Overview of price action
This lesson will cover the following
- How is price action generally interpreted?
- Price action in trending and non-trending markets
- High uncertainty
- Relevance of every single pip
- Different aspects of price action
In simple terms and from a traders perspective, price action refers to any change in prices, that is viewed on any type of price chart and on any time frame. The smallest measure of change in prices is the pip (in Forex trading practice), or the tick (in stock trading practice). It is the tiniest unit of movement, which a market can make. On tick charts and on time and sales tables, one tick may refer to any trade, which is executed during the course of the trading day, regardless of the size. In stock trading practice, one tick is usually one penny. Each time the price of an instrument changes, this very change signifies price action.
There is no universal definition of price action. That is why, because sometimes traders consider it useful to be aware of the smallest piece of information, which the market itself is presenting them. What is more, a piece of information, which initially seems of little relevance, has the potential to produce a very successful trade.
Every single bar on the price chart may be considered as a potential signal both for entering into a long and a short position. One group of traders may look to sell on the next pip, as they presume the price may not move a pip higher, while other traders may look to buy on the next pip, as they presume the market may not move a pip lower. It is possible that these two groups of traders are examining one and the same chart. The first group may spot a bullish formation, while the second may spot a stronger bearish formation. The reasons for both groups to make their trading decisions can also be countless.
However, one of the two groups will appear to be right, while the other – wrong. In case long-positioned traders are wrong and prices begin to plunge tick by tick, they will come to believe that their decision is incorrect. They will be forced to close their positions at a loss and make another entry in the market, but this time as sellers. As the number of short-positioned traders increases, prices will plunge even further. Initial sellers, on the other hand, may continue to open new short positions, or they may go long the certain instrument in anticipation of the moment, when more buyers begin to enter in the market. As the number of buyers increases, prices will go up, until market reverses its direction once again.
Trending or not trending
All traders during a single trading day attempt to decide whether the market is in a trend or not. Sometimes if they are examining even one single bar, they may be able to decide if a trend is occurring or not during this very bar. Traders may be examining a series of bars in order to decide whether the market is in a trend or in a trading range. In case the market is in an uptrend, traders will look to buy high or low, often on a breakout above a certain level of resistance. In case the market is in a trading range, they will look only to go long at the bottom of this range and only to go short at the top of the range.
As a traders major goal is to maximize his/her profit, to the last possible pip, he/she may not waste precious time determining what type of formation is currently unfolding (a horizontal triangle, a double top or bottom, or a head and shoulders). His/her attention may be focused solely on determining if the market is trending or not. If the trader decides that there is a trend currently occurring, he/she will look to catch it and ride it (he/she will enter into a position in the direction of the trend). If the trader decides that the market is not trending, he/she will look to enter into a position, which is in the opposite direction of the most recent move (the so called fading, or entering in a countertrend direction).
A trader may decide that there is a trend, as short as a single bar. When trading on a smaller time frame, a trend may be contained within this very bar. On larger time frames, a trend can last a whole day, a week or more. In any case, the trader makes this decision by closely examining price action on the chart.
50 percent probability
An important moment to note is that in most of the cases, there is a 50 percent probability that the next pip will be to the upside and a 50 percent probability that the pip will be to the downside. During most of a single trading day a trader may assume a 50-50 chance, that prices will move a number of pips up before decreasing a number of pips. The probability may change to 60-40 sometimes during the day, which allows traders to make some successful trades. Shortly afterwards the odds return to 50-50, where buyers and sellers seem to be in a balance.
As the number of traders increases on a daily basis and they use a huge variety of methods, markets are considered as efficient. If a trader decides to go long a certain instrument at any time during the day without even taking a look at the chart, while setting a profit target 15 pips higher and a stop-loss 15 pips lower, he/she still has a 50% chance to obtain a profit. If the trader initially went short and also used 15 pips of stop-loss and profit target, he/she also has a 50-50 chance to earn 15 pips of profit on the short position before losing 15 pips on the stop-loss. This is valid, if a trader uses a reasonable amount of pips for his/her stop-loss and profit target in accordance with most recent price action. However, there are exceptions, when stops and targets are placed within a distance too far.
High level of uncertainty
Trading in the global markets is accompanied by a high level of uncertainty. Traders always operate in a “fog”. Everything, which occurs in the market, is relative and everything can change to the exact opposite in a matter of seconds.
A trader may spot a trend line a number of pips above the high price of the current candle, but instead of entering into a short position, he/she may decide to go long, so that the trend line is tested. Although he/she made a mistake, it cannot prevent him/her from looking ahead. This mistake has nothing to do with the future, so the trader should ignore it and continue examining price action for suitable entry points. His/her profit/loss ratio for the current day does not need to capture his/her full attention.
Every pip matters
Every single pip introduces a change in price action, regardless of the time frame and of the chart type. A single pip may appear useless on a monthly chart, but it is much more useful on the smallest time frames (1-minute and 5-minute charts).
Aspects of price action
One of the most interesting aspects of price action is what comes next after the market moves beyond (breaks out from) prior bars or trend lines, set on a price chart. If the market moves beyond a significant prior high (peak) and each subsequent bar has a low price, which is above the low price of the prior bar, and a high price, which is above the high price of the prior bar, then price action signals that the market will likely be higher on some of the subsequent bars, even if it pulls back for several bars in a short term.
If the price breaks out to the upside and the following bar is a small inside bar (which means that it has a high price below the high price of the large breakout bar), while the next bar has a low price below this small inside bar, the probability of a fakeout and a reversal to the downside increases significantly.
Another moment worth noting is, that small formations may progress to larger formations, which can urge a trader to enter into positions in the same or the opposite direction. A common case is prices to break out from a small flag formation, then reach the profit target of a day trader (say, a scalper), after which a pullback follows, which results in a larger flag formation. This larger pattern has the potential to produce a breakout in the same direction, but it also might break out in the opposite direction.
A single pattern may also appear to be several different things. A lower high of a small bar may be the second lower high of a bigger triangle formation and even a second right shoulder in a much larger head and shoulders pattern.
It is common to spot opposite formations, building up at the same time. A small bear flag may appear to be a part of a larger bull flag. In such cases, naming these patterns is of little significance, as is the choice which one of the two to trade. What is important is how a trader reads price action. If his/her reading is correct, his/her trades will be successful. A trader will usually take the formation that makes the most sense. If he/she is not very certain, then probably, it is better to wait for further clarity.
We can say that price action has much to do with imagining the bullish case and the bearish case with every single pip and every single bar. As we said, the probability of making a specific number of pips in profit on a single trade is almost equal to the chance of losing the same number of pips during most of the day. This is so, because the market is constantly looking for a balance. At times the odds can be 60-40 in favor of a certain direction. What is more, if the market is in a strong trend, the odds may reach 80-20 for a short period of time. However, during the most of the day it is uncertainty and balance, that dominate.
A trader should always follow his/her plan, when the market moves in the opposite to his/her direction. Usually a good way to protect ones account from considerable losses, and eventually ruin, is to simply close the position, but sometimes it is better to reverse that position. In any case, what is of utmost importance is the awareness that the exact opposite to what one believes may happen at any time.
Beginner traders should also note that price action, which is to be observed on a daily basis, is the result of institutional (and/or corporate) activity, not the cause of this activity. As this institutional activity controls the markets move with a formidable volume, one can presume that these entities may have not entered into trades just to scalp, but with the intention to hold their positions for days or even months. Therefore, they will likely defend their entries.
The setup (a formation of one or more bars used as a basis to enter the market) is usually the first phase of a move a trader intends to make, while price action entry simply enables him/her to join in as early as possible. As more price action is present, more traders will likely enter in the direction of the move, thus, momentum is generated on the price chart, which, on the other hand, lures even more traders to enter.
Last but not least, the reasons to make an entry in the market can be countless and they are not that relevant, if one is to trade solely on price action. However, at times cunning price action traders use these reasons to their advantage, especially when it includes trapped traders (who have an open loss on their trades). If one is aware that stop-losses are likely placed at, say five pips below the current candle, and this will lead to losses for those who just went long, then he/she may intend to go short on a stop at that same price. This is because he/she has an opportunity to profit from those trapped traders, who will likely be forced out of the market.