Understanding Price Action: Learn to Read the Markets
Looking at a price chart is an effective way to instantly get an idea of what the market is doing, but it can raise the question of ‘how do I make sense of all of these price movements?’ Price action trading strips away the technical indicators and focuses purely on the ups and downs of price – technical analysis in its purest form. This guide is about making sense of raw price data by breaking down a simple approach to analysing price action on a chart: determining market structure, identifying liquidity zones and reading candlesticks.
What is Price Action?
Price action simply refers to the price fluctuations of an asset. Prices are always moving because of the constant battle between buyers (demand) and sellers (supply) – buyers push prices up, sellers pull prices down. The price chart is a visualisation of that battle, and making sense of it enables traders to determine who is controlling the market at any point in time. Unlike many forms of technical analysis, this approach adds nothing to the chart and instead reads what is already there. Indicator-based strategies are built on mathematical formulas, while price action focuses on the raw data: how far price moved, where it stalled and where it was rejected. This is why analysing price action offers a faster, clearer view of market transitions, often before they appear on lagging indicators such as RSI and moving averages.
Step 1: Analyse the Market Structure
Price action trading starts with analysing the market structure (trend direction) and identifying any breaks of that structure. It is crucial for traders doing any sort of technical analysis to get an idea of market structure in order to support their entries with context, regardless of whether or not they are trading in the direction of the trend.
- A market is in an uptrend when it builds a sequence of 'stair-steps' known as higher highs (HH) and higher lows (HL).
- A downtrend is the reverse – lower highs (LH) and lower lows (LL).
A break of structure (BOS) occurs when price fails to continue its current pattern. For example, price dropping below the previous higher low in an uptrend rather than making a new higher low is the first clear sign that the dominant trend has lost momentum and may be reversing. Recognising this can help traders avoid chasing a move that is already ending.
Step 2: Identify the Liquidity Zones
Once the trend has been established, the next step is to take a closer look at where that trend is most likely to be tested: the liquidity zones. Liquidity zones refer to the support and resistance zones on a price chart – it is at these price levels where liquidity is typically the highest. Finding support and resistance is a fundamental skill of technical analysis, and is crucial for price action trading because signals of trend reversal or breakout that appear in these areas carry significant weight (as long as there is confluence).
- Support zones are where price tends not to drop below; these areas are where there is high buying interest, which is strong enough to stop a decline.
- Resistance zones are where price tends not to rise above; these areas are where selling pressure is strong enough to halt an advance.
Liquidity is high at these price zones because it is where 'big money' is active; banks and institutions tend to place massive orders here, which provides a large amount of liquidity to the market. Identifying liquidity zones on a price chart gives a trader a better idea of where price has the highest probability of reacting, with the goal of only trading when price reaches support or resistance.
Step 3: Look for Signals
When price goes near a known liquidity zone, the focus then shifts towards the candlesticks. The individual candlesticks in a support or resistance zone can indicate whether price will reject or accept a new direction.
- Rejection of a new direction: Look out for long wicks as they indicate that price attempted to move into an area but was quickly overwhelmed by the opposite side. It marks a failed push and signals the zone is well-defended.
- Acceptance of a new direction: Look for follow-through after a breakout. A breakout is just the single moment price moves past a level; follow-through is when the candles after the initial breakout close in the direction of the break, which is the evidence that price will stay beyond the breakout. If price breaks a level but fails to show follow-through, it is likely a trap. Experienced traders often wait for the market to accept the new price before committing any capital.
Aligning All Three: Confluence in Price Action Trading
The strongest trades tend to occur through confluence – the alignment of multiple factors pointing the same way. Here are three key factors that should be in alignment:
- Market Structure: This provides the macro context – does the trade align with the trend on a higher timeframe?
- Liquidity Zone: Is price at support or resistance? If not, candlestick reactions do not mean nearly as much compared to if they were in a liquidity zone.
- Signals: Has a clear candle reaction appeared? Long wicks for rejection or a breakout with subsequent closes in the same direction for acceptance.
Technical analysis tools like moving averages or RSI can be used in addition to confluence as secondary filters to provide an extra nod of confirmation, but they should never be the primary reason for a trade.
Conclusion
Protecting capital is more important than trying to win every trade. This subtle shift in mindset moves price action trading away from predicting the future and towards following a structured process that looks for confluence. Every other tool in technical analysis is built downstream of price action, which is why the price chart deserves to be read before anything is laid on top of it. Indicators such as moving averages or RSI can be layered on for extra confirmation, but the chart itself should always come first.