Chapter One
Price Action
For a trader, the fundamental issue that confronts him repeatedly throughout the day is the decision of whether the market is trending or not trending. If it is trending, he assumes that the trend will continue, and he will look to enter in the direction of the trend ("With Trend"). If it is not trending, he will look to enter in the opposite direction of the most recent move ("fade" or "Countertrend"). A trend can be as short as a single bar (on a smaller time frame, there can be a strong trend contained within that bar) or, on a 5-minute chart, it can last a day or more. How does he make this decision? By reading the price action on the chart in front of him.
The most useful definition of price action for a trader is also the simplest: it is any change in price on any chart type or time frame. The smallest unit of change is the tick, which has a different value for each market. Incidentally, a tick has two meanings. It is the smallest unit of change in price that a market can make, and it is also every trade that takes place (so if you buy, your order will appear on the Time and Sales table, and your fill, no matter how large or small, is one tick). Since price is changing with every tick (trade) during the day, each price change becomes an example of price action. There is no universally accepted definition of price action, and since you need to always try to be aware of even the seemingly least significant piece of information that the market is offering, you must have a very broad definition. You cannot dismiss anything because very often something that initially appears minor leads to a great trade. The broadest definition includes any representation of price movement during the course of trading. This includes any financial instrument, on any type of chart, in any time frame.
The definition alone does not tell you anything about placing a trade because every bar is a potential signal both for a short and a long trade. There are traders out there who will be looking to short the next tick, believing that the market won''t go one tick higher, and others who will buy it believing that the market will likely not go one tick lower. One side will be right, and the other will be wrong. If the buyers are wrong and the market goes one tick lower and then another and then another, they will begin to entertain the prospect that their belief is wrong. At some point, they will have to sell their position at a loss, making them new sellers and no longer buyers, and this will drive the market down further. Sellers will continue to enter the market, either as new shorts or as longs forced to liquidate, until some point when more buyers come in. These buyers will be a combination of new buyers, profit-taking shorts, and new shorts who now have a loss and will have to buy to cover their positions. The market will continue up until the process reverses once again.
Everything is relative, and everything can change into the exact opposite in an instant, even without any movement in price. It might be that you suddenly see a trendline seven ticks above the high of the current bar and instead of looking to short, you now are looking to buy for a test of the trendline. Trading through the rearview mirror is a sure way to lose money. You have to keep looking ahead, not worrying about the mistakes you just made. They have absolutely no bearing on the next tick, so you must ignore them and just keep reassessing the price action and not your profit and loss (P&L) on the day.
Each tick changes the price action of every time frame chart from a tick chart or 1-minute chart through a monthly chart, and on all charts, whether the chart is based on time, volume, the number of ticks, point and figure, or anything else. Obviously, a single tick move is usually meaningless on a monthly chart (unless, for example, it is a one tick breakout of some chart point that immediately reverses), but it becomes increasingly more useful on smaller time frame charts. This is obviously true because if the average bar today on a 1-minute Emini chart is three ticks tall, then a one tick move is 33 percent of the size of the average bar, and that can represent a significant move.
The most useful aspect of price action is watching what happens after the market moves beyond (breaks out beyond) prior bars or trendlines on the chart. For example, if the market goes above a significant prior high and each subsequent bar forms a low that is above the prior bar''s low and a high that is above the prior bar''s high, then this price action indicates that the market will likely be higher on some subsequent bar, even if it pulls back for a few bars near term. On the other hand, if the market breaks out to the upside, and then the next bar is a small inside bar (its high is not higher than that of the large breakout bar), and then the following bar has a low that is below this small bar, the odds of a failed breakout and a reversal back down increase considerably.
Over time, fundamentals control the price of a stock, and that price is set by institutional traders (like mutual funds, banks, brokerage houses, insurance companies, pension funds, hedge funds, and so on), who are by far the biggest volume players. Price action is the movement that takes place along the way as institutions probe for value. When they feel that the price is too high, they will exit or even short, and when they feel it is too low (a good value), they will go long or take profits on their shorts. Although conspiracy theorists will never believe it, institutions do not have secret meetings to vote on what the price should be in an attempt to steal money from unsuspecting, well-intentioned individual traders. Their voting is essentially independent and secret, and comes in the form of their buying and selling, but the results are displayed on price charts. In the short run, an institution can manipulate the price of a stock, especially if it is thinly traded. However, they would make relatively much less money doing that compared to what they could make in other forms of trading, making the concern of manipulation of negligible importance, especially in stocks and markets where huge volume is traded, like the Eminis, major stocks, debt instruments, and currencies.
Why does price move up one tick? It is because there is more volume being bid at the current price than being offered, and a number of those buyers are willing to pay even more than the current price if necessary. This is sometimes described as the market having more buyers than sellers, or as the buyers being in control, or as buying pressure. Once all of those buy orders that can possibly be filled are filled at the current price (the last price traded), the remaining buyers will have to decide whether they are willing to buy at one tick higher. If they are, they will continue to bid at the higher price. This higher price will make all market participants reevaluate their perspective on the market. If there continues to be more volume being bid than offered, price will continue to move up since there are an insufficient number of contracts being offered by sellers at the last price to fill the requests to buy by buyers. At some point, buyers will start offering some of their contracts as they take partial profits. Also, sellers will perceive the current price as a good value for a short and offer to sell more than buyers want to buy. Once there are more contracts being offered by sellers (either buyers who are looking to cover some or all of their long contracts or by new sellers who are attempting to short), all of the buy orders will be filled at the current price, but some sellers will be unable to find enough buyers. The bid will move down a tick. If there are sellers willing to sell at this lower price, this will become the new last price.
Since most markets are driven by institutional orders, it is reasonable to wonder whether the institutions are basing their entries on price action, or whether their actions are causing the price action. The reality is that institutions are not all watching AAPL or SPY tick by tick and then starting a buy program when they see a two-legged pullback on a 1-minute chart. They have a huge number of orders to be filled during the day and are working to fill them at the best price. Price action is just one of many considerations, and some firms will rely more on it, and others will rely on it less or not at all. Many firms have mathematical models and programs that determine when and how much to buy and sell, and all firms continue to receive new orders from clients all day long.
The price action that traders see during the day is the result of institutional activity and much less the cause of the activity. When a profitable setup unfolds, there will be a confluence of unknowable influences taking place during the trade that results in the trade being profitable or a loser. The setup is the actual first phase of a move that is already underway and a price action entry lets a trader just jump onto the wave early on. As more price action unfolds, more traders will enter in the direction of the move, generating momentum on the charts, causing additional traders to enter. Traders, including institutions, place their bids and offers for every imaginable reason, and the reasons are largely irrelevant. However, one reason that is relevant, because it is evident to smart price action traders, is to benefit from trapped traders. If you know that protective stops are located at one tick below a bar and will result in losses to traders who just bought, then you should get short on a stop at that same price to make a profit off the trapped traders as they are forced out.
Since institutional activity controls the move and their volume is so huge and they place most of their trades with the intention of holding them for hours to months, most will not be looking to scalp and instead they will defend their original entry. If Vanguard or Fidelity have to buy stock for one of their mutual funds, their clients will want the fund to own stock at the end of the day. Clients do not buy mutual funds with the expectation that the funds will day trade and end up in all cash by the close. The funds have to own stock, which means they have to buy and hold, not buy and scalp. For example, after their initial buy, they will likely have much more to buy and will use any small pullback to add on. If there is none, they will continue to buy as the market rises.
Some beginner traders wonder who is buying as the market is going straight up and also wonder why anyone would buy at the market instead of waiting for a pullback. The answer is simple. It is institutions working to fill all of their orders at the best possible price, and they will buy in many pieces as the market continues up. A lot of this trading is being done by institutional computer programs, and it will end after the programs are complete. If a trade fails, it is far more likely the result of the trader misreading the price action than it is of an institution changing its mind or taking a couple ticks of profit within minutes of initiating a program.
The only importance of realizing that institutions are responsible for price action is that it makes placing trades based on price action more reliable. Most institutions are not going to be day trading in and out, making the market reverse after every one of your entries. Your price action entry is just a piggyback trade on their activity, but, unlike them, you are scalping all or part of your trade.
There are some firms that day trade substantial volume. However, for their trades to be profitable the market has to move many ticks in their direction, and a price action trader will see the earliest parts of the move, allowing her to get in early and be confident that the odds of a successful scalp are high. That firm cannot have the market go 15 ticks against them if they are trying to scalp 4 or 8 ticks. As such, they will enter only when they feel that the risk of an adverse move is small. If you read their activity on the charts, you should likewise be confident in your trade, but always have a stop in the market in case your read is wrong.
Also, since often the entry bar extreme is tested to the tick and the stops are not run, there must be institutional size volume protecting the stops, and they are doing so based on price action. In the 5-minute Emini, there are certain price action events that change the perspective of smart traders. For example, if a High 2 long pullback fails, smart traders will assume that the market will likely have two more legs down. If you are an institutional trader and you bought that High 2, you do not want it to fail, and you will buy more all the way down to one tick above that key protective stop price. That institution is using price action to support their long.
The big legs are essentially unstoppable, but the small price action is fine-tuned by some institutional traders who are watching every tick. Sometimes when there is a 5-tick long failure setting up and the price just keeps hitting 5 ticks but not 6 where you can scalp 4 ticks out of your long, there will suddenly be a trade of 250 Emini contracts, and the price does not tick down. In general, anything over 100 contracts should be considered institutional in today''s Emini market. Even if it is just a large individual trader, he likely has the insight of an institution, and since he is trading institutional volume, he is indistinguishable from an institution. Since the price is still hanging at 5 ticks, almost certainly that 250 lot order was an institutional buy. This is because if institutions were selling in a market filled with nervous longs, the market would fall quickly. When the institutions start buying when the market is up 5 ticks, they expect it to go more than just 1 tick higher and usually within a minute or so the price will surge through 6 ticks and swing up for at least many more. The institutions were buying at the high, which means that they think the market will go higher and they will likely buy more as it goes up. Also, since 4-tick scalps work so often, it is likely that there is institutional scalping that exerts a great influence over most scalps during the day.
Traders pay close attention to the seconds before key time frames close, especially 3-, 5-, 15-, and 60-minute bars. This is also true on key volumes for volume bar charts. For example, if many traders follow the 10,000 shares per bar chart for the Ten Year Note futures contract, then when the bar is about to close (it closes on the first trade of any size that results in at least 10,000 shares traded since the start of the bar, so the bar is rarely ever exactly 10,000 shares), there may be a flurry of activity to influence the final appearance of the bar. One side might want to demonstrate a willingness to make the bar appear more bullish or bearish. In simplest terms, a strong bull trend bar means that the bulls owned the bar. It is very common in strong trends for a reversal bar to totally reverse its appearance in the final few seconds before a 5-minute bar closes. For example, in a strong bear, there might be a High 2 long setting up with a very strong bull reversal bar. Then, with 5 seconds remaining before the bar closes, the price plummets, and the bar closes on its low, trapping lots of front running longs who expected a bull trend reversal bar. When trading Countertrend against a strong trend, it is imperative to wait for the signal bar to close before you place your order, and then only enter on a stop at 1 tick beyond the bar in the direction of your trade (if you are buying, buy at 1 tick above the high of the prior bar on a stop).
What is the best way to learn how to read price action? It is to print out charts and then look for every profitable trade. If you are a scalper looking for 50 cents in AAPL or $2 in GOOG on the 5-minute chart, then find every move during the day where that amount of profit was possible. After several weeks, you will begin to see a few patterns that would allow you to make those trades while risking about the same amount. If the risk is the same as the reward, you have to win much more than 50 percent of the time to make the trade worthwhile. However, lots of patterns have a 70 percent or better success rate, and many trades allow you to move up your stop from below the signal bar extreme to below the entry bar extreme while waiting for your profit target to be reached, reducing your risk. Also, you should be trying to enter trades that have a good chance of running well past your profit target, and you should therefore only take partial profits. In fact, initially you should only focus on those entries. Move your stop to breakeven and then let the remainder run. You will likely have at least a couple of trades each week that run to four or more times your initial target before setting up a reverse entry pattern.
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Excerpted from Reading Price Charts Bar by Barby Al Brooks Copyright © 2009 by Al Brooks. Excerpted by permission.
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