Price action trading is a term that you frequently hear among traders currently. It is popular due to its minimalism and applicability across different markets and timeframes. This method of trading uses pure price movement on a chart, with minimal use of complex technical indicators such as oscillators.
Many traders who have become frustrated with using multiple indicators, the problems of ‘analysis paralysis’ and conflicting signals eventually find their way to price action trading. Price action traders essentially use price patterns and major support and resistance levels for their trading decisions. Using Japanese Candlesticks is essentially price action trading and as we’ll see many of the patterns that are used equate to various Japanese Candlestick patterns.
The support and resistance levels that are used are often derived from important prior highs or lows, identified using horizontal lines. In this guide we’ll cover how to identify and trade classic price action set ups, including pin bars, inside bars and rising and falling momentum.
Coined by technical analyst Martin Pring, Pin Bar is short for Pinnochio Bar. He called them Pinnochio Bars because they lie about market direction. The long wick of the pin bar is like the long nose of Pinnochio when he lies. These are highly accurate reversal patterns when properly identified and occur at a support or resistance level.
The most powerful Pin Bars appear at the top of an uptrend or at the bottom of a downtrend and are candles with long wicks and short bodies. They are essentially the same as the shooting star (at the top of an uptrend) or hammer (at the bottom of a downtrend) in Japanese Candlestick analysis.
In the case of a bearish reversal Pin Bar, price probes higher during an uptrend, but then makes a sharp pullback closing near the open. This shows the lack of confidence among the buyers and that the sellers may subsequentially take charge.
Conversely, during a down trend a Pin Bar occurs when price reaches down to a lower level but bounces to close near where it opened. Here we see the bears losing their grip and that the bulls may overpower them in the next time frames.
Importantly, Pin Bars have a higher accuracy rate in trending markets. They provide especially strong signals when they reach up to test a major resistance level in an uptrend or fall to a major support level in a downtrend.
So how do you trade these patterns, where do you place your entry and exit?
When a Pin Bar forms at the top of an uptrend, the sell entry is typically initiated in the following bar if and when price trades below the low of the pin bar. The stop loss is often placed just above the high of the pin bar. If price trades this high it is clear that the pattern has failed. To be more conservative you could place the stop just above half of the Pin Bar.
In the case of a Pin Bar appearing at the bottom of a downtrend, the buy entry takes place when price rises above the high of the Pin Bar. The stop loss is often placed just below the low of the Pin Bar.
An appropriate profit target would be greater than the amount of risk assumed. A profit target of at 2 to 3 times the amount of your stop loss would be reasonable. For example if your stop loss is 15 pips from your entry level, your profit target can be placed at 30 to 45 pips from your entry level.
What time frame should I trade?
Generally, the longer the time frame, the more powerful the signal. However, the longer the time frame, the fewer signals you will get. The patterns that arise on the daily and 4 hour charts are among the most interesting but you will have a limited number of trades during the week. However, when trading these time frames you do not have to spend so much time in front of the screen – you can simply check your charts periodically through the day. Trading on the hourly time frame will provide more signals, but they will be less reliable and require much more time in front of the screen.
An Inside Bar is a two candlestick price pattern that equates to the Harami pattern in Japanese Candlesticks. The pattern is defined by a candle completely contained within the range of the previous candle (also called the Mother Bar). The Inside Bar should have a higher low and lower high than the mother bar.
This pattern indicates that the market is consolidating and reflects indecision and uncertaintly. Inside Bars can be traded as both continuation patterns and reversal patterns.
How to Trade the Inside Bar
When an inside bar occurs in the context of an uptrend you enter long when price breaks out above the high of the first bar (Mother Bar). The stop loss is typically placed below the low of the Mother Bar. A profit target should be greater that the risk assumed, at 2-3 times the distance of your stop loss.
When an inside bar forms in the context of a downtrend, the sell entry takes place when price falls below the low of the mother bar. The stop loss can be placed above the high of the mother bar with a profit target at 2-3 times the distance of your stop loss.
Inside bars are best traded on longer term time frames, such as the 4 hour, daily and even weekly charts.
Another important aspect of Price Action Trading is to understand what the size of a candle body tells us about the momentum in the market. A series of long bodied bullish (green) candles reflect that buyers are in control while consecutive long bodied bearish (red) candles indicate the the bears are in charge.
Additionally, when the size of the body of candles gets progressively smaller, this tells us that momentum is waning. When the body of candles get progressively smaller when approaching an important support or resistance level, this shows a loss of momentum and indicates a possible reversal at the support or resistance level.
Conversely, if a series of long bodied candles occur ahead a support or resistance level, this suggests that price is more likely to break through that level.
How to Trade Falling Momentum
When price is in a downtrend and the bodies of candles are getting progressively smaller when approaching a support level, this suggests that price is more likely to bounce at that level. You can trade this by placing your buy order at or just above the support level. Your stop loss can be placed below the support level.
In this instance your profit target could be larger in relation to the stop loss, placing it at 3-5 times the amount of the stop loss. The chart example pictured above shows candles getting progressively smaller before reaching the support level of the 200 period moving average, where price indeed reverses.
In the opposite scenario, when price is rising and the bodies of candles are getting progressively smaller when approaching a resistance level, this again indicates us that price is more likely to reverse at that level. You can trade this by placing your sell order at or just below the resistance level. Your stop loss can be placed above the resistance level. Your profit target should be greater than your risk assumed, with a reasonable target being 3-5 times the amount of your stop loss.
The Bottom Line
Price Action Trading is attractive in its simplicity, elegance and accuracy in pinpointing reversals and breakouts. The value lies in understanding what the patterns tell us about the psychology of the players in the market at key levels where the balance of power shifts between the bulls and bears.