Price action trading: The basics


This is the first of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets. Although there is no universally accepted definition of price action, I use the broadest one — it is simply any move up or down on any chart for any market.

The smallest move any market makes is one tick (one pip for forex markets). If a market moves up one tick, it is because there are not enough sellers at the current price to fill all of the buy orders, and the market has to go higher to find more sellers. If it falls one tick, it means there are not enough buyers at that price.

Day traders don’t have the ability to spend time thinking about anything other than whether the market will go up far enough to make a profit if they buy, or fall far enough to make a profit if they short. I make several assumptions that allow me not to worry about anything other than the price action on the chart being traded. It is impossible to know if my assumptions are true, but they are consistent with how the market behaves; if they prove wrong, change those assumptions.

Two sides

In every major market, no trade can take place unless there is at least one institution willing to take the buy side and another the sell side. Institutions dominate all major markets; individual traders are simply not big enough to have any effect. Although a trader might believe his order moved the market, that belief is almost always deluded. The market moved only because one or more bearish institutions and one or more bullish institutions wanted it to make the move, even though time and sales might show your order was the only one filled at that price.

Moreover, traders should accept that 75% or more of all trading is being done by computers. The math is too perfect and the speed is often too fast for anything else to be true. Still, every tick is important, especially in huge markets like the E-mini S&P 500. If you spend a lot of time studying the market, you can see a reason for every tick that takes place. In fact, you can see a reasonable trade to consider on every bar during the day.

What about all of those one-lot orders in the E-mini or the 100-share orders in Apple (AAPL)? The majority of them are being placed by computers conducting various forms of computerized trading (including high-frequency trading), and it often involves scaling in or out of trades and hedging against positions in related markets. Some firms are placing millions of orders a day across many markets. Scaling into a trade means to enter more than once, either at a better or worse price, and scaling out means to exit the trade in pieces. They are taking a casino approach, making a big number of small trades, each with a small edge, and this can result in tens or even hundreds of millions of dollars in profits each year.

All profitable traders, whether institutions or individuals, will only buy if they believe the probability of making a profit is greater than the probability of losing money. This is the “Trader’s Equation”: for a trade to be profitable, the probability of making a profit times the size of the profit (the reward, which is the number of ticks to the profit-taking limit order) has to be greater than the probability of losing times the size of the loss (the risk, which is the number of ticks to the protective stop). The risk and reward are known because the trader sets them; he decides where he will take his profit (his reward) and where he will take his loss (his risk).

The third variable is the one that causes the greatest problem for most new traders. They quickly discover that all of those books and courses that make trading look so easy hinge on a fallacy that there are a lot of perfect trades where the probability is high and the reward is much bigger than the risk. Perfect or nearly perfect trades cannot exist because every trade needs institutions on both sides.

If a trade is perfectly good for the buyer, it has to be perfectly bad for the seller, which means taking a low probability of winning where the risk is much bigger than the reward. No institution would ever take the other side of a perfect trade because it would lose money over time even if it occasionally won. The result is that no trade can be perfect. There has to be something in the trade for both the buying and selling institutions, the majority of which are profitable.

How can it happen that traders taking opposite sides of a trade can both make money? It comes down to trade-offs among the three variables in the trader’s equation: risk, reward and probability. You often hear about risk/reward ratios, but whenever you do, the author is implying the probability is high, which may or may not be the case.

Some trades are very high probability trades. For example, a high probability trade is where the market races up to your profit-taking limit order, but does not fill it, and then pulls back one tick. At this moment, you almost certainly will not change your order and will hold because you correctly believe the strong momentum will result in you getting filled within the next few seconds. That means you had to give up something on one or both of the other variables because otherwise you would have a perfect trade, which cannot exist.

What are you giving up with that high probability trade? Well, your reward is now only one tick, since you are trying to take profits one tick higher than the current price. This means that in exchange for your high probability, you are forgoing a big profit and are willing to take only a miniscule profit (see “High and low probability setups,” below). You are accepting a very small reward. Furthermore, you probably are relying on your stop, at least for the next several seconds, and your stop is probably many ticks away. Say your stop is six ticks below the current price. This means you are willing to assume a risk that is six times greater than your reward in exchange for a very high probability. You need to be about 90% confident for the “Trader’s Equation” to make this a worthwhile trade.
Traders never really have enough time to debate whether the probability is 90% at that instant, or if they just feel it is worth relying on the current stop and profit-taking orders for at least a few more seconds. Although it is not conscious, they have to believe they have a 90% chance of success to make this decision because that is the only rational basis for holding it. Does this make sense? Of course it does, and it is a decision all of us make whenever the market gets close to filling our profit objective.

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