Overview of Price Action Charts
If you browse the web at times, it can be difficult to determine if you are looking at a stock chart or hieroglyphics. When you see a chart with many indicators and trend lines, it is likely a trader trying to overcompensate for lack of certainty.
For example, I have talked with traders whose screens look something like the picture below.
Too Many Indicators
I have even seen some traders that will have four or more monitors with charts this busy on each monitor. When you see this sort of setup, you hope at some point the trader will release themselves from this burden of proof.
What if we lived in a world where we just traded the price action? A world where traders pick simplicity over the complex world of technical indicators and automated trading strategies.
When you remove all the clutter from the trades, all that is remaining is the price.
To see a chart minus all the indicators, take a look at the following image.
Price Action Chart
At first glance, it can almost be as intimidating as a chart full of indicators. Like anything in life, we build dependencies and handicaps from on pain of real-life experiences. If you have been trading with your favorite indicator for years, going down to a bare chart can be somewhat traumatic.
While price action trading is simplistic in nature, there are various disciplines. The disciplines can range from Japanese candlestick patterns, support & resistance, pivot point analysis, Elliott Wave Theory, and chart patterns [1].
In this article, we will explore the six best price action trading strategies and what it means to be a price action trader.
Chapter 1: What Makes up Price Action
Before we dive into the strategies, I want first to ground you on the four pillars of price action.
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If you can recognize and understand these four concepts and how they are related to one another, you are on your way.
Pillar 1 - Candlesticks
I have listed candlesticks here because this is the most popular form of charting in today's trading world. Historically, point and figure charts, line graphs and bar graphs were the raves of their day.
Not to make things too open-ended at the start, but you can use the charting method of your choice. There is no hard line here.
However, for the sake of not turning this into a thesis paper, we will focus on candlesticks. The below image gives you the structure of a candlestick. To learn more about candlesticks, please visit this article that goes into detail about specific formations and techniques.
Candlestick Structure
The key point to remember with candlesticks is each candle is relaying information, and each cluster or grouping of candles is also conveying a message. You have to begin to think of the market in layers.
Pillar 2 - Bullish Trend
This is a simple item to identify on the chart, and as a retail investor, you are likely most familiar with this formation.
A bullish trend develops when there is a grouping of candlesticks that extend up and to the right.
Think of a squiggly line on a 45-degree angle.
The key thing to look for is that as the stock goes on to make a new high, the subsequent retracement should never overlap with the prior high. This ensures the stock is trending and moving in the right direction
Make sense?
Pillar 3 - Bearish Trend
Bearish trends are not fun for most retail traders. Shorting (selling a stock you do not own) is likely something you are not familiar with or have any interests in doing. However, if you are trading this is something you will need to learn to be comfortable with doing.
This formation is the opposite of the bullish trend. This is where a security will trend at a 315-degree angle.
Pillar 4 - Flat Market
Get ready for this statement, because it is big. In general terms, the market is in a flat trading range approximately 70% [2] of the time according to author Heikin Ashi Trader, which is the pen name of a trader with over 15 years of futures and forex experience.
Rarely will securities trend all day in one direction. You will set your morning range within the first hour, then the rest of the day is just a series of head fakes.
If you can re-imagine the charts in these more abstract terms, it is easy to size up a security's next move quickly.
Flat markets are the ones where you can lose the most money as well. Reason being, your expectations and what the market can produce will not be in alignment. When the market is in a tight range, big gains are unlikely. The main thing you need to focus on in tight ranges is to buy low and sell high.
Chapter 2: Price Action Trading Strategies
#1 - Outside Bar at Support or Resistance
For those unfamiliar with an outside bar, an example of a bullish outside bar is when the low of the current day exceeds the previous day's low, but the stock rallies and closes above the previous day's high.
The bearish example of this would be the same setup, just the opposite price action.
outside down day
Therefore, it's not just about finding an outside candlestick and placing a trade. As you can see in the above chart of Cambrex (CBM), it's best to find an outside day after a major break of a trend. In the CBM example, there was an uptrend for almost 3 hours on a 5-minute chart prior to the start of the breakdown.
After the break, CBM experienced an outside down day, which then led to a nice sell-off into the early afternoon.
#2 - Spring at Support
Spring at Support
A spring is when a stock tests the low of a range, only to quickly come back into the trading zone and kick off a new trend. According to the author xxx, "springs, shakeouts, and tests usually occur late within the trading range and allow the market and its dominant players to make a definitive test of available supply before a markup campaign will unfold. [3]
I like to use volume when confirming a spring; however, the focus of this article is to explore price action strategies, so we will zone in on the candlesticks.
The one common misinterpretation of springs is traders wait for the last swing low to be breached. Just to be clear, a spring can occur if the stock comes within 1% to 2% of the swing low.
Trading setups rarely fit your exact requirement, so there is no point in obsessing a few cents. To illustrate this point, please have a look at the below example of a spring setup.
Spring Example
Notice how the previous low was never breached, but you could tell from the price action the stock reversed nicely off the low and a long trade was in play.
#3 - Inside Bars after a Breakout
Inside bars are when you have many candlesticks clumped together as the price action starts to coil at resistance or support. The candlesticks will fit inside of the high and low of a recent swing point as the dominant traders suppress the stock to accumulate more shares.
To illustrate a series of inside bars after a breakout, please take a look at the following chart.
Inside Bars
This chart of Neonode is truly unique because the stock had a breakout after the fourth attempt at busting the high. Then there were two inside bars that refused to give back any of the breakout gains. NEON then went on to rally almost 20% in one trading day.
Please note inside bars can also occur prior to a breakout, which strengthens the odds the stock will eventually breakthrough resistance.
This is honestly my favorite setup for trading. I love it when a stock hovers at resistance and refuses to back off. This is a sign to you that things are likely going to heat up.
The other benefit of inside bars is it gives you a clean set of bars to place your stops under. This way you are not basing your stop on one indicator or the low of one candlestick.
#4 - Long Wick Candles
Long Wick 1
Long Wick 2
Are you able to see the consistent price action in these charts? If not, were you able to read the title of the setup or the caption in both images?
Just having a little fun here, don't get sensitive.
The long wick candlestick is one of my favorite day trading setups. The setup consists of a major gap up or down in the morning, followed by a significant push, which then retreats. This price action produces a long wick and for us seasoned traders, we know that this price action is likely to be tested again.
Reason being, a ton of traders, entered these positions late, which leaves them all holding the bag. The counter pressure will be weak comparatively, so what can't go down must go up again. This leads to a push back to the high on a retest.
That may have been a little tough to follow, so let's illustrate this point through the charts.
Long Wick 3
Notice after the long wick, CDEP had many inside bars before breaking the low of the wick. After this break, the stock proceeded lower throughout the day.
#5 - Measure Length of Previous Swings
Measure Previous Swings
Have you ever heard the phrase history has a habit of repeating itself? Well, trading is no different.
As a trader, you can let your emotions and more specifically hope take over your sense of logic. You will look at a price chart and see riches right before your eyes.
Well, that my friend is not a reality. Did you know in stocks there are often dominant players that consistently trade specific securities?
These traders live and breathe their favorite stock. Given the right level of capitalization, these select traders can also control the price movement of these securities.
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What you can do to better understand the price action is to measure previous price swings.
As you perform your analysis, you will notice common percentage moves will appear right on the chart. For example, you may notice that the last 5 moves of a stock were all 5% to 6%.
If you are swing trading, you may see a range of 18% to 20%. Bottom line, you shouldn't expect stocks to all of a sudden double or triple the size of their previous swings.
I fully understand the market is limitless; however, it's better to play the odds with the greatest chance versus swinging for the fences. Over the long haul, slow and steady always wins the race.
To further illustrate this point, let's go to the charts.
Measure the Swings
Notice how FTR over a 10-month period experienced many swings. However, each swing was on average 60 to 80 cents. While this is a daily view of FTR, you will see the same relationship of price on any time frame.
As a trader, do you think it would make sense to expect $2, $3, or $4 dollars of profit on a swing trade? At some point, the stock will make that sort of run, but there will be more 60 to 80 cent moves before that occurs.
Just on this one chart, I can count 6 or 7 swings of 60 to 80 cents. If you can trade each of these swings successfully, you, in essence, get the same effect of landing that home run trade without all the risk and headache.
#6 - Little to No Price Retracement
No Price Retracement
Not to get too caught up on Fibonacci, because I know for some traders this may cross into the hokey pokey analysis zone. However, at its simplest form, less retracement is proof positive the primary trend is strong and likely to continue.
little retracement
The key takeaway is you want the retracement to be less than 38.2%. If so, when the stock attempts to test the previous swing high or low, there is a greater chance the breakout will hold and continue in the direction of the primary trend.
This is especially true once you go beyond the 11 am time frame. This is because breakouts after the morning tend to fail. So, in order to filter out these results, you will want to focus on the stocks that have consistently trended in the right direction.
Chapter 3: False Setups
Trading comes down to who can realize profits from their edge in the market. While it is easy to scroll through charts and see all the winners, the market is one big cat and mouse game.
Between the quants and smart money, the false setups are everywhere.
As a price action trader, you cannot rely on other off-chart indicators to provide you clues that a formation is false. However, since you live in the "now" and are reacting to directly what is in front of you, you must have strict rules to know when to get out.
For me, in lieu of a technical indicator, you can use time as a gauge.
Just to be clear, the chart formation is always your first signal, but if the charts are unclear, time is always the deciding factor.
I did a study of all my winning trades and over 85% of them paid in full within 5 minutes.
If you have been trading for a while, go back and take a look at how long it takes for your average winner to play out.
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