What is price action analysis?
Price action analysis is a method of technical analysis in which traders use price behavior to determine future price movements instead of using technical indicators. The concept behind price action analysis is to catch the market moves when they are just about commencing. Indicators are notorious for lagging, i.e. they respond late to price movements, and traders using them are at risk of fake outs if they enter too early, or getting into trades too late if waiting for the indicators to align properly.
The Rationale Behind Price Action Analysis
Price action is a function of order flows, and order flows are a function of market bias. Prices move up when there are more buyers in operation than sellers, or when the volume of buy orders surpasses sell order volumes. Likewise, prices drop when there is more net selling than buying. Traders will buy or sell depending on the opinion outlook formed on an asset. We see a good example of market bias in the Euro currency pairs when news of the sovereign debt problems in Greece, Spain and Portugal kept rearing their heads from mid 2010 till date. At that time, one could blindly sell the Euro with virtually no technical analysis and still make a killing.
(Impulsive selling on the EURUSD; 21 April to 7th June, 2010)
The chart above shows the movement of the EURUSD in the month when the extent of the Greek sovereign debt crisis began to unravel. Genuine fear about the disintegration of the financial unit of the Eurozone gripped global markets and traders threw all their Euros into the bin and headed for the exit door, causing a 1800 pip drop in 2 months of trading.
When we see such moves in the market, they are usually as a result of impulse and they are termed impulsive moves. Impulsive moves are very strong and sustained. The moves are driven by institutional sellers, who typically trade large volumes that tilt the scale of the market in favor of their flows. Traders who are able to get access to information about institutional trade flows will typically catch such moves early and take full advantage.
Another way of using price action analysis is by trading price corrections. Sometimes traders get confused as to whether what they see on the markets constitute a change in trend or merely a correction in the bigger picture of the existing trend. One way to easily separate the two is to ask: has the market fundamentals that produced the initial move really changed? If it has, then there is a change in trend. If it has not, then what you have is a correction to be followed by resumption of the previous trend. We see this in the EURCHF, at the same time that the EURUSD’s 1800-pip drop occurred.
Here, we had a correction, which latter price action of the asset confirmed as a mere profit taking correction. By the end of July 2010, nothing had really changed fundamentally and the sellers took over once more. Such corrective trading is suitable for those who missed the boat initially.
If you have hitherto not paid any attention to order flows, you need to start doing so, because price action analysis is what enables a trader to catch market moves early.