Trading is an exciting but challenging affair. Success appears just around the corner for most traders, yet they often fail at the same mistake repeatedly that prohibits steady profitability. But mastering three fundamental price action rules has been, for most, the panacea to address common mistakes in trading.
In this article, we’ll explore these crucial rules, shared by Mike Bellafiore, co-founder of a leading proprietary trading firm in New York City and Miami. These principles address common trading challenges and provide actionable strategies to improve your edge in the market.
What Are The Challenges Every Trader Faces?
Some traders get sucked into costly errors: there are only a few, but they are very prevalent. These include the following:
Pre Mature Entries
Traders enter trades too early before the full development of the trade. Multiple failed attempts leave them with less chances to capitalize on it when it is at the right setup.
Lack of Defined Plan:
Entering trades based on an idea that a trader hasn’t defined well leads to confusion. Without a plan, a trader fails to be able to adapt if a trade does move against them or else invalidates the trade idea.
Poor Trade Entry:
Many traders are supposed to add to winners but still fail to do so. They either add at the wrong time, thus reducing the expected value of the trade, or they fail to add when the opportunity arises. This type of mismanagement often turns probable winners into losses or underwhelming gains.
These difficulties can occur, but there’s nothing beyond this. These mistakes can be eliminated and true potential released by simply applying the following three price action rules.
The 3 Important Price Action Rules
Rule 1: Learn to Trade Continuations
Most price action traders don’t make enough off continuations. Actually, they largely ignore continuations. Their focus is on breakouts and overextensions. The fact is most trends will continue after their first retrace. One type of continuation trade setup is the Touch and Go trade.
The trade is executed when the price retests a prior support or resistance level and resumes its trend.
How It Works:
- Use a higher time frame, like a 15-minute chart, to find a strong trend.
- Wait until the price retraces to a key level of support in an uptrend or resistance in a downtrend.
- Confirm the continuation using a lower time frame like a 1-minute or 2-minute chart.
Example: In a downtrend, the price breaks through support and then retraces to test the same level now acting as resistance. As the price resumes its downward movement, it is possible for the trader to enter a short position aiming for the next low, with a stop-loss placed above the retracement high.
Why It Works:
Humans are pattern-friendly and continuation trades take advantage of repeatable patterns in trends. Continuation trades are different from breakouts, which are inherently timing-dependent; therefore, a much more relaxed approach to entries is taken into consideration while leaning on the market’s momentum.
Rule 2: Always Start with Your Stop
A rule of successful trading is establishing your stop-loss before entering a trade. It not only makes risk management possible but also makes your trading decisions lucid and more methodical.
Importance of a Stop-Loss
- It holds significant losses by limiting downside risk.
- It makes sure you have a clear-cut risk-reward ratio, which is crucial for finding the EV of the trade.
- It takes away your emotion-related decision at the time of volatile market conditions.
How to Set Your Stop-Loss:
- Use price action to determine natural levels for your stop-loss. For example, a breakout trade or a Touch and Go, the stop-loss would be placed above the high of the retracement candle, for example, in a downtrend.
- Risk/reward use entry, stop-loss, and target levels to calculate the ratio. A balanced ratio 3:1 ensures that winners will outnumber losers over time.
Example: Suppose now a downtrend, where the price breaks through a support, drops down to the test of that level as resistance, and then continues descending again. If you enter the trade at the confirmation point, your stop loss has to be placed just above the retracement high, so you would incur minimal risk in case this trade fails.
By always starting with your stop you give yourself a well-disciplined framework by which you will trade. Not only is your capital protected, but it also sharpens your ability to be objective and make data-driven decisions.
Rule 3: Add to Winners Strategically
Adding to winning trades can significantly boost profitability, but it must be done with precision. Impulsive additions, driven by the fear of missing out or under-sizing, often lead to poor outcomes.
Guidelines for Adding to Winners:
- Wait for a New Setup: Increase only when a fresh setup develops, which presents a clear entry and stop-loss clearly.
- Do not Add Impulsively: Adding to a trade based on any of the following reasons creates distortion of risk-reward profile and increases exposure unnecessarily.
- Adding to a trade because it is profitable
- Adding to a trade because your entry size was too small
- Establish New Risk Parameters: Treat every addition as a separate trade with its own stop-loss and entry criteria.
Example: Consider this: suppose you’re selling a Touch and Go in a downtrend. After entering the trade, the price consolidates at a lower level, forming a pattern like a puppy dog consolidation pattern (a small range near the lows). This consolidation provides a new opportunity to add to the position as the price breaks lower. You can safely increase your exposure by setting a stop-loss above the consolidation high and entering on the breakout.
Practical Application: Bringing It All Together
Let’s summarize how these three rules interact with one another:
- Identify Continuation Trades: Add Touch and Go to your trading playbook for high-probability entries as the trend continues.
- Start with Your Stop: Determine your risk before entering a trade. This not only helps protect the capital but also gives you a means of calculating the expected value of the trade.
- Add to Winners Strategically: Wait for new setups within an existing trend to add to your position. Treat each addition as a separate trade to maintain discipline and manage risk correctly.
Conclusion
Trading success very much comes down to eliminating costly mistakes and simply making small, consistent improvements to your process. By mastering the three price action rules discussed in this article, you can overcome common challenges and unlock your full potential as a trader:
- Leverage continuation trades like the Touch and Go to capitalize on trending markets.
- Always start with your stop-loss to define risk and improve decision-making.
- Add to winning trades strategically to maximize profitability without increasing risk unnecessarily.
Implement these rules in your trading strategy, and you’ll be well on your way to achieving sustainable success. For more advanced strategies and tools to improve your edge, consider exploring proprietary resources like webinars and EV calculators to further refine your approach.