The entire stock market is built around price, making it the stock market indicator that always has the last word. Here’s a look at how to analyze price action.
As a technical trader, I talk and write about technical and sentiment indicators a lot. Knowing how to spot and analyze patterns based on past market behavior helps me find high-probability trades.
Price is the stock market indicator that always has the last word
A few of my favorite indicators could be aligned, yet if price action doesn’t agree with what they’re saying, I will not place the trade.
Hence many traders (myself included) refer to price action as the king of all indicators. Without solid price action in either direction, you will never have a winning trade on your hands.
How to analyze price action
When price action is aligned with technical indicators, I have greater confidence in making a trade.
(Will that trade always work out? Of course not. There are no guarantees in the stock market!)
Here’s a rundown of the process I use to analyze price action and technical indicators:
Step 1: Identify a strong daily trend on the price chart
I’m looking for a clear move higher or lower on price. Is the stock or index making higher highs and higher lows in a bullish move over the past few weeks? Or is it making lower highs and lower lows, indicating a bearish move to the downside?
Step 2: Analyze the volume
Volume is the queen of indicators, because it tells you how strong or weak the price action is and how much conviction the buyers or sellers actually have.
To understand volume, I look at two things:
- Volume prints on a raw and accumulative basis – volume that is three to five times higher than normal indicate heavy institutional buying or selling.
- Accumulation of volume days – the stronger volume is over days, the stronger the price trend is important as it tells us how the trend of buying/selling is going.
Step 3: Look for followthrough on price
This is when I look for chart patterns. Here are two that are considered bullish:
- W pattern – this forms when a stock drops to a (price) bottom, rallies up to resistance, tests that bottom again, and moves past resistance to new highs. And yes, it looks like a “W” on the chart. The opposite of this, the M pattern, is a bearish signal.
- The golden cross – this occurs when the 50 day moving average moves above the 200 day moving average.(Moving averages tell you the price trend over a time period – 20 days, 50 days, 100 days, etc.) The opposite of this is the bearish death cross.
Step 4: Analyze the MACD
The MACD measures a price trend’s momentum. It tells us the trajectory of the trend before (not after) it actually occurs. This is powerful information.
When the MACD crosses above the signal line, that’s a buy signal. If it crosses below, that’s a sell signal. When it makes these crosses, I look for confirmation in the next day or two that this is a new trend.
Step 5: Look at relative strength
The relative strength indicator (RSI) tells me if a stock’s price is in an uptrend or downtrend.
If the stock is in an uptrend, the RSI will remain above 30. If it’s in a downtrend, it will most likely hover around 30 or fall below that level.
Step 6: Consider money flow
Money flow is a fantastic indicator, because it tells me how much money is flowing into or out of a stock. In other words, are traders buying or selling the stock – and how aggressively are they doing so?
It’s measured on a scale of 0 to 100. If a reading is at an extreme (above 80 or below 20), it’s a sign the current price trend could be about to reverse.
Step 7: Analyze option activity
Option flow is a bit different from money flow. This indicator tells me if institutions like banks and hedge funds are buying or selling positions in the name ahead of an expected short term move or if they are simply hedging their bets. Their trading volume is large enough that price will absolutely be affected, though it’s often over weeks, not days.
As you can imagine, when a lot of money is involved, buying or selling is backed up by data that you and I don’t have access to. But, again, there’s no guarantee. I find this indicator is correct about 70% of the time, which is pretty good odds.
Step 8: Assess the stock’s market condition
In other words, I want to know if the stock is overbought or oversold. Either condition tells you that traders have become too bullish or too bearish on a stock.
An overbought stock can stay that way for a while. The price might keep going up or might hold steady. Of course, you never know when sellng is going to commence.
An oversold stock usually doesn’t stay that way for long. Eventually, traders and investors will decide the price is a bargain and start scooping it up, pushing the price higher.
Remember, overbought and oversold are conditions and NOT signals to buy or sell. If you’ve been taught that, time to un-learn it.
But can you time a change in price?
The answer is not often, and not with any consistency.
I have said many times that trying to time a stock’s top or bottom is a fool’s game. If you time it just right once or twice, you might think you have stumbled up on a magic formula. Instead, you have gotten lucky.
If it was easy to time a change in the price’s trend, I’d be a billionaire. Most traders would.
You can find clues, though, that will help you determine if price is going to change direction. I like to use these three indicators:
Volume weighted average price (VWAP)
This indicator tells me the average price a security has traded at throughout the day. I want to see if a price has overcome resistance, which means it is likely to move higher.
Put/call ratio
Are traders buying more puts (a bearish sign) or calls (a bullish sign)? More puts versus calls (or vice versus) tells me the price trend is about to shift direction.
The McClellan oscillator
The McClellan oscillator is pretty accurate in telling me when the market is at extreme overbought levels (sell!) or extreme oversold levels (buy!).
Confirm price action before making that trade!
If you’re sitting on the fence over whether or not to place a trade, always go back to price action. Price is not emotional. It’s simply data.
And because the entire stock market is based on price, always let it have the last word.
If you enjoyed this deep dive into analyzing price action, you may be interested in our ebook, The Ultimate Guide to Stock Technical Indicators. I cover the indicators listed above, plus several others, in much more detail.
