Chapter 3: Price Action Trading Fundamentals

Introduction

Price action trading is the art of making trading decisions based on the raw movement of price, without relying heavily on indicators or oscillators. While technical indicators can provide valuable insights, they are ultimately derivatives of price and often lag behind actual market movements. Price action trading focuses on interpreting the “language” of the market directly through price movements, creating a more responsive and versatile trading approach.

In this chapter, we’ll explore the fundamental concepts of price action trading, building a foundation that will allow you to read market sentiment more effectively and develop trading strategies based on pure price movements.

The Philosophy of Price Action Trading

Price action trading is built on several core principles:

Price reflects all known information: According to the Efficient Market Hypothesis, all known information is already reflected in price. By analyzing price movements, you’re analyzing the collective decisions of all market participants.
Simplicity leads to clarity: By focusing on price alone, you remove the noise and confusion that can come from multiple conflicting indicators.
Price movement reveals market psychology: The way price moves reveals the psychology of market participants—their fear, greed, confidence, and uncertainty.
History tends to rhyme: While history doesn’t exactly repeat, price patterns tend to recur because human psychology remains relatively constant.

Key Elements of Price Action Analysis

1. Trend Identification

The most fundamental aspect of price action trading is identifying the prevailing trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).. Unlike indicator-based methods, pure price action traders identify trends through:

Higher Highs and Higher Lows (Uptrend):

Price consistently makes higher swing highs
Price consistently makes higher swing lows
Each pullback terminates at a higher level than the previous pullback

Lower Highs and Lower Lows (Downtrend):

Price consistently makes lower swing highs
Price consistently makes lower swing lows
Each rally terminates at a lower level than the previous rally

Advanced TrendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). Analysis:

Steepness of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). (angle of ascent/descent)
Consistency of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). (regularity of swing highs/lows)
Volume characteristics during trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). development

2. Support and Resistance Identification

Price action traders identify supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. through actual price behavior rather than indicators:

SupportA price level where buying interest is strong enough to prevent the price from falling further. Levels:

Areas where price has reversed from downward to upward movement
Zones where buying pressure has overcome selling pressure
Often identified by swing lows or areas of price consolidation

ResistanceA price level where selling pressure is strong enough to prevent the price from rising further. Levels:

Areas where price has reversed from upward to downward movement
Zones where selling pressure has overcome buying pressure
Often identified by swing highs or areas of price consolidation

Dynamic SupportA price level where buying interest is strong enough to prevent the price from falling further. and ResistanceA price level where selling pressure is strong enough to prevent the price from rising further.:

Trendlines connecting consecutive swing highs or swing lows
Moving averages that have demonstrated price reaction
Channels that contain price movement over time

3. Market Structure Analysis

Price action traders pay close attention to market structure—the arrangement of swing highs and lows that reveal the market’s directional bias and potential turning points.

Key Market Structure Elements:

Swing Points:

Swing High: A peak with lower highs on both sides
Swing Low: A trough with higher lows on both sides

Structure Breaks:

Break of Structure (BOS): When price breaks a significant swing high/low

Change of Character (CHoCH): When price creates a higher high after a series of lower highs (or vice versa)

Market Structure Shifts:

Accumulation: Sideways movement after a downtrend, often preceding an uptrend
Distribution: Sideways movement after an uptrend, often preceding a downtrend
Re-accumulation: Sideways movement during an uptrend, often preceding continuation
Re-distribution: Sideways movement during a downtrend, often preceding continuation

Price Action Patterns

Price action traders recognize specific patterns that frequently lead to predictable outcomes. These patterns are formed by the actual price bars/candles rather than indicator signals.

1. Reversal Patterns

Double Tops and Double Bottoms:

Double Top: Price reaches a high, pulls back, then reaches a similar high before declining

Double Bottom: Price reaches a low, rebounds, then reaches a similar low before advancing

Trading approach: Enter after confirmation of the reversal (break of neckline)

Head and Shoulders:

Head and Shoulders Top: Three peaks with the middle peak (head) higher than the two surrounding peaks (shoulders)
Head and Shoulders Bottom (Inverse): Three troughs with the middle trough (head) lower than the two surrounding troughs (shoulders)
Trading approach: Enter after break of the neckline with target equal to the pattern height

Triple Tops and Triple Bottoms:

Similar to double tops/bottoms but with three attempts at breaking through a level
Often indicates stronger resistanceA price level where selling pressure is strong enough to prevent the price from rising further./support than double tops/bottoms
Trading approach: Enter after confirmation with larger targets due to the stronger pattern

2. Continuation Patterns

Flags and Pennants:

Short-term consolidation patterns that form after a strong price move
Flags: Parallel channels that slope against the prevailing trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).
Pennants: Triangular consolidations with converging trendlines
Trading approach: Enter in the direction of the prior trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). when price breaks out of the pattern

Triangles:

Symmetrical Triangle: Converging trendlines with similar slopes
Ascending Triangle: Horizontal resistanceA price level where selling pressure is strong enough to prevent the price from rising further. with rising supportA price level where buying interest is strong enough to prevent the price from falling further.
Descending Triangle: Horizontal supportA price level where buying interest is strong enough to prevent the price from falling further. with falling resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
Trading approach: Enter on breakout in the direction of the breakout

Rectangles:

Price consolidates between parallel supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels
Trading approach: Enter on breakout with target equal to the height of the rectangle

3. Candlestick Patterns in Price Action Context

While we covered advanced candlestick patterns in the previous chapter, it’s important to understand how they fit within price action trading:

Engulfing Patterns at Structure:

Bullish Engulfing at supportA price level where buying interest is strong enough to prevent the price from falling further. level or after a downtrend
Bearish Engulfing at resistanceA price level where selling pressure is strong enough to prevent the price from rising further. level or after an uptrend
Trading approach: Enter in the direction of the engulfing candle with stop beyond the pattern

Pin Bars (Rejection Candles):

Long wick/shadow showing rejection of price level
Small body in the opposite direction of the wick
Trading approach: Enter in the direction of the rejection with stop beyond the wick

Inside Bars:

Candle completely contained within the range of the previous candle
Indicates consolidation and potential breakout
Trading approach: Enter on break of the mother bar in the direction of the breakout

Advanced Price Action Concepts

1. Order Flow Analysis

Order flow analysis involves understanding how large market participants (institutions, banks) are positioning themselves:

Absorption:

Price fails to continue moving despite continued buying/selling pressure
Often indicates large players absorbing the orders of retail traders before moving price in the opposite direction
Trading approach: Look for price stalling at key levels despite continued momentum

Liquidity Grabs:

Sharp price movements that trigger stop losses before reversing
Often occur just beyond obvious supportA price level where buying interest is strong enough to prevent the price from falling further./resistance levels
Trading approach: Wait for confirmation of reversal after the liquidity grab

Footprint Analysis:

Examining the volume at each price level during a move
Identifying where significant buying/selling occurred
Trading approach: Look for return to these significant levels for potential reactions

2. Smart Money Concepts

Smart Money Concepts (SMC) is an advanced price action methodology focused on tracking institutional order flow:

Fair Value Gaps (FVG):

Significant imbalances between buyers and sellers
Identified by gaps in price that occur during strong moves
Trading approach: Look for price to return to these gaps for potential trades

Breaker Blocks:

SupportA price level where buying interest is strong enough to prevent the price from falling further./resistance levels that have been broken and then retested from the opposite side
Trading approach: Enter when price retests these levels from the opposite direction

Optimal Trade Entry (OTE):

Specific zones where smart money is likely to enter trades
Often at the confluence of multiple technical factors
Trading approach: Look for reversal signals at these zones

3. Wyckoff Method in Price Action

The Wyckoff Method provides a framework for understanding market cycles through price action:

Accumulation Phase:

Range-bound price action after a downtrend
Characterized by tests of supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
Trading approach: Look for signs of strength before entering long positions

Markup Phase:

Rising price with higher highs and higher lows
Characterized by strong advances and shallow retracements
Trading approach: Buy pullbacks to supportA price level where buying interest is strong enough to prevent the price from falling further. in the direction of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).

Distribution Phase:

Range-bound price action after an uptrend
Characterized by tests of supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
Trading approach: Look for signs of weakness before entering short positions

Markdown Phase:

Falling price with lower highs and lower lows
Characterized by strong declines and shallow rebounds
Trading approach: Sell rallies to resistanceA price level where selling pressure is strong enough to prevent the price from rising further. in the direction of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).

Practical Price Action Trading Strategies

1. Trend Continuation Strategy

Setup:

Identify the prevailing trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). using higher timeframe analysis
Wait for a pullback to a key supportA price level where buying interest is strong enough to prevent the price from falling further./resistance level or trendline
Look for a reversal candlestick pattern at the pullback level

Entry:

Enter when price resumes in the direction of the trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).
Confirm with increased volume or break of local structure

Stop Loss:

Place stop loss beyond the recent swing point
Alternative: Place stop beyond the reversal candlestick pattern

Take Profit:

Target the previous swing high/low
Use measured moves based on the size of the pullback
Consider trailing stops to capture extended moves

2. Range Trading Strategy

Setup:

Identify a well-defined trading range with clear supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
Confirm multiple touches of both supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further.
Look for reversal candlestick patterns at range boundaries

Entry:

Enter long near supportA price level where buying interest is strong enough to prevent the price from falling further. when bullish reversal patterns appear
Enter short near resistanceA price level where selling pressure is strong enough to prevent the price from rising further. when bearish reversal patterns appear

Stop Loss:

Place stop loss beyond the range boundary
Alternative: Place stop beyond the reversal candlestick pattern

Take Profit:

Target the opposite boundary of the range
Consider partial profit-taking at the midpoint of the range

3. Breakout Trading Strategy

Setup:

Identify a consolidation pattern (triangle, rectangle, range)
Confirm decreasing volume during consolidation
Look for increasing volume as price approaches the boundary

Entry:

Enter when price breaks beyond the consolidation boundary
Confirm with increased volume and sustained movement

Stop Loss:

Place stop loss inside the consolidation pattern
Alternative: Place stop at the opposite boundary of the pattern

Take Profit:

Use measured move targets (pattern height projected from breakout point)
Look for previous supportA price level where buying interest is strong enough to prevent the price from falling further./resistance levels as additional targets

Risk Management in Price Action Trading

Effective risk managementStrategies and techniques used to limit potential losses in trading. is crucial for price action trading success:

Position SizingDetermining the appropriate size of a trade based on risk tolerance and account balance.:

Risk a consistent percentage of your account on each trade (typically 1-2%)
Calculate position size based on the distance to your stop loss
Adjust position size based on trade conviction and setup quality

Stop Loss Placement:

Use logical stop levels based on market structure
Place stops beyond significant swing points
Avoid using arbitrary pip values for stops

Risk-Reward Ratio:

Aim for a minimum risk-reward ratio of 1:2
Higher-probability setups may justify lower risk-reward ratios
Lower-probability setups require higher risk-reward ratios

Practical Exercise: Building a Price Action Trading Plan

Select a currency pairTwo currencies quoted together, showing the relative value of one against the other (e.g., EUR/USD). and timeframe that suits your trading style
Identify the current market structure and trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). direction
Mark key supportA price level where buying interest is strong enough to prevent the price from falling further. and resistanceA price level where selling pressure is strong enough to prevent the price from rising further. levels
Identify potential trading setups based on price action patterns
Develop specific entry, stop loss, and take profit criteria
Create a trading journal template to track your price action trades
Practice identifying setups without taking trades for at least two weeks
Review and refine your approach based on observed results

Case Study: GBP/USD Price Action Analysis

Let’s analyze a real-world example on the GBP/USD 4-hour chart:

Scenario:

GBP/USD has been in a downtrend on the daily timeframe
Price has formed a range on the 4-hour chart
A bearish engulfing pattern forms at the resistanceA price level where selling pressure is strong enough to prevent the price from rising further. of the range
Volume increases on the bearish candle

Analysis:

The range has formed within the context of a larger downtrend
The bearish engulfing at resistanceA price level where selling pressure is strong enough to prevent the price from rising further. aligns with the higher timeframe trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend).
Increased volume suggests strong selling pressure
The pattern forms at a previous supportA price level where buying interest is strong enough to prevent the price from falling further. level that has become resistanceA price level where selling pressure is strong enough to prevent the price from rising further.

Trading approach:

Enter short below the low of the engulfing pattern
Place stop loss above the high of the pattern
Set first target at the midpoint of the range
Set final target at the bottom of the range
Consider trailing stop after price reaches the midpoint

Conclusion

Price action trading provides a powerful framework for understanding market movements without the lag and confusion often associated with indicators. By focusing on the raw price movement, you develop a deeper understanding of market psychology and positioning. While price action trading requires more experience and judgment than indicator-based approaches, it offers greater flexibility and often earlier signals.

In the next chapter, we’ll explore Naked Chart Trading Techniques, which will build upon these price action fundamentals to develop an even more refined approach to market analysis.

Key Takeaways

Price action trading focuses on interpreting raw price movements rather than relying on lagging indicators
Market structure analysis reveals the underlying directional bias through swing highs and lows
Price patterns form due to recurring market psychology and often lead to predictable outcomes
Advanced concepts like order flow and smart money techniques help identify institutional positioning
Effective risk managementStrategies and techniques used to limit potential losses in trading. is essential for long-term price action trading success
Price action strategies can be applied to trendThe general direction in which a market is moving (uptrend, downtrend, sideways trend). continuation, range trading, and breakout scenarios