From the July/August 2014 issue of Futures Magazine • Subscribe!

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). 

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