Simple Price Action Trading

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Many traders overcomplicate their analysis with a plethora of indicators, trendlines, Fibonacci retracements and extensions, Gann fans, De Mark Indicators or other price overlays. The common belief is that “more is better”: if many different indicators offer the same signal, surely the confidence level is higher, right?

Wrong! In our experience, consistent traders adopt a minimalist approach, keeping their charts as clean as possible - because the technical picture is just one side of the story.

In this blog post you will learn how to adopt a minimalist approach and learn how to read price action with very few overlays on your charts.

What is Price Action Trading?

“Price Action Trading” is actually a vague term that has been used to describe many different approaches. However, the common denominators are:

• clean charts;
• focus on key candle patterns from the higher timeframes first;
• focus on key candle patterns on the lower timeframes for execution purposes;
• patience.

Especially for traders that are starting out in their career, or are trading around a day job with little time to sit in front of their screens, basic price action trading is advantageous, for various reasons:

• the analysis usually starts at the weekly level (at the end of each week) or at the daily level (at the end of each day). As such, you are rather detached from the intraday gyrations and the constant stream of news headlines, and your analysis is much more relaxed;
• the approach is, by definition, a swing trading approach;
• by remaining more distant from the intraday frames, there is less risk of emotional decision making;
• signals are clear and self-evident - which also removes some pressure.

Know the Markets, but also Know Thyself

Pure Price Action Trading on the higher timeframes has a certain allure to it. But whether it’s the right kind of approach for you personally is another matter altogether.

If you aren’t prepared to sit on your hands for extended periods of time (sometimes a week perhaps, sometimes more) waiting for your setups to appear, you will likely become frustrated and impatient.

This can lead to various errors: looking for other systems (instead of focusing on perfecting 1 system until you can execute it blindfolded); using higher leverage than is warranted (instead of using a proper money management algorithm); focusing on the moves you’re missing (instead of patiently waiting for the kind of situations that compliment your model).

Key Price Action Signals

The basis for all price action trading is a sound understanding of Candlestick charts, since the main reversal and continuation signals must be evident and well understood.

Our partners at 3CAnalysis have put together an excellent summary of the main candle patterns which you can read here.

However, there are only a handful of extremely powerful signals to keep in mind:

1. The Bullish Engulfing Pattern

Engulfing patterns (Bullish & Bearish) consist of 2 candles and signal a complete change of direction. Here you can see a Bullish Engulfing pattern with the 1st candle showing upside rejection and modest net losses but the 2nd candle shows strength of buyers that, open to close, totally engulfs (encompasses) the previous period’s ‘real body’. Obviously the larger the price action shown by the first candle, the more significant the reversal can be.

A note of caution however: exceptionally large candles, especially if back-to-back, probably depends on a significant market moving event and therefore the fundamental context becomes potentially more significant than the price action.

2. The Hammer

Although it is only a one candle formation, hammers can be extremely strong signals especially if they appear in conjunction with some kind of extended reading (oversold Stochastics, extended trend of consecutive positive or negative days, or prices basing near a moving average or support/resistance line).

The key element (for a bullish Hammer) is the rejection of lower levels and it often doesn’t matter if the net result is a minor decline or improvement. From the textbook the ‘tail’, difference between the real body and the low, should be at least twice that of the body (open-close) but in practice the longer the tail is, the stronger the signal is.

3. Long-Legged Doji

Doji patterns, in the broadest sense, are formed by minor net movement, positive or negative, but the nearer to an unchanged open to close the more they fit the theory.

Doji patterns are often formed in quiet periods and in those cases they lose relevance. But when formed in normal market conditions then the key to their impact is what price action has preceded the formation. They are certainly a point where some thinking has to be done.

The long-legged Doji (bullish, in this case) is a particular case where the high and low have been rejected for an unchanged, or almost unchanged, open to close but this time the low was a deep one and unsurprisingly, although the lack of net movement highlights uncertainty, it is the bounce that is most likely to have the impact.

Setting Up Your Charts

Now that we know what to look for, let’s explore 2 useful ways of setting up our chart templates.

There are a couple of approaches you can use, as a Price Action Trader. The first is a multi-timeframe approach:

a) Start your planning from the weekly chart. Plot the next key 2/3 resistances (which must be prior highs) price may encounter if it continues on the current path and the prior 2/3 supports (which must be prior lows) which price has left in it’s path.

b) Observe the Daily Chart when price approaches these levels and wait for key price action behaviour.

Recent price action on EURUSD has been largely rangebound. As such, reversal plays from the edges of the ranges (i.e. key levels plotted from the weekly chart) are the focal points. It is logical, in a rangebound market, to expect mean-reversion.

In the example above, the market posted 2 reversal days from a weekly resistance, and one possible reversal signal from the weekly support.

When these daily signals appear at our pre-identified locations, the confidence factor is high. However, the actual risk:reward of executing the trade from the Daily timeframe may not be acceptable. This is where drilling down to a smaller timeframe can be useful, in order to stack the odds more firmly in your favour.

We recently held an entire webinar on this subject, which I encourage you to view:

The second way of setting up your charts in a simple manner is simply to create some “context” for your trades via Bollinger Bands and an oscillator like the Commodity Channel Index or Stochastics.

Here is how to use Bollinger Bands to determine the market state:

For a bullish bias:

1. The 20 DMA (median line) must be broken to the topside and the slope must be positive.
2. There must be an increase in topside volatility (i.e. strong directional positive movement).
3. Prices should be directed towards the top Band.

For a bearish bias:

1. The 20 DMA (median line) must be broken to the downside and the slope must be negative.
2. There must be an increase in downside volatility (i.e. strong directional negative movement).
3. Prices should be directed towards the bottom Band.

Here is the same chart as above, highlighting the instances of a bullish bias (green), bearish bias (red) and range (no colour).

One simple way to use candle formations in tandem with Bollinger Bands (i.e. for continuation trades) is as follows:

• trade in the direction of hammers that compliment the Daily directional bias;
• trade in the direction of engulfing patterns that materialise during a pullback to/near the 20DMA in the context of a clear directional move.

Vice-versa: a simple way to use candle formations for reversal trades is as follows:

• trade in the direction of hammers and engulfing patterns that materialise at/beyond the Bollinger Bands (short from the top, long from the bottom);
• additional confidence comes if the oscillator is posting a simple divergence at the same time (bearish divergence for shorts, bullish divergence for longs);
• additional confidence comes if the market type is rangebound or there has been an extended run up or down the Bands.

Here are the clearest formations on EURUSD based on these rules:

Over to You

Many traders make their lives too complex. In reality, a simple approach is usually better because it keeps the decision making process straightforward and the risk of heightened emotions during trading is greatly reduced.

In this article you have learned a simple way to identify opportunities based on Price Action from the Daily and Weekly timeframes. You have also become aware that the risk:reward of trading off the Daily charts is usually unfavourable and as such, drilling down to a smaller timeframe (4H or 1H) is all that’s needed to shift the odds in your favour.

If you can keep your trading this simple and straightforward, I believe you will experience positive results going forward and you will eventually qualify for a funded account here at FCIMarkets.

However, if you want to take a shortcut up the learning curve, then come over to our Professional Trader Academy.

There will always be abundant opportunities for consistent traders here at FCIMarkets. But as always, just get in touch if you have any questions.

Good Luck!