Price Action: what is it?

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ok_5513
15 MIN READ
Trading
20 September 2023
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Price Action or Price Action is an approach to trading that focuses on predicting the trend of a quote chart based on the shape and structure of its constituent candlesticks and their combinations, without any additional indicators.  Unlike other methods of technical analysis, Price Action focuses on simplicity and efficiency. This approach is based on the idea that price includes all market factors.

Price action: an explanation

Price action is based on analyzing the various shapes and patterns that make up price charts. These patterns can give traders insight into the current state of the market and provide hints about possible future price behavior. They also help identify entry and exit points, stop loss and take profit levels.

There is a whole range of charting tools and chart settings to analyze price action. The most popular of these is the Japanese candlestick chart.  Japanese candlesticks form certain patterns or models on the chart. These patterns allow you to forecast possible further price movement and, accordingly, choose optimal points for entering and exiting trades.

Price Action patterns

In Price Action, there are many different patterns that traders can use in their trading strategy. Some of the most common patterns include the Pinocchio Bar (Pin-bar), outer bar, inner bar and rails.

Pinocchio Bar

"Pinocchio-bar" or Pin-bar, is one of the most common patterns of price action. It got its name because of its appearance - on the chart such a bar resembles a Pinocchio figure with a "long nose" protruding in one direction, while the "body" is on the other side.

Pin-bar is a pattern with a long shadow or "nose" indicating a reaction of a certain price level. It can be a strong reversal signal.

Pin bar example

Pin bar example

The essence of a pin bar is that its "nose" (long shadow) indicates that a sharp reversal has occurred in the market. In the course of trading, the price of an asset first moves in one direction, but then quickly pulls back, leaving behind a "long nose".

Pin bar

However, it is important to remember that using pin bars alone to make trading decisions can be risky. It is important to consider other factors such as market context, confirmation from other technical indicators and support/resistance levels. Without combining with other analysis tools, the pin bar, like any other price action pattern, is not a reliable tool for analyzing future market behavior.

External bar (absorption model)

An outer bar is a pattern where the current bar completely "engulfs" the previous bar. Also known as an engulfment pattern, is another powerful price action pattern often used by traders. It can be a signal of a possible trend reversal.

example of an outer bar

The figure above shows an example of an outer bar. We can see that the current bar completely absorbs the previous bar.

Price Action

It is important to remember that the outer bar, just like other price action patterns, is not a trading strategy in its own right, but merely a tool that can be used in the context of other aspects of analysis such as support and resistance levels, trends and indicators.

For example, if we see an outer bar forming near a support level in an uptrend, this can be a strong buy signal.

On the other hand, if we see an outer bar forming near a resistance level in a downtrend, it could be a sell signal.

In both cases, it is important to confirm the signals with other technical analysis tools such as indicators or other price action patterns. 

It is also important to note that when using the outer bar as a signal to enter a position, it is wise to place a stop loss slightly above the high or below the low of the outer bar (depending on whether the trade is a buy or sell trade). This allows you to minimize your risk if the market turns against your position.

External bar (absorption model)

The outer bar model is a powerful tool in the hands of a trader. However, like any other tool, it requires practice, patience and discipline to use effectively. Despite its simplicity, the outer bar can be incredibly effective when applied correctly. So, learn, practice and above all, trade responsibly.

Inner bar

An inside bar is a pattern in which a bar is completely inside the range of the previous bar. It may indicate a temporary lull in the market and potential excess supply or demand.

Inner bar

In the figure above, you can see an example of an internal bar. We can see that the current bar is completely contained within the previous bar.

pattern Inner bar

The inside bar can be used to predict the likely direction of price. When price moves out of the range of the previous bar, it may indicate the start of a new trend in the direction of the breakout. 

For example, if the price breaks the upper edge of the parent bar after the formation of the inner bar, it may indicate a possible uptrend. On the other hand, if the price breaks the lower edge of the parent bar, it may indicate a possible downtrend.

When using this trading approach, it is important to set a stop loss outside the range of the mother bar. This way, if the price returns inside the range of the parent bar after a breakout, the trade is automatically closed, preventing large losses.

predicting the likely price direction

The inside bar is a powerful concept that can be used in a variety of trading strategies. It provides the trader with a simple but effective way to predict the possible direction of price. But like any other technical analysis tool, it should be used in combination with other tools and techniques to maximize its effectiveness.

Rails

The Rails pattern is based on observing price candlesticks on the chart and analyzing their location. It got its name due to its similarity to the appearance of a pair of candlesticks that resemble rails on a railroad track. This pattern is often considered to be a trend reversal signal and can provide the trader with an opportunity to enter the market at the very beginning of a new movement.

an example of a Rails pattern

In the picture above you can see an example of the "Rails" pattern. We can see that the current bar is approximately equal to the close of the previous bar. But, in both cases there may be a small error.

The Rails pattern

Traders can use this pattern to make decisions about entering the market or closing a position.

The Rails pattern provides traders with the opportunity to identify moments when the price may change direction. This gives the opportunity to open positions at the very beginning of a new trend, which can lead to significant profits.

Examples of Price Action trading

The "Rails" pattern is a powerful tool for traders on the currency market. It allows you to identify trend reversal opportunities and make informed trading decisions. However, as with any trading tool, it is important to perform additional analysis and use confirming signals to increase the probability of successful trading.

Examples of Price Action trading

Let's look at a few examples of trading based on Price Action patterns that will help you better understand this strategy and apply it in your trading.

Pin bar - pin bar as a trend reversal signal

A buy deal on a pin-bar signal.

Pin Bar is one of the most effective Price Action signals indicating a possible trend reversal. This pattern is a candlestick with a long tail and a small body, which is usually on the opposite side of the tail. When a pin bar appears at a resistance or support level, it can be a strong signal that the trend may be reversing.

pin bar as a trend reversal signal

Example

On the chart above we can see that a pin-bar was formed at the support level. This signals a possible trend reversal and can serve as a signal to enter a buy position. A trader, relying on Price Action signals, can open a long position and lock in profit when the price starts to move upwards. The stop loss can be placed below the tail of the pin bar and take profit at the next key resistance level.

Outside Bar - inside bar as a trend continuation signal

Sell trade on a bearish takeover signal.

Now let's look at an example of a sell trade based on a bearish takeover pattern. In this case, we again start by analyzing the price action and looking for resistance levels on the chart. If we see a price pair approaching a significant resistance level and then a bearish engulfing pattern is formed, this can serve as a signal for action.

It is important to confirm this signal with other technical analysis tools. We could use indicators such as RSI or MACD to see if there is a divergence between the price action and the indicator. A divergence in this context could indicate a weakening of the bullish momentum and a possible shift to a bearish trend.

inside bar as a trend continuation signal

Example

After confirmation of the signal, we could open a sell trade right after the bearish engulfing pattern closes. In this case, our profit target would be at the next support level and our stop loss would be above the highest point of the takeover pattern. 

Advantages and disadvantages of Price Action trading

Trading based on price action has advantages and disadvantages that are important to consider.

Advantages include:

  • Can be used for any time period and in any market.
  • No need for complex and busy indicators.
  • Clarity and straightforwardness of analysis.
  • Constancy: price action models are valid at all times.

However, there are disadvantages as well:

  • Requires considerable practice and experience to use effectively.
  • Can be subjective: two traders may interpret the same model differently.
  • Requires constant market monitoring to identify patterns.
  • Performance depends largely on the level of discipline and psychological stability of the trader.

Despite some drawbacks, price action trading is a powerful tool in the hands of an experienced trader. It offers flexibility and adaptability that is difficult to achieve with other approaches.

Conclusion

In conclusion, I would like to emphasize that Price Action is not just a technical tool, but a whole philosophical approach to trading, which requires practice, patience and the desire for continuous learning. This approach can become a powerful weapon in the arsenal of any trader who strives for success in the financial markets.

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