Price action is simply another term for the movement of a security. And price action trading is a trading strategy that is neither technical analysis or fundamental analysis. Rather, price action traders observe recent price movements for technical indicators and then place their trades based on their individual decision making. Only the identification of the trade condition is based on established analysis criteria, the decision to buy, sell or hold is subjective. In this article, we will explore price action trading, look at examples, and discuss the strategy’s advantages and disadvantages. (For more see What does it mean when there is "price action"?)
How Does Price Action Trading Work?
Price action trading involves two steps: 1) identify a trade condition and 2) take a trading position based on individual thoughts. A trade condition could be a range breakout, the price breaking psychological levels, or a perceived entry into a bull or bear market. After identifying the trade condition, the trader makes a subjective decision.
Why take such an open-ended approach? Based on experience, a trader may refuse to blindly accept the defined rules of technical or fundamental analysis due to their limitations or due to unusual market conditions. Such a trader instead relies on his or her own gut feelings and decisions.
Understanding the Price Action Trading Concept
A trade occurs only when two different parties (the buyer and the seller) take two different views (buy or sell) on a the same security. In theory, the buyer and seller should have access to all the same information about the security—data from the news, technical indicators, and fundamental analysis recommendations. Despite this, the buyer and seller come to opposing conclusions. Why does this happen? Because each traders’ individual behavioral judgments lead to trading with opposite views. (See more in How To Trade The News.)
For example, a 15-day moving average (MA) crossing over 50-day moving average is a common occurrence and visible to all. However, this movement can be a buy signal for some and a sell signal for others. Buyers may base their decision on the standard recommendation of the moving average crossovers, while sellers may take a contrarian view that the standard recommendation to buy on crossovers will lead to an overbought situation and hence it is better to sell.
As you can see, instead of blindly following defined rules, traders can make buying and selling decision based on their own trading views.
Where Does Price Action Trading Fit in?
Technical analysis involves observing a security’s historical patterns and placing trades that assume the patterns will repeat in the future. The basic assumption is that history repeats itself. This assumption is also is the main weakness in technical analysis-based trading. There is no guarantee that history will repeat itself. (See related Trading Volatile Stocks with Technical Indicators.)
Fundamental analysis attempts to measure the intrinsic value of a stock by examining the financial, economic, qualitative and quantitative factors. It suffers from a basic challenge that input parameters and the calculated numbers (like earnings-per-share (EPS) or price-earnings (P/E) ratios) are mostly useful for comparing one stock against another. They do not produce a specific stock price number, though they can give clues about whether a stock may be over or under priced. A few fundamental techniques, like the dividend discount model-DDM, do give target price levels. However, irrational exuberance or pessimism in the market can always affect prices, limiting the usefulness of the calculated values.
Price action trading offers an intermediate solution to these challenges. It doesn’t go too deep into the history of a stock’s movements like technical analysis does. It also doesn’t rely on an almost limitless number of factors, like fundamental analysis. Instead, it allows for a subjective decision making based on recent, actual and instant price movements of a security.
Price Action Trading and Tools
Price action trading uses technical analysis tools to analyze instant and recent past price movements of a security. Tools include charts, patterns, price bands, breakouts and technical levels (of support, resistance and consolidation). This use of recent price history and technical analysis tools makes price action trading closer to technical analysis than fundamental analysis.
However, price action trading is not a condensed form of technical analysis. The technical analysis tools are complemented by the trader’s psychological, behavioral and personal interpretations on the security and the market. The decisions that follow spring from the experience and judgment of the individual trader and not hard rules from a textbook. Despite identical technical analysis, traders may take completely opposing views.
Examples of Price Action Trading
- A stock may have been hovering in the range of $19.75 to $19.85 for the last few hours. Technical analysis suggests that price will soon hit $20. The first trader, Nick, believes that once the psychological barrier of $20 is crossed, the price may shoot up to $22. He takes a long position. The second trader, Cathy, assumes that once the stock hits $20, there may be a big trend reversal that takes the stock down to $18.50. Cathy takes a short position. As you can see, the same situation (hovering in a range) and the same technical analysis result (breaching the psychological level $20 level) can result in opposite interpretations.
- Traders Paul and Peter use the same technical analysis software which predicts the intraday price range of a security. The software predicts a low level of $22 and high level of $26 for the day for the stock. Paul believes that the stock’s price will breach the high level of $26 today. He takes a long position (say at $23) and doesn’t sell even when the price reaches around $25.80, $25.90 or $26 because he is expecting further price appreciation. In contrast, Peter is firm that price will remain in the defined range of $22 to $26. Peter shorts the stock around these higher levels.
Why Is Price Action Trading Popular?
A book search on Amazon.com for term "Price Action" results in more than 1700 titles, which indicates the popularity of price action trading. Here are the major reasons why it is so popular:
- Allows traders to apply their own custom-made strategies without blindly following any rules.
- Can be applied across different asset classes, especially ones which are highly volatile, like high-beta stocks, options, and futures.
- Can be done with any trading software.
- Can be back tested on historical data (see related Backtesting: Interpreting The Past).
- Relies on instant and recent data for best results.
The Bottom Line
Price action trading offers several advantages over other trading strategies. However, the price action trading strategy also has challenges. Without any concrete guidelines, traders are left use their best judgment—a situation that can result in losses. (Suggested reading An Introduction To Price Action Trading Strategies.)