Technical analysis is the mainstay of most short-term trading. While many traders focus on the use of indicators because their signals are easier to spot, and they can easily be coded into trading algos, some short-term swear by price action. But what is price action trading strategies?
In the financial markets, price action refers to the movement of a security’s price over time, which is depicted in the price chart and forms the basis of technical analysis. Thus, price action trading strategies is a method of trading where traders make decisions about trades based on patterns of price movements rather than on indicators.
In this post, we take a look at the price action trading strategy, and at the end of the article, we provide you with a backtest.
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What is price action trading?
In the financial markets, price action trading refers to the movement of a security’s price over time, which is depicted in the price chart and forms the basis of technical analysis. It is the history of past and recent price movements as seen in the charts which traders can analyze to make trading decisions. Price movements are often recorded in specified durations or sessions known as timeframes. So, a price bar may represent price movement within an hour (1-hour timeframe), four hours (4-hour timeframe), or a day (daily timeframe).
The Japanese candlestick chart is mostly preferred for analyzing price action because it easily shows where the price opened and closed for the session and how it moved during the session. Also, the way the price moves during a session can give the price bar (candlestick in this case) some form of shape, and the arrangement of consecutive candlesticks and the pattern formed thereof may tell some important stories about price activity, which may have some predictive value. Moreover, price movements often form structures referred to as chart patterns, which can be used to predict future price movements.
Making trading decisions based solely on price action patterns is known as price action trading. Thus, price action trading strategies is a method of trading where traders make decisions about trades based on patterns of price movements rather than on indicators. By spotting patterns in the price movements of a security, a trader may be able to predict future price movements. Apart from the price movements and patterns, traders use some tools to help them identify the price levels and trends.
Price action indicators
Price action traders do not rely on technical indicators, so they do not often attach them to their charts, which is why their charts are usually naked and clean — not messed up with multiple indicators. However, there are some tools they use to know the right levels to look for their trade setups and the nature of their setups. Here are some of them:
- Candlestick chart: There are many chart types out there, but price action traders mostly love to do their analysis on the candlestick chart, and there is a reason for that. The candlestick price bars can easily show the open, high, low, and close prices during the trading session that formed the candlestick. With unique color codes, you can easily see the direction of price movement during the session and how the bulls and bears battled for price control. The price movements during the session can give the candlestick a shape, which traders can use to predict whether the price wants to reverse or continue in its present direction. Another reason is that groups of candlesticks can form patterns on the chart, which can give a clue about future price action.
- Trendline trading strategy: As you would expect, price action traders use trendlines a lot. They use trendlines to delineate the direction of the trend, which can help them determine their trading bias. Trendlines also help them to see potential support and resistance levels (dynamic support), even as the price is ascending or descending, as they are placed across the swing lows or swing highs. They also use trendlines to identify potential trend reversals, including pullback reversals. The breakout from a trendline can signal a reversal of the trend. Apart from the reversal of the main trend, they can use counter-trendline to identify pullback reversals that signal the continuation of the main trend.
- Fibonacci retracement and extension levels: The Fibonacci tools are very useful to price action traders in many ways. They can help them in knowing where to look for entry setups and where to exit a trade. The retracement tools show price levels (38.2%, 50%, 61.8%, etc.) where a pullback might reverse. Price action traders tend to look for reversal candlestick patterns around such levels to trigger their trade entry. On the other hand, the extension or expansion tool helps them to know where to place their profit targets.
- Support and resistance levels: These are key price levels where the price had reversed several times in the past. It is believed that the price could also reverse again around such levels because there are usually many limit orders around there, and also, many traders are monitoring such levels to enter the market. The support level is below the current price and may be used for entering a long position or taking profit in a short position. Resistance levels are above the price and may be used to enter a short position or to take profit in a long position.
- Pivot point trading strategy: These are price levels calculated from the previous day’s range and closing price. Some traders believe that the relationship of the current price to such levels may have some predictive value.
Price action patterns
As we stated earlier, price movements can form patterns both in the shape of the individual price bars or in the structures they form on the chart. Thus, there are two types of patterns price action traders look out for candlestick patterns and chart patterns. Both can be used for Price Action trading strategies.
Candlestick patterns
These are shapes formed by a single candlestick or a group of two to four consecutive candlesticks, which traders believe can tell how the price might move in the near future. As with the candlestick chart, the patterns originate from Japanese traders but have been adopted by traders from the west.
Candlestick patterns can be classified in different ways, including based on the number of candlesticks that form the patterns and based on the potential price movements expected from the patterns.
But it’s more useful to categorize them based on the expected price movements, and in that case, they can be grouped into:
- Bullish reversal patterns
- Bearish reversal patterns
- Bearish continuation patterns
- Bullish continuation patterns
- Indecision patterns
The bullish reversal candlestick patterns
Bullish reversal candlestick patterns are seen around the low of a price swing down, and they indicate a loss of momentum in the downswing and a potential reversal to the upside. The common bullish reversal candlestick patterns include:
- Hammer: This is a single-candlestick pattern with a small body at the upper end and a long lower wick that occurs after a price swing down — a similarly shaped candlestick after a bullish swing is not a hammer but a hangman.
- Bullish engulfing: This is a double-candlestick bullish reversal pattern that appears after a price swing low. The first candlestick has a bearish body, while the second one is tall and bullish, opening below the body of the first one and completely engulfing it.
- Piercing pattern: This is another double-candlestick bullish reversal pattern. The first candlestick is bearish, while the second one is a tall bullish candlestick that opened below the low of the first one and closed above its midpoint.
- Tweezer bottom: This consists of two consecutive candlesticks at the low of a price swing down, with their lower wicks ending around the same level.
- Bullish harami: Also known as the inside bar, the harami is a two-candlestick pattern — the first candle is long and can be bullish or bearish, while the second candle is small, with its range lying within that of the first one.
- Bullish hikkake: This is a multiple-candlestick pattern that involves a harami pattern, a false attempt to break below the harami pattern, and a subsequent upward breakout of the harami pattern.
- Morning star: This is a three-candlestick pattern that consists of a bearish candle, a small indecision candle, and a reversal tall bullish candle.
Note that the presence of these patterns is not enough to assume that a price reversal is underway. On their own, the patterns don’t carry high odds of success. To increase the odds of getting a high probability trade setup, price action traders look for these patterns around a support level, an up-trendline, or 50-61.8% Fibonacci retracement level in an uptrend.
The bearish reversal candlestick patterns
Bearish reversal candlestick patterns are seen around the high of a price rally, and they indicate a loss of momentum in the rally and a potential reversal to the downside. The common bearish reversal candlestick patterns include:
- Shooting star
- Bearish engulfing
- Dark cloud cover
- Tweezer top
- Bearish harami
- Bearish hikkake
- Evening star
These patterns are the exact opposite of the bullish ones. As with the bullish ones, seeing a pattern is not enough to assume that a price reversal is underway. The pattern must occur around a resistance level, a down-trendline, or the 50-61.8% Fibonacci retracement level in a downtrend.
Chart patterns
These are recognizable price structures created by price movements and transitions between rising and falling trends that can be identified with the help of trend lines, horizontal lines, and curves. Price action traders use the patterns to analyze the current price movements and predict future market movements based on price breakout from the patterns.
There are many chart patterns, and they are generally grouped into reversal chart patterns and continuation chart patterns, depending on whether the price is more likely to continue in the direction of the trend preceding the chart pattern formation or reverse.
The reversal chart patterns
These are chart patterns that often indicate a potential reversal in the trend direction. Examples of these patterns include:
- Head and Shoulders pattern: This forms at the end of an uptrend and involves three swing highs (the middle one being the highest) with two intervening swing lows. The line connecting the swing lows is known as the neckline, and a break below it is an indication of a potential downward reversal. When the opposite pattern occurs at the end of a downtrend, it is called the Inverse Head and Shoulders pattern.
- Double top pattern: The pattern forms at the end of an uptrend and consists of two swing highs that end around the same level. A horizontal line at the intervening trough is known as the neckline and a break below it is a sign of a potential downtrend. When the opposite pattern occurs at the end of a downtrend, it is called the double bottom pattern.
- Triple top: This forms at the end of an uptrend with three swing highs and two intervening swing lows. The line connecting the swing lows is known as the neckline, and a break below it is an indication of a potential downward reversal. When the opposite pattern occurs at the end of a downtrend, it is called the triple bottom pattern
- Rounding bottom: This pattern usually forms after a prolonged bear market, especially in stocks. It indicates a gradual recovery in the market after people have lost interest in the market.
The continuation chart patterns
These are chart patterns that indicate a continuation of the preceding trend. Examples of continuation patterns include:
- Cup and handle pattern: This is shaped like a cup with a handle. It is formed by a slow and gradually recovering pullback in an uptrend, which is immediately followed by a small, sharp pullback or consolidation before an eventual breakout to the upside.
- Wedge strategy: These patterns can be rising or falling. The rising wedge consists of slowly rising swing highs and sharply rising swing lows — a downward breakout in a downtrend signals the trend continuation. A falling wedge consists of slowly declining swing lows and sharply declining swing highs.
- Pennant or flags strategy: These are small triangular or rectangular price consolidations that form following a sharp price movement in an uptrend or a downtrend.
- Triangles: These patterns resemble triangles and can be ascending, descending, or symmetrical triangles.
Price action trading strategies backtest
A price action trading strategy backtest involves evaluating the historical performance of strategies using past market data.
Traders define their strategy, gather historical data, choose a trading platform, prepare the data, implement the strategy, execute the backtest, analyze the results, and iterate if needed. Backtesting helps assess strategy effectiveness, but it doesn’t guarantee future success.
Combining backtesting with forward testing and ongoing evaluation is crucial for continuous improvement. We like to incubate the strategies for at least 12 months before we commit real money. Better safe than sorry!
Let’s look at a specific price action strategy with defined trading rules and settings: the three-day lower lows and highs trading strategy. Its trading rules are simple:
- We buy the close when today has the third lower low and third lower high in a row.
- We sell at the close when today’s close is higher than yesterday’s high. This is the QS exit: when to exit a stock position.
How has the strategy performed? Let’s look at the equity curve of Pepsi-Cola:
There are 298 trades, and the average gain per trade is 1.1%. This is a mean reversion strategy, and as expected, the winners are smaller than the losers, but that is made back by a high win ratio of 80%.
The annual return, CAGR, is 8.8%, despite being invested only 11% of the time. The max drawdown is a modest 21%.
Of course, the backtest is done with the benefit of hindsight and survivorship bias (because most stocks end up worth practically nothing). But luckily, it works well on indexes with no problems with hindsight bias: lower highs and lower lows pattern trading strategy.
Price action trading strategies setups (example)
Because price action setups are difficult to code into trading algos, most price action traders are discretionary traders, which means their analysis and trade setups are subjective. However, it is common for price action swing traders to use reversal candlestick patterns at the end of pullbacks to trade impulse swings in the trend direction. For this, they use support and resistance levels. Here’s how they do it:
- In an uptrend, they use bullish reversal candlesticks as the trigger to go long after a pullback to a support level.
- In a downtrend, they use bearish reversal candlesticks as the trigger to go short after a rally to a resistance level.
Other discretionary setups include breakouts of chart patterns. For example, a downward breakout of a rising wedge in a downtrend is a trigger to go short. Similarly, a break above a falling wedge in an uptrend is a trigger to go long.
Quantified price action setups
Apart from discretionary price action setups, there are some quantified price action trading strategies. Interestingly, most of them are based on breakouts. Some examples include:
- Inside bar breakout: An inside bar, also known as harami, is a price action pattern that consists of two price bars, with the second one being within the range of the first bar. On the daily timeframe, it is called an inside day pattern. A trade signal occurs when the price breaks above or below the inside bar in the next price session.
- Narrow range breakout: Developed by Tony Crabel in 1990, the NR7 is a volatility strategy that takes advantage of the increased volatility that follows a day with a narrow trading range (low volatility). With the range defined as the difference between the high and the low of the trading day, the rules of the strategy are as follows: go long if at the day’s close if today has the lowest range of the previous last 6 trading days; exit at the close when today’s close is higher than yesterday’s high.
- Keltner Bands breakout: Keltner Bands are ATR-based bands that are placed on either side of the price and can aid in determining the direction of a trend. A breakout above or below the top and bottom is used as a trigger to enter a trade. Most Keltner Bands breakout trades are trend-following trades.
Do price action patterns work?
There are many reasons price action traders find the Price Action trading strategies attractive, such as the chart patterns that offer measurable profit targets and the fact that their charts are not stuffed up with indicators. But since we are in this game to make money, the key question is: do price action patterns work?
While some traders swear by it, you have to find out for yourself. The only way to know if any price action pattern can be profitable is by backtesting it.
Conclusion (Price Action trading strategies)
In conclusion, price action trading strategies is a popular approach used by traders in financial markets to make decisions based on the movement and patterns of price alone, without relying on indicators or other technical tools. It emphasizes the analysis of historical price data, such as candlestick patterns, support and resistance levels, and trend lines, to identify potential entry and exit points for trades. We provided you with a specific example in earlier in the article.
The main premise behind price action trading is that price reflects all available information in the market, including fundamental factors and market sentiment. By closely observing and interpreting price patterns, traders aim to predict future price movements and make informed trading decisions.
One of the key advantages of price action trading is its simplicity. It doesn’t require complex mathematical models or extensive knowledge of technical indicators, making it accessible to both novice and experienced traders. Price action trading also allows for real-time analysis, as traders can react quickly to market conditions without relying on lagging indicators.
Moreover, price action trading can be applied to various financial instruments, including stocks, currencies, commodities, and cryptocurrencies. This versatility enables traders to adapt the strategy to different markets and trading styles.
However, it’s important to note that price action trading is not guaranteed to generate profits. It requires skill, experience, and discipline to accurately interpret price patterns and make successful trades. Traders need to continually refine their understanding of price action and risk management techniques to enhance their trading performance.
In summary, price action trading strategies is a widely used approach that focuses on analyzing historical price data to predict future price movements. While it offers simplicity and adaptability, it also requires ongoing practice and refinement to achieve consistent profitability.
