When it comes to technical analysis, the foundation of the entire subject hinges on price action, or changes in an asset’s value over time. Apart from providing numerous insights about price momentum, identifying key levels, and giving a visual display of how volatility is changing, price action gives a good idea of where buyers and sellers are active along with clues about potential turning points in trends. On its own, price action can provide a wellspring of potential information when it comes to identifying and taking advantage of trading opportunities.
Measuring Price Action
Charts are by and large the simplest ways for investors to view how an asset’s price is changing over time. Besides giving a visual representation of how prices are trending over a defined period of time, charts are also a real-time graphic depiction of the interaction between supply and demand, or buyers and sellers. When there is a greater demand for an asset, or the buyers overwhelm the sellers in a marketplace, the price of an asset increases over time. Conversely, the when supply, or sellers overwhelms demand and the buyers, the price of an asset decreases over time.
One of the most popular ways to visualize price action are the Japanese candlesticks. Similar to bar charts, a candlestick incorporates the open and closing prices as well as the highs and lows. The candlestick has two major components, the body of the candle and the wicks. The body of candle shows the open price and closing price during the time period measured by the candlestick. The wicks show the high and low prices during the same period. The shorter the distance between the wicks, the more limited the volatility during the period, whereas a longer candlestick from wick to wick would imply higher volatility. Longer bodies are indicative of stronger directional price action and shorter bodies suggest weaker momentum.
Aside from volatility, the candlestick also gives information about the strength of a trend. If the trend is making new highs or lows, a long candlestick bar would indicate a strong trend where as a smaller candlestick would indicate a weaker trend. Additionally, a candlestick may give useful information about where support and resistance lie, especially if an asset has difficulty overcoming or falling below certain levels. This is valuable information about the strength of a trend and when the price action might potentially reverse because of strong buying support or selling resistance. If an asset fails to make new highs or lows around these levels, it could suggest an optimal place to establish bullish or bearish positions anticipating a reversal.
Placing Your Trades Using Price Action
If using a trend following strategy, reviewing the price action and the strength or weakness of an asset will be helpful in determining turning points and potential pullbacks to enter into bullish or bearish positions. Candles with shorter wicks and longer bodies are moving in the same direction indicates a strong trend with positions to be taken during a pullback from the prevailing trend.
Price action can also be useful for spotting reversals and changes in trends based on the highs and lows. Candlesticks with long wicks and nearly the same opening and closing prices (narrow candlestick body) indicate that the price action was very volatile with neither the buyers or sellers taking charge. Higher volatility almost always accompanies a change in direction. If this volatile candle occurs near a support or resistance level and the trend fails to reach new highs or lows, it suggests a great place to establish a position running counter to the earlier trend.
In the case that an uptrend fails to overcome resistance and volatility is high, this might be an opportunity to set bearish positions. Conversely, a downtrend that fails to make new lows or cross below a defined support level might suggest an opportunity to establish bullish positions.
Price action tells us more than just if an assets price is increasing or decreasing. Price action can be used to describe momentum, volatility, important levels, and the strength of trend, each of which are helpful tools when structuring a potential trade. No matter if the strategy is to follow trends or wait for reversals, analyzing price action gives investors the tools to make better informed decisions and take action when opportunities appear.