Multiple tools exist for analyzing stocks (or any other market), and while no single tool is perfect, analyzing price action is the purest form of analysis since ultimately price is what creates profits and losses. Two keys to analyzing price action are speed and size; these relate to how fast a price wave is moving (speed) and how much distance a price wave covers (size). Using just these factors much can be determined about whether a trend is likely to continue, is slowing down, or is likely to reverse.
Analyzing Price Action: Trends
Prices move in trends, creating impulse waves and corrections. Impulse waves are the larger waves moving in the overall trend direction, while corrections are smaller waves that move against the trend direction. The impulse waves being larger than the corrections is what allows a trend to make progress.
These concepts even apply to ranges. When the corrections are the same size as the impulse waves, the price is ranging.
Charts courtesy of FreeStockCharts.com.
Traders typically focus on trading trends since they offer the most profit potential. It then becomes a question of how to analyze trends in order to determine if it is a good time to enter a trade, stay in a trade, or get out. Determining the speed and size of impulses and corrections aids in this regard.
Analyzing Price Action: Size
When analyzing price action there are no absolutes; current price waves must always be considered in the context of (relative to) other price waves around it.
When there’s a large price wave in the trending direction it typically confirms the trend. When pullbacks are relatively small, compared to the impulse waves in the trending direction, this also confirms the trend.
A larger corrective wave against the trend (as big or bigger than the impulse moves) indicates a reversal, or at least that a deep pullback is likely underway.
If the impulse waves of the trend are continually getting smaller, then the trend is losing momentum. This will typically result in divergence on technical indicators such as the MACD or RSI. It may regain momentum, but right now it is showing signs that the trend is weakening. This occurs in figure 2. in March and April, before the trend has a deeper correction and then ultimately moves into a range.
Analyzing Price Action: Speed
The speed of a price wave isn’t as important as the size, but is used in conjunction with size to further analyze the price action.
Speed is how fast the price covers a distance. It is not absolute, but rather is always relative to prior waves. Some stocks always move quickly, while other stocks always move slowly, but if a “quick stock” moves quicker or slower than normal, that’s important information.
Fast movements are noteworthy and show that traders have a strong interest, relative to price moves that are slow. When the price moves slowly there is no urgency; quick price moves show urgency.
Therefore, small pullbacks that are also slow moving (hesitant) confirm the current trend direction. Large and fast price moves in the trending direction confirm the trend is healthy because it shows traders are eager to jump in on the current trend.
A price move that is both large and moving quickly confirms the trend more so than a price move that is only large, or only fast. In figure 2., the impulse wave in April decreases not only in size, but it also takes longer (slower) for the price to move higher. This doesn’t guarantee that the price will reverse, but it is a strong warning sign that the trend is slowing down and is therefore more likely to reverse because buyers are no longer as eager to buy the stock.
A large and fast price move (relative to prior price waves) in the opposite direction of the trend is a strong indication that the trend is reversing, and the direction of the new large and fast move will be the new trending direction.
The One Exception
Typically, large and fast price moves in the trending direction confirm the trend. One exception is when an extremely large and fast price move occurs, much bigger and faster than the price waves around it. This can often mean rampant speculation has taken over, and the extremely strong move actually indicates an end to the trend, not a continuation. This is common in commodity markets, such as the massive surges in silver and gold in 2011 which ended those multi-year bull markets.
Currency markets, individual stocks, and stock indexes—like the 2000 “dot.com” peak— also see such moves. Buyers or sellers plow in with such ferocity that they completely exhaust themselves and there is no one left to continue pushing the price in that direction—a reversal is imminent.
How to Trade with Size and Speed
Analyzing price action in this manner is not a strategy. It does not tell you where to enter or where to place stop-losses or target orders. Instead, it is used in conjunction with a strategy to let you know in which direction you should be trading, and when you should pass on a trade if conditions look unfavorable.
If price action confirms the trend is up and strong, then favor strategies which give you buy signals. If price action indicates the uptrend has reversed, then favor strategies which give sell/short-sell signals. If price action indicates the price is an a range, use range-trading strategies.
The size and speed concepts can be applied to all time frames. Therefore, while analysis is conducted on daily charts in the examples above, the same analysis could be done on one-minute or weekly charts. Being aware of the size and speed of price moves on different time frames will give you a more complete picture of trends, ranges and potential reversals.
The Bottom Line
Analyzing price action doesn’t require indicators, it is simply identifying impulse and corrective waves based on how large the waves are and how quickly they move. The size of a price wave is most important. Large price waves help confirm the trend, while a large wave in the opposite direction indicates a reversal (on that time frame). Speed is used in conjunction with size to help gain additional insight on whether the trend is accelerating or slowing down. Extreme moves may indicate a reversal.