What is Price Action Analysis?

I’ve received a great question in response to one of my old videos at YouTube:

  • lots of traders criticize indicators (and correctly so, apart from the moving averages and RSI, I don’t find these oscillators or macd good) and prefer price action.. what exactly IS price action, I mean, what methods would you categorize under price action? Thanks.

Price action analysis is simply the analysis of charts with a focus on price, rather than on indicators which are a derivative of price and therefore lagging.

Underlying all price action analysis is Dow Theory; a set of principles or guidelines for price movement developed by Charles Dow in the late 19th century and later refined by William Hamilton and Robert Rhea. Dow Theory can essentially be considered the starting point for modern day technical analysis. Of particular importance is the way Charles Dow defined the market stages of accumulation, participation (trending) and distribution. And how he used peak and trough analysis (swing highs and lows) to define price trends.

For a good overview of Dow Theory, see the following Investopedia tutorial which commences on this webpage: http://www.investopedia.com/university/Dowtheory/ . Please note that at the bottom of the page you’ll find links to the following nine sections (ten in total).

Beyond Dow Theory, analysis of price can largely be thought of as comprising two main approaches (at least as I see it).

The first is what I call pattern analysis. Most traders will be aware of this style of analysis, and in fact for many it will be the only type of price action analysis that they’re aware of.

Pattern analysis can also be further broken into two parts – macro patterns and micro patterns.

Macro patterns are the larger scale patterns describing the general market movement. You’ll recognize the names of these patterns, such as head and shoulders, double tops, double bottoms, triangles and flags. This work can be first attributed to Richard Schabacker, and later documented in the classic technical analysis book, “Technical Analysis of Stock Trends” by Robert Edwards and John Magee.

Micro patterns are the smaller scale patterns describing short-term market movement. You should be familiar with the basic candlestick patterns and price-bar patterns, as defined in the following video series:

The second approach to price action analysis appears to be less well known.

This approach can largely be attributed to Richard Wyckoff, and more recently through Tom Williams’ Volume Spread Analysis which expands upon Wyckoff’s work. For an introduction to some of Wyckoff’s work, see here: http://www.wyckoffstockmarketinstitute.com/archives.htm. In particular you’ll want to consider his three market laws.

This approach to price action analysis involves observation of the price bars and price swings in order to identify signs of bullish or bearish price behaviour, or signs of strength and weakness. To overly simplify, this approach is less concerned with where price has moved (patterns); instead focusing on why price has moved the way it has. Rather than looking at patterns, it looks at the nature of price movement within the patterns.

This is also the style of price action that I mostly relate to, as explained in much more detail within my YTC Price Action Trader ebook series, although my methods of strength and weakness analysis differ in some regards from these earlier works. Or for a quick introduction to my way of trading, have a look at the two-part article series commencing here (http://yourtradingcoach.com/trading-process-and-strategy/advanced-candlestick-analysis-part-1-of-2/) and the five-part article series here (http://yourtradingcoach.com/trading-process-and-strategy/better-than-candlestick-patterns-part-one/)

I fail to do justice to the work of Dow, Schabacker, Edwards, Magee, Wyckoff and Williams, through these simple explanations. Their work was of course much more comprehensive than I’ve described. But the general concepts are suitable for this discussion. Price action can be largely thought of as comprising two different approaches or styles; the pattern-based approach of Schabacker and the behavioural approach of Wyckoff.

Although the second approach provided me with the greater breakthroughs in my own trading journey, my belief is that there is great value in both approaches. Study the pattern-based approach to price action analysis. And study the behavioural approach to price action analysis. Find what works best for you.

The reality is that you’re not restricted to one or the other. You’ll likely develop your own blended form of analysis, incorporating aspects of both.

I’d also recommend you go to a deeper level and study the nature of price and price movement. Do a search on auction market theory for starters.

One key point that may be absent in much of the material you study, is the importance of context.

Whether trading via a pattern-based approach, or via assessment of the underlying forces of bullish or bearish pressure within the price bars and price swings, an understanding of context is essential to your success. The meaning of your analysis with regards to future price movement depends largely on where the current signal is occurring within the bigger-picture structure of the market.

Examine how price behaves RELATIVE to other key price areas, such as swing highs and lows or areas of support and resistance.

Consider how the behaviour of the current price swing compares with that of previous price swings, such as through observation of the ease of movement, speed and acceleration.

And examine how price behaves RELATIVE to other traders expectations. In particular when their expectations have failed.

Clues as to future orderflow (and future trend direction) are found through considering current price action within the context of prior price action and the mindset of the traders comprising the market.

So, where does this leave indicators?

Many traders assume that price action analysis means that charts comprise price only, and ABSOLUTELY NO INDICATORS ARE ALLOWED. That’s not necessarily so. Many price action traders will have indicators displaying on their charts. Usually there will be very few; perhaps just an EMA(20), for example. The difference is that the indicators are a decision support tool. They are NOT a primary means of analysis.

This is difficult for newer traders to understand. Normal human behaviour, when faced with a chart overlayed with indicators, is for our attention to focus immediately on the indicators. And the indicators provide simple objective signals which appear to satisfy our newbie desire for an easy and objective method of achieving trading success. Unfortunately that is not the way trading works.

Indicators are fine. But you need to understand exactly what they’re indicating! And you need to understand their limitations.

If you’re interested in how I conduct my own price action analysis, and the theories underlying my approach, you’ll find it outlined in significant detail in the YTC Price Action Trader. In fact, it goes deeper than price to consider the underlying cause of price movement itself.

Or if you prefer to follow your own path, this article has hopefully provided a whole lot of areas for future study and research. Enjoy! It’s a fascinating field of study.

Lance Beggs.

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YourTradingCoach – Admin

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