Learn to Read ‘Price Action’

If I handed you a book and said that it had information in it that could potentially make you a great deal of money I’ll assume you’d open it with great anticipation. You might think “I’ll just read the book and start making money right away, what could be easier than that?” You open the book and you see this on the first page:

“WTF is that? I thought the book would be written in my native language! What am I supposed to do with this?” Now, here’s my question for you: are you willing to take the time to learn an entirely new language or would you rather just pay someone to translate it for you? Of course, the problem with that is, if you can’t read it, how can you know if the person you’re paying can actually read and understand the content or are just pretending to in order to sell you their service? There is a simple solution to that dilemma, learn to read price action for yourself!

Below I’ll discuss several of my “X” posts from this past week about how I was interpreting the price action with the goal of helping you understand what was happening in the present and what was likely to happen in the future. There will never be certainty about future price action based on past price action but we can find areas on a chart where price has reached good trade location. We can then monitor price to see how it reacts in those areas to form opinions and trade based on a directional bias.

Below is a 30-minute chart of the Russell 2000 futures, /RTY. It has the 3SMA bands on it which I can use to determine the current trend. The upper band is the 3-period simple moving average of the prior candle’s high and the lower band is the same of prior candle’s lows. That helps me interpret the current trend but is just one piece of the puzzle. I also often use the 8SMA bands for the same purpose. When price breaks up and away from a rising upper band it’s considered to be strong buying demand and that trend should continue…if only it was that easy!

The next concept you must learn is how important Fibonacci (Fib) retracements and extensions are for translating price action and finding good location to place a trade. The 2 most important Fib retracements are the 50% and the 61.8% levels. They are the most important because many (most) algorithmic trading programs rest orders at those 2 levels. /RTY had been in a downtrend on the daily chart so even though the 30-minute chart looked bullish the daily chart was bearish. Placing the Fib retracements resistance zones on the prior 2 declines (1-2, 3-4) showed a confluence of resistance at 2280-86. I could know, with certainty, that there would be resting sell orders there. What I’ll never know is whether or not those sell orders would be strong enough to turn price back down. Still, that area is good location to place my order to go short with a stop above that area if price doesn’t turn down. That way I’m trading in sync with the algos!

Below is the 30-minute /RTY chart again to see how it reacted to that 2280-86 Fib resistance zone. The high of that 30-minute uptrend was 2286.10 and price strongly reversed and moved down. Great, so all you need to do is trade the Fib retracement zones and become rich! Nope, it’s not going to be that easy! Again, what that Fib zone represents is GOOD LOCATION for a trade. Sorry for yelling that but it’s that important to understand the concept. Often price will reverse in a 50%-61.8% Fib zone but sometimes it doesn’t. Even if it doesn’t you’re getting extremely important price action information that can be traded on. If, in this case, the algo sellers couldn’t reject price then it would be an indication that buyers are stronger and price is likely to continue moving higher with at least a retest of the prior high being the likely outcome! If price moves above that Fib resistance zone (breakout) but then falls back below it (failed breakout) then the buyers aren’t strong and that’s very bearish meaning price is likely to move back to the prior low. That Fib resistance area is what I refer to as the bull/bear level. Bullish above and bearish below that level. Again, think in terms of good trade location!

Below is the 30-minute chart of SPY. Price made a high and dropped down to #1 otherwise known as wave 1 (borrowing a Elliott Wave term). Following the low at wave 1, as price begins to rally, I wait and place no trades. What I’m waiting for is for price to reach good location for a short (bearish) trade at the Fib resistance zone. Another price action clue is that while price was rallying from the wave 1 low it was staying mostly inside the 3SMA bands. When price is in a strong rally price moves up and away from the rising upper band and typically spends much of it’s time trading above the upper band. That is clearly not what’s happening here. So I’m watching only a moderately strong rally develop and waiting for it to move into that Fib resistance zone to place a bearish trade. It’s a good time to point out that the best traders are also the best at WAITING! Sorry for shouting again but that’s another really important point! My favorite saying is Don’t chase…wait for the retrace(ment)!!!

Following the waves 1 & 2 I then use a Fib extension to set a target area for the completion of wave 3. The most common target, in my experience, is the 123.6% Fib extension. The second most common is the 100% extension. Yesterday’s decline barely paused at either of those levels which was an indication of how strong the selling was. I wouldn’t be at all surprised if SPY continued lower on Monday but price is no longer at good location to be adding short Deltas (bearish). The retracement back up in wave 4 is one more good trade location to trade short before a likely stronger rally occurs. At this point I’m still short Deltas but have hedged several of my positions so that I don’t give back much of my gains if/when price has it’s next rally.

Now I’d like to review some of this week’s posts that I made on “X”. This isn’t where I pat myself on the back for making bold, and sometimes correct, predictions! I never know what price is going to do so I NEVER use the word prediction! There I go with the yelling again. Sorry. What I can know, with absolute certainty, is where good trade location is. I don’t know how price will resolve at that location so I structure my option trades to risk little and potentially make a lot. More about that later.

I sold my GOLD Calls when, even though price was in a uptrend on the daily 3SMA bands, it clearly was forming a bearish reversal candle (long upper wick) near the 61.8% Fib retracement of the prior significant decline. Did I ‘know‘ that was the end of the rally? I did not. Did I ‘know‘ that was an area where the rally was likely to end? I did indeed. That’s why I sold my Calls.

Below shows the price action on the day following my sale of the Call options. Now, what if price rallies back above that bearish reversal candle high? Well then, it’s likely that the sellers have failed and price is heading higher again. Would I buy more Calls on that breakout? No, because I buy retracements to GOOD TRADE LOCATION, not breakouts at bad trade location. (I promise that’s the last time I’ll yell at you.)

The X post below was describing the weak momentum rally in TSLA followed by what looked like a potential bearish reversal. Even though that potential bearish reversal wasn’t all that bearish (closed as a green candle) the upper wick was decently long, and again, that candle was preceded by a very weak momentum rally so using a cheap OTM (out of the money) bearish trade initiated the day following that reversal candle at the 61.8% Fib retracement was a decent trade location. The stop on that trade would be above the 367.34 high of that reversal candle. Price opened the next day at 361.51, moved up to 362.30 and then spent the rest of the day selling off. What was the 61.8% Fib level? 362.12! So a short taken at 362.12 had a .18 drawdown and, at the low of the day, a 14.12 gain.

Below is what TSLA did the following day. So, a short taken at 362.12 with a stop at 367.35 would have a .18 drawdown and a 24.32 gain as of Friday’s close.

NVDA post on X.

A post about my hard and soft stops. The hard stop is always .01 above the potential reversal candle’s high but I also have soft stops where price doesn’t reverse but spends a relatively long period of time (several hours on a daily chart) trading above the 61.8% Fib retracement.

Below is the current NVDA chart. Price never triggered the hard stop above 143.44 nor did it spend much time above the 61.8% Fib resistance level.

Now on to the actual trading. Yes, it’s extremely important to understand price action and identify GOOD TRADE LOCATION (dammit I said I wasn’t going to yell again) but structuring the trade is even more important. You saw the SPY chart where I showed good trade location, well, below is where I show a good trade structure for a bearish trade using SPX (SPY’s big brother). Risk $2.30 to potentially make 10x-20x or more. The long Put has a lower IV (implied volatility) than the short Put so it’s relatively cheap. I like cheap option structures. You should too.

As of yesterday’s close the SPX Put Diagonal spread was up 137% over the initial cost. It could now be rolled down into a Calendar spread (selling the Mar17 SPX 5825 Put / buying the Mar17 SPX 5800 Put) for a $3.40 credit which would leave me owning a Calendar spread for a net $1.10 credit. That would mean the least I could make on the trade is $110 and the most would likely be in excess of $2,000. Nice reward/risk, yes?

Back to some price action. Below are 2 X posts regarding the ongoing rally to new highs in /ES (SPX futures). Previously I was quite bullish on the prospects for a strong push up into new ATH’s (all time highs) going into typically bullish Feb MOPEX (monthly option expiry). It made sense since the prior rally highs were stacking up which sets the table for price to push through the first level triggering the buy stops of traders who were short and that buying-to-cover triggering another rally triggering more short covering triggering a another rally triggering… (well, you get the idea, right?) Whenever highs, or lows, stack up in close proximity to each other, a ‘firecracker’ effect is a strong potential outcome. IF the /ES buyers were motivated in continuing the rally the opportunity was there for the taking! So what happened? Maybe there weren’t many shorts there? When shorts build up it becomes fuel for a rally. That’s why a high number of shorts is bullish, not bearish. When there aren’t many shorts, that’s generally bearish. I think that’s what we saw happen!

Regardless of the reason, clearly the bulls weren’t strong enough to take out those levels as price just lingered inside those prior highs. At that point on February 19th I was flipping from bullish to bearish /ES based on that lack of follow thru.

Below is the current /ES daily chart following Friday’s close. Should anyone be surprised that Friday was a bad day for the bulls, especially following Thursday’s price action slipping back below all 3 days prior highs? The buyers were clearly not motivated, wouldn’t you agree?

How about a different version of a similar effect? Price rising without being able to extend up and away from prior lows? AAPL daily chart. Do you see why I got short prior to Friday’s close? The best location to get short would be on Monday at Friday’s potential bearish reversal candles’ 246.96-247.36 Fib resistance zone but I was ok with getting good, not great, location for this short. Hard stop above Friday’s 248.69 high.

The target for a bearish trade is the Fib support zone of the prior rally in the 230-234 area. I utilized a ‘cheap’ (what a surprise) OTM Put Diagonal spread that I bought for $.80

2/24 Update: SPX rallied today following last week’s dump. I posted the chart (below) on X to ‘interpret’ the current price action. I use the word interpret intentionally since the title of the post refers to price action as if it’s a foreign language that you’re not familiar with! Again, you should never expect to predict future price action, the best you can hope for is to better understand the current price action in order to form a future expectation! If you can master that and learn to structure trades that would benefit from that expectation while maximizing reward/risk then you’ll find trading becomes a whole lot easier.

The text on the chart explains the principal idea of how SMA bands, whether 3, 8, 20 or whatever time frame you prefer to study, can help indicate how weak or strong a current trend is because a weak trend is much more likely to reverses than a strong one is. That understanding also helps with the expectation of whether or not a Fib resistance or support level is likely to hold or fold. A weak trending instrument is much more likely to reverse at a Fib level than a strong trending one!

Below are 2 trades that I made this afternoon based on the above chart. They’re both SPX 10-point wide short Call Diagonals initiated for a credit. This morning’s rally on the 30-minute chart started out relatively strong but soon exhibited the signs of weak buying momentum. By mid-day the candles were trading inside the 3SMA bands and the bands started to flatten, and then rollover, as price started taking out prior candle lows and started a downtrend. The short Call Diagonal that’s done for a credit can be both a bullish and bearish trade. It’s bearish initially because it’s short Deltas but, as time passes and the short options approach expiry, it can become quite bullish if price is below the short option’s strike. So, instead of using the 3SMA bands rolling over as a opportunity to take a strictly bearish trade I instead used them to take a not bullish trade for today (and hopefully the next few days). I hope this illustrates what I mentioned above that it the combination of reading price action and designing good trade structures that make for a successful option trader!

And below are my fills.

Finally (for today) I’ll share 2 X posts regarding META. My question to you after you’ve looked at the 2 posts is: why are you making this so hard? I mean, RSI, MACD, Bollinger Bands, Stochastics and paid subscriptions to services that use those indicators. Do they offer you anymore than what you can see on your own?

…and 3 days later, this.

I’m sure I’ll add more updates but if you have comments or questions, leave them down below.