Price action means simply the movement of the market - how far did price move, how fast did it move, did it oscillate wildly or did it progress smoothly from one level to another? Price action can occur in an infinite variety of ways. Some claim price action lies in the domain of technical analysis or charting, but actually one doesn't even need a chart to get a feel for price action. It is enough to follow the ticker. Price action traders define and quantify price action in many ways, and this article goes into detail about some of their methods.
Reading price action seems easy enough to understand - read what price is doing on a chart at any given time. Is it going up, is it going down or is it going sideways? So what advantage is there to this and why would you want to do it? Well simply put you’re looking for opportunity. You’re looking for an edge to make a profit.
Price action reading in hindsight, meaning after the fact, is relatively easy to master – even seconds after the fact. But, you do not profit this way as you cannot trade this way. You need to attain an understanding or a feel for what is occurring in the now, understand what potentially is causing the price action to unfold as it is before your eyes and doing so sub-consciously. The goal is to read price action as you would the words in a book. Reading words, sub-consciously you form understanding and ideas; the goal is to think this same way when reading price action.
Trading is easy, push the go long or go short button, see if you make a profit, if not exit. You could just enter at any location, but that would be more in line with gambling – lay your money down and see what happens. That approach is doomed to failure. If you have no idea of a stop loss-profit target (risk reward ratio), no judgment as to what is occurring in the market, no insight into who is in control - you really have no chance for success.
Reading price action and understanding market
context go hand in hand. As for example with news releases, the market context typically includes exceptionally wide and volatile swings. Review the ES or 6E futures charts at 10:00EST and notice how volatile that time of day can be. Scheduled reports are routinely released at that time. The close of a market is also another crazy time to trade. If you cannot hold
overnight you must exit your position before the market close. Those who can hold over night will be glad to help you exit your positions. Successful traders have a firm grasp of market context. Major and minor swings, number of traders in the market, type of traders in the market, time of day, time of week, time of month, time of year , trending or trade range, – all of these and more make up market context.
The best entries have obvious risk and reward price points which can be used as stop loss and profit targets. Look back on any chart and identify these locations. You know the ones, where you say, If I had entered here and had a stop loose there, look how far this trade would have run. Once identified, study the bars just before the obvious entry location – those are the price action patterns you want to learn to identify allowing you to prepare for the entry. Also with the prior bars, pay particular attention to the potential obvious stop loss and profit target areas. Keep these locations in mind should the market should prove you right and warrant an entry. Plan your trade and trade your plan.
Validating entry locations includes understanding the trade’s risk:reward ratio. Subconsciously learn how to calculate the risk:reward ratio. Many trading methods use this value as an entry guideline– why risk more than you can be rewarded by? One rule of thumb is a 1:3 minimum. Not all approaches follow this rule so regimentally. With trading, things are very dependent on market context. Some methods I have studied use stop losses as catastrophic stop loses and such stop losses are hit only in extremely rare occurrence the market does something crazy. Using a catastrophic stop loss, the trade is managed once initiated, but a profit target is always known/set in advance.
Scaling in/out can also be incorporated allowing you to fund a “free”
runner trade. For example, once you make profit to
cover your initial risk, you exit a portion and let the remainder run with the market while managing the trade stop loss accordingly.
By reading price action, you learn to understand where such entry locations are likely to begin and why. It is absolutely impossible to always be correct in your read; nothing works every time because the market context is never the same. More importantly anything can happen at any given moment. There will be times when the absolute best setup simply does not work out. There will also be times when the market takes off for no reason what so ever. A fine line exists between the prediction of market movement (which is impossible in my opinion) and reacting expediently to what is unfolding before you (if the market is behaving in line with how you are reading it). Reading price action and reacting as needed requires extreme confidence in one’s self.
It is critically important to have an opinion on is who is in control. Why, because it provides a base from which to measure. Is this a bull market or a bear market or a
trading range? In review of charts, it is easy to see who was in control, but as already stated you do not trade in hindsight. The sooner you establish who is in control the sooner you can trade on the “right” side of the market. Examples of the right side of the market are: going long at the end of a
pullback in an uptrend, going short at the end of a rally in a down trend or buying low and selling high in a trading range.
The standard candle stick bar provides insight as to who was/is in control for the period of the bar. A candle stick bars has a high, low, open and close value. If the close is above the open, the bar is an up bar. If the close is below the open, it is a down bar. Looking at a common 5 minute chart, a large bar that has no tails or wicks is obviously
bullish if it is an up bar and bearish if it is a down bar. This fact alone provides insight into who was in control for the duration of the bar.
The tails of the bars provide valuable information as well. If the distance from the high of the bar to the open or close of the bar is significantly larger than the body ( the body is the distance between the open and close) , the top of the candle will have a top tail or wick. I use the term tail and wick interchangeably; it just means there is a line that extends from the top, bottom or both sides of the candle. A large top wick means the bulls pushed price up to the high, but then the bears took control and pushed the price back down. Conversely if the bar has a relatively large bottom tail it signifies the bears pushed price down to the low only to have the bears gain control and push price back up. Now consider a bar that has a relatively large bottom tail, no top wick and is an up bar – this bar is very bullish. Conversely if a bar has a relative tall top tail and is a down bar, it is very bearish. Knowing how to interpret the orientation of candle stick bars aids tremendously in determining who is in control. Some say the tale is in the tails – long bottom tails indicate buyers, long top tails (wicks) means sellers. But again, you must understand market context. For example given two bars, if the previous bar has a large top tail and the current bar has the large bottom tail – are the bulls in control?
Understanding how the market works greatly aids in determining who is in control. The market utilizes two basic types of orders – booked orders (such as limit orders) and market orders (filled when they arrive at the exchange). Yes there are variations, but at a basic level there are orders on the book and orders filled when placed. Why is this important to know? Booked orders cannot be filled by other booked orders. Booked orders can only be filled by market orders. Thus, traders placing market orders can be readily and correctly identified as the aggressive traders.
If price is dropping that means trades are occurring at the
bid (the price someone is willing to buy at, yes buy at). The aggressor is the seller in this case, the initiator of the trade is a seller. Conversely if price is rising, trading is occurring at the ask (the price someone is willing to sell at). Aggressive traders sell at the bid and buy at the ask. You can test this – during a slow time, to avoid
slippage, and in simulation mode, place a market buy order and see what price you get filled at (note what the
bid and ask are when you enter) and conversely do the same with a sell. Another way to think of it, if you want to enter the market long and don’t care about price, are you going to get the lower or higher price? If you don’t care and you go long, you’re going to pay the higher price. The ask is higher than the bid. Aggressive traders, traders who initiate a trade, sell at the bid and buy at the ask. This fact provides the
basis for a tangible metric to aid in determining who is in control.
If price thrusts downward who is in control? You might say well dah, the sellers are. But guess what, at the start of a large down move and a large reversal, the charts will look exactly the same – a thrust downward. Force yourself to determine/pick who is in control, based on what you read from the chart – this judgment needs to become a habit. Always have an opinion of who is in control. So what If you’re proven wrong, when proven wrong you still end up knowing who is in control.
There can be and many times is a difference between the aggressor and who is in control.
I have come to think of the heard as the aggressor. The herd is the vast majority who are trading. Think of stampeding cattle. What gets them all aggressive and moving in one direction? Who controls the heard? There are stories of getting the heard all fired up, running full steam ahead only to fall off a cliff to their death. So if the heard are the aggressors, who is it that is in control? More importantly how can you determine the sentiment of who is in control?
Many times more than not, the aggressor is not in control. Many times the aggressor represents the laggards – always late to the party and rushing in chasing the market.
Take for example a price drop that plummets 10 ticks in seconds on high volume. Imagine all the trades that must have occurred, all the orders filled for this to occur. Then you see price stop at a value it has stopped at before, to the exact tick. The exact same price point hit, just a few minutes ago. Ask yourself, with heavy volume and the thousands of traders in the market – how is it that price stopped to that exact tick? Is this a random occurrence? Look back to the left of a chart to aid in what is occurring on the right hand side of the chart. Review your charts to see what happens the majority of the time when you get a
double bottom (DB matching lows) or double tops (DT matching highs). Who is in control on these locations? This type of action appears almost magical, price tries to move past some value but the move/attempt is repeatedly rejected. On a 5 minute bar you can see the intra-bar movement repeatedly hitting that low, but it simply will not pass that value. In this example down thrust, someone sells and someone immediately buys. No matter how much selling volume there is, all the sell orders are instantly bought up. No way is this random. Knowing how the market works, the aggressors are trying to go lower, but for some reason the market won’t go down. The heard is being re-directed by the controllers.
And with that said, also consider the vastness of the market, so many traders with their own agenda. Recall it was stated that nothing works all the time. In review of charts, take note of what happens when a DT or DB location fails to hold.
You have undoubtedly have heard “the trend is your friend”. Well who is in control in a trend? You want to be on their side and you want to be in control too.
- You read price action to ascertain who is in control
- You read price action to learn where the laggards are as they become “trapped traders”
Have you ever been in a trade only to have the market immediately go against you? How do you feel? If you’re smart what do you do? You exit the market. It is also very true that at every trade there is an initiator and the remaining trader. If you initiate an exit due the above scenario (for example exit a short entry), someone else needs to pick up the other side of your trade in order for it to be filled. Ask yourself, if you’re exiting because you’re feeling pain – who in their right mind is entering? In this example/context, the ones who are in control, the bulls, the buyers, that’s who is making so you can exit safely. How nice of them…
Imagine price is moving strongly downward. An aggressive trader jumps on the bandwagon and enters short. They are an above average trader and place a
stop order just above the entry bar. They place an “obvious” profit target at a respectable risk:reward ratio. Price now starts to move in their direction, volume increases meaning others are jumping on the bandwagon. But all of a sudden price stalls - it just will not go lower and is just shy of an “obvious” risk:reward ratio profit target. Price then starts heading upward towards the obvious stop loss exit, but it does not hit the exit either. Time moves on and magically price starts moving downward again. The aggressive trader’s emotions are going crazy – at first they were elated as it seems they were on their way to an easy profit. Then all of a sudden they almost got stopped out – whew what a close call. And now price is coming down again, yes this trade is going to work. Then it happens – price stops to the tick of the previous thrust, it just refuses to go down any further. The bulls, who are in control, are again rejecting again the 2nd attempt down of the bears – and to the tick. The laggard trader is trapped. What to do? Indecision ensues, do I exit now with partial profit, but my rules say never ever change my targets, what to do what to do what to do, panic sets in…. Price now races back to the stop loss. What happens next? What happens when those exists are hit? What happens if they exit with partial profit? If we are in a down move, those exits are buy orders. So now we have the bulls that are in control having defended the low a second time (double bottom). We also have the trapped trader exits that turn into more buy orders. Demand is building and supply is gone signified by the fact that price would not go down. What’s gona happen to price?
Enter the market to ease the pain of trapped traders in the direction of observed control (trend).
Limits, fractals and abstract thinking are applicable to price action reading. Here is one way to understand what thinking at the limit means. Stand facing a wall, 4feet or so from it. Now take a step half way to the wall, then repeat, again and again and again. Will you ever hit the wall? Fractals and limit thinking are an interesting combination when applied to trading. As an example of the fractal nature of trading consider a 1 minute, 5 minute and 10 minute chart. If a high is made on the 10 minute chart, that same high is also made on the 5 minute and 1 minute chart. Price action reading is fractal in nature - price is simply represented or printed in finer or more course detail on charts. On the 1 minute chart you will see pull backs whereas on the 10 minute chart you will only that action as intra bar movement. Both will end with the same high/low extreme, it’s just that one illustrates with more detail. The detail may provide you, or better stated, you may perceive opportunity in the detail where as another trade will call it noise. There is no right or wrong here, just what you perceive, how you react and how you trade (your style). Just remember the smaller the time frame, the smaller the opportunity. If you take this concept to the limit, to the single tick, the same principles still apply. With this said, there are always easier ways of doing things – you could fly to California or you could walk, one is just easier. Al Brooks advocates the 5 minute chart for Price Action Reading, but it will work on any highly liquid market with any periodic measure.
In keeping with the microscopic view (at the limit if you will) , at every price point traded there is a potential trapped trader because for every buyer there is a seller and for every seller there is a buyer. The higher the density of trades, the higher the probability of a trapped trader whose pain you can “help” ease. Trapped traders will gladly allow your fill with their stops. Based on this does it not make sense to look for these highly probable, highly dense trade areas on the chart?
This is why looking back to the left becomes important. Those previous peaks and valleys represent high probability locations of prior traders. I know of many methods that use closes of bars and just as many that use highs and lows of bars. Many methods use previous session highs and lows. Common trading methods, widely accepted methods serve up (more like T up) these highly probable locations on a silver platter. Patterns form and methods work, not due to magic, but due in part to being self-fulfilling in nature. If the majority of current traders within the heard believes the EMA20 price cross method, guess what the high likely hood of price action within the market (at that moment in time) will be when the setup occurs. And for every buyer there is a seller, so someone is always left holding the bag if you will. You need to understand the market you trade in; you need to get a feel for the way it behaves. Don’t chase the market, rather like in chess, think ahead of the next move and be prepared to take action when your thoughts are proven right. Don’t be greedy – but do be profitable.
You’re seeking to be on the side of control, you want to remain in control of your trade. If you’re in the market and not proven right – do not hesitate to exit. There is no hoping involved in trading – you are either proven right or you exit. Don’t let the market make that decision for you. You need to be in control of your trading, not the market. Lean to read where the high likely hood of trading will occur – you can easily identify these locations by reviewing your charts. Look for the locations where you say If I had entered here look what opportunity was available. Then consider what the market looked like just prior to that and look for that “setup” when reading price action in real time. Look for control, remain in control and trade in the direction of control.
I have recently started taking
screen shots of moves that I believe are great setups. When trading live I take the
screen shot as soon as I recognize it forming. I store these in a folder with a name based on the name I give the setup (for example 1st pull back). I periodically review the folders of images, sort of a flash card type approach to teaching my brain what to look for. I want to build my sub conscious mind to recognize this image as it forms just as I teach my mind to read what is going on – who is in control and where are the trapped traders I can help. Trading is very much mental – it needs to become second nature.
The mechanics of trading are not difficult. What is difficult is remaining in and maintaining mental control. Excitement and frustration are hard emotions to keep in check. Remaining in the “zone” focused on what is unfolding as told by price action is challenging and hard to do. It is extremely difficult to sit on your hands when you see the market accelerate and you’re not in the market. It is equally difficult to remain in the market when you are proven right and everything is indicating continued movement in the identified direction. And it is most challenging to exit when you are not proven correct. One way to remain in mental control is ensuring you are making your trading decisions. You can only control yourself, you cannot control the market. If you decide to get out of the market make sure it is because you decide to do so meaning exit before you catastrophic stop loss is hit. It’s akin to seeing an eighteen wheel semi speeding down the road directly towards you; as soon as you identify this situation does it not make sense to get out of the way? Letting the market take you out by hitting your stops become mentally challenging. Learn to listen to yourself. Learn to distinguish between the inner voice that is all excited about seeing a market thrust and the inner voice that identifies opportunity and trapped traders.
Reading price action is tool to aid in successful trading. Understanding how to read the market will provide you with the reasons why a DT or a DB works. It defines why the BPB (
breakout pullback) works. Patterns and methods are valid in trading, but reading price action provides reasons why they work and provides you an edge before they print. At first you may think your anticipating the move, but remember you cannot predict the unpredictable. You are reacting to the provided information you are receiving in real time that then leads to the pattern.
Another way to understand price action involves supply and demand. Why does price go up? Why does price go down - supply and demand or the lack there of. High demand means the supply is low and conversely high supply means demand is low. When the availability of an item to buy is low, what happens to its price? It rises. Think about gold, it is rare with a supply lower than the demand so its price is relatively high. Conversely, the supply of dirt in the world is higher than that of gold and thusly the price of dirt is less than the price of gold.
So how do you measure supply and demand? With trading, I don’t think you adequately measure it. The reason being you are not provided the reasons why someone is buying or selling. You do not know if they are selling to exit with profit, selling to exit with loss, or selling to enter the market. All you know is that trades occurred at a location. But I know you can react to supply and demand changes when identified.
There are millions of possible reasons why supply or demand change. I recall something I read one time about this techno-wizard showing a very wealthy old crony beans trader, his latest and greatest Holy Grail indicator. The techno wizard says all excited to the old crony – see this arrow this is a strong highly probable buy signal that works 95% of the time. The old crony says really, grabs the phone and places an order to sell 1000 bean
contracts at the market. Just as the market starts to raise a few ticks, it almost instantly drops 10 tics. The old crony then says to the techno wizards, thanks. The point is you never know what is occurring. You can be assured that supply and demand will change. Large institutions always have orders to sell or buy – because that’s what they do. The
High Frequency Trading (
HFT) computers may have just been programed with a new algorithm and it is being tried out for the first time. Some episodic news related item (Japan Earth quake) may have just occurred without warning. Some rouge trader may have just pushed the sell button. There are endless possibilities and all can and do affect supply and demand. But what can be recognized are areas where prices has hard time moving through, areas of
support and resistance. You can also watch intra bar and get a feel for what rejection and continuation looks like within the market your trade. Remember the fractal nature of the market, intrabar on the 30 minute can be a significant trend on the 1 minute.
When demand increases, price increases. When supply increases, price falls. In a trending market, when demand increases, supply falls and when supply falls, demand increases. Demand could be increasing, and then profit taking could occur causing a monetary drop in price, only to take back off upward again. That’s what a first pull back looks like in a trend.
Price has found equilibrium where demand and supply are in check. Price seeks equilibrium.
Equilibrium is identified on the chart as congestion – overlapping bars or barbed wire as Al Brooks calls it. Demand and supply for the moment are equal. When either side gains control, price moves again, and continues on a path seeking equilibrium. Again, you are looking for control. Is supply in control or is demand in control.
At the end of it all, what really causes price movement is greed and fear of human beings. Greed brings you into the market and fear takes you out. You enter because you observe an opportunity to profit. You exit for two possible reasons. If you exit with a profit, your fear is not so hard to accept, the fear of losing the profit potential you have. If you exit for a loss, your fear is more profound, the fear of losing more than you started with.
Price Action reading provides the ability to define an edge. It provides a measure you can use in any liquid market. It is as close to the Holy Grail of trading that you will ever find and you will still need to apply discretion. It offers you a way to understand and explain market movement and allows you a repeatable way to determine who is in control. Being in control and on the side of control is a definite advantage in trading. At its essence price action reading is the basis of all trading methods.
