How to Spot Trends and Trend Reversals Using Price Action
Cory Mitchell, CMT
Price action traders believe the price tells you everything you need to know. And it's true. You don't make money off fundamentals, off indicators, or off statistics. Money is only made based on price movements. If you buy and the price goes up, you have a potential profit there. It doesn't matter if every indicator and every fundamental and economic figure says something should rise. If it doesn't, and you bought, there is no profit there.
Price action is king.
Analyzing price action is noting how the price is acting so we can choose when and what strategies we want to implement.
How to Analyze Price Action
The most basic concept of price action is that you wait for a move in a direction before acting.
- If the price is falling, it is falling. It doesn't matter if you think it should go up. Falling is falling, and rising is rising. Similarily, sideways is sideways, until it breaks out and starts rising or falling.
Price action traders always require price confirmation for whatever they do. If they want to buy, they wait for signs that the price is starting to rise.
Next, we need to understand trends.
- Trends are created because Trending waves are bigger than Correction waves. How do we know which waves are Trending and which waves are Corrections? By their relative size.
Trending waves need to be bigger than corrective waves, otherwise, no progress is made. When a corrective wave becomes as large as the last trending wave, that indicates a potential trend change or a sideways period. The former trend is in question because corrective waves need to be smaller for a trend to exist.
Each of these concepts is discussed in detail in the video.
Constantly analyze the size of price waves to help assess the strength of the trend, when the trend is in question, and when it is reversing.
- Waves can also be dissected into what I call wiggles or gyrations. They are the small oscillations within Trending and Corrective waves.
These wiggles can also be analyzed based on the size of their moves.
- If the trend is down (last Trending waves down), and we are correcting to the upside, we can watch for bigger moves down and smaller moves up in the wiggles. This helps indicate the correction is running out of steam and the downtrend may resume soon. Once the price starts dropping, the analysis is confirmed.
- If the trend is up (last Trending wave up), and we are correcting to the downside, watch for bigger moves up and smaller moves down in the wiggles. This indicates the downside correction is running out of steam and the uptrend may resume soon. The price must move to the upside to confirm the analysis.
To aid in all this, we can connect swing high points to other swing highs points, and swing low points to other swing low points. By connecting highs to highs and lows to lows, we can see how the angle of a trend changes, and we can see the change in trend more clearly and visually.
Applying Price Action Concepts to Trading
Generally, we want to take trades in the direction of the Trending waves. This is the trend direction. Trading in the direction of the biggest waves provides the biggest profit potential...because the waves are bigger. Correction waves are smaller, leaving less room for profit.
I may trade in both directions if the price is extremely volatile, and making sharp moves in both directions. The Trending waves may still be bigger, but in these conditions, Corrections may provide a lot of profit potential as well.
Once we have established the trend direction, this is typically the direction we want to be trading in.
We then watch the Corrections closely. Once the wiggles in the correction provide us with clues that the correction is running out of gas, we get ready to pounce. Once the price starts moving in the trending direction again, we enter a trade in the trending direction. This is a hard concept to depict and explain in single charts, so please see the video for loads of examples.
A stop loss is placed just outside the correction low/high.
This is where a strategy comes in. You can analyze the price action, but you need to define exactly what has to occur in order for a trade to trigger. Write down your rules for entry, your stop losses, your position size, what markets you can trade, when trades can be placed (on holidays? only during the US session? Only during the London session?) and any other factors that help you avoid any confusion while you are actually trading.
If you start trading based on price action and you are always asking yourself, "Is this a valid trade?" you haven't fine-tuned your strategy enough and you need to get more precise.
Practicing Price Action Analysis
Practicing price action analysis takes time, but it is not difficult. The trick is being able to analyze what is going on in the moment. This way, no matter what the price does, you know what you are going to do (or not do). You are always thinking ahead.
- Open up a random chart.
- Scroll back in time.
- Draw lines on the big waves (Trending) and small waves (Corrective).
- Connect swing highs to highs and swing lows to lows.
- Our main goal is to assess which direction we want to trade, and what will need to happen to get us into a trade.
- Note the trend direction. This is our trade direction, usually.
- Monitor pullbacks/corrections for trading opportunities. The wiggles often help determine when a correction is running out of steam. Or simply consider what would confirm the price is moving back in the trending direction (to warrant a trade)?
- Always be considering:
- What would need to happen to cause a trend reversal?
- What has to happen to indicate the correction is over?
- What has to happen to trigger me into a trade?
- Practice this on your chart, unveiling price action by scrolling to the right.
- As you get better, try practicing on real-time price data.
I dedicated an article to false breakouts. They are important to the price action trader. Occasionally, you will be monitoring a corrective wave. Let's say the trend is down and we are in a corrective upwave. The wiggles start to indicate it is topping out. We have gotten a larger wiggle to the downside, and smaller wiggles to the upside and the price is starting to drop again. Our strategy tells us to get short with a stop loss above the correction high.
The price spikes up, stopping us out, but then quickly starts falling again. Short it again!
False breakouts happen. We sometimes get a short-term price burst in the opposite direction, but if it quickly fails, and everything still points to lower prices, we want to get back into that trade. Price action is still indicating more downside.
Price Action Still Produces Losing Trades
As just discussed, trading based on price action doesn't mean we are always right. Actually, trading has nothing to do with being right or wrong. Trading is about following a strategy to make money over many trades. Any single trade result is inconsequential. Like any strategy, we are just waiting for signals that give us a profitable edge over many trades.
We can't control what the market does. All we can do is trade what comes. Sometimes we will have an amazing setup, and the price will go the other way. That doesn't mean we were wrong in our analysis. That's why we have a stop loss. PRICE IS NEVER SUPPOSED TO DO ANYTHING. IT JUST DOES WHAT IT DOES. We incorporate the new price move in our analysis and proceed. Expect NOTHING of price. Just track what it does and act accordingly.
Price action trading is about adaptability. Price moves may indicate a move down, but then we have a sharp move up. That can't be predicted. We can never predict with 100% accuracy. And we don't need to. Money is made by cutting losses and riding the trades that do work out.
When the price moves the other direction, that tells us something. Think about what it is telling you, objectively. Don't think about winning or losing. Just think about which way the price waves are moving. Plan what to do (or not do) whether the price rises or falls, in any situation.
If this all seems a little too hard, you can always use a more systematic way of price action trading. When the price moves a certain distance in one direction, enter in that direction. Exit if the price moves a certain amount in the other direction (a new trade may be opened in that direction as well). This type of strategy was discussed in the Renko Charts article.
By Cory Mitchell, CMT. Join the discussion in my free Facebook swing trading group.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.