“Trade what’s happening, not what you think is gonna happen.” – Doug Gregory
Price action trading is the process of reacting to current price to make entry, exit, and holding decisions. It is replacing opinions and predictions with valid signals. A signal is a quantified reason to enter a trade, stay in a trade, and exit a trade. A signal should either be based on back tests of historically price data showing an edge in the past or price action trading can be used to create good risk/reward ratios by setting stop losses and profit target on entries. Both ways can be valid while backtested strategies tend to be more mechanical and using risk/reward ratios tend to be more discretionary.
- An entry signal can be based on price alone or a technical indicator. An entry signal should give you a better chance of profits than randomness. Where you get in should have an edge whether you are buying a break out or a dip in price there should be a good reason for the entry.
- A stop loss should be placed at a price level that tells you that the trade is not going to work out. A stop loss is to keep your losses small so you have a better chance to be profitable. A stop loss helps you figure out the risk in your risk/reward ratio. The biggest thing that causes unprofitable trading are big losses, stop losses remove big losses from your sequence of trades.
- A trailing stop can be used to tell you when it may be time to take profits because a winning trade may be reversing against you. It is also useful to maximize gains. When a trade moves in your direction you turn your initial stop loss into a trailing stop by rising the price level you will exit at to a higher price to both avoid giving back too many open profits and to have an exit strategy for when the trend bends.
- A profit target can be the technical level that your trade begins to have a bad risk/reward ratio due to the extension of price into overbought territory or an extension from a normal trading range. A profit target for price helps you determine if the risk is worth the potential reward.
Trading price action requires a quantified system that you create when the market is closed to use when the market is open. Your system has to be something you believe is a profitable process based on your data. It must meet your own risk tolerance levels and potential goals for returns.