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10 Rules for surviving price action trading

Trading price action is all about decluttering charts and concentrating on the primary data source. This appeals to the Dynamic Traders because of the simplicity, and besides, why overcomplicate trading with lagging indicators?

Yet trading price action isn’t without certain pitfalls. It requires a full understanding of how price moves and reacts to certain phenomenon. Here is a brief overview of the main events along with a few tips on how to identify them and how to use them to your advantage.

Candlesticks

Chart with candlesticksCandlesticks are used by the vast majority of price action traders (rather than bar or line charts). In fact, many believe this IS price action. Not so. A bar is just a moment in time.

Would you wish to be judged on just one moment in time? When we meet someone new this is pretty much what we do. We make a first impression. Then the very next thing they do or say either puts them up (or down) in our estimation. This is not the way to get to know someone or to enable us to anticipate what they may do next – we need more information. We need to know their history.

  • A candlestick on it’s own does not give us a history of a chart’s personality. We have to look back and compare it to other bars.
  • Is the price range much higher or lower?
  • Is the body or wick much bigger or smaller?
  • Where is the open compared to the previous bar’s close?
  • Is the bar bullish or bearish?
  • Is this with the trend or against it?
  • If there is a candlestick pattern forming is it relevant to the bigger picture?

A common mistake is to identify a candle as a doji, hanging man, or hammer (and so on) without thinking about where it is compared to other candlesticks. If it’s in the middle of a sideways move then it has no major relevance. The candle is not the price action – the sideways move is the price action.

So while it’s great to be able to recognise continuation or reversal candlesticks and candlestick patterns, remember to only pay attention to them when they actually offer value.

Chart patterns

Chart patternsThere are so many chart patterns that have been identified and cataloged. Sometimes I think it would take longer to learn them all than to learn how to trade without them. So I just stick to the main ones.

Most chart patterns are grouped into “reversal” or “continuation” categories. This can be very unhelpful as many fail more than they work. Logically, if a reversal pattern is only 50% successful then it would also be a continuation pattern 50% of the time.

By sticking to the most popular patterns (flag, double tops / bottoms, head and shoulders etc.) you are sticking to the ones that are statistically more reliable. Measured moves can help give rough estimates of future price targets. But never rely on a chart pattern to work – know when to both identify when it is confirmed and when to make the assumption it has failed.

Fakeouts

False breakoutFake breakouts are very common – they can (and most probably will) occur on any form of support or resistance line.

Fakeouts can trigger you into an unwanted trade – at a huge loss to your bottom line if this event occurs on a frequent basis. Allow a “margin of error” on your entry calculation. There are numerous techniques for this but a fairly straightforward one is to wait until the bar closes beyond the resistance (or support) level.

Fakeouts can affect your stops, too, depending on how you calculate them. For example, if you use a previous pivot high (or low) for a stop then add on a few ticks in case price tags the support (or resistance) before continuing in the direction of the trade.

A fake breakout can last longer than one or two bars (or the wicks of a candlestick). For this reason, some experienced trend traders tend are happier to wait longer to get into trades.

Support and resistance – part 1

The strongest levels of supportChart with a candlestick breakout and resistance are generally the horizontal ones – because they are based on price levels.

There are three main categories of horizontal support/resistance:

  • Zonal areas where price can get “sticky”.
  • Lines with the greatest number of “touches”.
  • Psychological round numbers (such as $100).

Zonal areas don’t pick out a particular price (e.g. $14.69) as support and / or resistance. It is more likely to be a small range (e.g. around $14 to $15). Price can often hover around these zones for a period of time and on multiple occasions. This is not the same as a consolidation, which will generally be deeper and last for long periods (possibly 3 months plus on a daily chart).

Horizontal lines with a number of touches also offer strong support and / or resistance. Sometimes they are touched by the body of a candle, other times by the wick. Occasionally they will be breached a little, but not by too much. These lines can offer a pretty accurate price point for support and / or resistance. But remember to allow for fakeouts if you are using them for entry, stops or exits.

Psychological round numbers are often unknown to new traders. Many traders will have a fixed target or entry in mind when they take a position out. And, being human, they like the symmetry of round numbers. Round numbers are easy to recall, so if you want to get out of a stock it’s far easier to remember $10 rather than $9.71. Round numbers are often profit-taking magnets, so lines of support and resistance will often form around them.

Fibonacci retracements can be added to this list, but even the most basic explanation of their application is beyond the scope of this article. The most popular level is a 50% retracement from a major high (or low) to a major low (or high) – price can often “bounce” off this level. In fact, this isn’t technically a Fib level but it does often hold true nonetheless.

Support and resistance – part 2

breakdownOther common areas for support and / or resistance are moving averages and trendlines.

Trendlines are linear but generally traders are far too subjective as to the price points used to create them. Some traders cut through the wicks, and even the bodies, of candles. This is in fact a line of best fit, rather than a trendline. There is nothing wrong with this – so long as you don’t then try and heavily rely on it as support or resistance for price action.

The main thing to remember about trendlines is that sometimes you just can’t draw one. Occasionally the reason for this is obvious – such as when price is in a range. But sometimes a chart clearly shows a strong upward trend yet drawing a trendline is next to impossible. Accept that this is okay – if you are wanting to use the line as support / resistance this can only be done if price enables you to do so. If it doesn’t, you need to find an alternative method to identify the support / resistance.

Moving averages can also be used. For support and resistance you need at least a 50MA – anything closer to price action may not work effectively as price will crisscross it too often.

Clearly larger MAs move quite a bit slower than price action so, as price approaches it, you already know the pullback may be deeper than you would like. Past price action is essential here – some stocks / currency pairs / commodities respond well to their MAs, others like to retest and / or breach even the larger ones (such as 200MA) on a regular basis.

Volatility

Volatility aheadVolatility has multiple meanings in trading but here I’m going to use it to be synonymous with predictability.

In this respect volatility can be measured in a number of ways. The main ones are:

  • Respect for horizontal support / resistance.
  • Respect for trendlines.
  • Respect for moving averages.
  • Relative bar size.

The first three have been pretty much covered in the previous sections. If price cleanly bounces off a previous area of support or resistance (either a price point, moving average, or trendline) then price action is fairly predictable. This makes it simpler to trade – so these are the charts we constantly seek out. And if price breaches an otherwise strong line of support / resistance, this is an early warning that price may be about to do something new.

The additional point here is relative bar size.

If the candlesticks have been historically small and of a similar size, this is what we would expect in the future. If they suddenly become very large (by comparison) or develop extended wicks then clearly this market has become more volatile – and less pedicatale. This may simply be a case of transforming to a “new normal” which we may be able to trade in the future – but for now it may be better to stand aside and see what develops.

On the other hand, if bars have been large and become very small it would be an indication that the momentum has run it’s course. Learn to judge what is “normal” for the chart you are analysing.

Both phenomena can often be observed at the very beginning or very end of a trend. Price is telling you that a change is underway. Take heed – and take appropriate action if necessary.

Breakouts

Goldfish jumping bowlThere are only two ways of trading price action – on the pullback or on the breakout.

Breakouts are easier to identify – the bar is higher (or lower) than the previous bar. The breakout signifies that the momentum is with the overall trend. Provided we have a system in place to avoid fakeouts, this offers a good-to-excellent chance of success.

Breakouts should only be traded in an established trend. One way to do this is to look at a higher timeframe. If this is heading in the same direction as the timeframe you are trading then you have a better chance of success than if it is trending in the opposite direction.

Sometimes after a breakout price can retrace a litlle – you should be able to establish how much it is likely to do so by looking at past price action (although this is no guarantee). For this reason you need a larger stop loss to accommodate the possible movement.

To some the larger stop loss can be seen as daunting and a disadvantage. However, this needs to be weighed up against the advantage of trading with overall price momentum. Almost all of the Dynamic Traders originally started with small stops (or no stops) and now all comfortably use larger stops to enable trading with the trend.

Pullbacks

Chart with pullbacksThe other way to trade price action is to trade pullbacks. Again, you need an established trend so you can identify how deep the pullbacks are likely to be.

The most difficult part of trading pullbacks is getting the reversal point right. Stops typically tend to be closer on pullback strategies (as price action is against the overall trend) to protect capital – the downside being you could get stopped out if you are out by one or two bars. There is not much flexibility here.

Of course, the upside is that, if you can get it right, you gain a few extra points / pips on each entry over the life of a trend. These can add up to a substantial sum.

Trading pullbacks is generally more time consuming – you have to anticipate the reversal point far more accurately. Until the next bar is formed you do not know if you were right or wrong. With a breakout bar you already know it’s a breakout bar – your only concern is protecting yourself against natural market movements.

Stalemate

Standing asideA vital rule with trading price action is to know when there is stalemate – in other words, no trend. Trend traders spend a lot of time inactive in the majority of markets waiting to see a trend.

With any form of trading you should never try to force a trade. You have to keep actively looking but that does not mean you are always actively trading. Standing aside is a position – it may not make you money but it is protecting your capital.

Do not confuse lack of trading opportunities with lack of action. Keep up with your analysis and the opportunities will come to you.

Checkmate

Losing streakIf you do not observe the stalemate rule you will find yourself in checkmate. If you try to force trades and ignore your rules and systems you will find yourself on a losing streak that is hard to break.

One of the biggest difficulties successful people find with trading is that they have no control over the market. It never does what you ask it to do and it never listens to even the most reasonable of demands.

As traders all we can do is look for the very best opportunity, risk a small amount of capital, get risk free as soon as possible and repeat as often as it is safe to do so.

We’ll have winners and losers but, if we can understand price action and apply a few sensible rules then our winners will generate enough profit to cover our losers and provide us with a healthy income.

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Good trend trading…

Anne Chapman

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