action Trading (PAT) strategy which is mainly used by traders who base their investment choices on the price movement of an asset. The definition of PAT derives from the brief evaluation of the security’s performance so traders can decide their future steps. Thus, if traders assume that the price will fall by monitoring the behavior of an index, commodity, or other asset they may go short. Otherwise, they may enter a long position to benefit from the rise in the price.

PAT can be analyzed from clear price charts that are discharged from various indicators that specify the support and resistance level of an asset. Since all financial markets provide information about the movement of the securities price, traders can examine the patterns that are formed and take advantage of the results.

Traders who use the Price Action Trading technique rely entirely on the data that are presented by the price charts without any formulas and further technical analysis. This is why this strategy is also popular as “pure” or “naked” price action. Thus, traders draw their estimations from the formed patterns that are known as price action signals and act as triggers for potential future price alternations.

Price Action Trading Tools

The Price Action Trading strategy embodies various tools which are used to predict future movements. Those are used by most professionals and are embodied in their trading strategies to help them make more efficient investment decisions. Some tools include but are not limited to the Breakout, the Candlesticks, Bullish and Bearish trend, and more technical theories such as support and resistance.

Breakout

This type of trading tool monitors any major trend movements in the market. A breakout can occur when the market moves over or below the limits of support and resistance levels. Breakouts can be either small or big and can occur in various patterns such as triangles, head and shoulders, ranges, and flag patterns.

Most traders monitor the price charts so they will have an immediate response if a breakout happens during a trend. This can offer huge profit potential. However, a breakout doesn’t come with the insurance that the trend will continue in the expected direction. This is known among traders as a “false breakout”, meaning that it shows a reverse trading opportunity than that of the trend.

Candlesticks

Candlesticks are one of the most popular Price Action Trading strategies. It is used by many day traders to take advantage of a quick generated profit in a short period. Each candle contains pieces of information about the past price movement of an asset. Moreover, they show four price points which are open, close, high, and low levels. Candlesticks are also a way for the traders to understand the trending of a market which is usually formed by emotion.

Bullish Trend

While monitoring the movements of an asset’s price on the chart, traders can identify various shifts in their positions. Thus, in a candlestick chart when the candles are escalating up and to the right, a bullish trend is taking place. This way the asset’s price is tending to form a new high which is higher than the previous candlestick’s high. This guarantees that the security is trending in the correct direction.

Bearish Trend

The bearish trend is the opposite state of the bullish trend on a chart. Traders that monitor the candlestick patterns of an asset may realize a decline in its price. This can appear when the candles are moving to the right and down. Thus, on the chart it’s possible to see lower highs than the previous candle and even lower lows. This is a sign for investors to go short and it is not very common among new investors.

Support and Resistance

With Price Action Strategies, most experienced traders prefer to place their activities and their investment choices near the support and resistance price areas. Those regions are formed in the past during strong reversals of the asset’s price and they are possible to be shaped in the future. Traders that use the support and resistance areas as a trading tool are more likely to buy during an uptrend and sell during a downtrend.

How to Read Price Action

The Price Action Trading Strategy is an efficient tool that, despite its simplicity, requires skills and experience to understand the trending direction of the market. Thus, to make the correct trading decisions, investors need to know how to read and interpret the candlestick’s pattern signs.

An asset’s chart involves various price action reversals that are expressed by impulses in the form of trending waves, and by corrective waves presented as pullback waves. To understand when it is the proper time to make a correct investment choice traders needs to spot the time the trending waves become higher than the corrective ones.

Another strategy to determine the asset’s price direction is to monitor the swing highs and lows of the trending waves. In the financial market, all securities pass through uptrend and downtrend periods which are formed inside the support and resistance area. Thus, just as with any technical analysis tool when an asset periodically forms a higher swing high in price it is considered to be in an uptrend. The reverse situation is a sign of a downtrend.

On a candlestick chart, traders can spot specific patterns that can be shaped depending on the price moves. Such patterns can be ranges, triangles, as well as expanding ranges that are sharp movements of the asset’s price with higher swing highs and lower swing lows. In the chart below there are some examples of formed trends and patterns.

Price Action Trading Strategies

Trading with PAT can be done in various ways by implementing each strategy with different trading tools. Those PAT strategies are also common among traders as “triggers”, “setups”, or “signals”. The most important strategies are the price action trend trading, the inside bar, the pin bar, trend following breakout entry, trend following retracement entry, head and shoulders reversal trade, and sequence of highs and lows.

Price Action Trend Trading

Price action trend trading is embodied in the general definition of PAT strategy. It is oriented toward studying the trends of the market through a chart. With this technique, traders can monitor the movement of the price from the past until the current time and spot different trend reversals.

In the chart below, any trader from the most experienced to the newest one can spot different trending directions as well as recent swings in the price. Thus, a strong buy position can be advised in the spots that are marked with a red circle so the trader will benefit from the uptrend. Conversely, on the downtrends, investors tend to open a “sell” or a stop loss position.

Inside Bar

The inside bar PAT strategy consists of two different bar-patterns. The pair is divided into the inside bar and the mother bar. The latter is always higher than the former and comes near the inside bar in all the candlestick charts. When this phenomenon is formed the traders can understand that either it is a period of consolidation in the market or, if it occurs on a key chart level, there is a strong signal of a price action reversal.

Pin Bar

The Pin Bar is an efficient trading strategy tool that helps traders to understand the size of the price that was discarded due to a sharp trend reversal. The pin bar, which is also popular in the forex market as the candlestick strategy, consists of a candle with a long wick that represents the price rejection.

The pin bar is widely used among traders since it is a powerful tool that can indicate the future price direction. If in a chart pattern there are candles with long lower tails day traders may be expecting the price to go higher since lower prices have been rejected. Conversely, if there are long higher wicks it can be a potential upcoming fall in the price.

Trend Following Breakout Entry

This strategy is used by traders to monitor any significant changes in the financial market, having always in mind that a price spike may be followed by a retracement. When a breakout occurs the market ranges outside of the specified limits of support and resistance level. Thus, if there is an uptrend in the market and the asset is trending over the resistance line, traders tend to enter a strong long position. Conversely, they will choose to enter a short position if the price of the security goes lower than the support level.

Trend Following Retracement Entry

This Price Action Trading strategy is considered to be one of the simplest. It is widely known among traders and is commonly used by newbies since they only have to follow the existing trend. It implies that if there is a continuous creation of higher highs and higher lows it is a sign that the trend is going upwards and the traders usually go long.

Head and Shoulders Reversal Trade

The head and shoulders reversal trade is one of the most popular Price Action Trading strategies widely used by traders. This is because it offers high levels of accuracy and it is an early sign that a current uptrend is about to end. Thus as a technical indicator, it can help traders to understand when it is the best time to exit or enter a position since it can predict a bullish-to-bearish trend reversal.

This price action technique can be spotted on the chart by its unique shape that forms three peaks, where the two exteriors are approximately the same size (known as shoulders) and the middle one (known as the head) is the highest one. In a price chart, these ups and downs are translated as the sequential rise and fall of the asset’s price that reaches three consecutive lows divided by temporary rallies.

The reason that this PAT strategy is considered suitable for many traders is that it gives them the capability to choose an entry point easily. Moreover, investors can set their own stop-loss point and benefit from the highest potential profit that can be received from the temporary highest peak.

Sequence of Highs and Lows

The general definition of the Price Action Trading strategy embodies the monitoring of highs and lows sequence. Since the philosophy of PAT is to trace the market’s price direction, the technique of spotting the reversals of highs and lows in an asset’s price makes this tool the core of PAT strategy. Price action traders follow the trend of the market to spot the higher highs and higher lows so they will understand the proper time to enter or exit the market.

Best Indicators for Price Action Trading

Most traders use the PAT strategy in its simplest form so they will apply this tool in an easy and clear way. This gives them a more precise and easier to comprehend picture of an asset’s price charts so they will make the proper investment moves. However, there are some other more experienced traders who choose to implement indicators on their charts to strengthen their Price Action Trading technique and help them understand the entry and stop-loss points. Such indicators are the Relative Strength Index (RSI), the Fibonacci Retracements, and the Stochastic Oscillator.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) term describes a measurement tool that is used to determine the price momentum of a stock or other security. When price action traders apply the RSI in their charts they usually utilize a 14-period price range and measure the levels that this indicator is located. If the RSI is more than 70% the price is located at its highest level. Conversely, the price is at its lowest level if it is less than 30%.

When the RSI indicator is implemented on the price chart in combination with the PAT strategy traders try to spot the buy and sell signs. Thus, if the RSI moves below and then above the 30%, it is considered to be an uptrend signal and traders tend to enter a buying position. However, if the RSI moves above 70% and then rallies down from this line a downtrend occurs and the traders are likely to go short.

Fibonacci Retracements

Another efficient indicator that can be used in combination with the Price Action Trading strategy to help traders make the most profitable investment choices is the Fibonacci Retracement. This indicator can be designed in two different ways depending on the direction of the trend.

The first choice is to draw a line from low to high and the other is vice versa. Both techniques can point to areas where the price could pull back. The levels that are depicted with the use of the Fibonacci Retracements are 23.6%, 38.2%, 50%, 61.8%, and 100%. However, if there is a strong trend in the market the highest level that is being reached is usually 38.2%.

Stochastic Oscillator

The Stochastic Oscillator is an efficient momentum indicator that can be used by price action traders to spot potential trend reversals. This indicator is very popular in forex trading since it is used as an index to compare the closing price with the trading range of a specific given period of time.

The Stochastic indicator has a similar use to the RSI and is designed in the same way. Two lines are drawn that are called the stochastic and the signal line with the former having a faster rate than the latter since it represents the Moving Average of the stochastic line. Traders who want to use the Stochastic Oscillator in the most effective way, need to constantly monitor the price chart and spot the moment when the price action and the stochastic signal surpass the signal line.

Benefits and Limitations of Price Action Trading

Traders who choose to imply the price action trading strategy in their portfolio need to know that this technique comes with its benefits but also with its drawbacks. Some of them are described in the table below.

Bottom Line

Price Action Trading strategy is a technique that helps traders monitor the market’s direction and spot potential reversals in prices. It is a simpler and more comprehensible tool than other trading mechanisms. However, it requires the traders to spend a considerable amount of time studying charts and patterns so they will understand its potential opportunities. It is a more flexible trading tool that gives the chance to users to select the entry and exit point of their choice. Last, but not least, choosing the correct price action trading strategy and implying it in your portfolio can help you see a “pure” picture of the price charts that are relieved by unnecessary variables and indicators.