Showing posts with label technical-analysis. Show all posts
Showing posts with label technical-analysis. Show all posts

THE OPTIONS COURSE- How to Spot Explosive Opportunities

THE OPTIONS COURSE


How to Spot Explosive Opportunities

Locating exceptional investment opportunities is the key to successful trading. The main objective is to discover opportunities that:

• Meet all the criteria for a good investment.
• Use your investment capital in the most efficient manner.
• Produce substantial returns in a relatively short period of time.

Throughout the years I have been investing and trading, I have thought of myself as being fairly successful, while in the eyes of others, I have been perceived as extremely successful. However, contrary to popular belief, I know that deep down inside I still have more room to grow. Over the past few years, I have been able to accelerate my profitability by being patient (as much as I could be) and by being selective when I made an investment.

I have to admit that I love the day-to-day excitement and the financial rewards of trading. However, I make a great deal more money by looking for opportunity intelligently. In other words, instead of being in the markets just because I feel I need to be, now I wait like a cheetah in the jungle, looking for a wounded animal to pounce upon. Although the cheetah can catch any animal, wounded or not, it preys on the sure thing. I have learned that this is the best way to trade—wait for everything to look right, then attack with speed and confidence.

Initially it may not be easy for you to do the same. However, this confidence and patience will come over time as you build up experience and increase your investment account through successful trades. How do you spot explosive profit opportunities? It’s an awareness that needs to be developed, and if done correctly will enable you to make 100 percent on your money, sometimes in minutes, hours, or days, instead of years.

How do you find the growing money trees hidden deep within the information forest? Simply use the vast amounts of information available to you; learn to filter the data and find the best investments. The problem is that there is so much information. This can be overwhelming and quite confusing. Many would-be investors pick up a newspaper, look at the financial section, quickly decide that they can’t make heads or tails out of the information, and promptly give up. The general feeling is that anything this complicated must be extremely difficult to succeed in.

What if you gave up the first time you fell off a bicycle? What if you gave up the first time you sat behind the wheel of a car to learn to drive? What if you gave up on anything halfway challenging? You wouldn’t get anywhere—which is why many people never succeed. Successful individuals persevere. This also is true in learning the financial markets. It may seem difficult at first; but once you know the basics about how to ride the bike, it gets easier. After a while, you’re cruising down the road yelling, “Look, Mom—no hands!” 

Recognizing an excellent trade when you see it is just half the battle. As a trader, you must know how to go about finding explosive profit opportunities. There are an overwhelming number of methods used by the investment community to evaluate trading opportunities. I will not attempt to impart an exhaustive study of analysis techniques—there are far too many of them, and most do not work on a long-term basis. However, there are two basic categories that should be included as basic components of a trader’s arsenal: fundamental analysis and technical analysis.

FUNDAMENTAL ANALYSIS

Fundamental analysis is a trading approach used to predict the future price movements of a market based on the careful analysis of an investment’s true worth. Various economic data—including income statements, past records of earnings, sales, assets, management, and product development—assist in predicting the future success or failure of the company. Thus, a fundamental analyst studies the fundamentals of a business—its products, customers, consumption, profit outlook, management strength, and supply of and demand for outputs (i.e., oil, soybeans, wheat, etc.). Fundamental analysts use this data to anticipate price transitions. They see a company or market as it is now in the present, and they attempt to forecast where it is going in the future. 

Annual reports and quarterly financial statements (and their close government-mandated cousins for publicly traded companies, the 10-K and 10-Q, respectively) are part of the information used in fundamental analysis. The first question is, “Why should we be concerned about financial statements?” They are, after all, simply a restatement of the past, not a road map to the future. There are two primary reasons. The first reason for looking at financial statements is to determine how well management has handled the affairs of the company, because if you own shares or have a bullish position on the stock using options, these people are handling your investments. Is management operating the company well or poorly? Is management efficient or inefficient? How is this firm’s management as compared to its competitors?

The second reason for looking at financial statements is to determine if the firm is positioned to carry out the goals of management. For instance, if they are about to run out of cash, expansion projects are probably not going to be realized. The first step in studying financial statements is to get one’s hands on the items from the annual or quarterly report. There are many sources for acquiring an annual report. The most direct way is to call or write the investor relations department of the firm you are interested in analyzing, and simply ask them to send you one. If you already own one or more shares in the firm, they will automatically send you both the annual report and the quarterly financial information. 

Most companies will post at least the numbers from their financial statement on their web site. Your local library will often have copies of firms of local interest. In addition, there are a number of web sites, including EDGAR Online, that will give you access to a firm’s 10-K statement and other financial information. Libraries also carry many other sources of financial data on a firm. One final bit of housekeeping: Which is better, a 10-K or an annual report? A 10-K is a financial statement required by the Securities and Exchange Commission to be filed with the SEC by every publicly traded company on an annual basis. The report is a comprehensive look at the financial dealings of the firm throughout the year. 

The difference between the 10-K and the annual report is that the 10-K requires all firms to file certain detailed information and to list it in a specific order. The annual report will often include the 10-K, but even if it doesn’t, it has basically all the information required in the 10-K, and sometimes with even more detail. Personally, I prefer an annual report because I like to look at all the photos of smiling employees and happy customers, as well as the management discussions that usually accompany the dry numbers. Okay, say you have an annual report in front of you. Where do you start? The first thing you should realize is that there are no absolutes in financial statements. Unlike the basic laws of physics, what you see is not necessarily what you get; and everything is always open to interpretation.

What we will be concerned with is not necessarily in coming to a conclusion on a particular annual report, but rather to point out the pitfalls and areas to be aware of when you start to analyze a statement. Remember: First, foremost, and always, an annual report is often a sales pitch—management pays for the annual report, and they will be putting their best foot forward in the presentation. Therefore, don’t let subjective statements sway your opinion of the company too much. Most fundamental analysts dig deeper inside the report and study the actual numbers.  Some traders overlook fundamental analysis. However, as most trades are not totally neutral (in other words you have a bias as to whether you would prefer the shares to go up or down), studying the fundamentals of a firm should at least help you to be in front of the trend. 

If you are looking at a strong company in a strong industry, you should think twice before putting a bearish trade on that stock and vice versa. This is especially true for longer-term trades. There are three important factors to consider when studying the income statement and also three from the balance sheet. On the income statement, you want to look at sales, gross profit (or operating income), and net income. From the balance sheet, you need current assets, current liabilities, and total assets. In addition to these six numbers, the curious investor will have to do a couple of divisions to glean about 80 percent of the information available. Sales are good. They are necessary to generate income, so more is generally better than less. 

In addition to the raw number, most investors divide this year’s sales by last year’s sales to look at the rate of growth. Increasing growth is generally better than decreasing growth, providing each sale is generating more revenue than it costs to produce it. To determine if a firm is generating profitable sales, we use the second number from the income statement, the gross profit. Dividing gross profit by sales gives the gross profit margin, a number that describes what percent of each sales dollar is available (after the direct costs of producing that sale) to pay for overhead, debt repayment, taxes, and, of course, dividends. Larger is better. A gross profit margin that is deteriorating from prior years is generally not so good. 

It may not be a problem, but a deteriorating number should raise a red flag so that your antennae are tuned into looking for the reasons when you read articles about that company. The reasons for a deteriorating gross profit margin can come from many things. Raw material and employee costs can escalate faster than the firm is able to raise prices; this is typically not a very good situation. On the other hand, the firm could simply be changing its sales mix (selling a larger percentage of low-margin products) or be going after sales that are less profitable (possibly large orders with associated discounts, etc.), which could be a good strategy. The idea, here, is for the investor to simply be aware that there is something happening.

Finally, the net profit line on the income statement is important. As a bullish investor, you want to see this number positive and increasing. If you are looking for a bearish position, negative and decreasing is your ideal. However, remember that net profit is a result of many things, not just the operations of the company. From your perusal of the footnotes and the auditor’s letter, you should be able to judge just how much confidence you can place on this particular number. While the income statement gives us a picture of just how well the firm prospered over the past year, the balance sheet gives us a glimpse as to how conservative the firm is with its assets and how efficiently it is using them. Current assets and current liabilities are defined as those assets and liabilities that either are or will, in the normal course of business, be turned into cash over the next 12 months. 

Thus, receivables will be collected, inventory will be sold, prepaid expenses will be utilized (et cetera) in the upcoming year. Similarly, all accounts will be paid, notes and loans will be paid, and unpaid taxes will, by definition, be paid during the upcoming year. Thus, if current assets are greater than current liabilities, there should be no trouble (barring some unforeseen circumstance) meeting all obligations with cash collected from various accounts, even if there are temporary glitches in sales, collections, or production. Obviously, the larger the difference in those two numbers (current assets and current liabilities), the better. The final number that we are concerned with on the balance sheet is total assets. By dividing “net income” by “total assets,” we get return on assets (ROA). 

This is a measure of just how efficient management is in utilizing the assets at its disposal. This is a more accurate measure of management efficiency than is the return on equity (ROE) that many investors utilize. ROE is a direct result of ROA, adjusted for the amount of debt management has assumed. By simply borrowing more money, management can usually increase the ROE without doing anything better operationally. In fact, the total profit will decrease, as additional funds will be needed to pay the interest costs of the new debt. If carried to the extreme, or if the firm hits a patch of trouble, the increased leverage of the additional debt will become critical. The standard income statement is generally constructed utilizing what is called “accrual basis accounting.” 

In layman’s terms, this means that management chooses when a sale is final and then records it, regardless of when the firm actually receives cash for that good or service. This gives rise to the balance sheet account called “accounts receivable,” or the amount of money owed the firm by its customers for goods and services delivered but not yet paid for. To fairly represent the true profitability of the firm, the costs of those raw materials used in the products delivered are then listed on the income statement as a cost, regardless of when they are paid for. Similarly, assets such as buildings and equipment are depreciated, or expensed a little bit each year as management feels they are used up, again regardless of when they are actually paid for.

The statement of cash flows, then, is the vehicle that converts accrual accounting back to a cash basis, and hence is far more critical than most investors give it credit for being. If the firm cannot generate enough cash from its operations to pay for those operations, it will never be able to pay for new investments needed for continuing operations nor be able to repay debt previously borrowed nor pay dividends to shareholders. Thus, the “net cash provided by operating activities” should always be positive (if the company is going to prosper), and the second major category (investing activities) should not always be negative. A negative number in this category is fine if the firm is doing major expansions, but it should, after a few years, turn positive. 

Finally, a glance at the financing activities section should clue you in on how the firm is paying for all the cash needs it has. Is it raising cash through debt (adding risk) or through the sale of more equity (diluting the shareholder’s position)? Or, as one would hope in a mature company, is it repaying past borrowings? The final section of numbers that the trader should look at is the “Reconciliation of Retained Earnings.” This statement is a detailed look at the depreciation and other noncash adjustments that resulted in the final balance of the shareholders’ equity account on the balance sheet. This account lists extraordinary items that have taken place during the accounting period as well as adjustments to prior years’ statements that do not directly flow through the income statement or any of the other balance sheet accounts. 

This statement should tie in with your investigation of the footnotes. While you are not looking for anything specific, strange entries should raise questions. Again, there is no right or wrong answer to any of these particular categories. You are just trying to get a feel for the general health of the firm. If too many of the numbers turn up negative, then you should recognize that this firm is not a slam-dunk gold-plated investment, and appropriate precautions must be taken in your trading efforts. Entire industries are built around fundamental analysis. Every major brokerage firm has armies of analysts to review industries, companies, and commodities markets. The majority of what you see and hear on television or read in the newspapers is fundamental analysis. Fundamental analysis comes in many shapes and forms. 

For example, you may hear that a company’s product is selling like hotcakes, or perhaps there has been a management change. Maybe the weather is killing the orange juice crop. It’s up to you to learn how to apply this information tomaking money in the markets. Typically, I don’t listen to others, because too often they are wrong. On the other hand, I love to find opportunities to do the opposite of everyone else. This is known as the contrarian approach—when all the information is too positive, look for an opportunity to sell, and when it is too negative, look for an opportunity to buy. Moral of the story: Listen to the market. It will tell you a great deal. Use a discerning ear when listening to anyone else.

TECHNICAL ANALYSIS

Technical analysis evaluates securities by analyzing statistics generated from market activity, such as past prices and volume, to gauge the forces of supply and demand. Furthermore, technical analysis is built in part on the theory that prices display repetitive patterns. These patterns can be utilized to forecast future price movement and potential profit opportunities. Technical analysts study the markets using graphs and charts to determine price trends and gauge the strength or weakness of an investment (stock, futures, index, etc.). 

The technical analyst is trying to understand the past price trends of the stock or commodity in order to try to determine price patterns that will forecast future price movements. The type of analysts that use this method of predicting stock movements are sometimes called technicians or chartists. Do I believe in technical analysis? Absolutely. I believe a good technician can look at many factors and determine future price action with a certain degree of accuracy. In fact, since many option strategies are relatively short-term in nature, it’s important to use technical trading tools to help improve the timing of certain trades. Many options traders use technical analysis more than fundamental analysis for that reason. 

However, no person or computer can predict the future 100 percent of the time.  We need to use all the information available about the markets in the past and present to attempt to forecast the future. Although many a profit has been made from complex technical charts, there are no crystal balls. Therefore, we recommend studying technical analysis and using it when implementing trading strategies, but don’t rely exclusively on charts, patterns, or other technical trading tools. The simplest and most widely used technical analysis tool is a moving average. 

A moving average is the analysis of price action over a specified period of time on an average basis. This typically includes two variables (more can be used). For example, we may look at the price of gold trading right now and how that price compares to the average over the past 10 days and the average price over the past 30 days. When the 10-day average goes below the 30-day average, you sell; and, conversely, when the 10-day average goes above the 30-day average, you buy. Technicians go to great lengths to fine-tune which time spans and averages to use. When you find the right time frames, the moving average is probably the simplest and most effective technical tool.

Moving averages and crossovers can be very useful tools. To keep their strengths and benefits in perspective follow these five suggestions regarding their use:

1. If you get a buy or sell signal and you take on a position, keep that position until the 18-day line goes flat or changes direction. Do not take on a new position until there is a proper realignment of all
three averages.
2. To protect accumulated profits along the way use the 50-day moving average as an exit point.
3. Think of the 50-day moving average as a support or resistance line.
4. Moving averages work very well in uptrends and downtrends and not as well in sideways markets. That’s because in sideways markets, you can get buy signals near tops and sell signals near the bottom. If you trade on those signals, you will more than likely incur losses.
5. Finally, because moving averages do not work that well in sideways markets, which can occur a fair amount of time, use caution. Try to find stocks that trend a great deal if you plan to rely on this tool.

Moving averages are a time-tested tool, and I would urge any new market technician to understand their proper use and application. 

Another technique is to use a momentum indicator. This technical market indicator utilizes price and volume statistics for predicting the strength or weakness of a current market and any overbought or oversold conditions, and can also note turning points within the market. This can be used to initiate momentum investing, a strategy in which you trade with (or against) the momentum of the market in hopes of profiting from it. It’s one of my favorite ways to trade because I can spot stocks, futures, and options with the potential to make money on an accelerated basis. Finding these explosive profit opportunities is the key to highly profitable trading. 

Briefly, a momentum investor looks for a market that is making a fast move up or down at a specific point in time, or there is an indication of an impending movement. Like a volcano about to erupt, a great deal of pressure starts to build, followed by an explosion for some time, with a calm thereafter. A momentum investor might miss the eruption but be able to catch the market move right after the eruption. Different techniques are used in each case. To catch the first move (another example is that of a surfer trying to ride a wave), you have to see the signs, place the appropriate strategy, and then get ready to get off when the momentum (or eruption, or wave) fizzles. This can be hours, days, or weeks. 

If you miss the first move, it’s best to wait until the movement fizzles and then look to place a contrarian trade. If you wait until there is a slowdown, you can then anticipate a reversal. If you employ a contrarian approach, you will be trading against the majority view of the marketplace. A contrarian is said to fade the trend (which suits me just fine). Very fast moves up lead to very fast moves down, and vice versa. Trading, investing, and price action are driven by two elements— fear and greed. If you can learn to identify both, you can profit handsomely. Momentum investing plays off of these two human emotions perfectly: greed not to miss a profit opportunity and fear that profits made will be lost if the market reverses course, thus intensifying the reversal in many cases. 

There are hundreds of technical analysis tools out in the marketplace. Be very cautious with those that you decide to use. Make sure you thoroughly test these systems over a long period of time (i.e., 10 years or more). Both fundamental and technical analyses have their proponents. Some traders swear by one and hold great disdain for the other method. Other traders integrate both methods successfully. For example, fundamental analysis can be used to forecast market direction while technical analysis prompts profitable trading entrances and exits. Most investors have had to use trial and error to determine which methods work best for them. 

Ultimately, it depends on what kind of trading you are more inclined to use, and which methods you are most comfortable employing. When you begin to select investment methods, try to determine why they work, when they work best, and when they are not effective. Test each method over a sufficient period of time and keep an accurate account of your experiences. If possible, you should always back-test systems as well. You can use trading software to back-test almost any technical analysis technique available. Inevitably, as the markets change, suitable methods of analysis will change also. The key is to remain open-minded and flexible so that you can take advantage of what works.

SENTIMENTAL ANALYSIS

The stock market is a fascinating place. It is particularly interesting in that the day-to-day fluctuations reflect the views, expectations, and forecasts of investors around the world. Indeed, it is an arena in which the final outcome depends not on one individual decision maker, but on the activity of millions of investors. Given that market moves are due to decisions of a mass of market participants, or the crowd and not one individual decision maker, history is replete with episodes of crowd or mob behavior. Basically, under certain decision-making situations, the individual may act quite rationally, but as part of a crowd, will act based on feelings and emotion. In the words of Humphrey B. Neill:

Because a crowd does not think, but acts on impulses, public opinions are frequently wrong. By the same token, because a crowd is carried away by feeling, or sentiment, you will find the public participating enthusiastically in various manias after the mania has got well under momentum. This is illustrated in the stock market. The crowd—the public—will remain indifferent when prices are low and fluctuating but little. The public is attracted by activity and by the movement of prices. It is especially attracted to rising prices(The Art of Contrary Thinking, 1963).

As an example, take the contagion that spread throughout global financial markets in the fall of 1998. The fact that the sell-off of one stock market in one country eventually led to a drop in another, and then another, was an example of extreme crowd behavior. It was labeled contagion: defined as the ready transmission of an idea, response, emotion, and so on. However, given that global financial markets recovered toward the end of 1998 and early 1999, obviously the panic selling and drop in global financial markets was overdone. In that case, it was the opposite of a mania, but still an example of crowd psychology in its worst form—fear, panic, and disengagement.

Given the nature and impact of crowd psychology on financial markets, many traders use sentiment analysis to gauge the overall attitude of the mass of investors, or the crowd. Studying market sentiment, in turn, is an endeavor in contrary thinking. In other words, one of the premises underlying the study of sentiment data is that, during certain periods of time, it pays to go against the masses. Specifically, when market sentiment becomes extreme in one direction or another, the contrary thinker will act in a manner opposite to the crowd. For example, at the apex of panic selling during the global financial crisis of 1998, the contrary thinker armed with an understanding of sentiment data may well have turned into a buyer: just as the crowd was getting rid of shares. 

Indeed, when the market is gripped with fear and panic, it usually turns out to be the best buying opportunity. An often-heard saying in the stock market is that investors are “right on the trend, but wrong at both ends.” In a rising or bull market, investors are better served buying shares. In a declining or bear market, the trend is downward and it is a better time to sell. In short, during significant market trends, it is more profitable to go in the direction of the market rather than contrary to it. So the crowd is not always wrong. The turning points, however, often catch investors unaware. Sentiment analysis offers a variety of tools for identifying the extreme crowd behavior or “the ends.” Let’s start by taking a closer look at put/call ratios.

Put/call ratios are widely used and easy to obtain. All of the necessary data is available on the Chicago Board Options Exchange. As the name implies, the put/call ratio is computed by dividing puts by calls. It can be done for shares or index options. I focus on two put/call ratios: the CBOE total put-to-call and index put-to-call ratios. While the CBOE put/call ratio uses the total of all option trades on the Chicago Board Options Exchange, the index ratio considers only index trading. For example, February 12, 2004, 508,743 put options and 916,360 calls traded on the CBOE. So the put-to-call ratio was .56 (or 508,743/916,360). The same analysis is repeated for the CBOE index put-to-call ratio, but the equation considers only index options. 

Put/call ratios are used as a contrary indicator. Since calls make money when shares or indexes rise, they often represent bullish bets on the part of investors. Conversely, puts increase in value when a stock or index moves lower and, therefore, reflect bearish bets. So when the put/call ratio increases, it suggests that there are a greater number of puts traded relative to calls, and market sentiment is turning bearish. When it falls, call buying is increasing in comparison to put buying. Again, studying put/call ratios is an exercise in contrary thinking. Specifically, if most market participants, or the crowd, are buying puts, it is a sign of negative sentiment and reason to turn bullish. Conversely, a low put/call ratio is interpreted as a market negative since the crowd is excessively bullish, but probably wrong.

In practice, readings of .50 or less from the total put-to-call ratio are a sign of heavy call activity and extremely bullish sentiment. In that case, the contrarian would turn more cautious or bearish. On the other hand, readings of 1.00 or more are a sign of excessive bearishness and reason to be bullish. The index put-to-call ratio will rise above 2.00 when investors are too bearish and drop below 1.00 when bullish sentiment is extreme. Adviser sentiment, which is used to measure excessive bearish and bullish positions, is one of the more popular contrarian indicators and is certainly one I employ. If adviser bearish sentiment is greater than 60 percent, this is a signal that a possible bottom is forming. If adviser optimism is greater than 70 percent, this signals a market top.

The mutual fund liquid assets ratio is based on the premise that cash balances rise as the trend nears a bottom when increased buying power exerts a bullish effect. If buying power is greater than 10 percent of balances, this is bullish. The Investment Company Institute (ICI) releases the number monthly. The first cousin of this indicator is customer credit balances and is based on the fact that the cash balances rise or fall as the market bottoms or peaks. The short interest ratio indicator consists of ratios of short interest to average daily trading volume. Readings above 1.75 are bullish and ratios under 1.0 are bearish. A related indicator is odd-lot short sales, which typically are wildly speculative in the wrong direction.

The final three contrarian indicators I look at are the over-the-counter (OTC) relative volume, market P/E ratio, and the Dow Jones Industrial Average dividend yield. OTC volume breakouts above 80 percent provide bearish signals of excessive speculation. Price-earnings ratios of 5 and 25 are approximate lower- and upper-trend boundaries. DJIA yields get as low as 3 percent at market tops and as high as 18 percent at market bottoms. The different numbers I have used for quantification purposes are typical rules of thumb used by most contrarian traders. I basically use them as a ballpark figure versus an absolute. They will change through time and should be considered in light of their long-term trends. 

As far as finding the latest readings for these indicators, information can be found in Barron’s, Value Line, and Investor’s Business DailyIn conclusion, there is a wide variety of sentiment tools that can be used to enhance your trading, especially if you are interested in becoming a contrarian trader. The premise holds that the crowd is not always wrong, but invariably on the wrong side of the market during major turning points. The goal behind using sentiment analysis, therefore, is to identify extreme cases of bullishness or bearishness and then trade in the opposite direction because the major turning points generally turn out to be the most profitable trading opportunities.

The rightmost column shows how each indicator can be used by market technicians to keep up with changing market trends. The market is always going to bounce around, and this constant fluctuation may indicate that there’s never an exactly right time to enter a trade, but there will always be a time that’s better than another. Professional traders use timing and technical indicators to secure the best moment of entry and exit. They take advantage of the market’s swings rather than letting volatility take advantage of them. That’s why it is so important to learn how to use timing indicators—to put the odds in your favor and dollars in your trading account.



TABLE  Key Contrary Indicators


TABLE  (Continued)


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TECHNICAL TRADING STRATEGIES

CHANNEL STRATEGY

Channel trading is less exotic but nevertheless works very well with currencies. The primary reason is because currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. By just going through a few charts, traders can see that channels can easily be identified and occur frequently. A common scenario would be channel trading during the Asian session and a breakout in either the London or the U.S. session. There are many instances where economic releases are triggers for a break of the channel. Therefore it is imperative that traders keep on top of economic releases. If a channel has formed, a big U.S. number is expected to be released, and the currency pair is at the top of a channel, the probability of a breakout is high, so traders should be looking to buy the breakout, not fade it. 

Channels are created when we draw a trend line and then draw a line that is parallel to the trend line. Most if not all of the price activity of the currency pair should fall between the two channel lines. We will seek to identify situations where the price is trading within a narrow channel, and then trade in the direction of a breakout from the channel. This strategy will be particularly effective when used prior to a fundamental market event such as the release of major economic news, or when used just prior to the open of a major financial market.

Here are the rules for long trades using this technique.

  1. First, identify a channel on either an intraday or a daily chart. The price should be contained within a narrow range.
  2. Enter long as the price breaks above the upper channel line.
  3. Place a stop just under the upper channel line.
  4. Trail your stop higher as the price moves in your favor.

Examples

Let us now examine a few examples. The total range of the channel is approximately 30 pips. In accordance with our strategy, we place entry orders 10 pips above and below the channel at 1.2395 and 1.2349. The order to go long gets triggered first and almost immediately we place a stop order 10 pips under the upper channel line at 1.2375. USD/CAD then proceeds to rally and reaches our target of double the range at 1.2455. A trailing stop also could have been used, similar to the ones that we talked about in our risk management section.


FIGURE  USD/CAD Channel Example

The total range between the two lines is 15 pips. In accordance with our strategy, we place entry orders 10 pips above and below the channel at 0.6796 and 0.6763. The order to go long gets triggered first and almost immediately we place a stop order 10 pips under the upper channel line at 0.6776. EUR/GBP then proceeds to rally and reaches our target of double the range at 0.6826.

The total range between the two lines is 13 pips over the course of four hours. The channel actually also occurs between the European and U.S. open ahead of the U.S. retail sales report. In accordance with our strategy, we place entry orders 10 pips above and below the channel at 1.2785 and 1.2752. The order to go short gets triggered first, and almost immediately we place a stop order 10 pips above the lower channel line at 1.2772. The EUR/USD then proceeds to sell off significantly and hits our target of double the range of 26 pips. More aggressive traders also could have trailed their stops to take advantage of what eventually became a much more extensive move lower. 

FIGURE  EUR/GBP Channel Example 

FIGURE  EUR/USD Channel Example


PERFECT ORDER
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A perfect order in moving averages is defined as a set of moving averages that are in sequential order. For an uptrend, a perfect order would be a situation in which the 10-day simple moving average (SMA) is at a higher price level than the 20-day SMA, which is higher than the 50-day SMA. Meanwhile, the 100-day SMA would be below the 50-day SMA, while the 200-day SMA would be below the 100-day SMA. In a downtrend, the opposite is true, where the 200-day SMA is at the highest level and the 10-day SMA is at the lowest level. Having the moving averages stacked up in sequential order is generally a strong indicator of a trending environment. Not only does it indicate that the momentum is on the side of the trend, but the moving averages also serve as multiple levels of support. To optimize the perfect order strategy, traders should also look for ADX to be greater than 20 and trending upward. Entry and exit levels are difficult to determine with this strategy, but we generally want to stay in the trade as long as the perfect order holds and exit once the perfect order no longer holds. Perfect orders do not happen often, and the premise of this strategy is to capture the perfect order when it first happens.

The perfect order seeks to take advantage of a trending environment near the beginning of the trend. Here are the rules for using this technique.

  1. Look for a currency pair with moving averages in perfect order.
  2. Look for ADX pointing upward, ideally greater than 20.
  3. Buy five candles after the initial formation of the perfect order (if it still holds).
  4. The initial stop is the low on the day of the initial crossover for longs and the high for shorts.
  5. Exit the position when the perfect order no longer holds. 

Examples

On October 27, 2004, moving averages in the EUR/USD formed a sequential perfect order. We enter into the position five candles after the initial formation at 1.2820. Our initial stop is at the October 27, 2004 low of 1.2695. The pair continues to trend higher, and we exit the position when the perfect order no longer holds and the 10-day SMA moves below the 20-day SMA. This occurs on December 22, 2005, when prices open at 1.3370. The total profit on this trade is 550 pips. We risked 125 pips on the trade. 


FIGURE  EUR/USD Perfect Order Example 

The next example is USD/CHF. In Figure, the perfect order occurs on November 3, 2004. In accordance with our rules, we enter into the trade five candles after the initial formation at 1.1830. Our stop is at the November 3, 2004 high (for a short trade) of 1.1927. The pair then proceeds to continue to trend lower, and we exit the position when the perfect order no longer holds and the 20-day SMA moves below the 10-day SMA. This occurs on December 16, 2005, when prices open at 1.1420. The total profit on this trade is 410 pips. We risked 97 pips.

The formation materialized on September 30, 2004. We count five bars forward and enter into the position at 1.2588 with a stop at 1.2737. The pair then proceeds to sell off and we look to exit the position when the perfect order formation no longer holds. This occurs on December 9, 2005, at which time we buy back our position at 1.2145 for a 443-pip profit while risking 149 pips.

HOW TO TRADE NEWS RELEASES
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One of the most popular methods of trading currencies is to trade news releases. This type of strategy is intriguing to many people because of the instant gratification. You lay on the trade minutes before the release, your heart pumps when the clock ticks within 60 seconds of the number coming out, and when it does, you feel either an instant sense of elation, the trading high, or an instant sense of frustration. This is great for traders who like a lot of action within a very short period of time. Trading news is based on the idea that when an economic number deviates significantly from the consensus forecast, there is usually a knee-jerk reaction accompanied by decent follow-through. However, there are many different ways to trade news releases, and if done incorrectly, it can lead to more losers than winners. The first strategy that I use is to place a trade before the number is released, the second is to take the trade only after the news release hits the wires, and the third is to do a combination of both.

FIGURE  USD/CHF Perfect Order Example

FIGURE  USD/CAD Perfect Order Example

One of the biggest advantages of proactive trading is the risk-to-reward ratio, which is usually very good because the strategy entails entering into a position 15 to 20 minutes before the number is released. The reason we do not wait until 5 minutes before the release is because spreads usually widen, and some brokers will make execution difficult. Once the economic number is out, the spike that is driven by the data creates an opportunity where profits can be taken on a portion of a position or the entire position. If your view on the economic data proves to be wrong, the stop would be hit almost immediately; in other words, you are either right or out.

Here are some general guidelines for proactive trading (use 5-minute charts).

Strategy Rules for Proactive Trading

Long

  1. Enter into a position no more than 20 minutes before a major news report will be released. Rule #1 gets you into the position when spreads are still relatively tight. Taking the trade 20 minutes before a release also gives you the opportunity to focus on the event risk and not any other news.
  2. Place a stop 10 pips below the range low or 30 pips below your entry price, whichever is closer. The range is defined as the past two hours of price action, but if the range is too small, look for the more obvious swing high or low.Rule #2 keeps the risk low.
  3. Take your profit on half of the position when it moves in your favor by the amount risked.Rule #3 is to bank profits when you have them and play only with the house’s money on the second half of the position.
  4. Trail stop on the remainder of the position by the 20-day simple moving average (SMA) or set a hard stop of three times risk.Rule #4, using the 20-day SMA, allows you to capitalize on as much of the move as possible.

Short


  1. Enter into a position no more than 20 minutes before a major news report will be released.
  2. Place a stop 10 pips above the range high or 30 pips above your entry price, whichever is closer. The range is defined as the past two hours of price action, but if the range is too small, look for the more obvious swing high or low.
  3. Take your profit on half of the position when it moves in your favor by the amount risked.
  4. Trail stop on the remainder of the position by the 20-day SMA or set a hard stop of three times risk. 

Let’s take a look at an actual news trade that we recommended for subscribers to BKForex Advisor. On February 8, 2008, the Canadian employment report for the month of January was due for release at 7 a.m. New York time. We believed that the number was going to be strong, because the Canadian economy had been performing very well thanks to skyrocketing oil prices. The leading indicators of Canadian employment that we follow also suggested that the number was going to be very hot. The market at the time was looking for employment to increase by only 11K after having dropped by 18K the prior month. Therefore, our trade recommendation was to go long Canadian dollars and short U.S. dollars (or short USD/CAD) 20 minutes before the number was to be released at 7 a.m.. Our entry price at the time was 1.0081. The high of the range for the past few hours was 1.0085, so our stop should be placed at 1.0095 (range high plus 10 pips), putting our risk at only 14 pips. Please note that this risk is actually quite small, because usually the stop is between 25 and 30 pips away from the entry price. As soon as the trade was initiated, we placed the target or limit on half on our position at 1.0067 (or 1.0081 minus 14 pips). To some people this may seem conservative, and it is, but one of the cardinal rules that we follow at BKForex Advisor is to never let a winner turn into a loser, which is why we always take profits quickly on half of our position and trail our stop on the remainder of the position.

The Canadian employment report came out at 7 a.m., and it quadrupled expectations by increasing 46.4K. This led to an immediate sell-off in USD/CAD. Our take profit was hit instantaneously as the currency pair fell from 1.0075 to 0.9983 (90 pips) in a matter of minutes. As soon as the first half of our position was closed, we moved our stop to breakeven on the remainder of the position and trailed the stop by the 20-day SMA on the 5- minute charts. The rest of the position was eventually exited at 0.9970 for a total gain of 125 pips or an average gain of 62.5 pips.


FIGURE  USD/CAD Proactive Trade

The biggest problem with proactive trading, however, is the difficulty of predicting economic data. BKForex subscribers benefit from having some of the work done for them with the weekly Event Risk Calendar, but unless you have a strong background in economics or years of experience trading fundamentally, it is hard to figure out whether a piece of data will increase or decrease from the prior month, let alone beat or miss expectations.

That is why most people prefer to trade reactively. There is no need to guess whether an economic release will be strong or weak, because the whole idea behind reactive trading is to pull the trigger only after the economic data report comes out and only if it is significantly better or worse than the market’s forecast. Most signal providers focusing on news trade reactively. A good rule of thumb is to trade an economic data release only if the surprise is greater than 100 percent of the market’s forecast.

For the Canadian employment report, for example, a reactive news trader should short USD/CAD only if Canadian employment is greater than 22K or go long USD/CAD only if employment is negative (remember the market is looking for an 11K rise). The bigger the deviation from the market’s forecast, the better the trade.

Here are some general guidelines for reactive trading (use 5-minute charts).

Strategy Rules for Reactive Trading

Long


  1. Enter into a position 5 minutes after a major news report is released. Rule #1 gives you a chance to make sure that there are no immediate retracements. If a number is big, there will be more than 5 minutes of follow-through.
  2. Place a stop at the low of the news candle. Rule #2 gives you a technically based logical stop. If the currency pair manages to retrace back to the low of the candle when the news is released, it indicates that the market doesn’t really believe in the surprise.
  3. Take your profit on half of the position when it moves in your favor by the amount risked. Rule #3 is to bank profits when you have them and play only with the house’s money on the second half of the position.
  4. Trail stop on the remainder of the position by the 20-day SMA or set a hard stop of three times risk. Rule #4, using the 20-day SMA, allows you to capitalize on as much of the move as possible.


Short


  1. Enter into a position 5 minutes after a major news report is released.
  2. Place a stop at the high of the news candle.
  3. Take your profit on half of the position when it moves in your favor by the amount risked.
  4. Trail stop on the remainder of the position by the 20-day SMA or set a hard stop of three times risk.


Going back to the example of the Canadian employment report, a reactive trader would enter the trade at 1.0015 with a stop at 1.0075 (which is the high of the 5-minute news candle). USD/CAD consolidates for approximately two hours before finally breaking down and hitting the first target of 0.9955 at 10:55 a.m. New York time. The stop is then moved to breakeven on the second half of the position.

FIGURE  USD/CAD Reactive Trade

According to the trading rules, the stop is trailed by the 20-day SMA on the 5-minute charts and eventually closed at 0.9975 for a total profit of 100 pips or an average profit of 50 pips on the trade.

Although reactive trading requires far less guesswork than proactive trading, the stop tends to be much larger, which may be difficult for some traders to stomach. Also, the move or the first target may not be reached for hours. With proactive trading, by contrast, as long as the surprise is fairly decent, the first target is usually reached within the first 5 minutes of the release. Although the second half of the position may remain open for a few hours, the stop is at breakeven, which means that there is no real downside risk to the trade.

Since proactive and reactive trading both have their pitfalls, the best way to trade is a combination of the two strategies. Although it may be difficult to predict every piece of economic data, we may often have a view on specific news releases. For example, if a country’s currency is very weak, it may not be difficult to make an educated guess that trade deficits will narrow or trade surpluses will increase because a weak currency could help to boost exports. The opposite would be true for a country with a strengthening currency. If the euro, for example, rose 500 pips in one month, there is a decent chance that in the same month or the month after, the U.S. trade deficit will narrow. However, it may not be worthwhile to initiate our entire position at one time if we do not feel strongly about the potential outcome of the economic release, because doubling our position doubles our risk. There are pieces of economic data that can be used to predict other economic data, increasing the accuracy of the economic predictions; and if they do not all line up, our confidence levels would decrease. Therefore, half of the position could be initiated ahead of number, and if the call is correct, we could initiate the second half of the position after the release. Even though we may be giving up potential profits, if we are wrong, our loss would be much less.

Here are the rules or guidelines that we use to trade proactively and reactively.

Strategy Rules for Proactive and Reactive Trading

Long


  1. Enter into half of the position no more than 20 minutes before a major news report will be released.
  2. Place a stop 10 pips below the range low or 30 pips below your entry price, whichever is smaller. If the economic data is in line with the initial proactive trade: 
  3. Enter the second half of the position 5 minutes after a major news report is released.
  4. Put a stop for the entire position at 45 pips below the second entry price, and then trail by 20-day SMA.
  5. Take your profit on half of the position when it moves in your favor by 45 pips.
  6. Trail stop on the remainder of the position by the 20-day SMA.


Short


  1. Enter into half of the position no more than 20 minutes before a major news report will be released.
  2. Place a stop 10 pips above the range high or 30 pips above your entry price, whichever is smaller. If the economic data is in line with the initial proactive trade:
  3. Enter the second half of the position 5 minutes after a major news report is released.
  4. Put a stop for the entire position at 45 pips below the second entry price, and then trail by 20-day SMA.
  5. Take your profit on half of the position when it moves in your favor by 45 pips.
  6. Trail stop on the remainder of the position by the 20-day SMA.


If the economic data is not in line with the initial trade, then do not take a second position; instead, exit out of the first position.

In the USD/CAD example, the first half of the position would be initiated at 1.0081 with a stop of 1.0095. After the economic data report is released, the second half of the position should be initiated at 1.0015 for a blended price of 1.0048. The stop of the entire position is then lowered to 1.0060 or 45 pips away from the second entry price (this is a rule that you can alter to your own trading style). Half of the position is taken off when the trade moves in your favor by 45 pips, or hits 0.9970. The remainder of the position is then exited when the price moves back above the 20-day SMA or 0.9975. The total profit on this trade is 151 pips, and the average profit on the trade is 75 pips.

Here are two more examples of combining proactive and reactive news trading.

In the first example, we are trading the U.K. retail sales numbers on February 21, 2008. The market believes that U.K. retail sales will be strong and we agree, but we think that there is a decent chance for an even greater surprise given the strength of the leading indicators for U.K. retail sales that we typically follow. Therefore, we go long the GBP/USD 20 minutes before the release at 1.9470. The stop on the initial position is placed at 1.9450, or 10 pips below the range low. The U.K. retail sales number comes out more than double the market’s forecast at 0.8 percent. The GBP/USD jumps 70 pips in the first 5 minutes after the release. We then enter the second half of the position at 1.9530 and move the stop on the entire position to 1.9485 (1.9530 minus 40 pips). The target or limit on the initial position is placed at 1.9575, which is reached approximately 90 minutes later. We remain in the position until the GBP/USD breaks the 20-day SMA on the 5-minute charts, which is at 1.9553. The total profit on this trade is 151 pips and the average profit on the trade is 75 pips. 


FIGURE  USD/CAD Proactive and Reactive Combined Trade 


FIGURE  GBP/USD Proactive and Reactive Combined Trade

In the second example, we are trading the German trade balance on April 8, 2008. The market believes that the German trade balance will deteriorate because of the strength of the euro, but we believed that it will actually be strong since new orders and manufacturing production have increased. Therefore, we go long the EUR/USD 20 minutes before the release at 1.5733. The initial stop on the position is placed 10 pips below the range low of 1.5727, or 1.5717. The German trade balance report comes out stronger than expected, and we enter into the second half of the position at 1.5740 and move the stop on the entire position to 1.5700 (1.540 minus 40 pips). The target or limit on the initial position is placed at 1.5785. Unfortunately, the EUR/USD does not make it to 1.5785, but we end up exiting both lots of the position when the price breaks the 20-day SMA at 1.5754, leaving the entire trade still profitable. The total gain is 35 pips and the average profit on the trade is 17.5 pips.


FIGURE  EUR/USD Proactive and Reactive Combined Trade

If any of our proactive trades were wrong, we would lose no more than 30 pips.

20–100 SHORT-TERM MOMENTUM STRATEGY
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Although many people like to trade off of 5-minute charts, there is a big difference between trading news and using other short-term trading strategies. News trading is not for the faint of heart, because many people may find it impossible to figure out a bias for economic data, while others may find it extremely difficult to pull the trigger in reaction to a piece of news when they see that a currency pair has already moved 50 to 60 pips in their desired direction.

For those types of traders, it may be helpful to think about using other types of strategies. The main reason short-term trading is often more popular than long-term trading is because many people do not have the patience to wait days for a trade to develop. These are traders who need things to happen immediately, cringe at every 10-pip move against them, and want the trade to turn a profit within the next few minutes or else they will abandon their position. They would be more than willing to take 10 pips 10 times a day than to make 100 pips on one trade with the potential of watching the position first move 50 to 60 pips against them.

The best strategy for this type of trader is a short-term momentum strategy. Although I prefer to trade news, one of my favorite strategies is the 20–100 short-term momentum strategy. The strategy outlined here can be used independently or as a method to achieve a better entry price for longer-term strategies. The whole premise behind the strategy is that you go long or short only when momentum is on your side. This is very important because the goal is to hit your first profit target as soon as possible.

In this strategy, we use three different indicators: the 20-day exponential moving average (EMA), the 100-day simple moving average (SMA), and the moving average convergence/divergence (MACD). The 20-day EMA is the trigger for the trading strategy, and the main reason we use the EMA instead of the SMA is because it places more weight on recent movements, which is what we need for fast momentum trades. The 100-day SMA is used to make sure that we take only trades that are in line with the broader trend, while the MACD is used to help gauge momentum and to filter out lower-probability signals. We use the default settings for the MACD histogram: first EMA = 12, second EMA = 26, signal EMA = 9, all using closing prices. The trade is taken only when the MACD has turned within five candles, because we want to enter into the trade when momentum is beginning to build and not when it is maturing.

These are the rules or guidelines for the 20–100 short-term momentum strategy.

Long Trade (Using 5-Minute Charts)


  1. Find a currency pair that is trading below both the 20-day EMA and the 100-day SMA.
  2. Wait for the price to cross above both moving averages by 15 pips, and make sure that the MACD has turned positive no longer than 5 candles ago.
  3. Buy at market.
  4. Place your stop at the low of the candle that broke the moving averages.
  5. Sell half of the position when the currency pair has moved in your favor by the amount risked, and move your stop on the remaining position to breakeven.
  6. Trail the stop on the remaining position by the 20-day EMA minus 15 pips.

Short Trade


  1. Find a currency pair that is trading above both the 20-day EMA and the 100-day SMA.
  2. Wait for the price to cross above both moving averages by 15 pips, and make sure that the MACD has turned negative no longer than five candles ago.
  3. Sell at market.
  4. Place your stop at the high of the candle that broke the moving averages.
  5. Buy back half of the position when the currency pair has moved in your favor by the amount risked, and move your stop on the remaining position to breakeven.
  6. Trail the stop on the rest of your position by the 20-day EMA plus 15 pips.
Here are some examples of the 20–100 short-term momentum strategy in action:

The first example that we will look at is a long trade. 

     On April 10, 2008, the EUR/USD broke above both the 20-day EMA and the 100-day SMA after a long Asian session consolidation. Before taking the trade, we checked that the MACD at the time had just turned positive, and then we waited for the price to break above the moving averages by 15 pips to go long. Since the moving average price cross occurred at 1.5742, we entered the EUR/USD trade at 1.5757. The stop would be placed at 1.5738, which is the low of the candle that broke above the moving averages. The first target is the entry price plus the amount risked. Since we entered at 1.5757 and our stop is at 1.5738, the amount risked is 19 pips. Therefore, the first target would be 1.5757 plus 19 pips, or 1.5776. It is hit a few hours later, at which time we move our stop on the rest of the position to breakeven. This is a money management rule that we use most often at BKForex Advisor, because having the stop at breakeven on the second half of the position means that we are trading with only our profits and are no longer vulnerable to losses. The position continues to move in our favor. Even though there are times when the price falls below the 20-day EMA, it never does so by more than 15 pips until 5:50 a.m. the following morning. At that time, our trailing stop is hit and we exit the remainder of the trade at 1.5804, which is the 20-day EMA minus 15 pips. The total gain on this position if two lots were taken would be 67 pips or an average gain of 33.5 pips.

The second example is a short trade in USD/JPY.

     On April 11, 2008, USD/JPY broke below both the 20-day EMA and the 100-day SMA at approximately 6:30 a.m. New York time. Before taking the trade, we checked that the MACD at the time had just turned negative and then we waited for the price to break below the moving averages by
FIGURE  EUR/USD 5-Minute Chart

15 pips to go short. Since the moving average price cross occurred at 101.88, we entered the USD/JPY short trade at 101.88 minus 15 pips or 101.73. The stop is placed at the high of the candle that broke the moving average, or 102.01. The first target is the entry price minus the amount risked. Since we entered into the short trade at 101.73 and our stop is at 102.01, the amount risked would be 28 pips. This puts our first target at 101.45, or 101.73 minus 28 pips. The first target is hit 10 minutes later, making it the perfect short-term trade. As soon as that happens, the stop is moved to breakeven on the remainder of the position. Then we continue to trail the stop until the price breaks back above the 20-day EMA by 15 pips. This occurs a few hours later at 10:45 a.m., when the second half of the position is eventually closed at 101.06 for a total gain on the trade of 95 pips (assuming two lots) or an average gain of 47.5 pips.

The third example is a short trade in the GBP/USD.

     On April 21, 2008, GBP/USD broke below both the 20-day EMA and the 100-day SMA at approximately 2:00 a.m. New York time. Before taking the trade, we checked that the MACD at the time had just turned negative, and then we waited for the price to break below the moving averages by 15 pips to go short. Since the moving average price cross occurred at 1.9992, we entered the GBP/USD short trade at 1.9992 minus 15 pips, or 1.9977. The stop is placed at the high of the candle that broke the moving average, or 1.9999. The first target is the entry price minus the amount risked. Since we entered into the short trade at 1.9977 and our stop is at 1.9999, the amount risked would be 22 pips. This puts our first target at 1.9955, or 1.9977 minus 22 pips. The first target is hit two hours later.

FIGURE  USD/JPY 5-Minute Chart 


FIGURE  GBP/USD 5-Minute Chart 

As soon as that happens, the stop is moved to breakeven on the remaining position. Then we continue to trail the stop until the price breaks back above the 20-day EMA by 15 pips. This occurs a few hours later at 7:20 a.m., when the second half of the position is eventually closed at 1.9855 for a total gain on the trade of 144 pips (assuming two lots) or an average gain of 72 pips.

The final example is one where the trade gets stopped out.

     On April 18, 2008, the AUD/USD broke above both the 20-day EMA and the 100-day SMA after a long Asian session consolidation. Before taking the trade, we checked that the MACD at the time had just turned positive within the past five bars, and then we waited for the price to break above the moving averages by 15 pips to go long. Since the moving average price cross occurred at 0.9368, we entered the AUD/USD trade at 0.9383. The stop would be placed at 0.9366, which is the low of the candle that broke above the moving averages. The first target is the entry price plus the amount risked. Since we entered at 0.9383 and our stop is at 0.9366, the amount risked is 17 pips. Therefore, the first target would be 0.9383 plus 17 pips, or 0.9400. The currency pair takes hours to move in our favor, but the rally does not have enough momentum to hit our first profit target. It stops 2 pips shy before reversing sharply to stop us out for a loss of 34 pips on the trade (assuming two lots) or an average loss of 17 pips. The only thing that could have given us a clue that the trade might not have much momentum could have been the fact that the MACD dip into negative territory was very narrow and came off of a longer period above positive territory. Either way, thankfully the stops on this type of strategy tend to be small, making the loss bearable.

HIGH-PROBABILITY TURN STRATEGY
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In the currency market, trends can last for a very long time. For some people, this gives them many opportunities to join the trend, but for other people who are contrarians by nature, the longer the trend lasts, the more frustrating it becomes. Based on my years of interaction with individual traders as well as the data from the FXCM Speculative Sentiment Index (FXCM SSI), I have seen that even though most traders deny it, they are top pickers or bottom fishers by nature.

The FXCM Speculative Sentiment Index is based on the positioning of the company’s most speculative clients. As indicated in Figure, traders started to short the EUR/USD when it was trading at 1.28 and as a group have remained net short from 1.28 all the way up to 1.56. There are obviously traders who drop in and out of the survey because they were stopped out, but the chart clearly indicates that short positions were increased around 1.35 and 1.40. The FXCM SSI is published once a week on DailyFX.com.

FIGURE  AUD/USD 5-Minute Chart 


FIGURE  FXCM SSI for the EUR/USD

Picking a top or bottom can be extremely difficult, and the FXCM SSI proves that many traders do it unsuccessfully. This makes finding a good way to time a turn extremely important. One of my favorite strategies is to look for extension moves, and I define an extension move as consecutive strength or weakness. There are many times that a currency pair will rally for six, seven, or eight days straight with virtually no retracement. The longer the move lasts, the more statistically significant it becomes and the higher the likelihood that the string of strength or weakness will come to an end.

Based on looking at 10 years’ worth of data, I have found that rarely do extension moves in the major currency pairs like the EUR/USD, GBP/USD, and USD/JPY last longer than seven days.

Starting with the EUR/USD, over the past 10 years, the longest extension move that occurred in the currency lasted for 10 days. The table is read in the following way: There have been 10 times when the EUR/USD has moved in one direction for seven days straight, with the move extending for an eighth day only five out of those 10 times. Of those five times, only twice did the EUR/USD’s move last for a ninth trading day, and only once did it then last for a tenth day. Therefore, once a rally or sell-off has continued for seven days straight in the EUR/USD, the odds for a turn within the next 24 hours increase exponentially, and those odds become even more compounded if the move lasts for an eighth day. This provides traders with a high-probability short-term trading opportunity. Please bear in mind that this strategy does not usually predict major turns, but occasionally the turn can become a meaningful one.

TABLE  Length of EUR/USD Extension Moves (10 Years)
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Number of Days                                       EUR/USD
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1                                                                     1292
2                                                                      595
3                                                                      273
4                                                                      125
5                                                                        64
6                                                                        35
7                                                                        10
8                                                                          5
9                                                                          2
10                                                                        1
11                                                                         0
12                                                                        0
13                                                                        0
14                                                                        0
15                                                                        0
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The next set of data is for the GBP/USD. Over the past 10 years, the longest extension move lasted for 12 days. As indicated by the data, trends in the British pound have lasted longer than trends in the euro. The longest move in the EUR/USD was 10 days. However, it is also important to realize that rarely do the moves in the GBP/USD extend for eight days; there have been only seven cases of this, which means that for the GBP/USD an eight-day extension has approximately the same statistical significance as a seven-day extension move in the EUR/USD.

The last table, provides the same data for USD/JPY. The longest move was nine days in length, and that happened only twice over the past 10 years.

How Can You Use This Information?

I have devised some rules to help traders utilize this valuable information:

Rules for a Long Trade (Using Daily Charts)


Look for seven consecutive days of weakness, when the close of each day is lower than the open.
  1. Buy at 5 p.m. New York time, which is when the next trading candle begins.
  2. Place a stop 30 pips below the entry price.
  3. Close half of the position when it moves by two times the amount risked. Move the stop on the remaining half to your initial entry.
  4. Close the remaining position when the price has moved by four times the amount risked, or 120 pips.


TABLE  Length of  GBP/USD Extension Moves (10 Years)
_____________________________________________________________
Number of Days                                       GBP/USD
_____________________________________________________________
1                                                                     1352
2                                                                      659
3                                                                      299
4                                                                      145
5                                                                        69
6                                                                        31
7                                                                        12
8                                                                          7
9                                                                          3
10                                                                        2
11                                                                         2
12                                                                        1
13                                                                        0
14                                                                        0
15                                                                        0
_____________________________________________________________


TABLE  Length of  USD/JPY Extension Moves (10 Years)
_____________________________________________________________
Number of Days                                       USD/JPY 
_____________________________________________________________
1                                                                     1334
2                                                                      652
3                                                                      323
4                                                                      159
5                                                                        66
6                                                                        33
7                                                                        12
8                                                                          7
9                                                                          2
10                                                                        0
11                                                                         0
12                                                                        0
13                                                                        0
14                                                                        0
15                                                                        0
_____________________________________________________________

Rules for a Short Trade


  1. Look for seven consecutive days of strength, when the close of each day is higher than the open.
  2. Sell at 5 p.m. New York time, which is when the next trading candle begins.
  3. Place a stop 30 pips above the entry price.
  4. Close half of the position when it moves by two times the amount risked. Move the stop on the remaining half to your initial entry.
  5. Close the remaining position when the price has moved by four times the amount risked, or 120 pips.


             Here are some examples of how this strategy works. The first example is a long trade in USD/JPY. USD/JPY dropped for seven consecutive trading days. Based on the USD/JPY table of extension moves, we see that only seven out of the 12 times that USD/JPY has moved in one direction for seven days straight did the move extend for an eighth day. Given this information, there is a high probability that USD/JPY would not sell off for an eighth consecutive day. For that reason, we go long USD/JPY when the next day’s candle begins at 5 p.m. New York time with a 30-pip money stop. The trade is executed at 108.56 with a stop of 108.26 (108.56 minus 30 pips). The first target is simply two times the amount risked, or 60 pips, which places our limit order to exit the first half of our position at 108.56 plus 60 pips or 109.16. This is reached the very next day, at which time we move our stop to breakeven, or our initial entry price of 108.56. The target on the second lot is four times the amount risked or 120 pips. Our entry price of 108.56 plus 120 pips is 109.76, and that, too, is hit 24 hours later, banking us a total profit of 180 pips, or an average profit of 90 pips per lot if two lots were traded.

FIGURE USD/JPY Daily Chart 

The second example is a short trade in GBP/USD. GBP/USD rallied for seven consecutive trading days. Based on the GBP/USD table of extension moves, we see that only seven out of the 12 times that GBP/USD has moved in one direction for seven days straight did the move extend for an eighth day. Given this information, there is a decent chance that the GBP/USD would not rally for an eighth consecutive day. For that reason, we go short GBP/USD when the next day’s candle begins at 5 p.m. New York time with a 30-pip money stop. The trade is executed at 2.0083 with a stop of 2.0113 (2.0113 plus 30 pips). The first target is simply two times the amount risked, or 60 pips, which places our limit order to exit the first half of our position at 2.0083 minus 60 pips or 2.0023. This is reached the very next day, at which time we move our stop to breakeven, or to our initial entry price of 2.0083. The target on the second lot is four times the amount risked, or 120 pips. Our entry price of 2.0083 minus 120 pips is 1.9963, and that is hit a few days later, banking us a total profit of 180 pips, or an average profit of 90 pips per lot if two lots were traded.


FIGURE  GBP/USD Daily Chart 


Does the Strategy Work for Other Currency Pairs?

This strategy does work on other currency pairs, but it is important to realize that each currency is different. Although seven days is significant for the EUR/USD, GBP/USD, and USD/JPY, eight days is more significant for currency pairs such as GBP/JPY, CHF/JPY, and GBP/CHF. Different currency pairs have different characteristics because some are more trending than others.

The following is an example of fading an extension in a currency cross such as EUR/JPY. As indicated in figure, EUR/JPY rallied for seven consecutive trading days. According to our strategy rules, we go short the currency pair when the next day’s candle begins at 5 p.m. New York time with a 30-pip money stop. The trade is executed at 164.54, with a stop of 164.84 (164.54 plus 30 pips). The first target is simply two times the amount risked, or 60 pips, which places our limit order to exit the first half of our position at 164.54 minus 60 pips or 163.94. This is reached the very next day, at which time we move our stop to breakeven, or our initial entry price of 164.54. The target on the second lot is four times the amount risked or 120 pips. Our entry price of 164.54 minus 120 pips is 163.34, and that is hit 24 hours after that, banking us a total profit of 180 pips, or an average profit of 90 pips per lot if two lots were traded.

FIGURE EUR/JPY Daily Chart 


Can the First Target Be Altered?

When examining this strategy, many people may realize that the first target is relatively tight and easily reached. Traders are free to alter the first target to try to bank more pips, but please remember that the reason the limit is placed at that level is because I like to focus on high-probability trading strategies, and having the first target easily achievable allows us to bank profits on the trade even if the turn that we are looking at is only temporary. When designing trading strategies, I am a big believer that it is important to start with a good foundation, meaning a strategy that works on the most simplistic level, because it is hoped that any improvements or alterations will only increase the strategy’s profitability. Trying to improve on a strategy that doesn’t work in the first place becomes far more difficult.

Could You Trade a Six-Day Move Instead?

Given the rarity of a seven-day extension move, some traders may wonder whether they can trade a six-day extension move instead because the chance of the move continuing for a seventh day is relatively small. Although this can be done, it is not recommended. Traders need to be mindful of the risks, because in all three of the major currencies, the move extended for a seventh day at least 10 times within the past 10 years.

What Happens If the Move Continues for More Than Seven Days?

One of the most common questions asked about this strategy is whether the trade should be taken again if the move extends for more than seven days. The answer is yes, because with each additional day that the move continues, the greater the chance of a turn. Also, the risk on the strategy is small enough to withstand a 10-day extension if both the first and second targets are eventually achieved. The math works out well as long as the extension does not continue for a twelfth day.

According to Table, if we trade two lots and the seven-day fade trade fails and the currency pair continues to move in the same direction for an eighth day, we lose 60 pips on the trade. However, if we take the trade again at the beginning of the ninth trading day and both target 1 and target 2 are achieved, we bank 180 pips. The net return on the two trades would be +120 pips.

If the move continues for the ninth day and we attempt to fade the move at the beginning of the tenth trading day, we would be starting off with two losing trades and a loss of −120 pips. If we are correct and the move does stop on the tenth day, the third trade would bank 180 pips, netting us a total of +60 pips on the three trades.

If we are so unlucky that the move continues for the tenth trading day and we attempt to fade the move again at the beginning of the eleventh trading day, we would be starting off with a loss of −180 pips on three trades. However, if we are right on the fourth trade, at least we would break even.

TABLE  Profit and Loss for Extension Moves 


And on the rare occasion that the move extends for the eleventh trading day and we decide to attempt the trade again on the twelfth trading day, we would be starting off with a loss of −240 pips on four trades. If we end up being right on the fourth trade, we would reduce our loss to −60 pips. A sequence of 12 consecutive trading days of strength is very rare; of the three major currency pairs, a move has extended to the twelfth trading day only once in the past 10 years, and that was in the GBP/USD.

The returns, of course, are not as good if the first target or limit is hit and the second lot is closed out at breakeven due to a retracement, because the losses start to build if the currency pair’s move extends for a tenth trading day. If the move continues for an eighth trading day and you attempt to fade it again on the ninth day, the best-case scenario based on the stops and limits of this strategy is breakeven. If the move is exhausted on the tenth day, the net loss on the trade would be 60 pips. This loss would grow to 120 pips if the move continues for another day and so forth. Thankfully, hitting just the first target usually does not happen, because the second target of 120 pips is relatively close and still easily achievable, especially as the moves become more extended. When a turn happens, it tends to be more than 100 to 150 pips.

Although the entry and exit rules for this strategy apply well for the EUR/USD, GBP/USD, and USD/JPY, when it comes to some of the other currency pairs, particularly the Japanese yen crosses, the entry and exit rules may have to be altered, because the wild volatility in some of these pairs may make a 30-pip stop-loss too tight.

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