Traders are often advised to develop strategies that reflect their goals and budget to achieve a profitable return. On the Internet, you can find many trading techniques that can help you to build your strategy. A popular trading technique is based on prices over a given time frame, also referred to as price action. It is at the core of every technical analysis of Forex, stocks, commodities, cryptocurrencies, and other financial assets.
Traders whose strategy is based on the price movement usually use Japanese candlestick charts as these show the open, high, low, and close values of a given security. Every experienced trader knows that different factors can cause the price movement, but supply and demand in the market is the leading force that determines the price of a stock.
Trading based on price action is a technique that can be used on different securities, including forex, commodities, bonds, etc. Yet it is important to understand that it considered more of an art than hard science as two traders analyzing the same chart might come to different conclusions.
Important Notions Related to Price Action
When talking about price action, you need to know what is a Pip.
A Pip, or “percentage in point”, is a unit that describes the smallest change of price in a currency pair in the forex market.
To describe it more comprehensively, currency pairs are usually quoted to the fourth decimal number. A pip stands for the last of those numbers. Despite representing a very small movement in prices, the common use of leverage in Forex trading makes it worthwhile for some traders just to try to gain a few pips of profits every day. As an example, buying a mini-lot in EURUSD and gaming ten pips is with 10 dollars, by the same trader can amp up their leverage to make the same pips worth $100, $1000, $10,000 or more.
The term used to describe the smallest movement in the price of a stock or futures contract is a tick. In other words, it represents the minimum price increment at which a stock could move. At the moment, the minimum tick size for stocks trading above $1 is $0.01.
How to Identify a Trending Market with the ADX Indicator?
In a trending market, the price is moving in one direction. If the price rises over a period, the market is an uptrend (a bullish market). Assuming that the price declines continuously, the market is downward (a bearish market). When using price action, traders are recommended to use more tools to accurately predict whether the market is in a trend or not.
Many traders use the Average Directional Index Indicator (ADX) to determine whether the market is trending or not. When ADX is above 25, the market is trending, and when it is under 20, there is no trend. If the ADX is declining, it indicates that the trend is weakening.
Traders often decide to buy when the price drops down during an uptrend or buy when the price is increasing after a significant trough. However, some investors claim that buying when the price is dropping is a risky adventure as you can never know when the price will start rising again.
If you decide to use a price action-based strategy, you have to keep in mind the liquidity of the security you intend to trade. Stocks with low liquidity could easily present an excellent trade opportunity. But if a large holder of the stock decides to cash out, then they will swiftly destroy a price action pattern. Forex, futures, and more liquid instrument tend to adherent better to price action strategies as one single holder of the asset has less impact on the asset’s price.
Price Action Strategy for Managing Financial Risk
There are different price action trading strategies. As we mentioned above, you have to first set your goals before you create your trading strategy. Even though there is no universal winning trading strategy, most strategies are built to take advantage of price trends. Whilst others are based on trying to time the end of a trend, and for the price to mean-revert. Whatever strategy you opt for, it is important to limit your downside.
Support and Resistance Levels
Looking at support and resistance levels will protect you from significant financial losses. As you might already know, these are horizontal price levels, connecting price bar highs to other highs and lows to lows. In an uptrend market, the historical peaks act as support, while in a downtrend market, the opposite is valid – the old throughs perform the role of resistance levels.
When a price action entry signal occurs on a key support or resistance level, it indicates good entry conditions. The key level provides investors with a better idea of where to place their stop loss. Key levels of support and resistance have the potential of becoming turning points in the market, meaning that the risk-reward ratio is good.