How to use price action as a day trader

Published: 29. February 2024

What is Price Action?

Price action refers to the fluctuation in a security’s price as it is charted over a period. It is the foundation upon which all technical analysis of stock, commodity, or any asset chart is built.

Short-term traders often depend solely on price action, drawing on the patterns and trends identified through it to guide their trading choices. Technical analysis, as a methodology, evolves from price action, leveraging historical price data in formulas that inform future trading strategies.

What Does Price Action Tell You?

Price action is observable and can be analyzed through charts that map out price movements over time. Different types of chart structures enhance a trader’s ability to recognize and understand trends, breakouts, and trend reversals. Candlestick charts are particularly favored by many traders for their ability to clearly depict price fluctuations, showing opening, high, low, and closing prices within the context of whether the session ended higher or lower.

Candlestick patterns, such as the Harami cross, engulfing pattern, and three white soldiers, serve as visual indicators of price action. These patterns, among numerous others derived from price action, help predict future market movements. While these formations are commonly associated with candlestick charts, they can also be applied to other chart types, including point and figure charts, bar charts, and box plots, facilitating a broad application of price action analysis across different trading instruments.

Beyond the visual patterns observed on charts, technical analysts frequently incorporate price action data into the calculation of technical indicators to discern patterns within what may appear as random price movements. For instance, the identification of an ascending triangle pattern, achieved by drawing trendlines along a price action chart, can signal an impending breakout. This pattern suggests that, after multiple attempts, buyers are progressively gaining strength and momentum, hinting at their potential to drive the price upward decisively. Such insights gleaned from price action not only aid in predicting future market behavior but also in formulating strategies that align with the underlying momentum and trends indicated by the price movements.

How to use Price Action

Price action is fundamentally regarded not as a trading tool per se, like an indicator, but as the foundational data source upon which all trading tools are constructed. Swing traders and trend traders, in particular, align closely with price action, often setting aside fundamental analysis to concentrate exclusively on analyzing support and resistance levels. They aim to forecast potential breakouts and periods of consolidation purely based on price movements.

However, even for traders who prioritize price action, it’s essential to consider additional factors that can influence the accuracy of their market interpretations. The trading volume and the time frames chosen to define support and resistance levels significantly affect the reliability of their predictions. These elements help traders gauge the strength behind price movements and the market’s commitment to a particular direction, thereby refining their strategy and enhancing the potential for successful outcomes. This holistic approach to price action trading underscores the importance of a nuanced understanding of market dynamics beyond just the immediate price information.

Tools Used For Price Action Trading

Price action trading leverages recent historical data and past price movements, incorporating various technical indicators like charts, trend lines, price bands, and technical levels of support, resistance, and consolidation, tailored to the trader’s specific strategy and preferences.

The array of tools and patterns at a price action trader’s disposal ranges from straightforward elements such as price bars and break-outs to more intricate configurations that include candlesticks, volatility measures, and channels.

A significant component of price action trading lies in the psychological and behavioral interpretations made by traders, influencing their subsequent decisions. For instance, if a trader sets a personal benchmark of 600 for a stock, and it ascends from near 580 to surpass 600, they might perceive this as an indicator of continued upward momentum and opt for a long position. Conversely, another trader viewing the same price movement might anticipate a reversal upon reaching 600 and decide to short sell.

This subjective nature of price action trading means that no two traders will view the same price movement identically. Each trader relies on their individual set of rules, interpretations, and understanding of market behavior, differing from the more uniform responses elicited by technical analysis scenarios, such as the crossing of moving averages which might prompt a collective move among traders towards taking similar positions.

Price Action Trading Steps

Experienced traders who adhere to price action trading often maintain a repertoire of strategies for discerning trading patterns, setting entry and exit points, stop-losses, and other critical market observations. Relying on a single strategy for a stock might not yield enough opportunities for trading. Typically, trading involves a two-phase approach:

  1. Identifying a Scenario: Traders pinpoint a specific market scenario, such as a stock entering a bull or bear phase.
  2. Identifying Trading Opportunities within the Scenario: For instance, traders assess whether the stock is more likely to overshoot or pull back during a bull run. Deciding on the stock’s direction is a subjective decision that varies among traders, even within the same scenario.

For example, consider a stock with a bullish engulfing. The trader perceives this as an indication that the price will increase, and considers going long. The trader must decide whether they believe a price surge will follow, or if it is a false flag.

Another scenario might involve a trader setting a perceived floor and ceiling for a stock’s price, based on expectations of low volatility and absence of breakouts. If the stock’s price remains within this range, the scenario is considered met. The trader may then predict that the established floor and ceiling will serve as support and resistance levels, respectively, or alternatively, anticipate a breakout in either direction.

When a breakout scenario is confirmed, it presents an opportunity either for continuation (further movement in the same direction) or a pull-back (returning to the previous level).

While price action trading is significantly supported by technical analysis tools, the ultimate decision to trade rests with the individual trader, offering a degree of flexibility rather than dictating a rigid set of rules. This approach allows traders to adapt their strategies based on their assessment of the market conditions and their personal trading style.

Limitations of Price Action

Interpreting price action is inherently subjective, leading to varied conclusions even when two traders analyze identical price movements. Where one trader might identify a bearish downtrend, another could interpret the same data as signaling a potential short-term reversal. The selected timeframe plays a critical role in shaping these interpretations, as a stock might exhibit several intraday downtrends while still trending upwards on a monthly basis.

It’s crucial to acknowledge that all trading forecasts derived from price action, regardless of the timeframe, are essentially speculative. Enhancing these predictions with a broader array of analytical tools for confirmation can improve their reliability.

Ultimately, however, it’s important to remember that the past performance of a security’s price action does not guarantee its future movements. Even trades considered to have a high probability of success are speculative, embodying inherent risks alongside the potential for rewards. Price action analysis tends to focus on price movements without directly considering the macroeconomic or external non-financial factors that may influence a security’s price. This limitation underscores the importance of combining price action with a comprehensive analysis approach to inform trading decisions effectively.

Clean vs. Messy Charts

In the realm of technical analysis, traders often find themselves choosing between “clean” charts and “messy” indicator-laden charts. Clean charts are minimalistic, focusing primarily on price action without the clutter of numerous technical indicators. This simplicity allows traders to interpret market movements and trends more intuitively, enabling a clear view of support, resistance, and historical price patterns. On the other hand, messy charts are dense with various indicators such as moving averages, RSI, MACD, and Bollinger Bands, among others. While these indicators can provide valuable insights and help confirm trends or signal potential reversals, they can also overwhelm the trader, leading to analysis paralysis where making a trading decision becomes exceedingly difficult. The choice between clean and messy charts boils down to a trader’s strategy, experience, and comfort level in extracting actionable information from the data presented.

This might be too many indicators for many traders. You should familiarize yourself with a select few to start out with.

Conclusion

Wrapping up our guide on using price action for day trading, it’s clear that getting good at this strategy takes time, a lot of practice, and a sharp eye for what’s happening in the markets. Price action trading is all about keeping things simple and focusing on how prices move. This way, traders can make decisions based on actual market activity, ignoring rumors and economic forecasts. Whether you’re a novice just beginning your trading journey or an experienced trader honing your strategy, price action offers a solid foundation upon which to build a robust trading methodology.

But becoming skilled in price action trading isn’t something that happens fast. It needs a solid understanding of how markets work, the ability to spot patterns in price charts, and sticking to your trading plan without getting sidetracked by too many indicators. The secret to getting really good at reading market movements is to never stop learning and to be flexible in your approach. Whether you’re just starting out or you’ve been trading for a while and want to get better, price action is a reliable base to build your trading strategy on.

At the end of the day, the way you think about trading is your most important tool. Building a mindset that values simplicity, focuses on the chances of success, and keeps you calm and disciplined will help you navigate the ups and downs of day trading. Price action trading isn’t just a method; it’s a deeper way to connect with the markets. As you keep going, keep improving your methods, stay patient, and let the market’s own movements be your guide.