Price action trading: The basics

August 23, 2014 07:00 PM

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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. 

Ulterior motives

While there always has to be an institution taking the opposite side of every trade, it is not as simple as saying that the instant your trade pulled back one tick, an institution shorted with the intention of doing the opposite of you. If such a theoretical institution existed, it would be giving up probability to attain a high profit relative to the size of its risk, which can make sense if the three variables are the right size. 

Rather, think of the opposite side as being made up of a pool of institutions, all of which have tested algorithms and concluded that their combination of risk, reward and probability has a profitable “Trader’s Equation.” Some of those bears want high probability, which means that their reward will be small compared to their risk; they might short and sell higher. A different bear might take the opposite side of your trade by structuring a trade that favors reward at the expense of risk and probability. It does not matter.

However, it is important to be comfortable believing that at every instant there is a way to structure both a long and a short trade that have positive “Trader’s Equations.” This is true even in the strongest trends. This frees you from only considering one direction and forces you to remember you are trading in a market where both the bulls and bears make money. It is possible to either buy or sell at any instant and make money if you structure the trade correctly. You also have to take enough trades; you can even lose on most of your trades if your winners are big enough.


New eras

A common topic is whether computers and cultural differences have changed the way markets behave. I have studied charts going back 100 years, and have traded since 1987. If you remove labels from charts, you can’t tell if the chart is from 1910 or 2010 or if it is a five-minute forex chart or a monthly Dow chart.

How can computers not have affected the price action? It clearly has some effect, but algorithms simply look for logical patterns and then structure trades where there is a mathematical edge. That is what all traders have done in all markets since the beginning of time.

Trading has always been part of civilization and crucial to the survival of society. The more fit traders have an advantage. Trading is genetically rooted, and computers simply move trading further along the evolutionary path. This is why the charts are the same as they were 100 years ago and why the charts of all markets and all time frames look the same and always will.

Traders learn early on that it is difficult to make money and the sense that the edge is small. They then naturally think of ways to increase their edge. One is to use indicators, like the ones they see in all of the ads online and in the magazines.

If trading is moving toward perfection, how can anyone make money? Simple. We live in a competitive world, and some will always be better than others. Better traders will always have an edge, which is a mathematical advantage, and they will make more than everyone else. What about the argument that trading is a zero-sum game and that no one can ever really make money long term? Over the next day or two, trading is essentially a zero-sum game. However, the world economy has been growing at about 3% a year forever, and this means there is 10-times more money in the world today than in 1987, and 100-times more than in 1927. The pie will always grow, so everyone can have a piece; the better traders will have the biggest pieces.

Reductio ad absurdum 

“If I can make more money on the five-minute than on the daily chart, then I surely can make much more on the one-minute chart.”

This logic ignores the practical limitations of the human brain. We are not computers, and we have real time limits for our ability to process information and make decisions accurately. If we do not have enough time, we are more likely to make bad decisions. For most traders, they should trade charts that have no more than 20 bars per hour. Most should trade a five-minute chart or an even higher time frame.

What looks obvious on a printed chart after the close, when you can see all of the bars to the right of your signal bar, is usually not obvious in real time. Also, a bar often looks far different in the second that it closes than it did even one second earlier. This means a trader has much less time than what he might believe when he looks at a chart at the end of the day. 

“If I can make money when scalping for 20 ticks, I can make even more if I take far more trades, scalping for one to three ticks!”

This is another fallacy that I see promoted on different websites; it is an example of theory colliding with reality. Not only is there the problem of our inability to process information accurately when we have to decide too quickly, there are the additional problems of slippage, spreads and commissions.

Most traders cannot trade E-minis for less than about $5 round turn commissions. If they scalp for one point, their net profit is $45 when they win and their net loss is $55 when they lose. If they scalp for one tick, then they make $7.50 on their winners and lose $17.50 on their losers. They usually have to give up one tick when they enter and another when they exit. This means the market has to move three ticks for them to make one. They almost always have to risk at least two to four ticks.

Let’s say a trader is trading the five-minute chart and risks three ticks, $37.50; he needs the market to move three ticks in his direction before it moves three ticks against him. When he is right, he will net $7.50, assuming there is no slippage and he never makes mistakes. When he is wrong, he will lose $37.50, or five times more. He has to be right 80% of the time just to break even. And that is not just on the next three trades for the next three days. It is for the rest of his career. Yes, theoretically it’s possible. Paul Rotter supposedly made millions scalping for three ticks in forex, but it is so difficult and unrealistic that traders should not try it. 


Fair targets

If a three-tick goal is too small, what is reasonable? It varies with every market, but traders can quickly figure it out by looking at the price action. If there are a lot of six-tick moves in the E-mini, then a lot of traders and computers are scalping for four ticks. (If they enter on a stop one tick beyond the signal bar, the market usually has to move five more ticks to secure a four-tick move). If there are a lot of 22¢ moves on crude oil, many are scalping for 20¢. If there are a lot of 12-pip moves in the EUR/USD, then traders are scalping for 10 pips. If a trader is looking at limit order sets, everything will be one tick less. For example, if there are a lot of nine-tick moves in the E-mini, then many traders are scalping for two points (eight ticks).

Because scalping is extremely difficult to do profitably long term, most traders should look for trades where the reward is at least twice as big as the risk. If a trader thinks he needs a 20-pip stop in the EUR/JPY, he should plan to hold for a 40-pip profit. During strong breakouts, the momentum is strong, which means the probability of follow through is high. In these cases, the probability of a profitable trade is 60% or more, which means it is mathematically reasonable to scalp for a reward that is the same as the risk, instead of two times bigger. If he risks $2 in a gold breakout, he can exit with a $2 profit and still have a mathematically sensible trade.

There is a little more to this because the initial risk is not the same as the actual risk, and the profit target usually should be based on the actual risk. If a trader initially risks 50 pips in a EUR/USD trade and the market went against him for 12 pips and then quickly went his way, he now knows he had to risk only 13 pips to avoid being stopped out. This means his actual risk was only 13 pips, not 50 pips. All of the computers can detect this, and many will then adjust their profit targets based on this actual risk. This means many will take partial profits at 13 ticks, where you will often see a small pullback from the profit taking.

Why choose a reward that is two times the risk for most trades? Because most traders are never too confident about their assessment of the probability when they enter a trade. Remember, there has to be something in it for the institution taking the opposite side of your trade. It has to be able to make a profit if it structures the trade correctly, which often means it will scale in.

The institution thinks its side is good, and you think yours is good. The result is that we trade in a gray fog. However, at almost every instant in every market, the probability that the next five ticks will be up rather than down is between 40% and 60%. If you buy or sell at any time and hold for a reward that is about the same size as your risk, you will have at least a 40% chance of success. If you plug 40% into the “Trader’s Equation,” you will see that you will need to hold for a reward that it at least twice as big as your risk to make a reasonable profit over time. Bottom line: You are always going to be uncertain when you enter, but if you always try for a reward that is twice as big as your risk, the math is on your side. 

Also, whenever you have a profit that is twice as big as your risk, you can always exit. The math always is good for this approach. If the trend is strong, the math is in your favor if you hold for a bigger profit, but it is always mathematically reasonable to exit part or all of any trade once the profit is twice the risk. Also, if the trade is a high probability trade (60% or more) it is mathematically reasonable to exit part or all of the position once the profit gets as large as the risk. 


The next article will cover the folly of fundamentals and indicators as well as scaling into trades.


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. He also provides live intraday E-mini price action analysis and free end-of-day analysis at www.BrooksPriceAction.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.