The mini Price Action Trading Course
Price Action Lesson #1
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Why do we use Price Action, and do we really need it?
Have you ever noticed how the most basic questions are the hardest to answer? If I were asking how do you enter, scale or exit a position you would have told me immediately, but why use price action… tough one, right? Let’s try to find out.
The purpose of everything, that available to us in trading is to be used to:
- generate our own trading idea
- piggyback on someone else’s trading idea
That creates two main approaches to the market that traders take.
Generating a new trading idea means to analyse the fundamentals and enter into a position before those fundamentals have started to actually move the market. As you can see, here is the kingdom of the fundamental analysis. Analysis of a company’s 10Ks and 10Qs, the climate and the crop (for commodities), anticipating an upcoming recession, a bubble burst or an upcoming currency peg removal and so on.
Performing such analysis might lead to a situation where you see that particular stock, for example, is not valued correctly, and its price should be higher or lower. Of course, you are probably not the first one who saw this, but still, the market hasn’t moved in that direction yet.
The second approach is the preferred way by the majority of retail traders. Because idea generation is too hard and time-consuming, we focus on techniques that will help us to trade somebody else’s trading idea. This is generally the technical analysis.
Said in other words, the second approach means to analyse the market behaviour and find the moments when the price will jump or fall. Of course, this comes after the market participants had started to price in the valuation changes discussed in the previous approach.
So where does the price action fits in?
Besides some small exceptions of wrong expectations leading to mean-reversion trades, the price action falls into the second group.
We use price action to track the intentions and actions of somebody else.
But who is this somebody else?
Those, yes it’s they, are the market players who know more than we do. The smart money. Big companies, with separate research departments, where 200 geniuses (from various backgrounds), are analysing a particular stock or industry until they know everything about it. The producers of a commodity or a hedge fund who gets more information than we do and quicker than we do.
If we are not trading with tens of millions, then we probably don’t have the same resources at our disposal and can not generate trading ideas as these guys do. That means we have to assume that the smart money will be ahead of us with idea generation. All else equal, they will always find a better company and a better trade before we do!
But here comes the good news.
After they have found it, they have to trade it. If they are positive about Crude Oil, they will have to buy. If they think fundamentals will drive a currency lower, they will have to sell.
And that leaves a trail!
The entry into a position leaves marks on the chart. This is what we are trying to read, the prints on the chart left by the intentions and actions of the bigger, more knowledgable and more informed players. Why? Because they are better with generating ideas and if they are starting to buy or sell something, there must be a good reason for doing so.
But wait that’s not all!
Our answer won’t be complete if we do not mention the others. As price action traders, we have to analyse the behaviour of another two groups. It’s the market makers and the crowd.
Who are the market makers?
Think of them as those institutions who are literally making the market. They are ready to buy and sell a particular instrument from or to other market participants. It will get easier after the following example. If a large hedge fund wants to buy some instrument, let’s say a currency, where do you think they will go? Yes, to the market maker which in this case might be a big bank.
The other group are the retail traders. Those are the smallest, less informed and mainly driven by emotions market participants.
It sounds good, but show me the real stuff, the patterns, I want to make money!
We’ll come to that but showing you different entries and exits will not mean that you’ll be able to use them. If you really want to make money out of this you must realise that price action patterns are an attempt to track and forecast the activity of those three groups. Without a deep understanding of how and why each group is buying/selling, a price action pattern will be just a nice drawing and nothing more.
Now you know what the purpose of the price action is. But another question pops up, right? So after you read this open the chart of your favourite instrument and ask yourself:
who is buying right now and who is selling?
More answers and some specific patterns are coming in the next lessons.
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