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Introduction to price action trading

Price action is simply the way a price moves on a chart. Looking at a currency pair chart, for example, will reveal many recurring chart patterns that can be exploited by an experienced trader to make profitable trades. Price action trading is therefore the discipline of trading based entirely on price charts, without the use of lagging technical indicators such as the RSI, MACD, or Bollinger Bands. All the information a price action trader needs is already contained in the price charts, and all their trading decisions are derived from the way the price moves on the chart.

Price action trading relies on the basic premises of technical analysis; that markets like to trend, those trends tend to persist, all fundamental data is disregarded, and specific chart formations have the ability to anticipate future price action.

Specifically, price action trading is based on identifying which price levels on a security or currency pair may experience increased buying or selling pressure. The main technical tools a price action trader needs are trend lines, horizontal support and resistance lines, channels, Fibonacci retracements and extensions, and a good knowledge of trend stages and major chart patterns. In addition, candlestick patterns can be used as confirmation signals to enter a trade setup, while moving averages can be used to identify dynamic support and resistance zones. Moving averages are the only technical indicator a price action trader needs in their toolbox.

Clean vs. messy chart

The only workspace a price action trader needs is a clean chart without any technical indicators (except moving averages in certain cases). A clean price chart helps the trader to focus on price action and not on lagging technical indicators. Technical indicators not only draw your attention away from the chart, but also take up useful screen space with little to no added value. The images below show a clean chart used by a price action trader (top), and a messy chart loaded with various technical indicators (bottom).

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How to determine the market trend?

As stated above, one of the basic premises of technical analysis is that markets trend, and that those trends tend to persist. In fact, all of the technical tools used by a price action trader have the sole purpose of identifying trends in their early stages, and price levels where those trends have a high probability of reversing. Knowing how to identify a trending market is the basis of successful price action trading.

There are basically three types of markets: upwards trending, downwards trending, and sideways trending markets. Different market conditions require different arsenals of trading tools in order to trade them successfully.

Trending markets form higher highs and higher lows during uptrends, and lower lows and lower highs during downtrends. The following picture shows what uptrends and downtrends look like.

If the price fails to form a new higher high during an uptrend or a new lower low during a downtrend, this means that the underlying trend is losing its strength and you should prepare for the possibility of a trend reversal. The two main ways trends reverse are by forming either a failure swing, or a non-failure swing. This is shown on the next picture.

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Notice how in the failure swing, the higher low at (B) fails to fall below the previous higher low (X). Still, (C) fails to push above (A) and forms a lower high – a sign that a trend reversal might be ahead. A sell signal is shown at point (S).

In a non-failure swing, (D) forms a lower low and falls below (B). An aggressive sell entry is shown at point (S1), while a conservative sell entry is shown at point (S2) with the break of the lower low (D). A non-failure swing has much more significance than a failure swing.

It’s also important to note that trends can come in three main categories: primary trends, secondary (intermediate) trends, and minor trends. Primary trends last from 6 months to a few years, and can be seen on large timeframes such as the weekly or monthly. Intermediate trends are mainly corrections of the primary trend that go in the opposite direction, and can last from a few days to a few weeks. Minor trends are generated by market noise and tend to last for just a few days or shorter, but can still be used to trade a variety of breakouts or chart patterns.

How to trade Forex with price action trading strategies

Now, let’s take a look at how price action traders use trend-following methods, support & resistance lines, chart patterns, and candlestick patterns to analyse the price action to try and enter high-probability trades.

Trend following and support & resistance

The primary goal of any trader is to catch a trend in its early stage, and to ride the trend until it proves to be invalid. The following chart shows an uptrend in the EUR/JPY pair which started in April 2017. Price action traders would look to enter the market with a long position at point 1, with the break of the previous resistance. In fact, the pair made a strong non-failure swing, and the price made a series of higher highs (HH) and higher lows (HL) in the following weeks.

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It’s important to note that price action traders look to combine a number of tools in their analysis, which increases the probability of successful trades. This is also shown on the chart above, with a rectangular chart pattern forming at point 2.

Chart patterns and confluence zones

We’ve already mentioned the rectangular pattern in the chart above. A rectangle is a continuation chart pattern that indicates that the underlying trend is about to continue once the price breaks above the rectangle. But what are chart patterns in the first place?

Simply put, chart patterns are specific price formations in a chart that can be used to forecast future price action. These are recurring price formations that have proven to have a forecasting ability in the past, and are a popular tool among price action traders.

Generally, chart patterns can be grouped into two categories: (1) continuation chart patterns, and (2) reversal chart patterns. While continuation patterns signal that the underlying trend is about to continue, reversal patterns signal the opposite; that the underlying trend is about to reverse.

The major continuation patterns are rectangles, flags, falling wedges (during uptrends) and rising wedges (during downtrends), while the major reversal patterns are head & shoulders, inverse head & shoulders, double tops and double bottoms, falling wedges (during downtrends) and rising wedges (during uptrends).

Covering all available chart patterns would be far beyond the scope of this article. That’s why we’ll focus on one of the most popular – the wedge and head & shoulders pattern.

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The chart above shows a rising wedge during an uptrend, which is a reversal pattern. Unlike triangle patterns, the lines of falling and rising wedges both slope is the same direction (downwards or upwards). A sell entry signal is given at point (1).

Remember that price action traders love to combine various tools in their analysis. With a little practice, you’ll able to spot a head & shoulders pattern at the same place as the rising wedge. A head & shoulders pattern is another reversal pattern, which contains a left shoulder, head (swing high), and right shoulder. The “neckline” of the pattern forms by connecting the lows of the head, and signals a selling opportunity with its break. The target price of an H&S pattern is the height of the pattern from the neckline to the head (shown by green arrows in the chart below).

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In addition, the target price of the head & shoulder pattern in the chart above happened to be exactly at a confluence zone of a support zone (yellow) and a long-term trend line (red). A confluence zone is simply a zone where two or more important levels overlap and intersect. Those can be support and resistance lines, trend lines, chart patterns, channels, Fibonacci retracements, or any other tool used to analyse the market. A confluence zone therefore has a much larger significance and acts as a stronger support or resistance zone for the price, compared to standalone zones that aren’t confluent.

Conclusion

Price action trading has arguably the highest success rate among all of the trading strategies. The reason for this is its foundation – price action trading is based on real supply and demand levels of currency pairs, reflected by trends, support and resistance zones, and powerful chart patterns. All tools of technical analysis are primarily used to measure the stage of a trend and potential reversal zones. In addition, price action traders often use candlestick patterns as confirmation signals to enter a trade.

All you need to successfully trade price action is a clean chart, which is much more elegant than a chart cluttered with various lagging technical indicators. With a little practice, the tools mentioned in this article are sure to make a significant difference to your bottom line.

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