How to Read and Trade the Price Action
Skerdian Meta • 7 min read
Trading can be as difficult or as easy as you want it to be. Indicators and trading strategies can make trading much easier, and knowing how to read the price action is one of the most useful ways to trade. This type of analysis was first introduced by Charles Dow, who laid the foundations for the technical analysis. It has since been developed and advanced remarkably.
Understanding the price action gives you that extra edge you need to get over the profit line. That´s the reason more and more traders are using price action as one of the main indicators when analyzing charts and making trading decisions. Since price action trading doesn´t predict the future like many other indicators, it never lies; it will tell you how the market will actually behave during different time periods and prices.
The price is always right – it never lies
What is the price action? Price action is the fluctuation in the price of a financial instrument. In order to predict future price movements, it is necessary to observe it for quite some time. This way you can see how the price reacts to economic events or when it gets to certain levels.
The movement of the price might look chaotic, and different people interpret it in different ways, so many people consider price action trading an elusive beast. But price action can be read through technical analysis as well; candlestick formations such as the swing levels, retrace strength, wide range candles and engulfing pattern, doji, pins, narrow range candles etc. are examples of price action during the period that the candle lasts.
Price action trading means that you read/analyze past or present price behavior in order to build a trading plan for the future. The strategies based on price action analysis can be divided into two groups: strategies where you have to observe the price fluctuation continuously in order to get an entry/exit point, and strategies where you have to look at the past price movement in the chart and leave a pending order.
Past price action strategies Finding swing levels – When a currency pair is following a trend, it´s much easier to trade the trend if you identify the possible swing/retrace levels. The price never goes up or down in a straight line. Instead, it makes a leg higher during an uptrend before making a retrace to start the next leg up. You should identify where the retraces will end or the swing low levels during an uptrend, so you can place a buy pending order.
First, you should identify what indicator is the trend leaning against. Is it a trend line? Is it a moving average, or the Fibonacci levels? If the trend is following the Fibonacci pattern then you should identify the Fibonacci levels. This will help you find the swing/retracement levels, since the Fibonacci numbers act as support/resistance. As you can see from the GBP/USD weekly chart below, the Fibonacci numbers have provided three trading opportunities in the direction of the trend and another two trading opportunities in the countertrend direction.
Swing levels based on the Fibonacci golden ratio numbers
When the trend is leaning against a trend line or a moving average, these indicators reject the price when it touches them, and they act as the swing low levels in an uptrend or vice versa in a downtrend. The strength of the trend might not be always the same throughout the course. When the trend is weaker, you should use the bigger period moving averages or less inclined trend lines. When the trend gains pace, you should use the smaller period MAs or the more inclined trend lines as swing low/high levels. As you can see in the picture below, when the trend is stronger, the 20 MA acts as resistance for the price, and when the trend loses strength, the 50 MA becomes the price rejection line.
Swing levels based on the 20 and 50 MAs
Swing levels analysis – After identifying swing levels, you have to make a risk/reward analysis of the current retrace. You never know how long a trend will last, so when buying the retraces/swings you should place the take profit near the top of the last high swing. But if the trend is based on a trend line or a moving average (MA) then you should check how far the last swing high went. Is it far enough to give you a good risk/reward ratio, thus justifying a possible trade?
There´s also a higher probability that your trade will be successful if there are a few candles at the top of the last swing. However, if there are many candles at the top it means that the resistance is very strong because it tried many times to break above that level but failed. Therefore, it is safer to enter when there are fewer candles at the top. On the chart below, we can see that the price easily broke above the top of the last swing which was made of only two candles. We can also see that on the second occasion, where the top is made of several candles, the price couldn´t break above it.
The more candles at the top, the stronger the resistance
Retrace strength – Once you have identified swing levels in a trend, you should find out how strong the retraces are. If we are planning to buy the retrace in an uptrend we want it to be weak because a strong retrace might take the price deeper below and could trigger the stop loss. In fact, strong retraces often turn into trend reversals because the bulls get scared and give up, closing their long positions after the price breaks several support areas. That´s why we should see how the price respects the indicator that the trend is based on, which might be a trend line or a moving average.
If the price has often pierced the trend line or the MA in the past, it means that the retraces are quite strong so it´s better to stay away because a reversal might take place at any time. We should also see how quickly the price has reversed in the past. If during the past retraces the price has reversed quickly without sticking too long to the trend line or to the MA, it means that the bulls have an appetite for risk so the retraces are weak. Therefore, it´s safe to buy on the retraces.
The chart below shows two phases of a downtrend: on the first phase, the price respects the 50 MA on which the trend is leaning against. The price reverses down whenever it touches or gets close to the MA. The retraces are weak, and it is safe to sell. On the second part, the price clearly breaches the 50 MA in yellow. Although it goes back below it, it´s not advisable to sell the retraces anymore because the trend might reverse anytime now that the retraces have become stronger. We see that the downtrend does reverse later on.
The weaker the retrace, the stronger the trend
Current/observing price action strategies, rejection time – This is one of the main price action strategies. It is crucial for trading because the rejection time shows us how fast certain levels are rejecting the price. Although after several attempts at the 1.0930-55, the EUR/USD chart below gives the impression of quick rejections because of the long wicks, this may not be the case. The price might have stayed at the top of the wick for almost the entire time, only to go down at the last minute before the candles closed.
That´s why you have to observe the price in real-time in order to see how quickly it reversed from the top. It is a bit time consuming, but you have to put in the effort to succeed in this business. If the price only spikes to the top for a moment, and then quickly reverses back down, it means that a lot of sellers are waiting to sell at that level. This makes it a very strong resistance, and thus a very safe place to open a sell position.
You have to observe the price to see how quickly the price reverses from the top
Big opposing candles/Doji/Pin/Hammers – This is a current price action strategy where you have to observe the price and trade as the pattern takes place. This is unlike the past price action strategies where you must identify the swing low/high levels and leave a sell/buy pending order.
During a trend, candles might be of different sizes and shapes. Yet, when a trend has run its course, one of the signs that a reversal is imminent is a big opposing candle. Quite often at the end of a trend, we see a big candle take place in the direction of the trend followed by an opposing candle of similar size. What does this mean? It means that the bears in a downtrend have had a last go at a level, pushing the price further. However, the bulls jump right back in and take the price to the level where the previous candle opened. This would mean that the buyers have finally matched the sellers. In this case, the sellers get scared and either give up on add more shorts or take profit on the ones that are already opened. Both these actions lead to a trend reversal.
The same logic applies to dojis, pins and hammers. When the opposing candle is bigger than the previous one, the pattern is called a bullish engulfing pattern in the case of a downtrend. It is an even stronger signal of a trend reversal since the buyers have outnumbered the sellers. You should observe the price when you see that one of these patterns is taking place and buy/sell, because a reverse is taking place right in front of you.
A bearish engulfing candle leads to a trend reversal
Narrow range candles – When the price moves in a narrow range it creates small candles. On such occasions, the buyers and sellers haven´t made up their mind yet and have let go of their positions after making small gains. When this happens you should observe the price, because these patterns lead to some explosive moves and you don´t want to be absent when it happens.
After one party makes up its mind and breaks the range, even slightly, the others get scared and remove all orders. This creates a liquidity hole which allows the price to move uni-directionally without any resistance. You can make two trades out of this pattern; you can enter immediately as the narrow range breakout happens and/or enter again when the price reverses back to test the range.
Narrow range candles are often followed by large moves
These are some of the most common methods to understand, read and trade based on price action. Price action trading tells you the mindset of the market and how basic human emotions, like fear and greed, play out in forex trading. It shows the important levels where the buyers or sellers don´t have the nerve to take the price above or below. Price action trading, combined with a few other indicators, can be very profitable and we hope the strategies explained in this article will help you identify some good trading opportunities.