How To Use Price Action To Trade Successfully

07/08/11 08:46:38 AM

by Billy Williams

Price action is the cornerstone to all trading systems and methods, but most traders lack an understanding of what it is and how to use it. Learning these core concepts can help you use price as an effective tool to profit in the market.

Security: CMG
Position: Hold

The ability to use price action for profitable trading is the foundation to every trading system or method. Price tells a tale to those traders who are experienced enough to know how to listen to it, which is through the price movement from past to present, revealing the most likely path it will move in the form of trends. Trends are to the trader what air is to the bird flying in the air -- it is the very thing that gives rise to a trader's investment capital. However, if you can't determine what the trend is and what the dominant forces are by using price action, then you are likely to travel a long hard road of frustrating losses and little progress.

Fortunately, there are a few key concepts to understanding price action that can help you grow in skill to identify trends, make more successful entries, and know at a glance whether you are to trade or stay out of the market entirely.

First, there is the First Corollary of trend trading which states that the larger time frames are more powerful than smaller time frames, while the Second Corollary of trading states that larger time frames identify the primary trend and smaller time frames identify the entry points. See Figure 1.

FIGURE 1: CMB. CMB finds support and then settles into a contracted price range before breaking a short-term trendline and moving upward. A primary intermediate-term trend forms, offering a second entry as another short-term trendline is broken as the bullsh intermediate trend goes on to make a series of higher highs and higher lows.

Graphic provided by: www.freestockcharts.com.

In addition to these corollaries of trading, you must also know the concept of expansion and contraction, which states that there are two types of price action: expansion and contraction. Expansion occurs when price is making a steady series of higher highs and higher lows in a bullish trend and lower highs and lower lows in a bearish trend.

Contraction occurs in the absence of any directional move -- either bullish and bearish -- and forms a trading range due to a lack of buyers or sellers to take control of the trend, leaving price to ebb back and forth between two price points that act as support and resistance until something breaks price out of this range.

When looking for trends to trade in the market, you must be aware that there are three types of trends to identify within their respective time frames: the long-term trend, the intermediate-term trend, and the short-term trend. The long-term trend forms over a period of months to over a course of years and is the preferred time frame for buy & hold investors in the stock market, the intermediate-term time frame spans from a matter of weeks to months going all the way up to about a year, making it the preferred time frame for swing traders, and short-term trends take place from as little as a minute up to a week and is common to daytraders in stocks, futures, and the forex.

Using price action, you would identify the dominant trend by going up one time frame to see what the trend is in the present, then drop down to the smaller time frame to find your entry point, and then ride the primary trend's direction until the smaller time frame's trend is broken by a larger amount of traders taking the other side of the trend and forcing price to reverse. If the primary trend is in place, you will wait for another entry to confirm on the smaller time frame, but until then, you can sit it out and wait in cash without being exposed to risk until the trend is back in your favor.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

Company:	StockOptionSystem.com

E-mail address:	stockoptionsystem.com@gmail.com
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How To Use Price Action To Trade Successfully

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