The Price Action Trader’s Plan
- This article is an extension in our series on the topic of Price Action Analysis.
- In our last article, we looked at a ‘cheat sheet’ for trading in each of the three ‘conditions.’
- In this piece, we’re going to integrate the cheat sheet with the nuances of an approach/strategy.
Over the past month, we’ve released quite a few articles on the topic of price action.
And they’ve all been leading into this one: The article where we can show you how to use price action to find trades and enter positions.
Surely, there are a lot of ways to go about finding trades. A lot of traders like to use fundamental analysis to get an idea for what ‘may’ happen in the future. Others prefer to use technical analysis, in which they can take a look at the historical patterns on the chart in an effort to determine what ‘may’ happen in the future.
There is just one problem with these methods: Neither will work all of the time. The future is unpredictable, and this holds true whether we’re using data points, or chart information, or tea leaves or anything else to try to project what may happen.
This, on its face, may not sound all that bad. But once you realize that it takes just one bad trade to wipe away the gains from 5, 10, or even 100 good ones – and the importance of risk management becomes obvious. Without solid risk management – most traders don’t even stand a chance of success.
And this is where price action comes into play. Just like fundamental analysis, or technical analysis – price action is not perfect (nor is it perfectly predictive). It’s simply the cleanest look at the chart and historical price patterns so that traders can get an idea for what may happen in the future.
In this article, we’re going to attempt to show you how traders can build their trading plans around the study of price action.
Don’t Wake Up in a New World Every Morning and Don’t Fly by the Seat of Your Pants
Perhaps one of the biggest culprits of failure amongst new traders is the lack of a trading plan.
I realize that putting together a trading plan isn’t necessarily an exercise in ‘fun,’ but that’s not the point. The point is that trading is difficult, and one can potentially lose a lot of money. Not only is the future unpredictable, but things can change pretty fast in markets.
If you don’t know how you want to approach/attack a market, you stand a very big risk of feeling lost. This is why the trading plan is so important: It defines the trader’s individual approach to the market. This is where a trader defines their timeframes, risk amounts, desired holding times, and strategies. This works like the trader’s personal ‘constitution,’ that defines their activities in a market.
This is where you can structure your process. The key sections to define in the trading plan are the trader’s desired holding time (which can then be used to determine chart time frames), risk amounts, profit target objectives, and strategy parameters.
If you want an example of a trading plan, the article, The Four-Hour Trader, A Full Trading Plan shows an example of how price action can be used in a Trend-Trader’s ‘plan-of-attack.’
Go With the Flow – Pick the ‘Right’ Strategy for the ‘Right’ Market
Have you ever felt like you were zigging while the entire world was zagging? And no matter how hard you tried or how well you did – you ended up seeing unfavorable results?
It’s sort of like trying to fit a square peg into a round hole, right?
That’s the same thing as trying to force your strategy on a market. The old saying goes ‘the market is always right,’ well that’s of the upmost importance when it comes to strategy selection and condition identification.
Well markets display distinct characteristics depending on which market condition is being displayed. Trends can last for a while, with higher-highs and higher-lows guiding the chart in a defined direction. Once all that new information is priced-in, the market can begin displaying range-bound tendencies as buying demand and selling supply equalize. And once more information comes out for that markets, traders will rush to price it in and this can lead to violent and extended price movements (the breakout).
We discussed this principal in The Price Action Cheat Sheet, and the table below, taken from the article, goes over some of the characteristics that make each of these conditions unique:
|Condition||Pros||Cons||How to handle|
|Range||Consistency, stop placement||Limited up-side potential||Look for higher winning %'s & less aggressive risk-reward ratios|
|Breakout||Huge profit potential||higher failure rates (false breaks)||Significantly more aggressive risk-reward ratios|
|Trend||Market bias (direction of trend)||Difficult entry timing||Multiple Time Frame AnalysisMinimum 1:2 Risk-Reward|
Taken from The Price Action Cheat Sheet, by James Stanley
Use Time Frames to Define Stance
We’ve discussed a theme throughout all of our price action materials that is worth mention before we go any further.
Any discussion of strategy in this series has pointed to multiple time frame analysis. This is the use of more than one chart to decide how you want to trade in that market. And the above section is a big reason for that.
Before we ever think about placing a trade, we want to define the ‘general condition’ of that market. When using Multiple Time Frame Analysis, this is relatively simplistic as the longer-term or the ‘bigger’ time frame can offer a ‘birds-eye-view’ of that market.
The table below, taken from the article The Time Frames of Trading, suggests chart time frames based on a trader’s desired holding period. The trader can use the ‘trend’ chart to ascertain whether or not a trend exists, and if so – which direction the trend is moving (and should be traded).
Taken from The Time Frames of Trading, by James Stanley
This birds-eye-view can offer a better look at the bigger-picture condition of that market. If the ‘bigger picture’ is showing an up-trend, well then the trader wants to look for ways to buy cheaply; and the short-term chart can help the trader get a granular, more detailed look at the prospect of doing so. If the bigger picture is range-bound, well then the strategy defines itself: On the shorter-term chart, traders can look to buy low, sell high, and then to wash, rinse and repeat. Or, if traders expect that range to break for whatever reason, they can look to use entry orders to buy new highs or sell new lows on the shorter-term chart.
How to Catch Entries Once You’ve Diagnosed the Trend (or lack thereof)
Most of the difficult work is done in step 1, when the market condition is diagnosed based on the ‘bigger picture.’ After that, the trader really just needs to trigger the entry to line up with that ‘bigger picture.’
The next logical question is ‘how to trigger the entry?’
More sleep, time, and money have been squandered by folks drilling over the minutiae of the fine points of entering positions. Let me save you some time: The future is unpredictable whether we’re talking the next tick, the next hour, or the next day. There is no such thing as a perfect entry. That’s the whole reason we’re using multiple time frame analysis – so that this part of the trade (enacting the entry) – is in terms of the ‘bigger picture.’
We’re not trying to call the exact high or low to the tenth of a pip – because that is impossible. Rather, we’re trying to get the probabilities of success in our favor; if even just by a little bit.
And since we already know the direction we want to trade, the entry itself is somewhat spelled out for us.
If a trader is looking to buy in a trend or a ranging market; then the stop is going to go on the other side of support. And logically speaking, the trader wants to enter after the early stages of support confirmation have been seen. So after the trader has diagnosed an up-trend, or a range at support – they can wait for a reaction on the entry chart; and once they see a long wick, highlighting the reaction – they can look to enter the position.
We discussed this type of setup in the article, The Power of Wicks in the FX Market.
Created with Marketscope/Trading Station II; prepared by James Stanley
The beauty of the wick is that they show the early stages of a potential reversal. Further – it allows the trader to adequately define their risk. They can look to place a stop on the other side of the wick (which should have been a reaction through support), and then look for their setup to work.
For traders that are more selective or very conservative, they can wait for a defined candlestick wick in concert of additional formations.
For example, the pin bar is more defined version of a long wick. The pin bar is simply a wick (at least as long as the candle body) that sticks out of previous price action. This is simply a long wick that has hit a new support or resistance level; but this can be a key setup for playing a reversal on the shorter-term entry chart.
Taken further, the morning star/ evening star setup will often develop around the top or bottom of a trend. These three-candle setups make a lot of logical sense. After an impulse move, followed by an indecision candlestick (like a doji or a spinning top), then a reversal move (seen below):
Taken from Trading Bearish Reversals; by James Stanley
You may notice a theme here: These entries are all just very simple ways of looking for potential reversals. The key here is that these reversals are in scope of the ‘bigger picture’ move, and the trader is essentially using these setups to trade the ‘bigger picture’ condition by fading the short-term move (buying support or selling resistance on the entry chart).
But to reiterate, the entry is simply a way to trade the ‘bigger picture’ of that market condition. So some traders work on not losing sleep over waiting for the exact picture-perfect candlestick setup on the entry chart; and instead focus on the ‘bigger picture’ theme of the longer time frame. For these traders, even a simple indecision setup like the doji can be enough to trigger a position on the entry chart under the presumption that the ‘bigger picture’ is attractive enough to take on the risk of the position.
We cover five different forms of ‘indecision’ setups in the article; The Price Action Trader’s Best Friend is Indecision.
--- Written by James Stanley
Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.
James is available on Twitter @JStanleyFX
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