Financial markets possess inherent volatility. They host a variety of participants, each with distinct goals. This diversity generates continuous buying and selling pressures, resulting in price fluctuations. Moreover, investor sentiment heavily influences financial markets and causes share prices to react to news and rumours.
By keenly observing these price actions, traders can identify certain patterns or formations and predict future price movements. Let us understand the concept of price action patterns in detail and learn how to use them.
What are price action trading patterns?
Price action patterns are formations based exclusively on the price movements of an asset. Being an integral part of technical analysis, they help traders in predicting:
- Future price movements, and
- Market direction
We can divide price action patterns into two broad categories, which are:
Candlestick patterns
- These are formations made by one or more candlesticks on a price chart.
- Some popular examples include:
- Bullish and bearish engulfing patterns
- Morning star candlestick pattern
- Doji candlestick pattern
- Hammer candles
Chart patterns
- These are formations created by the movement of prices over time.
- Some popular examples include:
- Heads and shoulders patterns
- Triangles
- Rectangles
- Flags and pennants
Why traders use price action patterns matter in trading?
One of the primary advantages of using price action patterns is that it helps traders identify trends in the market, whether they are:
- Upward
- Downward, or
- Sideways
Furthermore, they help in:
| Parameters | Determining entry and exit points | Confirming signals |
| Meaning | An observation of price action patterns helps identify entry and exit points. | Price action patterns act as confirmation signals for other
|
| Example |
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Hypothetical example showing usage of price action trading patterns
Let us understand the practical usage of a popular price action trading pattern—the Doji candlestick pattern—using a hypothetical example.
The scenario
- You are a technical analyst and observed a Doji pattern on a daily candlestick chart.
- This indicates that:
- During the trading session, the opening and closing prices were very close
- Neither buyers nor sellers were able to gain control
- There exists market uncertainty
- You interpreted Doji as a potential reversal signal that appeared after a prolonged uptrend
- Recognising a possible trend reversal from bullish to bearish, and vice versa, you adjusted your positions.
Adjusting positions
Post-spotting a trend reversal, you decided to adjust your positions in the following ways:
Reduce position size
- You reduced the size of your positions to:
- Minimise potential losses, or
- Lock in profits
Partial profit taking
- You took partial profits on existing positions to book unrealised profit.
- At the same time, you retained some exposure to potential market movements.
Initiate new positions
- You decided to open new positions based on the anticipated trend reversal.
- For example,
- While transitioning from a bullish to a bearish trend, you:
- Initiated a short position, or
- Purchased put options
What is the role of psychology in price action trading patterns?
In price action trading, human psychology plays an important role as it revolves around interpreting market movements. See how some common emotions significantly impact trades:
| Emotions | Impact |
| Greed |
|
| Fear |
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| Overconfidence |
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How to develop a strong trading psychology?
An accurate prediction of price action patterns and rational decision-making is possible only when you develop a strong trading psychology. Let us see how you can do it:
Self-awareness
- Understand your:
- Strengths
- Weaknesses, and
- Emotional triggers
- Recognise how emotions affect your decision-making process.
Mindfulness
- Practice mindfulness techniques to stay present and focused during trading.
- This will help you in:
- Avoiding impulsive decisions, and
- Maintaining clarity in your analysis
Acceptance of uncertainty
- Acknowledge that trading is risky and that losses are part of the process.
- Develop resilience to bounce back from setbacks
- Learn from your trading mistakes
Risk management
- Implement risk management practices to protect your capital and minimise losses.
- Mostly, this includes:
- Setting stop-loss orders
- Managing position sizes, and
- Diversifying your portfolio
Journaling
- Keep a trading journal to track your:
- Trades
- Emotions, and
- Thoughts
- Do this tracking before, during, and after each trade.
- Review your journal continuously to identify:
- Patterns
- Strengths, and
- Areas for improvement
Conclusion
Price action patterns are often considered the language of the market. Based on fluctuations in asset prices, they help traders predict price movements and spot emerging trends. These patterns are broadly classified into two categories: candlestick patterns, like Doji, hammer candles, and Morningstar, and chart patterns, like triangles, flags, and pennants.
Furthermore, traders must develop strong trading psychology to make accurate predictions using price action patterns. Some common human emotions like fear, greed, and overconfidence significantly impact the ability to interpret and lead to poor trading outcomes.
