Price action trading

Price action trading is the same across all markets, even forex trading​​. There are some nuances to be aware of though. Currencies trade 24 hours per day, yet some forex pairs are less likely to move when their respective markets are not open, even if a price action signal develops. Therefore, this article contains examples from all markets to demonstrate how price action trading works, whether it be for the forex, share, index or commodity markets.

Continuation patterns occur during a trend. Assume the trend is up, and a triangle forms. Because of the uptrend, the price has a slightly higher chance of breaking out to the upside because the trend is up. The same concept applies during a downtrend when a pattern forms. The strategy here is to wait for a trend to form, and then wait for a pattern, and then only trade if the price breaks out of the pattern in the trending direction.

Here is an example using silver.

Price action reversals occur when the rules of an uptrend or downtrend are violated. Once one of these basic rules is violated, the trend is in trouble. If both rules are violated, the trend will reverse based on the waves being viewed.

Consider an uptrend that is making higher swing highs and lows. When it makes a lower swing low, this is a warning sign. If the price then makes a lower swing high as well, this means that a reversal is underway. This does not mean that things cannot go back the other way, allowing the uptrend to resume. The evidence simply indicates that a reversal is likely to happen. The below Tesla [TSLA] chart shows a price action reversal from uptrend to downtrend, and then back to an uptrend.

Price rejection is when the price tries to move through an important level, but then reverses direction because there is not enough force to maintain the trading momentum. Rejections often result in hard and fast moves in the opposite direction. Here is what to watch out for:

Renko charts​​ form bricks, where each new brick appears once the price has moved a specified amount. Bricks only occur at 45-degree angles and they stay the same colour until a reversal occurs. A reversal is when the price moves two-bricks in the opposite direction.

Renko charts work well in trending markets. If the Renko chart stays the same colour and the trend continues, traders should stick with the trade. But if it reverses, then it may be time to exit the position. The Tesla chart we previously looked at has been recreated below, using Renko blocks. They would have kept the trader in for the entire rally starting in March.

Scalping is a trading strategy where profits and losses are taken quickly, as trades typically last a few minutes or less. In forex scalping​​, this may mean using a 3 to 5 pip stop loss and a 5 to 10 pip target. In the share market, it may mean risking a few cents a share in or order to make a few cents. Scalping involves entering and exiting a position quickly to take advantage of small price movements, for whatever a small price move is considered to be for that asset. Many scalpers typically use 1-minute charts.

A scalping strategy​​ aims to trade in the trend direction and enter during a pullback when the price starts moving back in the trending direction. To do this, traders look for engulfing patterns to signal an entry, such as when a candle in the trending direction envelops a candle in the pullback direction. This occurs during a pullback.

Below, arrows mark the engulfing patterns that signal potential trade entries on the Alcoa [AA] 1-minute chart. While this is one example of a scalping strategy, all the prior discussed strategies and concepts could be used for price action.

Any of the price action strategies mentioned above can be used as part of a swing trading strategy​​. Swing traders typically use hourly, 4-hour, and daily charts to find trade setups, although they may use 15-minute or 5-minute charts to fine-tune their market entries.

Let’s look at a supply and demand example, coupled with trading with the trend. The USD/CAD chart below shows an overall downtrend on this 4-hour chart. As you can interpret, the price rallies, puts in a swing high, declines and then enters a short-term downtrend, before rallying back to the prior high. Given that the trend is down and the price has entered a supply area, this is a potential short trade.

If you were to let the price enter the supply area, it would often exceed the prior high. If you are hoping to short the stock​​, you could enter when there is a bearish engulfing pattern or the price consolidates and then breaks the consolidation to the downside. The arrow marks the breakout of the consolidation, to the downside in this case.

The Fibonacci retracement is drawn on a chart from a low to a high (in an uptrend), or a high to low (in a downtrend). It indicates areas where the price could pull back to. The levels are 23.6%, 38.2%, 50%, 61.8% and 100%. In a strong trend, pullbacks are typically shallow, often only reaching the 38.2% level. In most trends, pullbacks exceeding the 50% and 61.8% levels are common.

The following chart shows a modest uptrend in crude oil. The last wave up is used to draw the retracement tool. The 100% goes at the bottom of the move and the 0% at the top because price is rising. You can reverse this method if price is falling.

Expect a pullback exceeding 50%. Then, wait for a trade signal as discussed prior. There is a strong move to the upside after the price drops below the 61.8% level. This is a potential buy signal. Read more about how to trade with Fibonacci retracements​​.

The relative strength index​​ (RSI) measures where the price lies in terms of its 14-period price range. When the RSI is above 70%, the price is in the upper realm of where it has traded in the last 14 periods. When it is below 30%, the price is in the lower realm of where it has traded in the last 14 periods.

Traders often wait for the price to move out of these areas during trends to help confirm trades. During an uptrend, traders will look to buy when the RSI moves below 30 and rallies above. During a downtrend, traders will look to short when the RSI moves above 70 and drops below. Other price action signals are typically used to confirm these signals.

Let’s look at the same crude oil chart as above, but this time an RSI is added. The RSI dropped below 30 and then rallied back above, at the same time that the price action and the Fibonacci retracement also signalled an entry.

A stochastic can be used to help spot turning points and confirm price action signals. It is used in a similar way to the RSI. There are two lines on the stochastic indicator​: the stochastic and the signal line. The signal line is a moving average​ of the stochastic, so it moves more slowly.

A trader that is interested in trading a price action signal can watch for the stochastic to move through the signal line. If contemplating a long trade, they should wait for the price action signal and for the stochastic to move above the signal line. The stochastic provides similar information as the RSI on the crude oil chart.