What is Price Action Analysis?
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What is the subject of Price Action analysis, and how does it differ from graphic or indicator analysis?
The graphic analysis is meant to detect certain patterns on the chart that often reflect the interaction of demand and supply (buyers and sellers). For example, a Triangle, often emerging in the way of the trend, is normally a trend continuation pattern. In essence, a trader practicing graphic analysis need only to know this fact (that the Triangle is a trend continuation pattern) to make a decision. This simplifies analysis but creates additional limitations.
If the trader wants to figure out the reasons for the price movement, such an explication will not suffice – they need a more intricate understanding of market mechanisms. This need leads many traders to Price Action analysis.
In reality, such a simplistic approach to Price Action analysis will hardly be efficient: if you are eager to understand market processes from scratch, your analysis must become more complicated, not simpler. The number of details and factors that you must pay attention to will increase in a non-linear manner, and making decisions will become harder because the number of conflicting parts of the picture will grow (more signals and scenarios will appear for both buys and sales).
Of course, a trader does not need to see and understand everything: in the end, every market player chooses two or three trading styles and focuses on several types of events, such as breakaways of ranges or the appearance of trends two-three weeks long, etc. However, the understanding of Price Action frees the trader from a fixation on certain patterns – they start to operate principles and become able to find trading opportunities in virtually any market.
On the one hand, information becomes so plentiful that it needs filtration and specialization in a limited number of market situations; on the other hand, the abundance of information lets the trader see more in the market that forms no known-by-all pattern and gives no direct answers.
What does Price Action analysis consist of?
Understanding of patterns
A pattern is a figure on the chart that indicates some market process with a higher or lower probability. For example, if on the chart we see a candlestick with a large body and several other candlesticks that the first one incorporates, we may presume that the market is consolidating, and the following few hours, at least, the price will remain within the range. Why is this information helpful? For example, if we have decided to buy along with the trend, we should wait until the consolidation is over, or the price escapes the range. Similarly, we may see a 1-2-3 pattern that often indicates a beginning reversal.
However, just knowing the patterns is not enough: this alone will not give you any statistical advantage because the predictability of any financial market is quite low, no higher than 60% but normally lower. Forecasts seldom correlate with real events. Any forecast must be confirmed by price dynamics.
Watching price dynamics
This point is named like this for a reason: on history, charts look smooth and appealing, but in real-time, the market moves smoothly from point A to point B extremely rarely, if ever. Much more often, the market leaps abruptly in this or that direction, causing imbalance to traders. How could we use this information?
In fact, it is price dynamics that may indirectly indicate certain market processes. For example, increased aggressiveness and speed of market movements will most likely mean a lack of directed demand and supply (when the asset is accumulated for subsequent medium- and long-term positions) followed by a lack of a trend. A combination of sloppy price dynamics in consolidations with bolt-like breakaways in the direction of the trend will, on the contrary, most often indicate trend scenarios.
All in all, such non-formal parameters as market aggressiveness and tempo combined with certain price levels may give useful information and top on the trader’s advantages.
Understanding of the market logic
Market logic is the understanding of the interests and horizons of market drivers. For example, if professional demand (Smart Money) accumulated the asset in the market, this phase will sooner or later be followed by the distribution phase when most traders will be buying recklessly, paying more and more for the asset so that we will see abrupt culminating movements. AT such movements, a professional buyer normally has good chances for closing their position, after which the market, remaining without support, will stop moving or correct the price.
Uniting the above-mentioned elements, we will get a holistic Price Action analysis that may help the trader be a step ahead of the market in their trading decisions.
First of all, let us debunk certain myths. Price Action analysis is often mixed up with simply following the price: “the price goes up, we buy – the price goes down, we sell” (or vice versa: “the price goes up, we sell – the price goes down, we buy”). In reality, the process is somewhat more complicated, and if simple price-based approaches did work, there would be many more traders that make real money.
Let us figure out: what is the price?
The question is not as primitive as it seems. The price has several main functions:
The price reflects the last completed trade.
This is more or less clear: the quotation is set at the level where the trade happened, regardless of who opened it, a buyer or seller.
The price is an advertising mechanism, attracting buyers/sellers.
This is more curious. The market, in essence, is an open auction: if you recall how a normal auction works, you will see through many market processes.
A bright example
Imagine an auction selling antiques. An auction house (best auction houses are usually English) puts something on sale for 1000 pounds but it turns out that no one wants to buy the thing for such a price. The auctioneer decreases it: 950 pounds, 900, 850, 800. AT last, a gentleman on the right is ready to buy. The auctioneer starts counting but an elderly lady offers 850 pounds. More and more participants get involved in the process, and the price soon overcomes 1000 pounds, where trading started, What has happened? Does the price not seem high anymore, or did auction players suddenly realize the value of the lot? In reality, the participants got involved in mass action, scared by rivalry or a probability to miss something important – anyways, the auction process has little in common with the real evaluation of a thing.
A similar process happens in the market with the only difference that in the market, the supply (the number of lots on sale) is not as limited as in a normal auction, and the price goes both up and down.
Thus, a price movement may have just an “advertising” effect. Will an increase in the price attract more sellers or a decrease – more buyers? To answer the question, you not only need to know what the price did earlier (increased, decreased, remained in a flat) but also have to know the logic of market players.
So, you need to understand: how much involved traders are at that stage? Which traders (horizon-wise) may enter the market: medium-term, short-term? Where will those already in positions start panicking and fleeting?
None of us has a magic crystal that gives 100% guarantees of what happens next; however, some observations increase your chances. The ability to evaluate the involvement and behavior of traders I call market logic, and we will discuss it in a separate article.
On the whole, Price Action analysis is not just an understanding of what the price was doing but also speculating on the behavior of traders that caused the price movements.