TRADE PARAMETERS FOR DIFFERENT MARKET CONDITIONS
TRADE PARAMETERS FOR DIFFERENT
MARKET CONDITIONS
MARKET CONDITIONS
After having gone through the emergence of the foreign exchange market, who the major players are, significant historical milestones, and
what moves the markets, it is time to cover some of my favorite
strategies for trading currencies. However, before I even begin going over
these strategies, the most important first step for any trader, regardless of
the market that you are trading in, is to create a trading journal.
KEEPING A TRADING JOURNAL
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Through my experience, I have learned that being a successful trader is
not about finding the holy grail of indicators that can perfectly forecast
movements 100 percent of the time, but instead to develop discipline. I
cannot overemphasize the importance of keeping a trading journal as the
primary first step to becoming a successful and professional trader. While
working on the interbank FX trading desk at J. P. Morgan and then on the
cross-markets trading desk after the merger with Chase, the trading journal mentality was ingrained into the minds of every dealer and proprietary
trader on the trading floors, regardless of rank. The reason was simple: the
bank was providing the capital for trading and we needed to be held accountable, especially since each transaction involved millions of dollars.
For every trade that was executed, we needed to have a solid rationale as
well as justification for the choice of entry and exit levels. More specifically, you had to know where to place your exit points before you placed
the trade to approximate worst-case losses and to manage risk.
With this sort of accountability, the leading banks of the world are
able to breed successful and professional traders. For individual traders,
this practice is even more important because you are trading with your
own money and not someone else’s. For interbank traders, when it comes
down to the bottom line, it is someone else’s money that they are trading with and regardless of how poorly they might have performed over the
prior two weeks, they will still be receiving a paycheck twice a month. At
a bank, traders have plenty of time to make the money back without any
disruptions to their daily way of life—unless of course they lose $1 million in one day. As an individual trader you do not have this luxury. When
you are trading with your own money, each dollar earned or lost is your
money. Therefore, even though you should be trading only with risk capital, or money that would not otherwise be used for rent or groceries, one
way or the other, the pain is felt. To avoid repeating the same mistakes
and taking large losses, I cannot stress enough the importance of keeping a
trading journal. The journal is designed to ensure that as a trader you take
only calculated losses and you learn from each one of your mistakes. The
trading journal setup that I recommend is broken up into three parts:
1. Currency Pair Checklist.
2. Trades That I Am Waiting For.
3. Existing or Completed Trades.
Currency Pair Checklist
The first section of your trading journal should consist of a spreadsheet that
can be printed out and completed every day. This purpose of this checklist
is to get a feel for the market and to identify trades. It should list all of the
currency pairs that are offered for trading in the left column, followed by
three columns for the current, high, and low prices and then a series of
triggers laid out as a row on the right-hand side. Newer traders probably
want to start off with following only the four major currency pairs, which
are the EUR/USD, USD/JPY, USD/CHF, and GBP/USD, and then gradually
add in the crosses. Although the checklist that I have created is fairly detailed, I find that it is a very useful daily exercise and should take no more
than 20 minutes to complete once the appropriate indicators are saved on
the charts. The purpose of this checklist is to get a clear visual of which
currencies are trending and which are range trading. Comprehending the
big picture is the first step to trading successfully. Too often I have seen
traders fail because they lose sight of the overall environment that they
are trading in. The worst thing to do is to trade blindly. Trying to pick
tops or bottoms in a strong trend or buying breakouts in a range-bound environment can lead to significant losses. For trending environments, traders will find a higher success rate by buying on retracements in
an uptrend or selling on rallies in a downtrend. Picking tops and bottoms
should be a strategy that is used only in clear range-trading environments,
and even then traders need to be careful of contracting ranges leading to
breakout scenarios.
The first two columns after
the daily high and low prices are the levels of the 10-day high and low. Listing these prices helps to identify where current prices are within previous
price action. This helps traders gauge whether we are pressing toward a
10-day high or low or if we are simply trapped in the middle of the range.
Yet just the prices alone do not provide enough information to determine
if we are in a trending or a range-bound environment. The next five indicators provide a checklist for determining a trending environment. The more
X marks in this section, the stronger the trend.
FIGURE EUR/USD Three-Year Chart
The first column in the trending indicator group is the “ADX (14) above
25.” ADX is the Average Directional Index, which is the most popularly
used indicator for determining the strength of a trend. If the index is
above 25, this indicates that a trend has developed. Generally speaking, the
greater the number, the stronger the trend. The next column uses Bollinger
bands. When strong trends develop, the pair will frequently tag and cross either the upper or lower Bollinger band. The next three trend indicators are
the longer-term simple moving averages (SMAs). A break above or below
these moving averages may also be indicative of a trending environment.
With moving averages, crossovers in the direction of the trend can be used
as a further confirmation. If there are two or more Xs in this section, traders
should be looking for opportunities to buy on dips in an uptrend or sell on
rallies in a downtrend rather than selling at the top and buying back at the
bottom of the range.
The last section of the trading journal is the range group. The first indicator is once again ADX, but this time, we are looking for ADX below
25, which would suggest that the currency pair’s trend is weak. Next, we
look at the traditional oscillators, the Relative Strength Index (RSI), and
stochastics. If the ADX is weak and there is significant technical resistance
above, provided by indicators such as moving averages or Fibonacci retracement levels, and RSI and/or stochastics are at overbought or oversold
levels, we identify an environment that is highly conducive to range trading.
Of course, the market overview sheet is not foolproof, and just because you have numerous X marks in either the trend group or the range
group doesn’t mean that a trend will not fade or a breakout will not occur.
Yet what this spreadsheet will do is certainly prevent traders from trading
blindly and ignoring the broader market conditions. It will provide traders
with a launching pad from which to identify the day’s trading opportunities.
Trades That I Am Waiting For
The next section in the trading journal lists the possible trades for the day.
Based on an initial overview of the charts, this section is where you should
list the trades that you are waiting to make. A sample entry would be:
April 5, 2005
Buy AUD/USD on a break of 0.7850 (previous day high).
Stop at 0.7800 (50-day SMA).
Target 1—0.7925 (38.2% Fibonacci retracement of Nov.–Mar. bull
wave).
Target 2—0.8075 (upper Bollinger).
Target 3—10-day trailing low.
Target 3—10-day trailing low.
Therefore, as soon as your entry level is reached, you know exactly
how you want to take action and where to place your stops and limits. Of
course, it is also important to take a quick glance at the market to make
sure that the trading conditions that you were looking for are still intact.
For example, if you were looking for a strong breakout with no retracement
to occur at the entry level, when it does break, you want to make sure that
the scenario that you were looking for plays out. This exercise is used to
help you develop a plan of action to tackle your trading day. Before every
battle, warriors regroup to go over the plan of attack; in trading you want
to have the same mentality. Plan and prepare for the worst-case scenario
and know your plan of attack for the day!
Existing or Completed Trades
This section is developed and used to enforce discipline and to learn from
your mistakes. At the end of each trading day, it is important to review
this section to understand why certain trades resulted in losses and others
resulted in profits. The purpose of this section is to identify trends. I will
use a completely unrelated example to explain why this is important. On a
normal day, most people will subconsciously inject a lot of “ums” or “uhs”
into their daily conversation. However, I bet most of these people do not
even realize that they are even doing it until someone records one of their
conversations and plays it back to them. This is one of the ways that professional presenters and newscasters train to kick the habit of using placeholder words. Having worked with more than 65,000 traders, too often have
I seen these traders repeatedly make the same mistakes. This could be taking profits too early, letting losses run, getting emotional about trading,
ignoring economic releases, or getting into a trade prematurely. Having a
record of previous trades is like keeping a recording of your conversations.
When you flip back to the trades that you have completed, you have a perfect map of what strategies have or have not been profitable for you. The
reason why a journal is so important is because it minimizes the emotional
component of trades. I frequently see novice traders take profits early but
let losses run. The following are two samples of trade journal entries that
could provide learning opportunities:
February 12, 2005
Trade: Short 3 lots of EUR/USD @ 1.3045.
Stop: 1.3095 (former all-time high).
Target: 1.2900.
Result: Trade closed on Feb. 13, 2005—stopped out of the 3 lots @
1.3150 (–105 pips).
Comments: Got margin call! EUR/USD broke the all-time high, but I
thought it was going to reverse, and did not stick to stop—kept letting
losses run, until eventually margin call closed out all positions. Note to
self: Make sure stick to stops!
April 3, 2005
Trade: Long 2 lots of USD/CAD @ 1.1945.
Stop: 1.1860 (strong technical support—confluence of 50-day moving
average and 68% Fibonacci retracement of Feb.-Mar. rally).
Target: First lot @ 1.2095 (upper Bollinger and 5 pips shy of 1.2100
psychological resistance).
Second lot @ 1.2250 (former head and shoulders support turned resistance, 100-day SMA).
Result: Trade closed on Apr. 5, 2005—stopped out of the 2 lots at
1.1860 (–85 pips).
Comments: USD/CAD did not continue uptrend and was becoming
overbought; I didn’t see that ADX was weakening and falling from
higher levels and that there was also a divergence in stochastics. Note
to self: Make sure to look for divergences next time!
Unlike many traders, I believe the best trades are where both the technical and fundamental pictures are telling the same story. In line with this
premise, I prefer to stay out of trades that contradict my fundamental outlook. For example, if there is a bullish formation in both the GBP/USD
and the AUD/USD due to U.S. dollar weakness, but the Bank of England
has finished raising interest rates, while the Reserve Bank of Australia has
full intentions of raising rates to tame the strength of the Australian economy, I would most likely choose to express my bearish dollar view in the
AUD/USD rather than the GBP/USD. My bias for choosing the AUD/USD
over the GBP/USD would be even stronger if the AUD/USD already offered
a higher interest rate differential than the GBP/USD. Too often have I seen
technicals thwarted by fundamentals, so now I always incorporate both
into my trading strategy. I use a combination of technical, fundamental,
and positioning and am generally also a trend follower. I also typically use
a top-down approach that involves the following:
- First I will take an overall technical survey of the market and pick the currency pairs that have retraced to attractive levels for entry in order to participate in a medium term trend.
- For currencies with a dollar component (i.e., not the crosses), I determine if my initial technical view for that pair coincides with my fundamental view on the dollar as well as my view on how upcoming U.S. releases may impact trading for the day. The reason why I look at the dollar specifically is because 90 percent of all currency trades involve the dollar, which makes U.S. fundamentals particularly important.
- If it is a cross-currency pair such as GBP/JPY, I will proceed by determining if the technical view coincides with the fundamental outlook using Fibonacci retracements, ADX, moving averages, oscillators, and other technical tools.
- Then I like to look at positioning using the FXCM Speculative Sentiment index to see if it supports the trade.
- If I am left with two equally compelling trade ideas, I will choose the one with a positive interest rate differential.
HAVE A TOOLBOX—USE WHAT
WORKS FOR THE CURRENT
MARKET ENVIRONMENT
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Once you have created a trading journal, it is time to figure out which indicators to use on your charts. The reason why a lot of traders fail is because
they neglect to realize that their favorite indicators are not foolproof. Buying when stochastics are in oversold territory and selling when they are in
overbought territory is a strategy that is used quite often by range traders
with a great deal of success, but once the market stops range trading and
begins trending, then relying on stochastics could lead to a tremendous
amount of losses. In order to become consistently profitable, successful
traders need to learn how to be adaptable.
One of the most important practices that every trader must understand is to be conscious of the environment that they are trading in. Every trader needs to have some sort of checklist that will help them to
classify their trading environment so that they can determine whether the
market is trending or range-bound. Defining trade parameters is one of
the most important disciplines of trading. Too many traders have tried to
pick the top within a trend, only to wind up with consistently unprofitable
trades.
Although defining trade parameters is important to traders in any market (currencies, futures, equities), it is particularly important in the currency market since over 80 percent of the volume is speculative in nature. This means that currencies can spend a very long time in a certain trading
environment. Also, the currency market obeys technical analysis particularly well given its large scale and number of participants.
There are basically two types of trading environments, which means
that at any point in time an instrument is either range trading or trending.
The first step every trader needs to take is to define the current trading
environment. The shortest time frame that traders should use in step one
is daily charts, even if you are trading on a five-minute time frame.
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