WHAT IS PRICE ACTION TRADING?

Ask different traders what Price Action Trading means and you’ll probably get some different answers. To me, it means trading off a price chart without indicators that are mathematically derived from price.

For example, Stochastic, RSI,and MACD Indicators to name a few.

In my opinion, static drawing tools, such as trendlines or support and resistance lines, that obviously do not change dynamically with price, do not exclude you from being considered a price action trader.

What do I mean by change dynamically with price?

Depending on how you have your indicators set, generally the default setting is for indicators to update in real-time, along with the last price bars closing price. What this means is you could be watching a 10 minute bar chart and be witnessing a Stochastic Indicator crossing, or a moving average cross, or an RSI indicator crossing above 70, etc. and you think you’re getting a signal to buy or sell, you make the trade.

But, all of a sudden price makes an immediate change in direction before the close of the bar. causing the signal for your trade to disappear!

No more cross. gone. And now you wish you hadn’t of made the trade.

This doesn’t happen with price action trading. Price either does something or it doesn’t. Did price breach the resistance of that bar’s high. yes. Did price breach the support of that trendline. no.

Some might say, just wait until the price bar closes to make your trade, that way you know for sure you’ve got a signal And this of course, is where most of the term ‘indicator lag’ comes from.

That’s what the rest of this page is about. A demonstration of price action trading versus price indicator trading.

PRICE ACTION TRADING VS. PRICE INDICATOR TRADING

I’m watching Halliburton Co. (HAL) this morning, since it gapped up. You’ll notice it formed a Strategy #1 set-up (from the day trading strategies page) on the third 10 minute bar (inside bar) after displaying much higher volume than it’s 50 period average.

HAL then gives a perfect breakout on expected higher volume. Entry and Stop are plain and simple using support and resistance lines anyone can understand. No second guessing of moving indicators here.

OK, now lets take a look at a popular indicator, the Stochastic Indicator on HAL. Since we’re talking day trading here, I quickened the Stochastic from it’s usual default setting of 14 periods to 5 periods to be fair.

Notice how the Stochastic %K line is indicating an extreme overbought condition near 100 on the breakout bar (orange arrow).

No buy signal of any kind can be found on that indicator, anywhere. unless you look back to the previous day and that doesn’t count. So what does the Stochastic do for you here? At least for this type of trade, nothing.

Today, I’m also looking at Jacobs Engineering Group (JEC). JEC makes a morning gap, forms a double inside bar pattern, or a triangle, then very cleanly breaks out with a tall candle.

For this comparison, lets use another popular indicator, the Commodity Channel Index (CCI) using the default setting of 14.

As you can see, during that entire price advance after the breakout, the CCI kept decreasing. It doesn’t give it’s popular ‘zero-line reject’ signal until after 11:00am. In this case, price action trading provides a nice entry with a very tight, low risk stop. What else can you ask for?

Another gainer this morning is FTI. It runs up quickly, then forms a lateral and breaks out. Do you need an indicator here?

Let’s try adding an indicator with a big name — the Ultimate Oscillator and we’ll include a couple of moving averages as well.

And lets say you’re using it as a momentum indicator with buy signals coming from a cross above the 70 line, and an exit is a cross below the 70 line. OK?

The yellow arrow is where your entry would be. How does that compare with the entry above?

Fortunately, for this entry FTI kept moving higher, but look at where the exit would’ve been. The Ultimate Oscillator closed below the 70 line, exiting you from your trade just as price is making a new higher high (HH). Not good if you want to let your winners run.

How about the moving averages. Useless here for an entry. They didn’t even come close to giving a signal to trade. They do, however, make useful trailing stops.

This time lets try price action trading versus the RSI Indicator using a Strategy #4 set-up. On the same morning, Tesoro Corp (TSO) gaps up, fills the gap on the first 10 minute bar, and then breaks out with a higher range candle.

TSO then forms a relatively large triangle pattern, before breaking out and advancing a second time. At this point, a trendline exit strategy looks pretty decent to use.

Since many traders use the RSI as a momentum indicator, we’ll try that here, just as we did with the Ultimate Oscillator. Again, lets say your buy signal is a cross above 70, and an exit is a cross below 70.

That tall breakout candle generates the RSI buy signal, causing an entry at the open price (or thereabout) of the next bar. Because of the length of that breakout bar, your entry is quite a distance beyond the entry price of someone using price action trading strategies.

But, entry is only part of the picture. What about the exit? If you took the exit according to RSI crossing below the 70 line, there would’ve been a small loss. Price had just recently made a new high and was consolidating into a triangle, not indicating, at least to me, that it would be time to exit.

Because of the calculation of the RSI and the three consecutive closes of those red candles below their opening price, this initiates a cross below the 70 line causing a premature exit from the trade. A consequence of indicator calculation, when in reality price was simply moving into a lower volatility state and a triangle pattern.

I’ve seen so many times over the years on various trading related forums, traders posting images of their trading screen with not only two, but three or four indicators. I don’t know how they decide when to make a trade, since each may not agree with the other.

I suppose they’re looking for a majority to line up in one direction, but that just seems to confusing to me. To each his own, that’s what makes a market.

If you haven’t already, I think it’s worth your time to take a look at price action trading at least on a simulator. If you’re really into indicators, well then you might be interested in some strategies I’ve listed my stock market strategies page.