Trading with price action analysis

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Are you focused on the map or the landscape?

© yossarian6/stock.adobe.com

They say the map is not the territory. That might sound like a no-brainer. Yet, we’re all prone to occasionally fixating on a map such that we miss the landscape right in front of us.

In the financial markets, technical indicators are like maps. They can give shape to a dynamic market environment, making price movements clearer to see and easier to interpret. But on the flip side, indicators can also oversimplify or even blot out the very thing they’re trying to analyze: the price action itself.

And that’s why some traders prefer to ditch the proverbial map by chucking most or all indicators, opting for a more minimalist approach. This is what price action trading is all about: working directly with an asset’s price and price history to analyze and anticipate its potential direction.

Price action refers to the characteristics of an asset’s price movements over time. These price movements are often plotted on a chart and displayed without supplemental technical indicators (except maybe volume). Although such bare charts may, at first, seem a little too minimal to provide much information, focusing on price alone can help uncover nuanced movements that might be difficult to detect via an indicator.

Price action trading is a method of financial analysis and speculation that generates its insights and actions solely from the interpretation of price movements.

William Blake suggested we can “see a world in a grain of sand.” In this case, it’s about observing the movement of price—from small grains to large gaps—to see what it might indicate in terms of future shape and direction.

Indicators were designed to emphasize certain technical aspects of the markets (including volume, trend, momentum, and so on). But in doing so, they exclude other technical aspects. This is why traders often combine indicators—to compensate for gaps in technical perspective.

For all the insights indicators may provide, they invariably produce blind spots:

If you plan to analyze or trade markets based solely on current and historical prices, you’re likely to focus on three things: trends, chart patterns, and significant technical events.

Trends. In general, an uptrend is defined by higher highs and higher lows (see figure 1), while a downtrend consists of lower lows and lower highs. So, is a stock trending up, down, or sideways? Some traders draw simple trendlines to identify these movements. Other traders might use a formula to detect trends.

Chart patterns. The chart pattern universe is extensive. There are classic chart patterns, such as the symmetrical triangle (see figure 1). You can also study a smaller range of sessions by analyzing groups of bars, such as the bullish engulfing candlestick pattern (figure 1).

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Figure 1: WATCHING THE PRICE ACTION. Simple patterns and single-period movements can sometimes help you see the big picture.

Image source: StockCharts.com. Annotations by Encyclopædia Britannica, Inc.

Technical events. Prices may move according to or against expectations at a critical technical juncture, such as near a support and resistance level, trendline, or major pattern. For price action traders, these events and their outcomes are important. They’re historical reference points that help guide future trading setups and decisions.

A price action approach allows you to view price charts without clutter or extra biases generated by indicators. Ultimately, this allows you to interpret prices directly instead of interpreting an interpretation.

The big limitation is that price action readings can be just as subjective and variable as most indicator readings. Two traders will interpret the same price action as differently as they might indicator data.

It probably sounds like jumping from one frying pan (using indicators) into another (using price action). But there is no holy grail when it comes to analyzing and trading the markets. Instead, it’s best to find an approach that resonates with your trading personality, your way of thinking, your goals, and your risk tolerance.

As with all technical trading approaches, price action analysis is a blend of art and science. It isn’t for everyone. But if it resonates with the way you prefer to analyze and trade markets, then perhaps this discipline is worth a try.

You can also create a hybrid or custom approach that focuses on price action, but also includes a few technical or fundamental indicators. Again, reading the charts is a blend of art and science.