Becoming a Better Trader: 3 Principles of Price Action Analysis
Price action lies at the heart of technical analysis and is a simple, yet powerful way to identify trading opportunities. We examined in depth with examples the three main tenets of price action; trend, support & resistance, and market reaction.
- Price action analysis is a powerful way to isolate potential trading opportunities
- We look at how to identify the trend, support & resistance, and reaction signals for validation
- Tying it all together and arriving at trading decisions
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Technical analysis is comprised of numerous disciplines, but at the foundation of it lies price action. There are three key components – trend, price levels (support/resistance), and the reaction of the market which provide ‘actionable’ signals.
There are many indicators which identify the trend and its strength, but what really defines a trend from a simple price standpoint is whether the market is making higher-highs and higher-lows (uptrend), lower-lows and lower-highs (downtrend), or neither (range). Which way is the chart ‘tilted’; Up, down, or sideways? We looked a few examples of trends along with when the market could be undergoing a trend-change. When taking trends into consideration, they occur on all time-frames, but the general rule to follow is that the higher time-frame takes precedence over the short-term periodicity. For example, in FX using the daily and 4-hr is a solid combination, and so while a strong trend may be developing on the daily there may be an uptrend visible on the 4-hr. In this case, more respect should be paid to the trend of the daily chart.
USDJPY: 4-hr Chart (Clear downtrend marked by lower-lows & lower-highs)
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Support and Resistance
The next important aspect to price action trading are price levels, support and resistance. Support is simply a point where demand (buyers) have stepped in and kept price supported, while resistance is a form of supply (sellers), a point where the market has failed to continue moving higher. There are numerous ways to identify these levels such as Fibonacci levels and moving averages, but the focus here was primarily on actual price levels and trend-lines, or slopes. Looking for confluence of varying angles of support or resistance makes for a stronger, more reliable level. For example, if you have a horizontal price level coupled with a trend-line it strengthens the validation of that particular price level or price zone.
USDJPY: 4-hr Chart (Building on the prior chart – Prior lows become resistance & trend-line)
Market Reaction (Validation, Invalidation)
The third aspect to price action trading we discussed, is how the market reacts to price levels and within the context of the trend. Is the market displaying behavior which confirms or invalidates what we have on our chart? This is where the rubber meets the road, and a trading decision can be made.
A simple way to identify if the market is adhering to a particular level, is by using candlestick analysis. Those candlestick types which demonstrate a clear reaction such as key-reversal bar (aka ‘pin’ bars, ‘shooting stars’, ‘bullish hammers’), ‘engulfing bars’, etc. With these we are looking for a rejection away from the price level in question, a change in momentum which shows the markets willingness to reverse from our identified levels. It doesn’t necessarily need to be a swift turn, but is more ideal in showing the presence of buyers and sellers.
From here we can use the swing-low (for longs) and swing-high (for shorts) to determine where to place stops. By placing the stop-loss beyond the low or high by a sufficient amount we are allowing for ‘wiggle room’ to let the trade work itself out, and if the market moves beyond those levels the market is effectively invalidating the trade. Targets should allow for ample reward relative to the risk taken (as a general rule of thumb, a 1:2 risk/reward ratio or better). Targets are best based on the distance to the next technical level (resistance for longs, support for shorts).
USDJPY: 4-hr Chart (Building onto chart #1 & #2, validation through change in momentum)
For the full conversation and set of examples, please see the video above…
Past ‘Becoming a Better Trader” webinars you may also be interested in: Classic Chart Patterns, Part I, Classic Chart Patterns, Part II,Analysis, keeping it simple; Using a Checklist; Risk Management; Handling Drawdowns; 6 Mistakes Traders Make; Focusing on the Process; Creating a Trading Plan
---Written by Paul Robinson, Market Analyst
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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.