Profiting From A Price Action Study – Part 1

Mark Thomas — Trade On Track

This is the first part in a new article series where we study how price moves and how we can profit from the results of what we uncover. This topic of “price action” was inspired by a report that was recently sent to me called “Predicting Price Action”, written by Scott Owens with Omer Lizotte in November 2004 (it can be found here). That report is obviously dated, and its methods and results were questionable. So, this article series will expand on this report, bringing it up to date with more recent backtesting, and explaining in more detail how we can profit from the results found.

The basic question we are trying to answer in our price action study is, “how likely is it that price will continue to move in a particular direction and to certain levels?”. If price starts moving up or down, we are going to analyze what the probability is of price continuing in that up or down direction. We should be able to use this information to build a profitable trading strategy from scratch, or to assist us in making existing strategies more profitable.

Let me give an example: if we find that price breaks past a previous level (perhaps a high or closing price) by 15 pips, we could analyze historical price action to determine how often price kept going to a 30 pip level, or to a 50 pip level or beyond. This would give us a probability (as a percentage), as to how likely price is going to continue past the 15 pip break-out point to higher levels. We’ll need to introduce some rules in our analysis, such as a stop loss point, otherwise we could be waiting forever to see if price ends up going past our break-out point.

By going back through historical price data, we should be able to calculate some decent statistics as to these price continuations. If we can find, for instance, that price continues to a 40 pip level after breaking through a 15 pip trigger level 70% of the time, and that’s with a 20 pip stop loss, then we could formulate a profitable trading strategy from those statistics.

The original “Predicting Price Action” report attempted to do this type of thing by presenting probability figures on a number of different currency pairs, over a number of different time periods. At first glance, the figures looked extremely promising. For example, they stated that on a 1hr EUR/USD chart, if price broke a previous close by 15 pips, it was 72.4% likely to continue to a 40 pip level without hitting a 20 pip stop loss. So, without taking spread into account, it looked like we could make 25 pips (40 – 15) 72% of the time while risking 20 pips. That’s a reward:risk ratio of 5:4 with a 72% win rate. That’s pretty good, considering the only criteria for entering and exiting a trade is price – there is no need for any other indicators.

There were others who read this and did their own testing and got nowhere near those reported results though. The way the results were calculated was not totally clear, a little ambiguous if you like. For instance, was the 20 pip stop loss level calculated from the original ‘break’ point, or from the trigger level (15 pips past the break point)? Another question raised was: is the trigger only determined at the close of a bar (IE. the close is 15 pips beyond the previous close), or is it triggered as soon as price goes 15 pips past the previous close?

I can’t be sure exactly how the probability results were calculated in that original study, but it doesn’t really matter because I’m going to do my own research, calculate my own probabilities, and publish the results in this article series. I’m confident that we will be able to find some favorable results, particularly on the higher time frames, which we’ll be able to use to design a trading strategy that is profitable in the long term.

Price action is often an underestimated component in technical analysis. However, it can and probably should be the foundation for any decent trading strategy, because in the end, price is what we are trading. In the next article I will explain exactly what historical data we’ll be using, what currency pair we’ll be focusing on, what bar periods and also what trigger and target levels we’ll be working with to study our price action continuations.