STEP ONE—PROFILE TRADING ENVIRONMENT
There are many different ways that traders can determine whether a currency pair is range trading or trending. Of course, many people do it visually, but having set rules will help to keep traders out of trends that may be fading or to prevent traders from getting into a range trade in the midst of a possible breakout.
ADX (Average Directional Index) Less Than 20 The average directional index is one of the primary technical indicators used to determine the strength of a trend. When ADX is less than 20, this suggests that the trend is weak, which is generally characteristic of a range-bound market.
TABLE Trend/Range Trading Rules
An ADX less than 20 and trending downward provides a further confirmation that the trend not only is weak, but will probably stay in a range trading environment for a while longer.
Decreasing Implied Volatility There are many ways to analyze volatility. What I like to do is actually track short-term versus long-term volatility. When short-term volatility is falling, especially after a burst above long-term volatility, it is usually indicative of a reversion to range trading scenarios. Volatility usually blows out when a currency pair experiences sharp, quick moves. It contracts when ranges are narrow and the trading is very quiet in the markets. The lazy man’s version of the way I track volatility is Bollinger bands, which provide a fairly decent measure for determining volatility conditions. A narrow Bollinger band suggests that ranges are small and there is low volatility in the markets, while wide Bollinger bands are reflective of large ranges and a highly volatile environment. In a range trading environment, we are looking for fairly narrow Bollinger bands ideally in a horizontal formation similar to the USD/JPY chart.
Risk Reversals Flipping between Calls and Puts A risk reversal consists of a pair of options, a call and a put, on the same currency.Risk reversals have both the same expiration (one month) and the same sensitivity
FIGURE USD/JPY Bollinger Band Chart
TABLE Risk Reversals
JC = Japanese Yen Call
EC = Euro Call
SP = Sterling Put
SC = Sterling Call
CC = Swiss Call
to the underlying spot rate. They are quoted in terms of the difference in volatility between the two options. While in theory these options should have the same implied volatility, in practice these volatilities often differ in the market. Risk reversals can be seen as having a market polling function. A number strongly in favor of calls or puts indicates that the market prefers calls over puts. The reverse is true if the number is strongly in favor of puts versus calls. Thus, risk reversals can be used as a substitute for gauging positions in the FX market. In an ideal environment, far out-ofthe-money calls and puts should have the same volatility. However, this is rarely the case since there is generally a sentiment bias in the markets that is reflected in risk reversals. In range-bound environments, risk reversals tend to flip between favoring calls and puts at nearly zero (or equal), indicating that there is indecision among bulls and bears and there is no strong bias in the markets.
What Does a Risk Reversal Table Look Like? According to the risk reversals we can see that the market is strongly favoring yen calls (JC) and dollar puts over the long term. EUR/USD shortterm risk reversals are near zero, which is what you are looking for when profiling a range-bound environment. The most readily available free resource that I know of for up-to-date risk reversals is the IFR news plug-in which can be found on the FX Trading Station.
ADX (Average Directional Index) Greater Than 20 As mentioned earlier when we talked about range trading conditions, the Average Directional Index is one of the primary technical indicators used to determine the strength of a trend. In a trending environment, we look for ADX to be greater than 25 and rising. However, if ADX is greater than 25 but sloping downward, especially off of the extreme 40 level, you have to be careful of aggressive trend positioning since the downward slope may indicate that the trend is waning.
Momentum Consistent with Trend Direction In addition to usingADX, I also recommend looking for a confirmation of a trending environment through momentum indicators. Traders should look for momentum to be consistent with the direction of the trend. Most currency traders will look for oscillators to point strongly in the direction of the trend. For example, in an uptrend, trend traders will look for the moving averages, RSI, stochastics, and moving average convergence/divergence (MACD) to all point strongly upward. In a downtrend, they will look for these same indicators to point downward. Some currency traders use the momentum index, but only to a lesser extent. One of the strongest momentum indicators is a perfect order in moving averages. A perfect order is when the moving averages line up perfectly; that is, for an uptrend, the 10-day SMA is greater than the 20-day SMA, which is greater than the 50-day SMA. The 100-day SMA and the 200-day SMA are below the shorter-term moving averages. In a downtrend, a perfect order would be when the shorter-term moving averages stack up below the longer-term moving averages.
Options (Risk Reversals) With a trending environment, we are looking for risk reversals to strongly favor calls or puts. When one side of the market is laden with interest, it is usually indicative of a strongly trending environment or that a contra-trend move may be brewing if risk reversals are at extreme levels.
STEP TWO—DETERMINE TRADING TIME HORIZON
Once you have determined that a currency pair is either range-bound or trending, it is time to determine how long you plan on holding the trade. The following is a set of guidelines and indicators that I use for trading different time frames. Not all of the guidelines need to be met, but the more guidelines that are met, the more solid the trading opportunity.
Intraday Range Trade
- Use hourly charts to determine entry points and daily charts to confirm that a range trade exists on a longer time frame.
- Use oscillators to determine entry point within range.
- Look for short-dated risk reversals to be near choice.
- Look for reversal in oscillators (RSI or stochastics at extreme point).
- It is a stronger trade when prices fail at key resistance or hold key support levels (use Fibonacci retracement points and moving averages).
Indicators Stochastics, MACD, RSI, Bollinger bands, options, Fibonacci retracement levels.
Medium-Term Range Trade
- Use daily charts.
- There are two ways to range trade in the medium term: position for upcoming range trading opportunities or get involved in existing ranges: Upcoming range opportunities: Look for high-volatility environments, where short-term implied volatilities are significantly higher than longer-term volatilities; seek reversion back to the mean environments. Existing ranges: Use Bollinger bands to identify existing ranges.
- Look for reversals in oscillators such as RSI and stochastics.
- Make sure ADX is below 25 and ideally falling.
- Look for medium-term risk reversals near choice.
- Confirm with price action—failure at key range resistances and bounces on key range supports (using traditional technical indicators).
Indicators Options, Bollinger bands, stochastics, MACD, RSI, Fibonacci retracement levels.
Medium-Term Trend Trade
- Look for developing trend on daily charts and use weekly charts for confirmation.
- Refer back to the characteristics of a trending environment—look for those parameters to be met.
- Buy breakout/retracement scenarios on key Fibonacci levels or moving averages.
- Look for no major resistance levels in front of trade.
- Look for candlestick pattern confirmation.
- Look for moving average confluence to be on same side of trade.
- Enter on a break of significant high or low.
- The ideal is to wait for volatilities to contract before getting in.
- Look for fundamentals to also be supportive of trade—growth and interest rates. You want to see a string of economic surprises or disappointments, depending on directional bias.
Indicators ADX, parabolic stop and reversal (SAR), RSI, Ichimoku clouds (a Japanese formation), Elliott waves, Fibonacci.
Medium-Term Breakout Trade
- Use daily charts.
- Look for contraction in short-term volatility to a point where it is sharply below long-term volatility.
- Use pivot points to determine whether a break is a true break or a false break.
- Look for moving average confluences to be supportive of trade.
Indicators Bollinger bands, moving averages, Fibonacci.
Although risk management is one of the simpler topics to grasp, it seems to be the hardest to follow for most traders. Too often we have seen traders turn winning positions into losing positions and solid strategies result in losses instead of profits. Regardless of how intelligent and knowledgeable traders may be about the markets, their own psychology will cause them to lose money. What could be the cause of this? Are the markets really so enigmatic that few can profit? Or is there simply a common mistake that many traders are prone to make? The answer is the latter. And the good news is that the problem, while it can be an emotionally and psychologically challenging one, is ultimately fairly easy to grasp and solve.
Most traders lose money simply because they have no understanding of or place no importance on risk management. Risk management involves essentially knowing how much you are willing to risk and how much you are looking to gain. Without a sense of risk management, most traders simply hold on to losing positions for an extremely long amount of time, but take profits on winning positions far too prematurely. The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning positions than losing ones, but ends up with a negative profit/loss (P/L). So, what can traders do to ensure they have solid risk management habits? There are a few key guidelines that all traders, regardless of their strategy or what they are trading, should keep in mind.
Traders should look to establish a risk-reward ratio for every trade they place. In other words, they should have an idea of how much they are willing to lose, and how much they are looking to gain. Generally, the riskreward ratio should be at least 1:2, if not more. Having a solid risk-reward ratio can prevent traders from entering positions that ultimately are not worth the risk.
Traders should also employ stop-loss orders as a way of specifying the maximum loss they are willing to accept. By using stop-loss orders, traders can avoid the common predicament of being in a scenario where they have many winning trades but a single loss large enough to eliminate any trace of profitability in the account. Trailing stops to lock in profits are particularly useful. A good habit of more successful traders is to employ the rule of moving your stop to break even as soon as your position has profited by the same amount that you initially risked through the stop order. At the same time, some traders may also choose to close a portion of their position.
For those looking to add to a winning position or go with a trend, the best strategy is to treat the new transaction as if it were a new trade of its own, independent of the winning position. If you are going to add to a winning position, perform the same analysis of the chart that you would if you had no position at all. If a trade continues to go in your favor, you can also close out part of the position while trailing your stop higher on the remaining lots that you are holding. Try thinking about your risk and reward on each separate lot that you have bought if they are at different entry points as well. If you buy a second lot 50 pips above your first entry point, don’t use the same stop price on both, but manage the risk on the second lot independently from the first.
Using Stop-Loss Orders to Manage Risk Given the importance of money management to successful trading, using the stop-loss order is imperative for any trader looking to succeed in the currency market. The stoploss order allows traders to specify the maximum loss they are willing to accept on any given trade. If the market reaches the rate the trader specifies in his/her stop-loss order, then the trade will be closed immediately. As a result, using stop-loss orders allows you to know how much you are risking at the time you enter the trade.
There are two parts to successfully using a stop-loss order: (1) initially placing the stop at a reasonable level and (2) trailing the stop—meaning moving it forward toward profitability—as the trade progresses in your favor.
Placing the Stop-Loss There are two recommended ways of placing a stop-loss order.
Two-Day Low Method These volatility-based stops involve placing your stop-loss order approximately 10 pips below the two-day low of the pair. For example, if the low on the EUR/USD’s most recent candle was 1.1200 and the previous candle’s low was 1.1100, then the stop should be placed around 1.1090—10 pips below the two-day low—if a trader is looking to get long.
Parabolic Stop and Reversal (SAR) Another form of volatility-based stop is the parabolic SAR, an indicator that is found on many currency trading charting applications. The FX Power Charts, for instance, offer this indicator, freely available to all course subscribers. Parabolic SAR is a volatility-based indicator that graphically displays a small dot at the point on the chart where the stop should be placed.
There is no magic formula that works best in every situation, but the following is an example of how these stops could be used. Upon entering a long position, determine where support is and place a stop 20 pips below support. For example, let’s say this is 60 pips below the entry point.
If the trade earns a profit of 60 pips, close half of the position in a market order, then move the stop up to the entry point. At this time, trail the stop 60 pips behind the moving market price. If the parabolic SAR moves up so that it is above the entry point, you could switch to using the parabolic SAR as the stop level. Of course, during the day, there can be other signals that could prompt you to move your stop. If the price breaks through a new resistance level, that resistance then becomes support. You can place a stop 20 pips below that support level, even if it is only 30 to 40 pips away from the current price. The underlying principle you have to use is to find a point to place your stop where you would no longer want to be in the trade once the price reaches that level. Usually the stop falls at a point where the price goes below support.
Aside from employing proper risk management strategies, one of the other most crucial yet overlooked elements of successful trading is maintaining a healthy psychological outlook. At the end of the day, traders who are unable to cope with the stress of market fluctuations will not stand the test of time—no matter how skilled they may be at the more scientific elements of trading.
Traders must make trading decisions based on strategies independent of fear and greed. One of the premier attributes good traders have is that of emotional detachment: while they are dedicated and fully involved in their trades, they are not emotionally married to them; they accept losing, and make their investment decisions on an intellectual level. Traders who are emotionally involved in trading often make substantial errors,as they tend to whimsically
FIGURE Parabolic SAR
change their strategy after a few losing trades, or become overly carefree after a few winning trades. A good trader must be emotionally balanced, and must base all trading decisions on strategy—not fear or greed.
Know When to Take a Break
In the midst of a losing streak, consider taking a break from trading before fear and greed dominate your strategy.
Not every trade can be a winning one. As a result, traders must be psychologically capable of coping with losses. Most traders, even successful ones, go through stretches of losing trades. The key to being a successful trader, though, is being able to come through a losing stretch unfazed and undeterred. If you are going through a bad stretch, it may be time to take a break from trading. Often, taking a few days off from watching the market to clear your mind can be the best remedy for a losing streak. Continuing to trade relentlessly during a tough market condition can breed greater losses as well as ruin your psychological trading condition. Ultimately, it’s always better to acknowledge your losses rather than continue to fight through them and pretend that they don’t exist. Make no mistake about it: regardless of how much you study, practice, or trade, there will be losing trades throughout your entire career. The key is to make them small enough that you can live to trade another day, while allowing your winning trades to stay open. You can overcome a lot of bad luck with proper money management techniques. This is why we stress a 2:1 reward-to-risk ratio, as well as why I recommend not risking more than 2 percent of your equity on any single trade.
Whether you are trading forex, equities, or futures, there are 10 trading rules that successful traders should live by:
- Limit your losses.
- Let your profits run.
- Keep position sizes within reason.
- Know your risk-reward ratio.
- Be adequately capitalized.
- Don’t fight the trend.
- Never add to losing positions.
- Know market expectations.
- Learn from your mistakes—keep a trading journal.
- Have a maximum loss or retracement in profits.