In the stock market, we have three different types of market participants: the bulls, the bears and the undecided traders. Prices of a stock or any other financial securities traded online are the result of the actions of all these market participants at a particular point in time. To know price action trading, you are first required to understand market psychology.
Market Psychology
The basic human nature of a buyer is to enter a trade by spending as little as possible. Conversely, a seller wants to sell his share for as high of a price as possible.
The undecided traders are the people who eagerly look at their computer monitor to see which side will prevail so that they can participate. These undecided trader’s participation along with the force of bears/bulls will decide which side the market will move.
In the market, buyers will buy as they expect prices will go up. When more buyers participate in the market, they start bidding higher prices. In this way, buying by bulls pushes the market up, which is also referred to as “Buyers are in control”.
When undecided traders see the market is in control of buyers, they jump in as buyers to accelerate price increase by creating a feeling of urgency.
On the other hand, we have sellers who expect the prices will go down. When more sellers participate in the market expecting prices will go down, the market goes down. This type of situation is expressed as “Sellers are in control”.
By knowing sellers are in control, undecided traders jump in as sellers assuming they may not be able to sell any higher and will end up selling at even lower prices if they miss selling now. This urgency of selling in addition to the selling pressure from bears, pushes the price even lower.
An intelligent trader will try to figure out when the buyers and sellers will end up in control, and then make a calculated move. They will try to get in the winning group.
Fight and mass psychology of these different types of traders are reflected in candlestick charts. Therefore, a successful day trader is also known as a social psychologist sitting in front of a computer and charting software to find out who is in control.
What is Price Action?
Price action can be defined as a technique used to observe and study the current market based on current or actual price movement plotted over time. This movement is quite often analysed with respect to price changes in the past.
This means, price action generally refers to the up and down movement of a security’s price when it is plotted over time i.e. the action of price. It describes the characteristics of a security’s price movement.
In simple terms, price action is the behavioural analysis of market psychology. It’s used by many retail traders, institutional traders and hedge fund managers to predict the future direction of the price of a security.
Price action is part of technical analysis in which you ignore the fundamentals, instead rely more on past and present price movements.
In pure price action trading, decisions are based on the naked price chart, which means there are no lagging indicators. By using price action techniques, traders read the market and make subjective trading decisions based on the recent and actual price movements.
Different candlestick patterns can tell you about the trend of a stock and the power of buyers and sellers in the market. The candle displays who is winning or who is in control of the market at that point of time.
If buyers are in control, you will see the candle moving up to form a bullish candle. If sellers are in control of the price, you will see the candle moving down to create a bearish candle. If the candle is neither bearish or bullish, it’s referred to as DOJI, which means indecision among buyers and sellers.
Reading price action comes only with practice and experience. You can learn more about candlestick charts and different price action patterns to understand how the market behaves.
Experienced traders analyse different price action patterns to pinpoint stop-losses, entry and exit opportunities. No two traders are likely to take the same trade in the same way, even if they see the same price action. Each trader will analyse price patterns and anticipate future moves differently.
Indicators used for price action trading
Here are the most important indicators used in price action;
- Trend lines
- Candlestick charts (instead many traders use bar, point and figure charts).
- Swing Lows and Highs
- Support and resistance
- Breakouts
- Channels and
- Consolidation Levels
The biggest misconception about price action is “Price action is a simple trading approach“. However, it is the opposite. It’s very easy to read and educate yourself on price action by reading books and blogs, but very challenging to master. It has to be combined with proper risk management, patience and discipline.
Different indicators such as moving averages, relative strength indicators (RSI), Stochastic, MACD, VWAP, Bollinger bands, Supertrend and ADX used in technical analysis are calculated from price action and projected into the future to inform trading decisions.
Candlestick patterns such as the engulfing candlestick pattern, dragonfly doji, gravestone doji, pin bar pattern and Inside candles are all examples of visually interpreted price action.
Many day traders use price action as a trading technique to read the market and to make subjective trading decisions based on the recent and actual price movement, rather than relying solely on technical indicators which are derived from it.
Others believe that the market follows a random pattern and there is no clear systematic way to define a strategy that will always work, therefore, they use technical indicators in conjunction with the price action strategy to identify trade opportunities. While using, they might give little weightage to technical indicators as they believe that the only trustworthy source of information comes from the price itself and its movements.
Price action traders often uses the phrase “KISS – Keep it simple stupid” in reference to the fact that trading is something many market participants over-complicate by clouding their charts with number of unnecessary technical indicators. Pure price action trading is also sometimes referred to as “naked trading”or “clean chart trading”.
Here is a list of candlestick patterns for your reference;
- Evening Star
- Morning Star
- Bearish Abandoned baby candlestick pattern
- Bullish Abandoned baby candlestick pattern
- Three Inside up/down
- Three outside up/down
- Inside Bar
- Bullish Piercing
- Spinning Top
- Shooting Star and Inverted Hammer
- Hammer & Hanging Man
- Gravestone, Dragonfly and long-legged Doji
- Engulfing Candlestick Pattern
- Spinning Top
- Marubozu
- Dark Cloud Cover Candlestick Pattern
Be sure you practice identifying and trading these candlestick patterns on a demo account before trading them with real money.
In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
