Day Trading Price Action Strategy — What Is It? (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

Day trading is becoming popular among retail traders in many markets. Many new retail traders want to try out a day trading price action strategy.

Price action refers to the pattern of price movement of an asset. Thus, a price action strategy is using patterns of price movements to determine when to enter and exit a trade. The strategy can be used in different styles of trading, including day trading where the trader looks for such patterns on the intraday price charts.

In this post, we take a look at price action.

What is price action?

In technical analysis, price action literarily means the action of price. It refers to the patterns created by price movements. The analysis of the basic movements of the price, to use the patterns to generate signals of entry and exit in trades is known as price action trading. Price action analysis is a form of technical analysis since it looks primarily at the history of an asset’s price movement and ignores the fundamental factors of the asset.

What differentiates price action from other forms of technical analysis (with indicators) is that it focuses on price movements alone, with little or no input from indicators. It studies price swing highs and swing lows, as well as the characteristics of the individual price bars, trying to use it to explain the sentiment and behaviors of market participants. That is, it incorporates the behavioral analysis of market participants as a crowd from evidence displayed in price movements.

At the macro level, price action traders observe the broad price structure — whether it is trending or range-bound — using trend lines, moving averages, and support and resistance levels. They look for chart patterns that may reveal how the price might move next. They may further look at the individual price bars, observing their size, shape, and development during the price sessions they represent.

Patterns traders look out for in price action trading

In price action analysis, traders look out for two kinds of patterns:

  • Chart patterns
  • Candlestick patterns

Chart patterns

These are recognizable structures on the price chart formed by a series of price swing highs and lows. Chart patterns often have the shape of physical objects, and they are named after whatever object they resemble. These patterns can be classified into the following:

Reversal chart patterns

These are chart patterns that form after a prolonged price movement in one direction. They can be seen in an uptrend or a downtrend and indicate a potential reversal of the existing trend. An example of a reversal pattern is the head and shoulders pattern that forms at the end of an uptrend, indicating a potential reversal to a downtrend. The inverse head and shoulders pattern forms at the end of a downtrend and indicates a potential reversal to an uptrend. Other examples include:

  • Cup and handle
  • Bump and run
  • Rising wedge in an uptrend
  • Falling wedge in a downtrend
  • Double top/bottom
  • Triple top/bottom
  • Rounding bottom

Continuation chart patterns

There are chart patterns that indicate a potential continuation of the existing trend. Examples include:

  • The triangle patterns (symmetrical, ascending, and descending)
  • Rectangle pattern
  • Flags/pennants
  • Rising wedge in a downtrend
  • Falling wedge in an uptrend

Harmonic patterns

These are advanced chart patterns that are formed by four consecutive price swings with unique configurations. They include:

  • Gartley pattern
  • Butterfly pattern
  • Bat pattern
  • Crab pattern
  • Shark pattern

Candlestick patterns

These refer to patterns formed by the shape of an individual candlestick or a group of candlesticks. Since a candlestick shows how the price moved during a given trading session, candlestick patterns may indicate market sentiment during the trading session. Examples of candlestick patterns include:

  • Hammer
  • Shooting star
  • The dojis (regular, long-legged, gravestone, and dragonfly)
  • Marubuzo
  • Harami (inside bar)
  • Engulfing
  • Piercing
  • Morning star
  • Evening star
  • Hikkake

Is price action good for day trading?

Yes, high levels of price activity are necessary for day trading. Day traders love to see volatility in the market.

However, in terms of price action as a form of strategy, it depends on individual traders. While some traders may prefer using price action analysis to spot their trade entry and exit, others may like to use indicators for that. Some day traders even trade based on news releases — trading the opportunity created by the increased volatility that follows a news release is their own strategy.

Price action indicators and tools

Pure price action traders don’t normally use trading indicators. They simply analyze the price swings and candlestick patterns to determine when to make a trade and when to close the trade. This category of traders may only use tools like trend lines to indicate the trend direction and support/resistance levels and pivot levels to mark important price levels.

Some other traders may combine price action analysis with indicators analysis. The indicator commonly used is the moving average to indicate the trend and provide dynamic support/resistance levels. Some traders also use the VIX indicator to gauge the market volatility when trading, while some use the RSI to track the price momentum of price swings, especially as regards impulse waves and pullbacks.

Best price action strategy

It is hard to tell which is the best price action strategy. You need to back-test each price action strategy you create to know how well they performed in the past. But the problem is that price action patterns and strategies are difficult to code, so back-testing them won’t be easy.

Manual backtesting may not be an option because of cognitive biases. If you can find a way to code your price action strategies and back-test them, you would be in a position to know the strategies that work best for a given market.

Price action strategy rules

There are no general rules. It depends on each strategy and the market you want to trade. What works in one market may not work in another. The most important thing is to make sure that the strategy is quantified through backtesting. It’s from backtesting and optimization that you arrive at the definitive rules of your strategy.

One more thing, it is always a good idea to use different strategies and trade different markets so you can achieve diversification, which can help minimize risks in changing market conditions.

Day trading price action strategy (backtest and example)

A backtest of a day trading price action strategy is coming soon.

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