Trading insights

Price action explained

Although I do make my trading setups partly based on indicators, price action is leading. Indicators are lagging and price action is providing real time information about what game buyers and sellers are playing. The candles are telling a story and I use some indicators as MA's and cycles to confirm my candlestick analysis. By integrating cycle theory and supply and demandzones with price action, traders can discover powerful trading setups and make informed decisions.

In this blog, SDC Trader explains everything about price action, what is price action, what clues does candle provide, how to recognize the trend and off course the trap! Whether you are just starting out or are an experienced professional, understanding these principals can be an essential tool for creating good setups and growing your wealth.

What is Price Action?


Price action trading is a method used by traders to operate in financial markets by analyzing price movements over time. At its core, price action refers to how prices change—the "action" of price. Unlike traditional technical analysis, which often relies on lagging indicators, price action trading focuses solely on price, allowing you to see in real-time what buyers and sellers are planning.


This methodology enables traders to develop a framework for understanding market structures by examining historical price patterns, such as swing highs and lows, and support and resistance levels. Price action traders interpret these movements to infer the underlying psychology of market participants, using "clues" from price charts to anticipate future price changes.

Price action trading emphasizes simplicity, often summarized by the phrase "Keep It Simple Stupid." In fact, you can assess a chart based solely on the candles, a method also known as "clean chart trading" or "naked trading." The candles on a chart reveal the actions and intentions of buyers and sellers, providing valuable insights into market sentiment. By analyzing these price movements, traders can gain a better understanding of potential future trends. By understanding the price in context, traders can make informed decisions and effectively implement their trading strategies.

What clues do the candles provide?
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Shape: Different shapes such as inside bars, dojis, and engulfing candles give important signals about price rejection or potential reversals. A doji indicates uncertainty or indecision, as the opening and closing prices are close together. In an inside bar, the current candle fits entirely within the previous candle, indicating energy build-up for a larger movement, and traders wait to enter long or short until it becomes clear which side the inside candle will break. An engulfing candle is a two-candle pattern where a previous candle is completely engulfed by a larger candle. There are two types:

Bullish engulfing: This consists of a red candle followed by a larger green candle, indicating strong buying pressure and potentially signaling an upward trend.

Bearish engulfing: This consists of a green candle followed by a larger red candle, indicating strong selling pressure and potentially signaling a downward trend. The engulfing candle should ideally lead to a continuation, as control has shifted from buyers to sellers, or vice versa.

Candle color: The color of the candle (green or red) shows whether the price closed higher or lower than the opening price, also signaling market sentiment. A series of candles of the same color indicates a trend.

Wicks: The body of the candle marks the open and close of that candle, while the wicks indicate the extremes. In a red candle, buyers initially had control, but sellers entered the market at the wick high, driving the price down. In a green candle, the opposite occurs as buyers enter the market, pushing sellers out. Thus, wicks represent price rejections that can lead to reversals.

Body and wick ratio: A long body with short wicks can indicate strong price action, while a short body with long wicks often signals uncertainty or rejection.

Placement within the trend: Look at where the candle is situated in the context of the broader trend. This can help identify potential support or resistance levels.

Price action patterns: Often referred to as triggers, setups, or signals, these are crucial for price action trading as they provide important insights into potential future price movements. Price action patterns, often referred to as triggers, setups, or signals, are crucial for price action trading because they provide important insights into potential future price movements.

The fake break

This is a trading signal characterized by a false breakout. In a bull trap, there is initially a breakout above a resistance level or previous swing high, but that breakout fails to hold and then closes (or quickly in the subsequent candles) back below the breakout level. Buyers are caught off guard and may need to close their positions, providing extra fuel for a price decline. In the case of a bear trap, the opposite occurs. The price first breaks below an important level, possibly triggering stop losses at “logical points,” only to use that liquidity to initiate a sharp reversal. On Twitter, I often use the term “look above/below and fail” to indicate that a trap has occurred or may occur.

You and I, as retail investors, cannot significantly move prices, but large institutional investors can. They have the ability to mislead the markets, making investors think that the market is moving in a particular direction, only to reverse and trigger a price movement in the opposite direction. So, be cautious of traps at clear support and resistance levels!

The most reliable price action signals occur at "confluent" points, where multiple factors align with a price action entry signal. Confluence refers to the coming together of various elements. In trading, this means finding areas on the chart where at least two or more factors support a price action signal. For example, a pattern forming in an upward market at a support level creates confluence between the trend and support, giving the pin bar buy signal more weight. The more factors that support a price action signal, the greater the chance of success.

In the chart below you can see a perfect example of a failed break, or bear trap. The stock opened below a clear support level, dropped a bit lower, but then buyers stepped in, quickly driving prices higher.

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The trend


Also, look at the bigger picture: what does a series of multiple candles look like? Is there an upward movement, a pullback to a higher low, followed by another upward move to new highs? Then the trend is upward. Buying on weakness is the best strategy in this case. Conversely, in a downward trend, there are series of lower highs and lower lows, and you should sell on strength. There is also a sideways trend, or trading range, where the price remains trapped between a certain level on the upside and does not break support on the downside. In this scenario, buy and hold yields little or nothing; it’s better to trade contrarian at the extremes, going short on the upside and long on the downside.

In the chart below you can see the impressive uptrend of American Airlines (UAL) since the recent August low. Every single (tiny) pullback is getting bought, resulting in new highs each time. Don't fight the trend until you see clear signs that the trend has changed.

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Conclusion


Since most indicators are lagging, there is always a degree of delay, while with price action, you can read in real-time what the players are planning. I personally combine price action with the supply and demand zone strategy and a cycle theory for support. If what I derive from price action is supported by these other elements, then a setup has an even greater chance of success. In other blogs, you can read extensively about what supply and demandzones entail and how my unique cycle theory works.

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