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What is price action and chart pattern?

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Forex and crypto trading
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Lesson 1

Price action is a form of technical analysis that traders use to identify when to enter and exit the market. Forex and crypto traders use price action methods, such as analysing trend lines, support and resistance levels, and chart patterns.

By learning price action, you can increase your insights about the market as a whole, thus making the odds in your favour when you trade forex pairs or cryptocurrencies.

For most beginners in forex and crypto trading, price action is often intimidating. However, learning price action methods could be a game changer for many traders who have been struggling to make consistent profits.

Many technical traders combine indicators, such as Bollinger bands, Moving Averages and Stochastic Oscillators, hoping to obtain reliable signals on the next price direction. The auto-trading robots are also based on similar math formulas.

Price action traders, on the other hand, do not use any indicators. Instead, they analyse clean charts. They draw support/resistance levels, trend lines and chart patterns to identify possible reversal or trend continuation.

What is price action analysis?

Price action analysis focuses on the past price movements and how they correlate with the present moment. Based on the past data, traders can identify important support and resistance levels, which will help them in their trading decisions.

There is considerable subjectivity involved in everyone’s price action analysis, and what is an important support/resistance level for one, could be indifferent for others. The analysis also depends on the chart timeframe and whether you use candlesticks or area charts.

The depth of analysis, of course, depends on the trader’s experience and screen time on the charts. There are traders who overstate the game by continually adding indicators until they can’t see the actual price. Some price action traders also tend to lose themselves in fancy drawings.

You can look at price action as a form of art trading, but in the end, what is the point of all these butterflies and diamonds on the chart if you can’t tell where the price is heading.

In our view, price action should simplify our decisions rather than complicate them. In this article, we focus on the most important aspects of price action:

  • Support and Resistance
  • Trend lines
  • Chart patterns

Support and Resistance

support and resistance levels

Support and resistance levels form the most basic aspect of price action. These are areas of supply and demand. When demand overwhelms supply, or vice versa, support and resistance levels are formed, respectively.

Traders look for different ways to identify potential support and resistance levels. Some use Fibonacci retracements or Pivot points, and others simply analyse the past lows and highs on the chart.

Trend lines

trend lines

Trend lines, as the name suggests, are used to determine the trend. The basic principle of trend lines is to connect consecutive highs or lows to form a falling (trend) line or a rising (trend) line, respectively.

Trend lines work similarly to support and resistance. They identify potential areas of supply and demand. Traders often wait for a trend line to be broken and retested to ascertain a change of trend or a correction to the trend.

Channels

price channels

The channels are usually created by two trend lines, one connects the price highs and the other the price lows. Traders plot two trend lines to form a price channel. Thus, you see the upper and the lower boundary of a channel.

When price breaks a falling price channel or a rising price channel, quite often, price fails to reach the opposite end of the channel. This can be a precursor to a potential change in the trend.

Chart Patterns

In addition to support/resistance levels and trend lines, price action traders analyse chart patterns to decide when to open and close positions. The patterns are usually simple geometric shapes, such as triangles or rectangles. Chart patterns are analysed because these pattern formations tend to produce the same outcomes.

As a trader, you are mostly interested in continuation and reversal patterns. When you analyse chart patterns, you obviously want to know whether the price will reverse or the trend continue after a pullback. To better visualize the patterns, traders use different drawing tools, such as trend lines, horizontal lines and parallel channels.

Continuation patterns

continuation pattern

The continuation patterns usually indicate the price will continue in the previous trend direction. These are called retracements as the price retraces before it continues in the major trend direction. The most popular continuation patterns include triangles, flags and pennants.

Reversal patterns

reversal pattern

When you identify reversal patterns on the chart, you can expect the trend to change direction. Some of the reversal chart patterns that are definitely of interest are double tops and bottoms, head and shoulders and cup and handle.

When these pattern formations are completed, the trader waits for breakouts to open a short or long position accordingly. It is up to the trader to build his or her own trading style based on chart pattern formations. Some traders also analyse Japanese candlestick patterns, such as the doji candle, harami pattern and pin bars.

Price action analysis works because the market has a memory, which means the chart patterns repeat themselves in time periods. If you compare it to technical indicators, the price action analysis would definitely give you more insights into the forex and crypto markets. However, price action should not be considered the Holy Grail of technical analysis as the markets can turn irrational.

The markets are often moved by individuals, and you can’t know what is going on in everyone’s mind. With price action, you can analyse the collective behaviour, which includes all participants in the market. By learning chart patterns, you can’t expect to profit on every trade, but you can put the odds in your favour.