If you are willing to develop your own price action trading system then keep these five things in mind and make them a part of your trading system before you enter in any trade.
1. Market Structure
Market structure is the first step in developing the price action trading system. Market structure comes first when we talk about price action trading because you cannot understand the charts and buying and selling points or stay away time until you are getting aware of the market structure. But if you understand it well then price action trading opportunities will be right in front of you.
Market structure is basically the way to differentiate the market into different stages and then deciding your trade on the basis of those market stages. It will give you the clear idea of making your decision regarding buying, selling or staying away from the market. In this article we are going to break the market into four stages.
A. Uptrend Stage in price action trading
If the price is moving in the upward direction, then this is an advancing or uptrend phase. This market condition can be identified with the help of higher highs and higher lows. At this stage, majority of the traders look for the buying opportunities. It is better to purchase when market is giving some discount and stock or currency pair is trading close to its moving average. Market is not trending all the time. As the trend gets weaker, it enters into the next phase which is the distribution stage.
B. Distribution Stage in price actin trading
The distribution or consolidation stage in the price action trading system is the market condition in the upward trend in which market move in a range bound. For example, in an uptrend, in the distribution stage the bullish traders will buy as the price is expected to move higher and after the distribution phase and bearish trades will sell as the price is too high and a reverse is expected. The balance between two make the distribution stage and the dominance of one of them either bullish traders or bearish trader make the market to change the condition. So, if you are a bullish trader, you can find the buying opportunities at the support level and if you are bearing then you can find the selling opportunities at the resistance level.
C. Downtrend Stage in price action trading
It is a market condition in which the market moves in the lower direction. This can be identified with the help of lower high and lower low. At this stage the bearish traders dominate the market and always look for selling opportunities. It is better to sell when the market gives some discount or sell close to the moving average. As the market cannot move high all the time, similarly, the market cannot move low all the time. So, it enters into next stage after a downtrend that is accumulation stage.
D. Accumulation Stage in price action trading
The accumulation stage appears in the downtrend and when the market moves in range bound. At this stage bearish trades find selling opportunities because they are of the view that the price will move further downward. On the other hand, bullish traders will see the buying opportunities as the prices has fell a lot and these are chances of price reversal. At this level, you can see the selling opportunities at the resistance level, and buying opportunities at the support level. The competition and battel between bearish and bullish traders give birth to this accumulation stage. The winner of any of them will lead the market to either in the upward trend if bulls got winner or further downward trend and bears win.
2. Area of Value in Price Action Trading System
Till now, you have learned what the market structure and how to behave in different kind of market structure in price action trading system, and what kind of position you are supposed to take in these different market stages. Now the point is, if you want to take a buy position or sell position then what should be the exact point at which you should take a trade to get maximum risk to reward ration and when there will be minimum chances of failure. That exact point at which you can take trade is called area of value. The buying and selling pressures normally build around that area of value. The area of value can be identified on the basis of
A. Support and resistance
B. Moving average
Support is an area where there is a possibility of potential buying pressure and resistance is an area where there is a possibility of potential selling pressure. You can see the area of support and resistance in the below picture.
If you want to know in the details about how to identify and draw support and resistance levels then see the relevant article on this website.
Moving average show the average price of a stock over a certain number of periods i.e. 20 period moving average. It is better to use exponential moving average than simple moving average as it gives more importance to the latest values. Every stock or currency pair respect different period of moving average. For example, a stock may follow the 20-period moving average and reverse every time it hits the 20-period moving average, while on the other hand, a stock may follow the 50-period moving average. In a trending market, we identify the area of value with the help of moving average and in the range bound market, we identity the area of value with the help of support and resistance.
3. Entry Trigger in Price Action Trading System
After finding out the exact area of value in the price action trading system, the next point is to wait the entry trigger that is the sign that market is going to reverse from here. This is the point where your trigger your purchase or sell order means exact point to enter the trade. If we talk about price action trading then these trigger signals can be based on two techniques.
A. Break of Structure
For example, a price is moving in the downward direction and making the lower high and lower low. If after making a lower high, it does not make a lower low instead it makes higher low. It means it has broken the structure. The price is no more in the downward trend. After making the higher low, as the price makes a higher high, we will enter the trade as buy order. The higher low will provide us the right point to set our stop loss. The same is true for taking the long trade but in reverse order.
B. False Breakout
Let’s also understand it with the help of an example. Suppose the price is moving in range bound and after some time, it breaks its resistance line and start trading over it. We shall call it a breakout in the upward direction. But after breaking out, it does not continue its movement in the upward direction rather it comes back into the range after hitting all stop losses of ranger bound traders. At this level, we will enter the trade as short trade because a false break out has happened and it is a good entry trigger signal with tight stop loss and excellent risk reward ratio.
4. Stop Loss in Price Action Trading System
After identifying the market structure and area of value, we entered the
trade throughout trigger point in price action trading system. The next step is to identify where we can put our stop loss because even extreme careful entries with all our trading rules, the market can go in reverse as well. So, we should have a stop loss point that can save us from losing all of our capital. Now, the point is where to put our stop loss? One way to do it that we put our stop loss where our market structure condition changes. For example. You take a trade on support level considering that the market will reverse from here. But instead of reversing, the market start trading below our support level. In this scenario, the market has been entered from range bound market to downtrend and hence our market structure changed. So, we will put our stop loss below the support level. The next point is where to put the stop loss if the market is trending. For example, a market is in uptrend and you enter into a long trade after it make higher low which is also an area of value and showed the entry trigger. In this scenario, we will put the stop loss below the swing low where we have entered the trade.
Now the question is, how far our stop loss should be from our entry
point. In this case, there are two things to be considered. First thing that your stop loss should have high risk to reward ratio. We recommend 1 to 1.5 risk to reward ratio. If your stop loss is at a distance of one then your profit target should be at a distance of 1.5. Secondly, your stop loss should give price enough room to hover around before it moves in your favor. Your stop loss should neither be too tight that small price movements can hit it or it should not be far away that in case of loss, it can take a lot of your trading capital.
5. Market Direction in the Higher Time Frame
This is the most important thing of price action trading system and this is the point where beginners price action trader got deceived. We may say it the most important part of a price action trading. If you see a market structure in the one hour time frame for example, you see an uptrend in a one hour time frame, you will definitely take a long trade at your entry level. But what if, the market is in uptrend in the one hour time frame but is in the consolidation phase in the one day time frame then this one hour time frame uptrend will end soon. Most importantly, if you take trade in a one hour up trend but you ignore the one-day time frame and in the one-day time frame the price is at resistance level that there are higher chances that you will lose the trade even you fulfill all the other requirements of price action trading. If you have mistakenly too any trade with different market structure on different time frame then it is better to exit from the trade as early as possible. To increase the chances of winning and to get the higher profitability ratio, the market structure should be aligned in the lower and higher time frame. Now, how to select the higher time frame. It is simple a multiplication of 4 or 6 of your trading time frame. For example, if you are trading on one hour time frame then four hour or six hours will be your higher time frame. The chances of winning the trade are much higher if you take the trade on the basis of two consecutive time frame and the both the time frames are in the same market structure and providing the same entry signal and area of value.
Now, to summarize all this.
The market structure is giving us idea whether we should go for buy or sell trades or simple stay away from the trades.
The area of value will tell us the possible reversing point where we can enter into the trade.
The entry trigger are our actions points. When our entry signal are shown, we can enter the trade by putting our trade orders in the system.
We have to plan our stop loss orders in a systematic way, either break of structure or swing high or swing low level. The stop loss should create a balance that not too tight to hit with small price movement or too far to wipe away a lot of our capital.
Take only those trade which are equally good in lower and higher time frame and when the trend in both the time frames is in the same direction.