TRADE PARAMETERS FOR DIFFERENT MARKET CONDITIONS

TRADE PARAMETERS FOR DIFFERENT
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 

TABLE  Currency Checklist


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.

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:

  1. 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.
  2. 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.
  3. 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.
  4. Then I like to look at positioning using the FXCM Speculative Sentiment index to see if it supports the trade.
  5. 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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