Price action trading: How to trade

December 15, 2014 05:40 AM

There are three phases to the market cycle: Breakout, channel and trading range; and traders use different entries, stops and exits, depending on what the market currently is doing. There are trading opportunities on every bar for traders who understand where in the cycle the market is at the moment.

A strong trend is just another term for a breakout, which simply means a move up or down from an established range with little or no pullback. A breakout can be one big bar, two or more medium bars, or five or more small bars. Once the market forms a pullback, traders then will look for a transition into the channel phase. Sometimes there can be a second or third breakout before a pullback leads to a channel. Channels are weaker trends and eventually evolve into trading ranges, where the market is once again neutral and the probability of trend resumption drops once the range has 20 or more bars.

In general, when a trend is strong (the breakout phase), traders will look to trade only in the direction of the trend. As it weakens into a channel, traders will be quicker to take profits and more willing to scalp in the opposite direction, especially if they are willing to scale in as the market goes against them. As the channel phase of the trend transitions into a trading range, traders switch to “buy-low,  sell-high” scalp trading.

“Range trading” (below), which shows the five-minute EUR/USD forex market, provides an overview. During the strong bear breakout (highlighted in green), traders will look to short for any reason. They will sell:

  • at the market,
  • any small pullback as the bar is forming or after it closes,
  • on the close of any bar, whether there is a bull or bear close,
  • above the high of the prior bar using limit orders,
  • below the low of the prior bar using a stop order.

The ideal protective stop is above the top of the breakout (the bar 1 high). Some traders are unwilling to risk that much and they might use a money stop, such as 20 pips (ticks) from their entry price. Remember the math. If a trader chooses to risk less, he will have to pay for it with a lower probability of success. Wide stops have a higher winning percentage, but the occasional loser can be as big as several smaller losses with tighter stops. There is no right answer, but some stops are obviously too tight or too wide.

Another way to reduce risk is to trail the stop to just above the high of the most recent strong bear bar. (Trailing the stop in a bear trend means to move the stop down as the market continues to fall.) After each new leg down, traders will move their stop down to just above the most recent lower high.

Once there is a pullback (the turquoise area), the market usually enters the channel phase, but sometimes there will be another breakout or two before the channel begins; at other times, the channel is so small that the market just enters a trading range, as it did here. During the channel phase, traders will be more cautious with their entries. They will no longer short below or above every bar. They will begin to prefer to sell a little higher, like below the low of a bar in a small rally to near the moving average. Many will still be willing to sell above bars and scale in higher if the bar is part of a weak looking buy setup.

The idea is that if the bull reversal setup looks weak, there probably will be more sellers than buyers above the high of the buy signal bar, and therefore selling exactly where these losing bulls buy makes sense. The stronger the bull bars (the more buying pressure), the more the bears will want a strong bear signal bar before shorting.

Waiting game

Channels transition into trading ranges, but not all trading ranges are worth trading. When a range is particularly tight, the height of the range is only one or two times the size of a minimal scalp and most traders should simply wait. Some traders will scalp by shorting above the highs of bars in the top third of the tight trading range, scale in higher and then scalp out for maybe 10 pips. They also look to buy below bars in the lower third and scale in lower, looking to scalp out with a 10-pip profit. Traders should never scalp for less than 10 pips or ticks, and most traders should go for targets that are at least twice as big as their protective stops.

Traders trade channels and trading ranges similarly because they both are areas of two-sided trading. Because a channel is simply anything between two lines, a trading range is just a horizontal channel. In a channel, one side is stronger and in a trading range, both are equal.

In general, use the size of a scalp to determine whether to take a countertrend trade. If an E-mini scalp is four ticks, look for a recent move down of eight to 12 ticks before shorting in a trading range or in a bull channel. Similarly, look for an eight- to 12-tick rally in a trading range or a bear channel before considering long scalps. If  looking for a 20-pip scalp buy in a trading range or a bear channel in the EUR/USD, look for a recent 40-pip rally first to show that the bulls are strong enough to move the market up far enough for your scalp to be profitable.

Once the market appears to be in a trading range (the pink area), traders will buy low, sell high and scalp. Buy low can be to take profits on a short or to buy to go long. Sell high can be to take profits on a long or to initiate a short. A pullback that grows beyond 20 bars loses most or all of the influence of the trend that came before it, and the probability of trend reversal becomes the same as that for trend resumption. Once there is a successful breakout in either direction, the process begins again.

Breakout watch

Trading ranges always look like they are about to break out. Strong legs up trap traders into buying high because the traders will assume that the strong leg up will have a second leg up after any pullback. Strong legs down trick traders into looking for shorts at the bottom of the range, again because the move looks so strong that it makes them erroneously believe that there will be a successful breakout. This is the opposite of what experienced traders will do.

People are naturally hopeful, and it takes time to get past the tendency to believe that a strong breakout attempt will succeed. These strong rallies are just buy vacuums that test the resistance at the top of the range, and the strong sell-offs are caused by the support at the bottom of the range vacuuming the market down for a test (see “Trading in channels,” Below).

When a leg is strong, traders should wait for a second entry before fading. If the market races to the top of the range, maybe with four consecutive bull trend bars, it is usually better not to sell below the low of the prior bar. Instead, wait to see if the market turns up from that pullback. If it then reverses down a second time, traders might sell below the low of the prior bar. This is a second entry short.

A second approach is to wait for a bear breakout (one or more strong bear trend bars). As long as the market is still in the upper third of the range, many traders will short the close of that bear bar. If there are three or more consecutive bear bars, but the market is still in the upper half or third of the range, traders might then short using a limit order above the high of the most recent bear bar. They are betting that the strength of the bear breakout is enough of a surprise that there are now bulls holding longs who want to get out. This usually leads to a second leg down, at least big enough for a scalp (see “Leg strength,” below).

Traders will look to short below the low of a bar at the top of the range and buy above a bar at the bottom of the range, and scalp out (take profits around the middle or hopefully the opposite side of the range). If the move up or down is too strong, they will wait for a second signal before entering. If there is a bull flag at the top of the range, some traders will short above the high of the signal bar or above the high of the highest bar in the range, betting that the bull breakout will fail.

Roughly 80% of breakout attempts up and down in trading ranges fail. Likewise, some traders will buy below bear flags or below the low of the lowest bar at the bottom of the range, betting that the breakout is a bear trap, tricking bears into losing positions.

Always-in, long or short

Some traders are constantly afraid of entering because they are waiting for the perfect trade. They have not yet come to accept that perfect trades cannot exist because there always has to be a reason for an institution to take the other side of the trade. The result is that all trades look uncertain.

Once traders accept this reality, their trading lives become more relaxed. Those who are still struggling with it should consider adopting an always-in approach to trading. If a trader looks at any chart and has to enter either long or short at that moment, his choice is the always-in direction. The choice is not always clear, but he can almost always pick one.

Sometimes a trend is so strong that the choice is obvious and other times it is much less certain. When in doubt, traders should assume that the choice is the direction of the most recent three- or four-bar breakout. If a trader believes that the market is always-in long, he can buy for a swing at the market or on a pullback, and place his stop below the low of the most recent bull breakout. This is the most recent strong leg up, which is the most recent bull trend resumption, and usually is from one to five bars in duration.

Once a trader is long, he can then add to his position as the bull continues, trailing his stop to below the low of the most recent bull breakout. 

He can also take partial or full profits at resistance levels or at new highs and then put his full position back on during a pullback. Similarly, if a trader believes that the market is always-in short, he can short at the market or on a pullback, and place his stop above the high of the most recent leg down, whether a bear breakout or trend resumption (see “Always-in reversal,” below).

You often hear traders and analysts say it’s time to buy, sell or hold. This does not make sense because the two choices are really just buy or sell. For example, if your friend has a $100,000 portfolio of stocks that his advisor says are “holds” and you have $100,000 in cash, you could simply buy his identical collection of stocks, even though they are rated hold and not buy. You would then have his identical portfolio, which his advisor considers worth holding.

Traders should look at their portfolio at every instant as being made up of either buys or sells. If you have a profit on a stock, it is not someone else’s money. It is in your account, so it is your money, and holding it is no different from someone else simply buying it this instant, if he uses the same profit target and protective stop as you. This is the basis of always-in trading.

If you look at a market and wished that you had bought earlier and now are waiting for a pullback, then you should buy at the market. If you believe that it is good enough to be holding the stock at this moment, using a certain stop and target, you should just go ahead and buy it now. If you think that it is better to look to buy a pullback, then, if instead you were long, you should sell out and wait to buy again lower.

Traders constantly should evaluate their account as being totally available to enter any position or exit any position at any time, and no decision should be based upon when and at what price you or someone else entered. This ignores tax considerations, which should be part of the decision, but are irrelevant to traders because of their small time frame.

Al Brooks, MD, has traded for his personal account for 27 years. He is a regular contributor to Futures and the author of a three-book series on price action published by Wiley: Price Action Trading: TRENDS; Price Action Trading: TRADING RANGES; and Price Action Trading: REVERSALS. He also provides live intraday E-mini price action analysis and free end-of-day analysis at www.BrooksPriceAction.com. His 36-hour-long video trading course is available at www.BrooksTradingCourse.com.

About the Author

Al Brooks, M.D., is author of the Brooks Trading Course (27 hours of videos at BrooksTradingCourse.com), several books on Price action (Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader, Wiley, 2009, and the 500,000 word, three-book series, Trading Price Action, Wiley, 2012), and numerous articles in Futures Magazine. He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.