Introduction to Price Action Analysis
Price action simply refers to a market’s price movement on a chart and traders who look at pure price action alone tend to do so without the use of indicators when making their trading decisions.
When most traders start out they tend to believe that the more indicators they use the better their performance would be. This could not be any further from the truth and it is my belief that it’s the wrong place to start when you enter the world of trading.
Instead, a better place to start would be to understand how markets move on a chart and why they move the way they do without any indicators. Learning how to read pure price movement on a chart, regardless of the time frame, is an essential skill that successful traders have acquired through experience.
Experienced traders would tell you that they have a good “feel” for the markets that they trade and that they can often tell you which direction price would move in based on price action alone, without the use of indicators.
The purpose of this article is to show you a few techniques that can help you define price action in a way that brings structure to what you see on a chart so that you can make sense of what price is currently doing and what it could be doing next. Price action may seem random to most traders but with the use of some basic technical analysis methods, it becomes possible to make sense of what is really happening on your chart.
Technical Analysis vs. Fundamental Analysis
Traders who engage with the markets tend to use technical analysis or fundamental analysis. Sometimes traders would use a blend of both but how much they rely on either one of them often depends on their trading style i.e. day traders or swing traders would mostly rely on technical analysis whereby fundamental traders could use a buy and hold approach over the long term.
This article will focus on the technical analysis aspect of trading and how it can be used to read price action in a structured way. The following technical methods can however be used on any time frame regardless of what your trading style may be.
Defining Price Action with Technical Analysis Methods
The human brain is very good at recognizing patterns but it can also get tremendously confusing when it cannot make sense of a pattern. Looking at price action on a chart without any indicators or lines drawn on it is one such example where confusion can set in very quickly.
The chart above is a weekly chart of Copper and it was just a random chart that I have picked so that I can demonstrate how certain technical analysis methods can help a trader make sense of what otherwise appears random.
Using the same chart of Copper, I drew in some basic trend lines (green and red) and marked some corrective patterns in orange which in turn I labeled from number 1 – 7.
One thing I have to mention is that this was done in hindsight which is useless to a trader when making up to the minute trading decisions while price action is unfolding in real-time BUT studying past price behavior and learning to see patterns and how they unfolded is the only way our brains will learn to spot these patterns forming in real-time. Patterns happened in the past and they will happen again in the future, so knowing what they look like and how they develop can give you a serious edge.
On the chart above I used basic trend lines to define trend direction but we will mainly focus next on those corrective patterns because they lend themselves to great trading opportunities if you know how to define them and have the capability to know when they are coming to an end.
What follows are 3 methods to help define these corrective patterns in a way that can help us find better trading opportunities.
Method 1: Basic Wave Analysis of Corrective Patterns
Most traders are familiar with Elliott Wave Theory (EWT) as a method to forecast future price behavior. The problem that most traders have with this method of analysis is that it can be very subjective in nature and works very well in hindsight but when EWT is used in combination with other techniques there is no denying that EWT has an important place in technical analysis.
Basic EWT states that a trend will move in 5 waves before it comes to an end, while counter-trend corrections generally move in 3 wave formations. EWT then goes as far as to identify four main categories of corrective patterns which are:
- Double threes and triple threes.
Next, we will be taking a look at those 7 corrective patterns I labeled previously to see which types of correction they were.
Corrections 1 and 7: Triangle Corrections
We have two triangle corrections on the chart I marked out previously and the first one we will take a look at is called a Descending Triangle. Triangles according to EWT are always labeled as A-B-C-D-E and their main shape (orange trend lines) is what gives them their names.
Our first triangle correction has an angled top and a flat bottom which is why it’s called a descending triangle.
Our second triangle on the Copper chart simply has a different shape than the previous one and is called a Symmetrical Triangle due to the narrowing sideways movement that it tends to display. Note that although the shape differs from the first one that the labeling remains the same.
Note: Triangle corrections end in an E wave before a trend resumes and later we will have a look at how we could have used additional methods to find where those E waves were most likely to end.
Corrections 2 and 3: Expanded Flat Corrections
Both corrections 2 and 3 are named Expanded Flat corrections and are labeled A-B-C.
Note how the second Expanded flat correction’s B wave exceeded the high of wave A, wherein our first example wave B ended in line with the A wave.
Our second example had the C wave end in line with the A wave while the first example had the A and B wave line up BUT in both cases, two of their waves lined up while one wave exceeded the other. This is why they are called Expanded Flats.
Corrections 4 – 6: Single ZigZag Corrections
These are the most common corrections and are yet again labeled A-B-C. In our example above the B, a wave made a higher low than where the correction started from with the C wave extending above the A wave.
Both the 5th and 6th corrections on our Copper chart are Single ZigZag’s and they all ended in a C wave.
Method 2: Fibonacci Ratios
Corrections 1 and 7: Triangle Corrections
The use of Fibonacci ratios has been around for a very long time and traders use them in many different ways but what we will look at in the following examples will show you how well they work together with Triangle Corrections in particular.
First up is our Descending Triangle and what you should take note of is how the angled top of the triangle keeps making lower highs in a stair-stepping fashion AT important Fibonacci retracement levels.
Wave E in this example ended right at the 0.618% Fib retracement measured between wave C and D.
Our Symmetrical Triangle had all of its waves end at important Fibonacci retracements and what is interesting to note with this Symmetrical example is that wave E also ended right at the lower orange trend line connected from wave A to C and extended forward.
Correctly labeling Triangle Corrections and knowing that their individual waves tend to end at important Fibonacci retracement levels makes it easier for a trader to spot them while they are developing and gives them a good expectation as to where they may end and in which direction price should follow afterward.
Method 3: Market Geometry
Market geometry uses drawing techniques aimed at defining market structure in such a way that an analyst can have a good idea of where price may be moving to and where support and resistance may influence price in the future.
One such drawing tool is called the pitchfork and by using 3 important pivots or swings on a chart, lines are projected forwards in time at an angle. Price action is almost magically drawn towards these lines and it’s a great way to project and forecast future price movement.
Corrections 2 -7: Expanded Flats and Single ZigZag’s
Pitchforks work very well to determine where corrections could end especially when used with Expanded Flats and Single ZigZag corrections. On the chart above I simply anchored my pitchfork to the 3 important pivots of my correction after which blue and red lines were projected forwards.
Knowing where to anchor your pitchfork to is crucial and is why I also use alternative time frames to figure that out. Unfortunately, that’s another article for another day but what is important in this example is that the C wave ended right on my lower red pitchfork line.
Sometimes labeling the corrective waves properly can be a challenge but when you allow your pitchfork to guide you then knowing where a correction tends to end becomes much easier.
Wave C ended right at the lower red line on the second Expanded Flat correction.
The Single ZigZag’s wave C ended at the upper Blue line of my pitchfork.
Both the Single ZigZag’s 5 and 6 (below) ended at the upper blue pitchfork lines.
Using these methods I have shown you above, only served one purpose which was to define price action in such a way that their underlining structure becomes clearer. Going over as much historical price action as you can, on any time frame and marking out these patterns trains the eye and the brain to recognize them better when they pop up in real-time.
I only provided a glimpse of the tools I use, when in fact I have an entire strategy dedicated to finding the end of corrections within trends and trading them with low-risk entries that often yield huge returns.
Knowing how price action behaves and combining that with the methods I have shown you can help with your price action analysis and what to expect from the market’s next move.
If you would like to know more about my analysis techniques then be sure to check out my course here.
Until next time
All the best