Fundamental analysis is completely cut off from any trade decision and calculations, while traders rely exclusively on raw price data to identify trends and patterns for potential entry and exit points for their trades.
The basic idea behind price action trading is that historically price movements over a specific period show sign of repeated patterns, hence trends and reversals may be easier to spot. These patterns can be useful for future price predictions and movements. Price action traders may look for specific formations like:
Candlestick patterns: Traders can analyze price charts by checking visual representations of price movements over specific periods. At the same time, important prices and levels can be checked from open-close-high-low prices from candlesticks. Certain candlesticks (e.g. engulfing candlestick) can be useful for potential price movements.
Support and resistance levels: Traders can identify horizontal levels on a chart where the price of an asset can form support or resistance depending on the price movement.
Support levels are areas where the buying pressure may overcome the selling pressure, causing the price to bounce back up. On the other hand, resistance levels are areas where the selling pressure may overcome the buying one. Traders should always keep in mind any breakout scenarios too.
Trend lines: Trends can be spotted either by noticing higher highs or lower lows, while also checking the market’s volatility for the trend momentum. In case a trader identifies a trend, the main trading principle is to follow the direction of the trend, which is more likely to continue rather than the price to move against the trend.
Chart patterns: Price action traders can spot specific chart patterns, such as head and shoulders scheme, teacup formation, double tops/bottoms, etc and anticipate potential price movements.
Price action trading often comes with limitations and poor judgement. It can be subjective and different traders may interpret the same chart differently, leading them to take different trading decisions. Another limitation is that the strategy is based on pure historical data and prices, which may not be always a valid predictor for future outcomes and price movements.
Price action trading may be profitable and effective for short- and mid-term trading, but it would be wise to consider that it requires significant trading experience, skills in reading the charts, and discipline interpreting price movements. It is usual that professional traders often combine price action analysis with other forms of technical and fundamental analysis to result in more solid decision-making trades. As with any trading approach, risk management is crucial and a must have in place for a solid trading plan.
