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The Forex Strategies Guide
For Day and Swing Traders
2.0
Updated and Expanded, 2014, 2015:
Strategies and Methods for Conquering the World’s
Currency Market
~by Cory Mitchell, CMT~
http://vantagepointtrading.com
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© 2012, © 2014, © 2015 Cory Mitchell, CMT – All rights reserved
http://vantagepointtrading.com
UNAUTHORIZED DUPLICATION AND/OR DISTRIBUTION OF
THIS COPYRIGHTED MATERIAL IS STRICTLY FORBIDDEN.
YOU ARE NOT AUTHORIZED TO SELL THIS EBOOK IN ANY
FORM SUCH AS ONLINE AUCTIONS (i.e. eBay), NOR GIVE IT
AWAY FOR FREE, NOR PLACE IT ANYWHERE ON THE INTERNET
WHERE SOMEONE MAY DOWNLOAD IT, NOR MAKE IT
DOWNLOADABLE BY TORRENT.
This eBook has been formatted for easier on-screen reading.
The PDF allows commenting and highlighting, so you can highlight text or
make comments to yourself as you read through the book. This is encouraged.
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Government Required Risk Disclaimer and Disclosure Statement
This book is for informational purposes only and should be used at your own discretion. The
reader of this material agrees that they are acting of their accord and waive Cory Mitchell or
http://vantagepointtrading.com of any liability associated with losses or hardships which may
result from using information within this book.
Trade at your own risk. The information provided here is of the nature of a general comment
only and neither purports nor intends to be, specific trading advice. It has been prepared without
regard to any particular person's investment objectives, financial situation and particular needs.
Information should not be considered as an offer or enticement to buy, sell or trade.
You should seek appropriate advice from your broker, or licensed investment advisor, before
taking any action. Past performance does not guarantee future results. Simulated performance
results contain inherent limitations. Unlike actual performance records the results may under or
over compensate for such factors such as lack of liquidity. No representation is being made that
any account will or is likely to achieve profits or losses to those shown.
By purchasing this book, you acknowledge and accept that all trading decisions are your own
sole responsibility, and Cory Mitchell, www.vantagepointtrading.com or anybody associated
with these entities cannot be held responsible for any losses that are incurred as a result.
The risk of loss in trading can be substantial. You should therefore carefully consider whether
such trading is suitable for you in light of your financial condition.
If you purchase or sell Equities, Futures, Currencies or Options you may sustain a total loss of
the initial margin funds and any additional funds that you deposit with your broker to establish or
maintain your position. If the market moves against your position, you may be called upon by
your broker to deposit a substantial amount of additional margin funds, on short notice in order
to maintain your position. If you do not provide the required funds within the prescribed time,
your position may be liquidated at a loss, and you may be liable for any resulting deficit in your
account.
Under certain market conditions, you may find it difficult or impossible to liquidate a position.
This can occur, for example, when the market makes a "limit move." The placement of
contingent orders by you, such as a "stop-loss" or "stop-limit" order, will not necessarily limit
your losses to the intended amounts, since market conditions may make it impossible to execute
such orders.
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About the Author
This eBook is written by me, Cory Mitchell, a Chartered Market Technician
(CMT), member of the Market Technicians Association, Canadian Society of
Technical Analysts, and by extension the International Federation of Technical
Analysts. I’ve been a trader since 2005, pulling millions
of dollars in profit out of the markets.
I worked for six years as a proprietary trader for a
trading firm(s), doing one of the toughest jobs on the
planet (also the most fun)–extracting profit every single
month; if I didn’t make a profit, I didn’t get paid (no
salary, everything was dependent on performance).
These are forex trading strategies forged by
relentless dedication to trading, and tens of thousands of
trading hours and trades. In 2011 I moved my focus to trading independently, and
helping others by sharing what I've learned.
I freelance for and have been vetted by some of the largest financial sites in
the world, including About.com (a top 100 site) and Investopedia, among many
others. I am the founder of VantagePointTrading.com where I regularly post
articles about trading.
I usually write for a couple hours, helping others, and trade for one or two
hours each day (that's all it takes). I spend my spare time rock climbing, on the
running trails, training for the next fitness challenge, playing volleyball and golfing
during the summer.
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Table of Contents
Table of Contents ........................................................................................................................................ 5
Introduction & 5 Step Plan for Trading Success (Read this all!) ................................................................ 10
1. Forex Basics........................................................................................................................................... 18
Understanding Foreign Exchange (FOREX) ............................................................................................ 18

Currency Pairs to Focus On ....................................................................................................... 19

Buying, Selling and Short Selling ............................................................................................... 21

The Bid/Ask Spread ................................................................................................................... 21

Lot Sizes .................................................................................................................................... 23

Pip Value ................................................................................................................................... 23

Forex Market Hours and News .................................................................................................. 26

Leverage .................................................................................................................................... 28

Rollover ..................................................................................................................................... 29

Order Types ............................................................................................................................... 32
2. Being Successful in the Forex Market .................................................................................................. 36
The Trading Plan ................................................................................................................................... 37

Risk Management ..................................................................................................................... 38

Position Size .............................................................................................................................. 39

Daily Risk ................................................................................................................................... 41
Forex Correlations................................................................................................................................. 43

What is a Forex Correlation? ..................................................................................................... 44

How to Use Forex Correlation Data........................................................................................... 46
How Much Leverage to Use .................................................................................................................. 49

How Much Forex Leverage – Scenarios ..................................................................................... 50

Why Do Brokers Provide Such Huge Leverage? ........................................................................ 52
Averaging Down .................................................................................................................................... 53
Pyramiding ............................................................................................................................................ 54
Record Keeping ..................................................................................................................................... 56
The Blissful Lack of Information ............................................................................................................ 58
Moving Forward .................................................................................................................................... 59
3. Recommended Minimum Capital for Forex Trading (Day or Swing) ..................................................... 61
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How Much Money Do I Need to Trade Forex? - Why It Matters ....................................................... 61
How Much Money Do I Need to Day Trade Forex? ............................................................................ 62
How Much Money Do I Need to Swing Trade Forex? ........................................................................ 63
4. Pip Potential Relative to Spread – Day Trading Forex ........................................................................... 66
Spread to Pip Potential Examples ......................................................................................................... 68
5. Introduction to Swing Trading and Day Trading .................................................................................... 71
Swing Trader or Day Trader? ................................................................................................................ 72
Final Thoughts: Adapt Methods to Suit You .......................................................................................... 75
6. Picking a Forex Broker ........................................................................................................................... 76
How to Pick a Forex Broker – ask yourself the right questions........................................................ 76
How to Pick a Forex Broker – does your broker offer this? .............................................................. 78
How to Pick a Forex Broker – don’t always trust reviews or other people’s opinions ................... 81
How to Pick a Forex Broker – personally “test out” the broker(s) you choose ............................... 81
Don’t Take the “Bonus” ....................................................................................................................... 82
7. Best Time to Day Trade and Swing Trade .............................................................................................. 85
Open Major Markets Means Increased Action ................................................................................... 85
Best Time to Day Trade– EUR/USD, GBP/USD and USD/CHF .......................................................... 87
Best Time to Day Trade– USD/CAD.................................................................................................... 90
Best Time to Day Trade – AUD/USD and NZD/USD .......................................................................... 90
Best Time to Day Trade – Other Forex Pairs ..................................................................................... 91
Time of Day and Swing Trading ............................................................................................................. 92
8. Introduction to Japanese Candlestick Charts ........................................................................................ 93
Japanese Candlestick Creation ........................................................................................................... 94
Japanese Candlestick Interpretation .................................................................................................. 98
The Secret Life of Charts ....................................................................................................................... 99
The Bid/Ask Spread and Your Charts .............................................................................................. 100
9. Trading Chart Patterns ....................................................................................................................... 103
Chart Patterns to Focus On and How to Trade Them.......................................................................... 104

The Triangle ............................................................................................................................ 105

Wedges ................................................................................................................................... 114

The Head and Shoulders Pattern............................................................................................. 118
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
Flags and Pennants ................................................................................................................. 126

Trading with Multiple Profit Targets, Stops and Positions ...................................................... 132
Additional Chart Patterns ................................................................................................................... 133

Double Top/Bottom, Triple Top/Bottom ................................................................................. 133

Rectangle (Ranges) .................................................................................................................. 139

Broadening Wedge.................................................................................................................. 147
Finding Patterns .................................................................................................................................. 149
10. Trendlines, Horizontals and Shifting Markets ................................................................................... 152
Horizontal Support and Resistance Guide ........................................................................................... 157
Trendlines Guide ................................................................................................................................. 159
Using Trendlines and Horizontals in Shifting Markets......................................................................... 160
11. Combining Engulfing Candles with Trends ........................................................................................ 165
Recognizing Engulfing Candles ............................................................................................................ 165
Using the Trend with Engulfing Patterns............................................................................................. 167
Zeroing In on the Entry Point ........................................................................................................... 171
12. Trading the News .............................................................................................................................. 175
Rules of the Strategy: .......................................................................................................................... 177

Trade Example ........................................................................................................................ 179
13. The Carry Trade................................................................................................................................. 181
What to Watch For ............................................................................................................................. 182
How You Make Money ........................................................................................................................ 185
14. Statistics and Averages Every Trader Should Track ........................................................................... 188
Daily Range ......................................................................................................................................... 189
Inner-Daily Range................................................................................................................................ 191
Day of Week Averages ........................................................................................................................ 192
Homework .......................................................................................................................................... 193
15. European Open Strategy ................................................................................................................... 195
The Trade Set-up................................................................................................................................. 195
Trade Rules ......................................................................................................................................... 198
Considerations and Performance ........................................................................................................ 206
16. Truncated Price Swing Strategy ........................................................................................................ 208
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Truncation Strategy Considerations .................................................................................................... 217
17. Channel Breakout Strategy ............................................................................................................... 219
The Nature of Trends .......................................................................................................................... 220
Mini-Channel Breakouts ..................................................................................................................... 220
Stops and Profit Targets ...................................................................................................................... 223
Correction Channels............................................................................................................................ 227
18. Scalping Round Numbers .................................................................................................................. 233
Scalping Round Numbers .................................................................................................................... 233
19. The "Good-Bye Kiss" Strategy ........................................................................................................... 237
Good-Bye Kiss Considerations............................................................................................................. 241
20. Always Weigh the Probabilities ......................................................................................................... 243
What are Realistic and Reasonable Criteria? ...................................................................................... 246
21. Anticipating Chart Pattern Breakout Direction ................................................................................. 248
What is Front-Running a Chart Pattern Breakout? .............................................................................. 248
Anticipating a Chart Pattern Breakout ................................................................................................ 249
Guidelines for Anticipating Chart Pattern Breakout Direction ............................................................ 255
22. Interpreting Price Action: Velocity and Magnitude ........................................................................... 257
Velocity and Magnitude: Why They’re Important .............................................................................. 257
Analyzing Price Action: Magnitude .................................................................................................... 257
Analyzing Price Action: Velocity ....................................................................................................... 259
Analyzing Price Action – How to Use This Information .................................................................... 261
23. "Strong" Support and Resistance and the Crotch Strategy ............................................................... 262
Minor (inaccurate) Support and Resistance ........................................................................................ 262
STRONG Support and Resistance ........................................................................................................ 264
The Crotch Strategy ............................................................................................................................ 268
The Crotch Strategy and "Rangey" Pairs ............................................................................................. 272
Ranges in Similar Economies ............................................................................................................... 273
Time of Day ......................................................................................................................................... 275
24. The Trend Channel Trading Strategy ................................................................................................. 280
25. Psychological Pitfalls You Need to Understand ................................................................................. 286
How Not Losing Keeps You From Winning .......................................................................................... 286
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
Avoiding Losses ....................................................................................................................... 287

Losing Means Winning? .......................................................................................................... 288
A Psychological Trick ........................................................................................................................... 288
Wanting to Be First In and Last Out .................................................................................................... 290
Protecting the Ego .............................................................................................................................. 290
On and Off Discipline .......................................................................................................................... 291
Don’t be Arrogant. Develop Confidence and Self-control ................................................................... 292
Losing Objectivity ................................................................................................................................ 293
The “All In” Mentality/Revenge .......................................................................................................... 293
Random Reinforcement ...................................................................................................................... 294
26. Active Trade Management ................................................................................................................ 296
27. How to Incorporate All This Information .......................................................................................... 301
28. Bringing Everything Together into Your First Trading Plan ............................................................... 305
Swing Trading Plan ............................................................................................................................ 306
Specificity Matters .............................................................................................................................. 311
29. Checklist For While You Are Trading ................................................................................................. 314
30. False Breakouts - A GIFT to Active Traders........................................................................................ 317
31. Create Your Own Trading Strategies ................................................................................................. 321
Creating Strategies .............................................................................................................................. 321

What initiated the Move? ....................................................................................................... 321

Look For an Exit ....................................................................................................................... 323

Money Management – What’s the Risk? ................................................................................ 323

See if it's Reliable .................................................................................................................... 324
32. Meditation for Traders ...................................................................................................................... 327
What Meditation Is, and How it Relates to Trading ............................................................................ 327
Using Meditation For Improved Trading ............................................................................................. 327

Improving Performance Meditation ........................................................................................ 329
Altering the Meditation ...................................................................................................................... 330
33. Trading Resources ............................................................................................................................. 333
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Introduction & 5 Step Plan for Trading
Success (Read this all!)
Whether you're an experienced trader or new to forex trading (or trading in
general), throughout this book you'll find information that will help you profitably
tackle the global currency market. It's my hope that with some effort, patience and
discipline you'll be able to fruitfully create a trading plan and implement these
strategies effectively...allowing you to achieve your goals.
While certain chapters may be of greater interest to you than others, read all
the chapters, in order. Each will add to your market understanding, and be
beneficial when building your trading plan (your plan of attack for the markets).
Interspersed throughout the book are insightful points on trading, which are missed
if the material is glanced over.
This book provides strategies for trading in any type of market, whether
trending, ranging, volatile or sedate. It'll demonstrate how to determine which of
these market environments is currently underway, and when the market shifts from
one type of environment to another.
The ability to determine shifts in the market will take time to master. In
order to become a better trader you should understand these concepts before
applying any of the strategies discussed. That means you should read the whole
book before applying the specific strategies contained within it (see the 5-step plan
below). Combine all the information, and don't just blindly follow the individual
strategy rules I've laid out.
You'll then need to go through the process of applying the strategies in the
market, but only when combined with the knowledge you've acquired about
general market movements by reading through the entire book. In other words,
don't just read one chapter to nab a strategy...this won't help your trading over the
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long run. Understand market dynamics first, then start applying the strategies so
you can better understand when a strategy should be used, and when it shouldn't.
No chapter is complete on its own. All the chapters build on each other. To
take full advantage of each strategy, and to learn how to employ them, you'll want
to understand all the other chapters. Don't be in a rush; read it all.
It's one thing to see a pattern or trade after the fact, it's quite another to
realize what's happening in the moment and execute the trade without hesitation.
While you read, if possible, follow along on your own charts by pulling up
any free chart website/platform, such as TradingView.com. As topics are
discussed, find examples on the chart. Don't attempt to trade based on the
information just yet; that'll come later. Instead, as you read, just look for examples
so the information is better absorbed, and the reading becomes more of an
interactive hands-on learning process.
As you get to the end of the book you'll need to open a demo account (or use
a current one) and make trades in real-time, but with fake money. Demo accounts
are a useful tool, but still fall well short of trading with real money. Trading is
mostly psychology. I can't stress this enough. If a trader is bouncing from strategy
to strategy, trading book to trading book, it's likely not their strategies which are
at fault, but their discipline and psychology that need work.
You'll have many tools and ideas for tackling the forex market (and other
markets) after reading this book, yet it takes discipline to implement these methods
as outlined. Failure in trading is rarely from a lack of sufficient knowledge. Failure
results from a lack of discipline to implement, and stick with, a course of action
once it's initiated.
Following the plan for each trade is what matters, regardless of what occurs
while the trade is open. Many traders have the discipline to execute a trade, but
begin to crumble and abandon their plan once the trade is under way and gyrating
between a profit and loss. Throughout the book you'll learn what's included in a
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trading plan, and build your own, so you don't ever have to question yourself
before or during a trade again.
The demo account helps you get a feel for market movement, be able to spot
market shifts and see trades in real-time, but it doesn't adequately mirror the
psychological barrage of emotions which affect you when real money is on the
line. Especially when losing money people have a tendency to begin blaming
anything but themselves, resulting in a negative performance feedback loop.
Instead, as a trader, you must take full responsibility for yourself, your education,
your trading plan and following it.
Watching your profits and losses gyrate up and down won't be easy. Your
mind will want to give in to impulsive action, but doing so will sabotage your
trading. Follow your original trade plan, and use the demo account to practice this
skill. If you're unable to stick to a trading plan without changing that plan midtrade, you're not ready to trade real money. Trading real money only magnifies
trading related psychological and disciplinary issues.
When I was on the trading floor the expression “Maybe it’s the archer
behind the bow...” was commonly used when a trader began to complain about the
market, or blamed a strategy for their bad trade/day. In other words, we were
saying “It's not the market's fault....adjust your attitude/outlook/plan...learn from it,
if there's something to learn, and then move on.”
No matter what happens, each trader is ultimately responsibility for their
own actions, and must take 100% ownership of that fact. Taking full personal
responsibility means being able to adapt, change, learn and grow; blaming external
forces or events only leads to personal set-backs and an inability to fix problem
areas.
Accept the market as it is. Know that if you put in the effort and practice to
implement your trading plan, in a disciplined and risk controlled fashion, you
stand a very good chance of becoming a successful trader. The effort and practice
never ends though; it's an ongoing process, not a destination where all of a sudden
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you get to stop. As soon as you stop practicing and maintaining discipline, losses
will mount.
You may have bought this book to learn some winning strategies, yet a
strategy is only a portion of a winning formula. The other required elements of the
formula include being able to implement the strategy, knowing when to do so and
managing risk/money.
This brings us to the five steps for becoming a successful trader, and how
you should use this book.
There's a lot of information in these pages. The temptation will be to open a
demo account right away (or use your current demo or live account), skip to the
strategy chapters and start trying things out. Don't do this. Instead, trust a proven
process—in all fields, not just trading. You've likely already tried the approach
above—grabbing a strategy and testing it out—but did that ultimately work?
Below is a new approach. Commit to the following 5-step process while you read
this book, and until your account is consistently growing each month.
1.
Read this entire book before you place any live or demo trades.
Instead of placing actual trades, follow along on some free charts, note
examples, draw on the charts, watch how prices act, but don't trade.
The human mind is impulsive. But traders can't be. If you want to be a trader
you need to reign in that impulsive nature. This step is your first task: saying
NO to something you want...which is to trade. You only get to trade after
you've read this book (some chapters may require several read throughs).
If you're already trading, and seeing success with the trading plan you trade,
then continue to trade that plan. Don't implement the strategies discussed in
this book into your trading plan until you've read the entire book though.
2.
Once you've read the book your mind will be filled with ideas and
strategies. This is the time to create your first trading plan. You'll know
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everything about risk management, placing entries/stops/targets and a whole
lot of strategies and analysis tools that'll help you determine exactly where
these entries/stops/targets should go.
Choose a couple strategies you like and build your trading plan around them.
What a trading plan is, and how it's constructed, is revealed in the chapters
that follow.
3.
With trading plan in hand, you're ready to begin implementing
it...with a demo account. Open a demo account (this gives you a chance to
test out brokers, as discussed in the book) and practice implementing your
plan.
This is the MOST important step. The temptation is to make a deposit and
make live trades in an effort to make some money. This is short-sighted. It's
easy to look at historical charts and pick out patterns and trades, or read the
examples in this book. It's entirely different to see trades, and make trades,
when the price is moving in real-time and everything to the right of the
screen is unknown.
Trading requires practice, and the strategies in this book require practice in
order for them to be profitable. If you choose two strategies to include in
your trading plan, at minimum you should practice them for at least two
months. If you're profitable after two months in a demo account, open a live
trading account and begin to implement your plan with real capital.
If you're unprofitable after two months, then you either need more practice
or you need to adjust your plan (step 4). If you're following the plan exactly,
then it's the plan that needs work. If it's you that's not following the plan
exactly, it's your discipline that needs work...you need more practice and
need to discipline yourself into following that plan and never deviating.
Building discipline is developed by practicing discipline...there's no
shortcut.
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4.
Adjust your plan. Initially when you create your plan you may not
account for certain factors, or you realize your time and/or capital constraints
don't allow you to implement the trading plan as you intended. When this
occurs, go back to drawing board and re-construct your plan based on your
demo trading experience.
You'll also need to adjust your trading plan if you were unprofitable while
practicing for a number of months in a demo account.
Once you have a new plan, practice implementing it again for another couple
months. If you're profitable after implementing the plan for at least two
months in a demo account, then move on to step five. If you're unprofitable,
then repeat step four—adjust your plan, make sure you're following it and
practice implementation until you're profitable in the demo account over a
number of months.
5.
Step five is opening a live trading account (according to the guidelines
discussed in the "Choosing a Forex Broker" chapter). It should take two
months or more to get to this stage. For many traders it'll be six months or
more.
This is the process of becoming a successful trader; success isn't the result of
just knowing a few strategies.
When I began trading it took six months until I was consistently profitable.
Most of my trading friends took between six months and year before they
were consistently profitable. You need to practice, and that takes time. If you
rush it, you'll lose your money.
Once you're consistently profitable there will be hiccups where you mess up
or lose your discipline for a while. But usually, if you can become consistent
once by following this process, you'll have the tools to become consistent
again.
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That's the process you undertake if you want to be a trader, and it's the
process you should commit to right now. Do you want to keep doing what you're
doing and getting the same results? Or do you want to commit to learn, practice
and adjust until you get it right? This is how you get it right, and if you never get it,
then at least you haven't lost any real money trading.
Trading is tough; if it was as easy as reading a book, and there are hundreds
of books by great traders, then there would be a lot more successful traders. So
something is obviously missing; successful trading isn't just about knowledge, it's
about effectively being able to implement knowledge under adverse psychological
conditions. The rest of the book gives you the knowledge, while the process above
shows you how to implement that knowledge. That last part is the missing key in
most books. You now have it.
Knowledge is the door which I can offer you; walking through can only be
done by you, and it requires your commitment to the five steps above, completed
in sequence. No cheating. If you cheat, you cheat yourself out of experiencing your
own full potential.
A note about the charts in this book: The charts are from screenshots I've
taken over the years. This means the charts aren't uniform in size or look. Instead
of replacing all them with new examples, I've opted to keep many of these old
charts, as they show times of different volatility across the years. During low
volatility times it's hard to remember that pairs can move 300+ pips a day...every
day...for weeks. Nothing stays static for long in the forex market, as the charts
throughout the book show.
You'll also notice technical indicators on some charts. Don't be distracted by
these. I don't use indicators, and indicators aren't used for any of the strategies in
this book (except the odd one for reference). From time to time I put indicators on
my charts to see if an indicator works better than just reading price action—upon
which all the strategies in this book are based. So far, reading price action trumps
all indicators.
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There's one "indicator" (not a technical analysis one) I use frequently, and it
shows when global trading sessions start and end. Throughout the book you may
notice some charts are yellow, others are beige and some are blue. I've set the
indicator to mark the London session in yellow, the US and London overlap period
in beige, and the US session (London closed) in blue. Other charts are just plain
black or white. If that didn't make sense, it will shortly, as you move through the
book and see some chart examples. The "session indicator" mentioned above is
listed in the resources section at the end of the book.
Now, let’s jump in, and may you find the answers you seek and the life you
deserve.
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1. Forex Basics
Find additional information at VantagePointTrading.com. The site has
frequent swing trade signals, based on a trading plan in this book, providing a
continual source of examples so the concepts can be fully understood before
trading.
Understanding Foreign Exchange (FOREX)
The retail forex market offers many opportunities, yet it's a dangerous and
confusing place for those who don't understand how it works. The forex, or foreign
exchange market, is where the world’s currencies are traded. A currency is always
traded relative to another currency. When we see “EUR/USD,” the corresponding
rate is the value of one currency relative to the other. Let’s look at an example.
The EUR/USD is trading at 1.3600. The easiest way to understand
currencies is to view the first currency, in this case the EUR, as 1. So the rate,
1.3600, is how much of the second currency (the USD in this case) it takes to buy 1
EUR.
The first currency in the pair is our directional currency on a chart. If you
open a EUR/USD chart (in your trading software or on a free platform such as
TradingView.com) and the price is rising, the EUR is increasing in value relative
to the USD. If the rate is falling, the EUR is losing value against the USD.
Based on the example above, you may have the following questions: “What
are the currency symbols, and what do they mean?” Also, not all currency pairs are
ideal for trading purposes, therefore traders commonly ask “What forex pairs
should I focus my trading efforts on?”
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
Currency Pairs to Focus On
There are many symbols representing the currencies of the countries (and
zones) around the world, although for trading purposes there are only a handful
you really need to be aware of. These symbols and their corresponding currencies
are listed below. For most short-term or active traders these are the currencies to
focus on:
USD = United States Dollar
EUR = Euro (Euro Zone countries)
JPY = Japanese Yen
GBP = British Pound
CAD = Canadian Dollar
AUD = Australian Dollar
CHF = Swiss Franc
NZD = New Zealand Dollar
Remember, each currency is traded relative to another currency, creating a
pair. The following are heavily traded pairs and are therefore the most commonly
used for speculative purposes.
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
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
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


EUR/USD
USD/JPY
GBP/USD
USD/CHF
USD/CAD
AUD/USD
NZD/USD
EUR/JPY
GBP/JPY
The list above shows currency pairs which are used for both day trading and
swing trading. This isn't to say there isn't movement or profit potential in other
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currency pairs which aren't listed here. The list simply shows pairs which are
heavily traded globally, and therefore acceptable for day or swing trading.
In addition to the above pairs, swing traders can also trade the following
pairs, which include combinations of all the major currencies: EUR, GBP, AUD,
NZD, JPY, CAD, CHF and USD.


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















EUR/GBP
AUD/CAD
EUR/CAD
EUR/NZD
GBP/NZD
AUD/JPY
EUR/AUD
EUR/CHF
GBP/CHF
CAD/JPY
AUD/NZD
AUD/CHF
CHF/JPY
CAD/CHF
NZD/JPY
GBP/CAD
GBP/AUD
NZD/CAD
NZD/CHF
These pairs can also be day traded, but only if your broker offers low
spreads and the current volatility warrants trading in the pair. The spread and
volatility are discussed later.
While there may be potential outside of these pairs, these lists should
provide more than enough trading opportunities. There's little reason to trade
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obscure currency pairs when we have all these to choose from. Day traders need to
be especially careful about which pairs they trade, which is why the recommended
list for day traders is smaller.

Buying, Selling and Short Selling
In the forex market, one currency is always traded relative to another. If you
buy the USD/CAD, you've bought the USD and sold the CAD. Traders will often
say they're “long” the currency that was bought. Similarly, if you sell the
USD/CAD, you've sold the USD and bought the CAD. This is commonly referred
to as being “short” or "shorting" the USD/CAD.
Buying and selling occurs on every transaction. This is confusing at first, yet
remember the first currency listed in the pair is the directional currency on the
chart. If the price of the EUR/USD is rising and you think the upward direction
will continue, you'll buy the EUR/USD hoping to sell it at a higher price later. If
the price of the EUR/USD looks like its heading lower, then you sell the
EUR/USD hoping to close the position for a profit at a lower price later on.
In the forex market traders buy or sell at any time, without restriction,
making (or losing) money whether a currency pair rises or falls in value.
Become familiar with the terms selling, shorting and short, as they'll be used
throughout the book, as will buying, long and going long. Understanding these
terms will become easier as we progress through examples.

The Bid/Ask Spread
The bid/ask spread causes a lot of confusion for new traders, and can also
result in losses simply because the trader doesn't understand how their orders are
being executed. It's also possible to misinterpret price charts because of the bid/ask
spread.
The EUR/USD is a popular trading pair, and does the highest trading volume
most days. The EUR/USD generally has a one to three pip spread with most
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Transaction ID: 6YD31355T17923521
brokers. If the bid price is 1.3601, with a three pip spread the offer would be
1.3604. The pip is the smallest unit of currency. Most currency pairs have four
decimal places (five if the broker offers fractional pip pricing), except for JPY
currency pairs which have two: 98.15 (or three, 98.153, if fractional pip pricing is
used).
If you want to buy a currency pair you'll always have to buy at the offer
price, and sell at the bid price. In the EUR/USD example above, if you want to go
long (“long” means “buy”) you pay the 1.3604 rate. If you sell immediately after
going long, your sell price is 1.3601. You lose three pips without the currency pair
even moving.
The spread is equivalent to a commission being charged by a stock broker.
In the forex market most retail brokers don't charge commissions, rather they force
you to pay the spread. This is how forex brokers make their money.
Most forex brokers now offer “fractional pip” pricing. This means there's
five decimal places in the rate of most currency pairs, and three in the case of Yen
(JPY) related pairs.
The EUR/USD for example may have a bid price of 1.36056. This means
instead of paying 1.3606 (the non-fractional price) you'll pay 4/10 of a pip less, just
as an example. Fractional pip brokers typically have smaller spreads than fixed
spread brokers; always trade with a fractional pip broker.
There are also ECN brokers. These brokers offer access to spreads as low as
0.0 pips, though usually it'll be 0.1 pips to 0.4 pips. For this you'll pay a
commission in the neighborhood of $2US to $4US for each 100,000 lot traded
(more on what a "lot" is shortly). ECN brokers are recommended for day traders
trading on short time frames, such as 1-minute charts. By the end of the book you'll
have a good idea if that's going to be you.
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
Lot Sizes
In the stock market, a standard lot is 100 shares. In the forex market we also
trade in lots, except that a lot is a certain dollar amount of currency.
A standard lot is 100,000 worth of currency.
A mini lot is 10,000 worth of currency.
A micro lot is 1000 worth of currency.
Some large institutional brokers don't allow micro or mini lot trading, as
these lot sizes are primarily used by retail traders. Trade through brokers that allow
mini and micro lot trading. Even if trading a large account, being forced to trade
only standard lots limits the number of positions taken and doesn't allow you to
fine tune your risk and positions sizes. Having the option to trade mini and micro
lots is a big advantage—you can still take large positions, but also small ones if
you wish. When trading a standard lot account the minimum trade size is much
bigger, therefore you don't have the trading flexibility that you have with a mini or
micro lot account.

Pip Value
A pip has a value attached to it, and that value will vary depending on the
currency pair you're trading. The pip value of certain pairs fluctuates as the rate of
the pair changes. This means drastic changes in the rate of a currency pair will
greatly affect the pip value, which must be considered when calculating risk and
ultimately position size.
The EUR/USD is the most heavily traded currency pair and has a fixed pip
value. No matter what the rate of the currency pair is (for example it could be
1.25356 or 1.89222) the value of the pip is the same.
In the EUR/USD the pip value (in US dollars) on a micro lot ($1000) is
$0.10. Each time the rate moves one pip, if you're holding a one micro lot position,
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you'll see your profit/loss adjust by $0.10, depending on if the move is favorable or
not. The pip value of a mini lot ($10,000) is $1, and the pip value of a standard lot
($100,000) is $10. Currency pairs that have the USD listed second in the pair, such
as EUR/USD, GBP/USD, AUD/USD, NZD/USD all have the same pip values as
indicated above.
Other currency pairs have a fluctuating pip value, based on the value of the
currency. For instance, the pip value of a mini lot ($10,000) in the USD/CAD is $1
/ USD/CAD rate. In other words, it's $1 divided by the current USD/CAD rate. As
the USD/CAD appreciates, the pip value is less. If the USD/CAD drops in value
the pip value increases.
When trading a US account (you deposited US dollars to open the account)
the pip value is determined in US dollars even if you're trading a pair that doesn't
have the USD in it. For example, if you're trading the EUR/GBP the pip value of a
standard lot (100,000) in US dollars is $10 x GBP/USD rate. The list below shows
how each pip value (standard lot) is calculated for different pairs.
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521

Forex Market Hours and News
The forex market is open 24 hours a day from 10 PM Sunday night (GMT)
to 10 PM Friday night (GMT). There are many opportunities to trade throughout
the day, yet not all strategies will work at all times of the day.
The chart below shows when various markets are open throughout the day in
different parts of the world, based on the 24-hour clock.
Note: All Times is EST
To see when markets are open based on your own time zone, go to
http://www.forexmarkethours.com/markethours.php. From the drop down menu
select your time zone and click "Go." The chart will update and provide the open
and close times of the major sessions based on your time zone.
Since brokers are located all over the world, your personal time zone may
not match the time zone on your charts. Make sure the time in the green box (on
the site above) matches the current time on your charts. In this way you can mark
off when sessions begin and end on your charts.
The markets shown on the figure above are high impact markets. When
these markets are open it greatly affects the currency pairs associated them. I
recommend trading currency pairs which have at least one currency (from within
the pair) “open for business” when day trading.
For example, the EUR/USD currency pair is most active during the London
and/or New York sessions. It's likely to be especially active during the four hour
overlap period when both these markets are open and trading the pair. During the
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Transaction ID: 6YD31355T17923521
London and/or US session is the ideal time to trade this pair. When London and
New York banks are closed for business, there's less opportunity.
To see how each pair acts throughout the day in terms of volatility, see the
http://vantagepointtrading.com/daily-forex-stats. This topic is also covered more
extensively in Chapter 7: Best Time to Day Trade.
Forex market price react significantly to planned economic news releases
(and surprise economic events as well). Economic news is released at scheduled
times throughout the week. Forex brokers often provide a news feed that alerts you
when news is coming out. Also, many sites display a global economic calendar so
you're aware of all news events beforehand, and can prepare for news which has a
market impact.
Only being aware of one country’s news events isn't enough. Make sure the
economic calendar you're viewing shows all significant global news events that
may affect the currency pair you're trading.
A significant news event for the Euro zone is likely to impact not only the
EUR/USD, but also the USD/CHF, GBP/USD and potentially others.
Here's an economic calendar that shows scheduled economic events in all
the major currencies: http://www.dailyfx.com/calendar. Be sure to adjust the time
zone. Events marked "High" importance (usually colored red) deserve special
attention.
Avoid trying to predict how a pair will move based on a scheduled high
importance news event. Stop day trading at least five minutes before the highly
important news event. After the highly important news is released wait at least
three or four minutes before day trading again. This gives the market time to
choose its direction based on the news, and we avoid getting caught in wild price
swings which could cause significant losses.
Trading the news is covered in Chapter 12, “Trading the News”.
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
Leverage
Leverage is what makes the forex market attractive. Leverage is borrowing
money and adding it to your own so potential profits are increased. While no one is
likely to borrow money to increase losses, this also occurs. All transactions are
magnified, both good and bad, when leverage is employed. Let’s look at a quick
example of what leverage is:
Assume you have $10 and are offered a trade where you can make 10%.
You accept this trade, make 10% and now you have $11 (attained by $10 + ($10 x
0.1) = $11).
Now, let’s assume you went to a friend, and asked to borrow an additional
$90 for making the trade. You now have $100, and accept the trade making 10%
on the full $100. You now have $110 (attained by $100 + ($100 x 0.1) = $110).
You return $90 to your friend and are left with $20. Based on your original $10
investment, the return on your money is 100% (instead of only 10%)! You doubled
your original investment by borrowing and making money on the larger amount.
Had you ended up losing on the trade though, you may have lost your friend's and
your own money.
The forex market allows you to do this. FX (forex) brokers commonly give
from 1:1 up to 400:1 leverage. This means that for every one dollar you deposit
you can receive up to $400 in capital to trade with. This is beginning to change due
to stricter regulation. For instance, in the US traders are limited to 50:1 leverage,
which is still more than most traders will need as you'll discover over the next
couple chapters.
Let’s assume you choose to have 100:1 leverage in your account, and you
deposit 1000. You'll have 100,000 in total buying power you can make money off
of.
To open a position worth 10,000 means you put up 100 in margin (with
100:1 leverage). This is your good faith assurance of the trade, and as long as you
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
maintain 100 in unused capital in your account that trade can stay open (and of
course you can exit at any time you wish, whether with a profit or a loss).
If you take too large of a position using leverage, and the market moves
quickly against you, you could lose more money than you have in the account. If
this occurs, you'll need to deposit more into the account to make up for the loss.
Certain brokers have provisions and safeguards which prevent this from
happening, but it's important to understand the legalities of using leverage and the
risks associated with it. This should never, ever, happen. Throughout the book I'll
drive home that money and risk management are the most crucial elements to
successful trading. I tell you the maximum you can risk on each trade, and how to
calculate it.
There's generally no interest charged for using leverage in forex trading,
although there is rollover. Some brokers do charge for the use of leverage though,
and it's also possible to open accounts which have no interest or rollover. Be sure
to read through all the legal documents when opening an account as each broker
may have slightly different policies.

Rollover
Brokers commonly “rollover” positions in your account. This is so the trade
isn't actually “settled,” which would require taking possession of the currency you
purchased. Since nearly all retail traders are trading for speculative reasons, and
not because they wish to actually receive the physical currency they purchased,
roll-over is an automatic process.
Rollover means that each day you'll be credited or debited the difference in
the interest rates between the currencies in each pair you're holding. This isn't
interest on the leverage your broker has provided to you.
If one country has an interest rate of 4% and another has a 2.5% interest rate,
this difference is credited or debited from your account depending on if you're long
or short the higher interest rate currency, respectively.
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Rollover is credited or debited each day at 5 PM Eastern time. It doesn't
matter if the position is open for two minutes or 23 hours; a position held at 5 PM
is considered to be held “overnight” and is subject to an interest rate credit or debit.
Day traders should be aware of this fact, as holding a position for only a few
moments around 5 PM can be an advantage or disadvantage depending on what the
position is.
Let’s look at an example of how this works each day. Say you buy the GBP
(British Pound) and sell the USD (United States Dollar). In other words, you buy
the GBP/USD pair. Assume the following interest rates in these economies: GBP =
4% and USD = 1%. There's a 3% interest rate differential.
If you hold this position for an entire year (and interest rates don't change)
you'll make 3% interest on the value of the position. The value of the position is
the full position, not just the margin which is used to maintain the position. Since
markets fluctuate, the interest you receive won't be exactly 3%, but is a rough
approximation.
If you go short the GBP/USD (sell GBP, the higher interest rate, and buy
USD, the lower interest rate) you'll lose, or be debited, roughly 3% interest on the
full value of the position if you hold it for a year.
When you use leverage, the effect of roll-over is substantial. Assume for a
moment you buy $10,000 worth of the GBP/USD and receive 3% in interest per
year for holding the position. That's $300 per year in interest income. But you're
not required to put up the entire $10,000. If you use 100:1 leverage, you're only
required to put up $100 of your own funds for the trade. Therefore, interest alone
gives you a 300% return on invested capital because of the use of leverage—you
get $300 for your $100 investment.
This also works in reverse though. If you're short the GBP/USD in this
example, your capital is rapidly depleted as you're debited the interest rate
differential each day. About one third of the way through the year, even if the
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
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exchange rate hasn't moved against you, you'll have lost $100 due to leverage. If
you hold the position an entire year, you'll lose about $300 even if the exchange
rate doesn't move significantly against you.
Of course the exchange rate is always moving, and therefore the trend of the
currency must be considered when making trades as well. Trading decisions
shouldn't be solely based on roll-over, as movement in the exchange rate can easily
offset any gains or losses accrued because of roll-over
Most brokers provide up to date information on how much the credit or debit
will be if you hold a position overnight. Therefore, you don’t need to calculate
anything; your broker should provide you with all the information you need. Also,
the calculated value is unlikely to be what the broker actually credits or debits from
your account. Rollover, like the spread, is a situation where brokers take a bit for
themselves, so rollover rates vary from broker to broker.
For those who wish to manually calculate the roll-over debit or credit, the
following formula is used, where the “base currency” is the first currency listed in
the pair and the “quote currency” is the second currency listed in the pair.
Position size in dollars X (base currency interest rate – quote currency
interest rate) / 365 days X current base currency rate = daily rollover interest debit
or credit.
Using the formula, if you're long $100,000 of the EUR/USD at 1.3030, the
EUR interest is 3% and the US interest rate is 1.5% you can calculate how much of
a credit you'll receive per day (what the broker gives you may vary slightly):
$100,000 X (0.03 – 0.015) / 365 X 1.3030 = $5.35
Credits and debits occur automatically and no action is required on your
part. Every time you hold a position over night, you'll see a credit or debit appear
in your account activity.
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Keep in mind the currency markets are fluctuating all the time, so the credits
and/or debits are separate from capital gains made on the movement of the
currency. For tax purposes track interest and capital gains separately—this should
be easy to see in your account history report. Tax laws vary by country and region;
consult a tax professional on how to report your forex interest and capital gains in
your region.
Since banks/markets are closed on Saturday and Sunday, the interest for
these days is made up on Wednesday (usually). Positions held on Wednesday at 5
PM EST are subject to three days worth of interest credits or debits.
Interest rates change over time. Watch for changes in interest rates, as a
change in these rates shifts the bias of buyers and sellers, both in the short-term
and the long-term.
Strategies involving rollover and interest rates are covered in Chapter 13,
“The Carry Trade.”

Order Types
Next, you need to know how to place orders and manage trades. Platforms
have come a long way in recent years and are quite user friendly. Most retail
platforms use “Buy” and “Sell” buttons which are used for instant execution
(confirmation may be required depending on platform set-up) at the current ask or
bid price. Placing a buy or sell at the current market price is called a "market
order."
Recall from earlier, that “Buy” means you're buying the first currency in the
pair, expecting the price to rise on your charts. It also means you'll be buying at the
“ask” price. “Sell” means you're selling the first currency in the pair, expecting the
price on your charts to drop. It also means you'll sell at the “bid” price.
You then have other elements of a trade to consider, such as quantity
(position size), stop loss, and profit target. Position size or quantity is how much
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you want to buy/sell, and is determined by a simple formula covered in the next
chapter.
A stop loss is an order placed at a price where you know you're wrong about
the trade. Where to place stops is covered in more detail throughout the book. The
stop loss is protection from excessive losses; if the market moves to the stop loss
price, the position is closed at a loss. This is so you don't lose more than is
warranted on any one trade. And since the stop is placed with the broker, it'll
execute even if you're not around or don't have your trading platform open.
You can also set a profit target order. How to calculate and use profit targets
is covered in detail throughout the book. A profit target is a price which, if hit, will
close the position (or part of the position) at a profit. It's a price you expect the pair
to move to which will give you a profit. A profit target closes your position, if the
target price is hit by the market, even if you're not around or your platform is
turned off.
What if you only want to buy the EUR/USD if it breaks out of the trading
range it has been in? Such a breakout could be 10, 33, or 226 pips away from the
current market price...and the breakout happen while you're away from your
computer.
In this case you'll place a “pending order.” A pending order may or may not
get executed; it'll only execute if the price you set for the order is reached by the
market.
Here's the basic run down of how to use pending orders. This may sound
complex when written, but in your trading platform all you need to do is fill in the
blanks (entry price, stop loss and target) on the order form with the price levels you
want. The software does the rest.
Buy Stop: Used to buy the currency (pair) at a price higher than the current
market price; only if the market moves there is the order executed. For instance, if
you wish to Buy the AUD/USD at 1.0621 and currently it trades at 1.0522, place a
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Buy Stop order at 1.0621—if the market goes to that price your order is executed
and you'll have bought (be long) that currency pair.
Why use it? There may be a big resistance level up there, and you only want
to buy the pair if it breaks through that resistance level at 1.0620…hoping it will
trigger another move higher. A Buy Stop is also used as a stop loss order for a short
position.
Buy Limit: Used to buy the currency (pair) at a price lower than the current
market price; only if the market moves to that level is the order executed. For
instance, if you wish to Buy the AUD/USD at 1.0220 and currently it trades at
1.0430, place a Buy Limit order at 1.0220—if the market goes to that price your
order is executed and you'll have bought (be long) that currency pair.
Why use it? A price range (discussed later) may be present, and you only
want to buy along the lows of the range. Or the pair is trending higher and you
want to buy when the price pulls back, assuming that the trend will continue higher
after the pullback. A Buy Limit is also used as a profit target for a current short
position.
Sell Stop: Used to sell the currency (pair) at a price lower than the current
market price; only if the market moves there is the order executed. For instance, if
you wish to Sell the AUD/USD at 1.0225 and currently it trades at 1.0380, place a
Sell Stop order at 1.0225—if the market goes to that price your order is executed
and you'll have sold (be short) that currency pair.
Why use it? The pair may be dropping but is approaching a crucial support
level. You're not sure if the level will hold, so you only want to enter a short
position if it breaks through the support level, hoping it'll trigger a further decline.
A Sell Stop order is also used as a stop loss order on a current long position.
Sell Limit: Used to sell the currency (pair) at a price higher than the current
market price; only if the market moves there is the order executed. For instance, if
you wish to Sell the AUD/USD at 1.0300 and currently it trades at 1.0200, place a
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Sell Limit order at 1.0300—if the market goes to the price your order is executed
and you'll have sold (be short) that currency pair.
Why use it? The trend may be down and you want to get short, but decide to
wait for a rally higher to get short hoping the downtrend will then continue after
the rally ends. A Sell Limit order is also used as a profit target order on a current
long position.
With pending orders you can also set an expiry date. This is an option you
may wish to use. If an expiry date isn't set the order will remain pending until
canceled or filled. If there's a time constraint the trade needs to take place within,
be sure to set an expiry date. For example, if you only day trade, make sure all
orders are canceled at the end of the day, or set all your orders to expire at the end
of the day.
Be aware of all outstanding orders in your order log, and make sure you still
want them. If you don't, cancel the orders immediately to avoid the possibility of
getting filled on the order in the future. Conditions change, so stay on top of any
pending orders you have outstanding.
If you're going to be away from your trading platform for a long period of
time, make sure pending orders are canceled and/or they have a stop loss and profit
target attached to them.
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2. Being Successful in the Forex Market
Being successful in any market requires discipline and hard work. In order to
be successful you must have the discipline to follow through on the trading plan
you set out for yourself. The trick is, the trading plan has to be set out before
trading, not during.
This is why most novice traders fail – they don't create a plan for their
trading success. They don't properly plan out their trades. Before every single trade
you should know:




What the entry point is (and criteria required for entry).
What the stop loss level is (the exit criteria for a losing trade).
The size of the position (based on account size and anticipated risk).
Where/how to exit a profitable trade (what criteria need to materialize
to take a profit, and what's the profit target?).
In other words, you need to answer all these questions:
 “How and why are you entering?”
 “How and why will you exit?”
 “How much capital will be put at risk?”
Most traders only consider the entry point, which probably has the least
impact on trading success of the factors mentioned above. How you exit and
manage your trades is more important than the entry. The exit is where profits are
locked in or losses are taken. Well planned entries are important too though. Each
factor is a crucial element in successful trading. All the factors go hand in hand.
When any of these elements are neglected, your trading suffers.
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The Trading Plan
All the preparation for trading is done before a trade is even made. The
preparation is even done before a trade is found. A Trading Plan is a written
document which states exactly how to trade with regard to entries, exits and risk
management. The three areas cover everything including stops, trailing stops,
profit targets, how money is managed and position size.
Within your trading plan, lay out how you're going to enter a trade. Are you
going to enter as soon as the price crosses a barrier on our chart (this is the method
I use)? Or are you going to wait for the bar to close before you enter the position?
What time frame are you going to trade on? Are all signals going to be
traded? Or is a filter going to be used? An example of a filter would be: “A signal
is traded only if it aligns with the overall trend" (the plan must also cover how you
determine trends in this case). Alternatively, you may decide to trade every signal
you see without filtering the signals at all.
You won't be able to effectively answer these questions yet, though by the
end of the book you will. The 5-step plan outlined in the Introduction advised to
read through the entire book and then start building your trading plan.
Once you've learnt a strategy and decided how to implement it, it can then
be included in the trading plan. All the rules for how strategies are implemented,
and how the resulting positions are managed, should be written down and strictly
followed.
Consider all possible contingencies when making the plan. As information
and knowledge is attained from real trading, the Trading Plan is fine-tuned to
reflect your newly acquired data. Yet, once in place, the Trading Plan should be
followed and not significantly altered until the Plan has been proven faulty. If you
continually change your trading approach after every few trades, it's impossible to
get a true sense of what works and what doesn’t.
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Transaction ID: 6YD31355T17923521
While we often think we have great memories about what works and what
doesn’t, unfortunately this isn't the case. If we don’t follow a plan we're destined to
keep reliving our mistakes, and creating new ones.
Successful trading becomes apparent over many trades, not only a few.
Continually adjusting your Plan or strategies means your trading results are likely
to become random. A continually changed plan means that even though “work” is
being put in, you'll have little to no advantage over the person who puts in no effort
at all. You're both flip-flopping between strategies. This approach offers little
competitive advantage.
We choose a Plan and certain strategies because they provide us with an
advantage over many trades. If you continually change your approach you lose that
advantage. Even the best systems and strategies have losing trades. A losing trade,
or even several losing trades in a row, is no reason to start from scratch or change
your methods.

Risk Management
The methods outlined in this book work on different time frames, yet the
methods and time frame used must suit your personal situation. For example, if
you don't have a lot of capital, you're limited to short term trading. This is because
the stop levels (discussed shortly when we get to Position Size) are too large on
longer term charts and will expose you to too much risk. Leverage is a double
edged sword. For traders with little capital, leverage combined with taking on too
much risk per trade can mean a trading account is quickly and easily wiped out.
When considering how you'll enter the market, and also your stop levels, be
realistic about what you can reasonably do in the market with the capital you have.
Don’t risk more than 1% of your trading account on a single trade. The risk on the
trade (the difference between the entry and stop price) multiplied by the position
size shouldn't be more than 1% of the capital in your account.
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As you progress, the risk should decline to less than 1%. Professional traders
rarely risk more than 1% of their capital on a single trade, and generally only risk a
fraction of this.
Why risk only 1% of your account on a trade? When you risk only 1% of
capital you'll survive even a long string of losing trades. Even great trading
systems have losing trades; you need to plan in advance for this fact. Risking 1%
(or less) means we can lose 10 trades in a row and still have almost all our capital
intact. Several winning trades will make those losses back. On the other hand, if
you risk 10% of our capital on each trade, and lose 10 trades in a row, your money
is gone (or very close to it). After depleting the account so much there's almost no
hope of regaining your original capital. Don’t put yourself in this position by
taking big risks on each trade.
Risking a small amount on each trade still creates great returns over the
course of a year. In fact, risking only a small amount on each trade has a far, far,
FAR greater chance of producing solid returns over the course of a year than
risking a lot per trade. The trader who risks too much per trade never lasts long and
usually completely wipes out their account...it's only a matter of time.

Position Size
Determining proper position size will greatly affect your long term
sustainability in trading. To determine position size you must first know your entry
and stop loss prices. The stop loss should be at a logical price which is out of range
of normal market movements. If hit, the stop loss lets you know you're wrong
about the direction of the market—at least for the time being. The strategies
discussed throughout the book tell you where the entry and stop loss levels are
placed. Don’t risk more than 1% of your capital on a single trade. Less than 1% is
better.
Your risk is determined by a maximum dollar amount which is less than 1%
of the account, or by using a fixed maximum percentage, such as 0.5%, of
whatever your current account value is. Using the maximum percentage is
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recommended. It's also recommended you risk the same percentage—as close as
you can get, without going over—on each trade.
If your account is $5000, you can have a maximum loss of $50 if you risk
1% of your capital on the trade. Let’s say you choose a stop which is 50 pips below
your entry buy price in the EUR/USD. From this information determine your
proper position size. You can take a maximum of one mini lot. Why? If your stop
is hit, you'll lose 50 pips X $1pip value X 1 mini lot, or $50, which is your
maximum loss (each pip is worth $1 when trading a mini lot in the EUR/USD).
Note: Recall, from the Pip Value section in the prior chapter that the pip
value of each currency pair may be different. Therefore, make sure you know the
dollar amount each pip is worth in the currency pair you're trading so the position
size is calculated accurately.
Taking one mini lot on this trade allows you to have an ideal stop (this will
be different for each trade) and keep your risk in check. If you choose a bigger stop
(risk) on the trade, your position size decreases. If you have a smaller stop on the
trade, your position size can increase. As your account grows your position size
can also increase as you're able to risk more capital on each trade. This is because
1% of $10,000 is larger than 1% of $5000. With the larger account, you can take
on larger positions while still keeping your percentage risk in check.
Experience doesn't equate to taking larger positions. Only when experience
is producing profits and growing your capital is position size increased
proportionately to the growing account. Position size only grows when the account
is growing, and position size should decrease if the account declines in value.
With a $500,000 trading account you may not want to risk even 1% on a
trade. So instead of risking $5000 (1% of the account) you may choose to risk only
$2000 instead. The method above is still used. If $2000 is your maximum loss and
your risk on the trade is 50 pips, it means you can take 40 mini lots or 4 standard
lots on this trade.
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The formula is:
# of lots X pip value X risk in pips = total risk in $
Plugging in the numbers from the above example:
4 standard lots X $10 X 50 = $2000
or
40 mini lots X $1 X 50 = $2000
Whether you risk a percentage of your account on each trade, or choose a
fixed dollar amount you're willing to lose, the method above is employed to
determine the proper position size. The position size is based on the stop level
which is ideal for the trade, and should limit the risk of the trade to less than 1% of
your capital. Each trade may have a different position size (1 lot, 3 lots, 22 lots,
etc) and use a different risk level (15 pips, 40 pip, 225 pips, etc) depending on the
dynamics of the trade set up.
As you go through the strategies in the book, you'll discover where to enter
trades and where to place both stop losses and profit targets. It's up to you to
control your position size so you're only risking a small portion of your account on
each trade. Only take trades where risk can be limited to 1% or less of the account
capital.

Daily Risk
If you're going to day trade, it's recommended that you not only control the
risk on each trade, but also your risk each day. Some days the market is erratic, and
no matter which strategy you use or how you try to adjust, the market is going to
take your money. This is the reality of trading; it doesn't have to happen often, but
it will happen.
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
Maybe something personal is going on and you aren't totally focused, or
there's no structure to the market and you lose trade after trade. On such days,
admit the market has beaten you, and stop trading.
Exactly when you'll stop trading is defined in your trading plan. I know
many traders who stop trading if they lose their first three trades in a row. Risking
about 1% of your capital on each trade that means you've lost 3% of your capital.
After you've read the entire book and start trading (first a demo account then
live trading), I recommend only risking 0.5% on each trade, and setting your daily
risk limit at 3%. That way you can lose 6 trades in a row before you're forced to
quit for the day.
Once you have a track record and are profitable, set your daily risk limit
(daily stop) at slightly more than what you make on your average profitable day.
Say, on average, you make $300 on your winning days. Make $300 your risk limit
for the day. If you lose $300 while day trading, stop for the day.
The risk limit is imposed to make sure that no single day ruins your week or
your month. I've seen traders lose everything because they were upset, unfocused,
or just couldn't admit they were wrong.
Don't let this happen to you. There's always tomorrow. If you lose your
specified amount in a day, close all positions, get away from your trading screen
and go do something else.
It's also recommended you employ a "loss from top" threshold. Your loss
from top threshold is the same figure as your risk limit, except it only applies to the
highest point of profit you've accumulated so far in the day. Confused? Here's an
example.
Assume you've imposed a daily risk of $300 on yourself. If you lose this
amount in a day you stop trading. But instead of losing, you start out the day on a
tear, winning several trades in a row and you're now up $900 (based on closed
trades). The $300 dollar loss rule still applies, except now it's applied to the $900
(your highest profit point). If you drop down to $600 in profit, quit trading for the
day.
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
See how it works over several trades:
Start of day: Profit is $0 so daily stop is -$300
After 1 Trade (winner): Profit is $100 so daily stop is -$200, because +100 - 300 is
-200.
After 2 Trades (loser): Profit is $50, daily stop stays at -$200
After 3 Trades (winner) Profit is $200, so daily stop is -$100
After 4 Traders (loser) Profit is $100, daily stop stays at -$100
After 5 Trades (winner) Profit is $300, daily stop at $0
After 6 Trades (winner) Profit is $500, daily stop at $200
After 7 Trades (winner) Profit is $700 daily stop at $400
After 8 Trades (loser) Profit is $600, daily stop stays at $400
After 9 Trades (loser) Profit is $500, daily stop stays at $400
After 10 Trades (loser) Profit is $400, daily stop is $400, STOP TRADING.
The loss from top protects you from losing your maximum (in this case
$300) when you've started out the day profitable. Usually hitting the loss from top
means you've lost several trades in a row, which indicates you're off your game or
the market structure has changed and isn't conducive to the strategies being used.
Daily risk limits and loss from tops are useful tools for day traders. A daily
stop loss is mandatory; a loss from top is recommended. These tools stop you from
doing significant damage to your account in a single day. Define exactly how
you'll limit your risk, and how you'll implement these rules in your trading plan.
Forex Correlations
After addressing position size and trading plans it's important to look at a
related topic—forex correlations. For reasons which will become clear shortly,
taking a long position in the EUR/USD and GBP/USD, when these pairs are highly
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correlated (and they often are), is essentially like taking two of the same trade. Not
exactly of course, though we'll cover this topic in a moment. If you want to
effectively manage your trades and be aware of when you may be inadvertently
increasing your risk, then you should be aware of forex correlations.
At http://vantagepointtrading.com/daily-forex-stats you'll find forex
correlation tables updated regularly for hourly, daily and weekly data. Correlation
tables are also available at https://www.mataf.net/en/forex/tools/correlation. Forex
correlation stats may seem daunting, but a basic understanding of correlations goes
a long way toward helping you to become a better trader. Not understanding forex
correlations can be disastrous.

What is a Forex Correlation?
A correlation is a measure of how much one currency pair moves with
another. Correlations measure between -100 and +100, the former meaning they
move in exact opposite directions, and the latter indicating they move in exactly
the same direction.
Assume you wish to know the correlation of the EUR/USD and the
GBP/USD. Quite often these pairs will move in a similar fashion, although not
exactly. If two pairs move in a similar way they'll have a + correlation. Therefore,
the EUR/USD and GBP/USD may have a +70 correlation on an hourly time frame,
+83 on a daily time frame and +86 on a weekly time frame (just an example,
correlations fluctuate).
When pairs move in the opposite direction of each other, they have a
negative (-) correlation. The EUR/USD and USD/CHF are usually negatively
correlated, and may have a -87 correlation on the daily time frame, for example.
A +100 correlation means two pairs move in exactly the same direction. A 100 correlation means the pairs move in exactly opposite directions. A correlation
of 0 (zero), or a small + (positive) or – (negative) number, means the pairs have no
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Transaction ID: 6YD31355T17923521
real correlation and if they do happen to move together on occasion it's more likely
to be random than anything significant. A correlation of +35 or -41, for example,
means the pairs don't have a strong correlation, and one pair isn't likely to provide
much information about the other.
Correlations change all the time. The statistics on the aforementioned
sites are updated regularly to reflect the forex correlations between pairs. The
correlations are presented in a matrix as shown in the figure below, and are
presented for hourly, daily and weekly data.
Daily Forex Correlation Table – August 30, 2013
If we look down the EURUSD column we can see the EUR/USD is highly
correlated to the GBP/USD at +85.7, and almost perfectly inversely correlated to
the USD/CHF at -97.6.
The NZD/USD also has a strong inverse correlation to the USD/CAD at
-86.6.
To find what the correlation is, look across from the NZD/USD row to the
USD/CAD column, or look down the NZD/USD column to find the USD/CAD
row. Either method produces the correlation between the two pairs you're
comparing.
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
Below are some guidelines and uses for forex correlation data.

How to Use Forex Correlation Data

If you have multiple positions that are highly correlated (positive value over
70), those pairs move somewhat in tandem. This means you may be overexposed
to one currency, even though the risk on each position is managed.
Say for example you risk 1% on a EUR/USD long trade, and then decide to
risk 1% on a USD/CHF short trade. This is essentially the same trade. Since the
pairs are strongly inversely correlated, as the EUR/USD goes down the USD/CHF
goes up (and remember you're short the USD/CHF)—you lose on both (or make on
both if they move the other way). I'd consider this the same trade, and a violation
of my trading rules; I'm basically risking 2% (not 1%) of my account on this multiposition trade.
The same situation applies if I go long the GBP/USD and also go long the
EUR/USD. Since these pairs are strongly positively correlated, by going long in
both, I overexpose myself. If the market moves against me I lose on both trades,
not just one. To rectify the situation, risk 0.5% on each trade, or pick one trade
with the best set-up or reward potential.
When I'm taking multiple trades at one time, ideally I want the correlation
between all my positions to be weak. Let's look at the correlation table again to
find some trades:
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
Assuming I get viable signals in the pairs, I'm fine taking trades in the
EUR/USD, in addition to positions in the EUR/JPY or GBP/JPY (choose one or
the other since these pairs are highly correlated to each other), USD/CAD,
AUD/USD or NZD/USD (once again, choose between USD/CAD or NZD/USD
since these two pairs are highly correlated to each other).
If I already have positions, I check the correlation to see how my current
positions interact with the potential new position. I want trades that move
independently of each other (for the most part). In this way if I lose on one position
I can still win on the others, but if my positions are all correlated and I lose on one,
losses in the others are more likely.
The exception is if I want to hedge. Hedging is when you take one position
which will likely lose while another gains, or gains while another loses.
Occasionally you'll get signals in two pairs and the pairs will form a hedge. That's
fine, because you'll likely lose on one but win on the other, and our wins are bigger
than our losses.

You can hedge a long trade with a long trade in another pair that has a high
(below 80) negative correlation. You can also hedge a long trade with a short trade
in another pair that has a high (above 80) positive correlation, or vice versa.
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Buyer: Georgios Stavrou (gstavrou7@hotmail.com)
Transaction ID: 6YD31355T17923521
By taking these directional trades based on the positive or negative
correlations, you hedge your risk. This means the pairs move in an opposite
fashion. Based on the correlation matrix I could go long the EUR/USD and also
long the USD/CHF as a hedge. Both positions must be longs (or both shorts) in
order to form the hedge, since the correlation is strongly negative. As one goes up
the other goes down; any losses in one pair will likely be at least partially offset by
the other.
I could also go long the EUR/USD and short the GBP/USD (or vice versa).
The positions must be opposite to form the hedge since this correlation is strongly
positive.
Just because two pairs are highly negatively or positively correlated doesn't
mean they'll completely “offset” each other's losses or gains. Since each pair
moves a different amount (more or less volatile), volatility is another factor which
must be considered when looking at hedging. Correlation is focused on direction,
not necessarily magnitude. Volatility studies are also available at
http://vantagepointtrading.com/daily-forex-stats.

Here's another trading application for correlation data. Imagine you see a
trade setup in the EUR/USD. Since you know the GBP/USD is often correlated,
you know that a setup may also be forming in that pair. A quick glance lets you
know. If both pairs have a setup you can choose the one you like best, based on
lowest risk, highest reward potential, strength (for longs) or weakness (for shorts).
Correlations give you options for picking trades which have similar, yet slightly
better, trade setups.

Correlations fluctuate over time. Be aware of what current correlations are
and make decisions based on that (if required). Don't attempt to predict what
correlations will do in the future.
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 Forex Correlation Summary
This is a brief introduction to correlations. It's recommended traders educate
themselves further on correlations and acquaint themselves with basic statistics.
Pick up an entry level college text book on the matter (can often be found secondhand for cheap) and work through the material. It'll help in your risk management
and understanding of other market concepts.
Correlations can affect your risk without you knowing it. You may be
accidently making highly correlated trades and taking on too much risk, or you
may accidently be hedging yourself, thus making little headway in producing
profits because you're actually risking too little.
Refer to the correlation pages mentioned to be aware of current correlations.
See how positively and negatively correlated pairs interact with each other. You
may find correlations help you control risk, find alternative trading strategies and
alert you to potential dangers or opportunities.
How Much Leverage to Use
With some forex brokers offering up to 500: 1 leverage, it's little wonder
why “How much forex leverage?” is such a common question especially among
new forex traders.
Most traders realize leverage is a double-edged sword, magnifying profits as
well as losses. To answer the question “How much forex leverage?” we'll look at
examples for different account sizes and trading styles. The examples provided in
this section assume money management rules are followed and only 1% of
deposited capital is risked per trade, as risking more than this on one trade isn't
recommended.
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Transaction ID: 6YD31355T17923521

How Much Forex Leverage – Scenarios
The easiest way to discuss leverage is to look at some examples using
different combinations of account size and trading style.
$10,000 account – swing trader
If swing trading, stop losses are likely to be bigger (in pips) than a day
trader’s (as well as profit targets) so this needs to be accounted for. Based on the
account size the trader can risk $100 per trade (1% of 10,000). If a trade develops
which has a 300 pip risk the trader can take 3 micro lots, which results in a $90
risk. In this case really no leverage is needed. Taking a trade such as this means
$3000 (value of 3 micro lots) is deployed and the account balance more than
covers such a transaction.
If this scenario matches your situation, but you often take multiple positions
at the same time, then you'll want some leverage. Leverage levels such as 10:1 or
15:1 should suit your needs.
By the end of the book you'll have a good idea of the appropriate leverage
level based on the strategies you like and wish to practice.
$10,000 account – day trader
Since a pair like EUR/USD usually moves between 90 and 120 pips a day
(may expand or contract beyond this range), most day traders shouldn't risk more
than 10 pips on a trade, or up to 1/3 of the daily range on the very high end. Risk
more than that and the potential profit may not be enough to compensate for the
risk. Losses on individual trades should be kept to 1% of account size or below.
A trade with 25 pips of risk means the trader can take 40 micro lots or 4 mini
lots, which equates to a risk of $100 in the EUR/USD.
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Transaction ID: 6YD31355T17923521
4 mini lots is $40,000—the account is only $10,000—so some leverage is
needed. Risk is well controlled so in this case leverage is a great asset to
this strategy.
If this is how you trade, you may end up having multiple positions with
similar risk levels at the same time. If you have 5 similar positions, then $200,000
in capital is needed. Therefore, you need an absolute minimum of 20:1 leverage.
Take the leap to 40:1 or 50:1 to make sure you have room for taking multiple
trades.
If your account is a different size, or you trade in a slightly different fashion,
use the approach above to determine the amount of leverage you need.
$50,000 account – scalper
Sticking to not risking more than 1% of deposited capital, this scalper can
risk up to $500 per trade. Scalpers usually risk a small amount (in terms of pips) on
each trade. Let’s assume this trader risks 10 pips on a trade. That means in the
EURUSD they can take 50 mini lots or 5 standard lots. If they lose 10 pips on 5
standard lots they've lost $500 or 1% of the account.
5 standard lots cost $500,000, so leverage is required to take such a position.
It's also quite possible this trader has multiple positions at any given time. If up to
three positions are held at a time, then $1,500,000 is needed to open the positions.
Therefore, this trader needs at least 30:1 leverage. For a bit of extra room, 50:1 to
75:1 is recommended (if available).
Leverage Scenario Summary
Based on these examples of risking a maximum of 1% of the account on a
trade, and even having multiple positions out at the same time, there's little need to
be over 100:1 leverage…and even that's high for most traders. If you need to use
200:1 or 400:1 leverage just to trade, you're likely undercapitalized and should wait
to begin trading until you have more trading capital available.
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Dramatic events occur and liquidity can dry up, making positions impossible
to liquidate at the stop loss price. Such events expose you to more risk than
anticipated. If you're leveraged to the hilt when a drastic situation occurs, your
account could be wiped out.
Use as much leverage as needed, while still trading in a risk-controlled
manner.

Why Do Brokers Provide Such Huge Leverage?
If you're wondering why brokers offer leverage of up to 500:1 the answer is
simple. It entices traders to invest only $100 (or so) and try to gamble their way to
profits. There are thousands of traders who will open an account for a couple
hundred bucks, and since most of that money will be eaten up by the broker's
spread or commissions, it is easy money for the brokers.
A micro lot costs $1000, a mini lot $10,000 in a pair such as the EUR/USD,
so opening an account for less than $1000 means the trader needs leverage just to
buy the smallest increment available. And since most new traders come to the
forex market with delusions of grandeur it's likely they'll risk far more than 1% of
their account on each trade. Leverage provides a way to do that. Insanely high
leverage allows people to swing for the fences in the hopes of hitting a couple
winners. It rarely happens.
Don't be afraid of leverage. Use it, as leverage is a valuable asset. Just use it
wisely. Keep your risk per trade below 1% of your personal capital.

Summary – So how much forex leverage?
Once you've learned some strategies, you'll be able to calculate how much
leverage is needed for your account size and the typical trades you'll be taking.
Many traders find they actually don’t need much leverage, but having some is fine,
especially if you're likely to have multiple positions open at one time. If you're a
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swing trader it's almost imperative to have multiple positions open at any given
time in order to grow your account consistently. As a day trader, you may only
trade one pair (one position at a time), in which case you may not have multiple
positions since the shorter time frame makes them harder to juggle.
There will always be another trade, so there's little need to pile into one
trade, risking a lot and requiring excessive leverage. For most of you, 50:1to 100:1
leverage is way more leverage than you require.
Averaging Down
Don't add to a position when it's losing money. This is called “averaging
down” and is extremely dangerous. Mainly this is because it's highly likely to
increase the originally anticipated risk of the trade. A losing position shows that so
far you're wrong about the market, and the trade therefore doesn't warrant
additional capital being directed to it.
Averaging down is considered negative because when a trader does it,
they're increasing their risk and refusing to admit they're wrong – throwing good
money after bad.
Averaging down also shows you're getting emotionally involved, and far
worse, you're deviating from your original plan. If you're going to risk 50 pips with
one lot on a trade and you're now showing a loss of 60 pips, adding to your
position defeats the entire premise of planning and managing your risk. Your
losing trades should be exited when originally planned...not added to. There's
always another trade— no point doubling down on a trade which is losing money.
Averaging down may work a few times, as markets do move back and forth.
It's the time that it doesn’t which leads to catastrophe. A maximum of 1% should
be risked on any one trade, ideally less than 1%. If you cancel your stop, and
double your position when you're down 3% it gets ugly fast. What if it keeps
dropping? If you add again, a quarter of your account could be gone in no time.
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There's no plan here; these actions are based entirely on emotion, and emotional
traders don’t make money over the long run.
As a general rule, don't average down. There's no reason to. There will
always be other trades. Take a loss when your plan requires it and then move on.
Later on certain strategies or concepts will be introduced which could give
the illusion of averaging down. Casting a Net with Orders for example, discussed
later in the book, is a method of trading where you don't pick one price as an entry
and/or exit, but rather average into (or out of) the position at multiple prices. This
is very different than averaging down, as the approach is methodical and planned;
the potential risk is calculated and weighed before the trade is made, not during.
Pyramiding
Pyramiding is a way of adding to your position—making it larger—when the
trade is showing a profit.
If a trade is showing a profit large enough for you to move your stop to the
entry price, then you can add to the position. You can do this because the current
position is now riskless—your stop is at your entry price. In a sense, it's like
making a new trade, but instead you're adding to your current position, and will
once again risk about 1% of capital on the additional position. This process allows
you to increase potential gains on winning trades, while not increasing your
original risk.
To clarify, assume your original position had a 1% risk, but the price has
moved enough in your favor that you can move your stop to the entry price of the
position (when to do this is discussed at the end of the book in Active Trade
Management, but for now just grasp the concept), making it riskless. You add to
the position, making it larger, and again risk 1% of capital on the additional portion
of the position. You now have a larger position, though your risk is still the same
as when the trade started.
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As an example: You buy 1 lot of the EUR/USD at 1.3600, and place a 50 pip
stop at 1.3550 (50 pips of risk on one lot). The position moves in your favour and
is now showing a 50 pip profit (trading at 1.3650). You move your stop to
breakeven (1.3600). You then buy another lot at the current rate of 1.3650 and
place a 50 pip stop at 1.3600. You now have 2 lots, and both lots have a stop at
1.3600. One lot was purchased at 1.3600 and another at 1.3650. If the price retreats
to 1.3600 and the trades are stopped out, you'll only lose 50 pips on the second lot
and none on the first. 50 pips was the original risk of the trade. If the price
continues to rise, for every pip movement above 1.3650 (this is where the second
lot was purchased) you'll make double what you would've made if you only kept
the original one lot position.
Pyramiding maximizes gains when you're right, and the price continues to
move in your direction. The downside is that instead of breaking even on one lot
after moving your stop to your entry price on the original trade, if you have
pyramided and the price hits your stop, you'll lose money on any positions
purchased at a higher price.
In the example above, if you only kept the original position you'd move the
stop to breakeven, and if it's stopped out (the stop on the trade is hit) the net result
is $0—your exit is the same price you entered the trade. If you purchase a second
lot at a higher price and the stop is hit, the result is a 50 pip loss on the second lot
purchased. A potentially “flat” trade became a losing trade in an attempt to
maximize profit be pyramiding the position.
In the event the price goes to 1.3700, and you only have the original lot you
make 100 pips. If you pyramid using the method and numbers above, you make
100 pips on the first position, and 50 pips on the second lot purchased. Thus, you
earn an extra 50 pips by pyramiding. If the position continues go in your favour
you'll earn even more, yet your risk is still limited.
Continuing with this example, with the price now at 1.3700 you move your
stops to 1.3650, and then purchase another lot at 1.3700 which also has a stop at
1.3650. You now have 3 lots, with an overall average price of 1.3650 (you bought
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at 1.3600, 13650 and 1.3700 which averages to 1.3650). You can't lose money on
this trade, yet if the price continues to rise you make triple for every pip movement
above 1.3700. If the price moves back to 1.3650 you don't make or lose anything.
If the price goes to 1.3750 and you exit the trades, you'll make 150 pips on the first
lot, 100 pips on the second lot and 50 pips on the third lot. A total of 300 pips
profit, and when you purchased the last lot your total risk was zero (breakeven).
If the rate moved to 1.3650 after purchasing the third lot, the trade nets $0
(flat trade). Had the third lot not been purchased, and you exited the two lots at
1.3650, you would've made 50 pips. It's only advantageous to add to a position if
the trend continues in the direction of your trades and money is made on each
incremental addition to the position. Of course you can’t know if the trend will
continue before making the decision to pyramid or not.
So there's most assuredly a trade off. Pyramiding is recommended in strong
trends, as it allows you to maximize profits on a continual move in a particular
direction. Pyramiding is difficult in weak trends or during choppy price action. The
strategies and analytical tools within this book, if studied and practiced, aid you in
identifying high probability times to fully capitalize (possibly pyramiding) on
market moves, and when to trade cautiously.
Ultimately, pyramiding is a personal choice; it doesn't need to be done,
though it also doesn't need to be avoided. If pyramiding is something that's
appealing, it should be incorporated into the Trading Plan in association with a
strategy which is highly effective, proven and will benefit from pyramiding.
Record Keeping
Record your results and keep trading notes to be successful in the forex
market. Writing down what trades you're making—when and why—is very
important. It provides you with insights into what times are more profitable for a
strategy, or if certain currency pairs are more profitable than others. It's important
to also write down if you see a trade set-up but opt not to trade it. “Why did I not
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trade it?” By recording everything you may learn that trades you're not taking for
some reason could actually be profitable.
This process, while requiring a bit of time, is an important part of trading. If
you have no record of what has worked and what hasn't, how can you alter your
plan to become more profitable? You won’t be able to!
Recording information on a spreadsheet is an exceptional tool for analysis
down the road. I recall one time I was working on a new strategy for the
USD/CHF, GBP/JPY and EUR/JPY. The two latter pairs were very volatile during
this time and resulted in spectacular short-term gains. The USD/CHF on the other
hand failed to trigger trades, and when it did the gains were mediocre, at least
compared to the returns of the other two currency pairs.
I recorded all the results in a spreadsheet, and after one month analyzed the
data. In my mind I was sure that the GBP/JPY would be the best pair for the
strategy because it was the most volatile and provided the most pips when the
strategy worked. It turned out that EUR/JPY had the highest total profit. Also, the
EUR/JPY was less volatile, and exposed me to less risk on each trade. Therefore, it
came out ahead of the GBP/JPY for that particular strategy.
When other criteria were analyzed, the uneventful (in my opinion at the
time) USD/CHF then became a star performer. It had very few losses, although
gains were smaller. Maximum draw downs (biggest losing trades) were must less
than the other pairs. Since the pair had proven it was less risky based on the
strategy, it was easy to see that if I took slightly larger positions in the USD/CHF
(but still keeping the risk below 1% per trade) it would likely outperform the other
two currency pairs.
By recording trade information I was able to see that by increasing the lots
traded in the USD/CHF I could increase gains to the levels of the other pairs. The
lack of volatility, an apparent weakness, was turned into strength by increasing the
number of lots traded.
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This of course is only an example, and the characteristics of currency pairs
continually change, which requires the constant recording of new trade data and
recalibrating. Data doesn't need to be analyzed each day, or even each month.
Analyze it when the currency pairs are no longer acting as they were when you
originally analyzed the data, or analyze your trading results at a set interval that
works for you, such as every two months.
Recording and analyzing trade information provides you with an edge
because you're able to adjust and fine tune your trading based on actual results and
statistical data.
There are great programs and websites that track and analyze your trades for
you. http://www.myfxbook.com/ is one example. Connect your account to it and it
tracks your trades, and breaks down your trading into various statistics. This is a
great additional tool, but it doesn't replace your personal record keeping.
Myfxbook doesn't know the trades you pass up, which can drastically affect
performance...only you can record that.
I recommend using a program like Myfxbook though, as it shows which
hours you're profitable in (especially useful if day trading—stop trading during
hours you don't make money), which pairs you make the most money with and
profitability by day of week. This tool can save you a lot of money: avoid trading
at times or in pairs where you consistently lose money. Simple as that.
The Blissful Lack of Information
We're a news-driven society; most people watch the news and try to
anticipate how the events of the day will affect the markets. Similarly most traders
do this, watching CNBC constantly as well as scouring financial websites for "guru
opinions" on the markets and trade signals.
If you want to be a successful trader, don't do any of this. Ignore other's
opinions on the markets, and don't watch the news while you trade.
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If you choose to keep up on the events of the world, then so be it, but don't
let other's opinions affect how you trade. Didn't you buy this book to get strategies
and learn to trade for yourself? If so, then you're on the right track, because trading
is about implementing a defined set of protocols when certain market conditions
materialize. Nowhere in this book will you find a strategy that says "Buy when soand-so on CNBC tells you to."
Your only job as a trader is to implement a strategy as best you can; acting
according to the guidelines you've laid out for yourself, which you'll learn by
reading this book. Once you've made a trading plan that plan is all that matters.
The world could be crumbling, but you stick to that plan. Even if I call you myself
and yell "You need to get long the EURUSD right now!" Your response should be
"Thanks for letting me know, but I have my own plan to follow."
Don't let anyone throw you off course. Ignore news which could result in
you not following your plan. Avoid the market opinions of others unless their ideas
align with your trading plan. Once you have strategies you like, focus only on that.
Your search is over. Implement your strategies; there's no need to seek out
opinions from others.
The only news you should track is planned economic news releases. These
are listed on an Economic Calendar and are discussed more thoroughly in the
Trading the News chapter. As either a day or swing trader, we don't care what these
actual numbers are, and I encourage you to not even look at them or listen to
commentary on them. Analyzing these numbers/news won't improve your trading.
Instead, simply be aware of when these events are as they can cause big moves in
the market, and it's best to avoid trading for about five minutes before and a couple
minutes after the release. After the planned news release, we can jump back in and
implement our strategies.
Moving Forward
The following chapters cover strategies which are used with the guidelines
and principles discussed so far. Some strategies require that you add your own
“flavour” to them. This is because some short-term strategies may not work exactly
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the same from one year, or even one month, to the next. The concept may still be
sound, but how the strategy works may change. Alternatively, volatility or lack of
it, may conceal a signal which was easily seen before. Regulation changes, laws
and other factors also shape how markets act and may erase a strategy in its present
form from the market.
Sound trading principles last forever, but a strategy may need to be tweaked
from time to time, to adjust to an overall shift in market/investor psychology. As
you read and implement these strategies, personally test each one before using it.
Strategies should be adapted to current market conditions and shouldn't be trusted
blindly.
As discussed in the Introduction you should follow the five step plan: read
this entire book, formulate an initial trading plan based on strategies you like,
practice in a demo account for several months, re-tweak the plan if needed and
repeat prior steps until consistently profitable. Only then do you commence to live
trading with a finely-tuned trading plan. Each new strategy added to your arsenal
should be vetted through this same five step plan.
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3. Recommended Minimum Capital for
Forex Trading (Day or Swing)
Which broker you choose, trading platform, or strategy you employ are all
important, although how much money you start with will be a colossal determinant
in your ultimate success.
Not all traders are alike, and not everyone trades the same way. A day trader
may not need the same amount of money to start trading as a swing trader does.
The amount of money you need to trade forex is also determined by your goals—
are you looking to simply grow your account, or do you seek regular income from
your forex trading?
How Much Money Do I Need to Trade Forex? - Why It
Matters
Does it really matter if you start an account with $100 or $3000? Yes!
One of the most significant issues new traders face is being undercapitalized. Forex brokers are guilty of fostering such an environment by offering
to open accounts for as little as $5 in some cases...although the minimum opening
balance is usually about $100.
If you want to start trading, it's likely because you want an income stream.
Well, you aren't going to have much of an income stream if you start with $100.
Since very few people are patient enough to let their account grow, they'll risk way
too much of their capital on each trade trying to make an income, and in the
process lose everything...likely several $100 deposits in this case.
I'm a firm believer in never risking more than 1% of capital on a single trade
(getting sick of hearing that yet?). If your account is $100, that means you can only
risk $1 per trade. In the forex market that means you can take a one micro lot
position, where each pip movement is worth about $0.10 (depending on which pair
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you're trading), so you'll need to keep the risk to less than 10 pips. Trading in this
way, if you have a good strategy, you'll average a couple dollars profit a day.
While this will build your account slowly, most traders don't want to make a
couple dollars a day, they want to build their account much faster and therefore
will risk $10 or $20 per trade—sometimes more—in an attempt to turn that $100
into thousands as quickly as possible. This may work for a time, but will inevitably
result in an account balance of $0.
The other problem with trading forex with such a small amount of money is
that it offers almost no flexibility in your style of trading, or the trades you can
take. If you deposit $100, and follow proper risk management protocols, you can
only risk 10 pips if you take a 1 micro lot position. You pretty much have to be an
active day trader. With a 10 pip stop there's no way you can swing trade, or even
day trade many pairs, since you'll easily be stopped out by normal market
fluctuations before a big move happens.
Traders are far better off to save up more money before opening a forex
account; having adequate funding is essential to trading properly.
How Much Money Do I Need to Day Trade Forex?
If you want to day trade forex, I recommend opening an account with at least
$1000, preferably $5000.
With a $1000 account, and risking no more than 1% of your account, you
can risk $10 per trade, and can likely make about $20 to $25 per day. This assumes
you make 5 trades a day, win on average 3 of them, lose $10 on the losers and
make about $15 on the winners.
If you make more on the winners, then your income will be a bit higher. If
make more trades, and maintain the same win ratio, your income will also increase.
With a $3000 account and risking no more than 1% of your account on each
trade—$30 or less—you can make about $60+ per day, based on the trading
scenarios above.
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With a $5000 account, you can risk up to $50 per trade, and therefore you
can reasonably make an average profit of $100+ per day. This is possible because
let's say you risk about 10 pips per trade, so you can take a position of about 5 mini
lots ($1 per pip movement), which will lose $50 or make about $75 if your average
gain is 15 pips. Of course you won't win every trade, but if you win 3 out of 5,
you've made yourself $125 for the day. Some days you make more, and some days
you make less.
With a $5000 account you can start to create a decent stream of daily
income. If you allow the account to grow to $10,000 you can make roughly $250
per day.
These are rough estimates; some of the strategies in this book will only
result in a few trades a week, while others could be used to produce many trades a
day. Each strategy also has a different reward-to-risk ratio. In the scenarios above
it's been assumed that we're risking 10 pips to make 15 pips on the winners (as an
example)—a 1.5:1 reward-to-risk ratio— but usually we'll be looking for trades
that offer a 2:1 or 2.5:1 ratio.
It's possible to start an account with a smaller amount, such as $500. If doing
so make a commitment to grow the account for at least a year before withdrawing
any money. If you do this, and don't risk more than 1% of your account on each
trade, you can make about $12 per day to begin with, which over the course of a
year will bring your account up to several thousand dollars.
How Much Money Do I Need to Swing Trade Forex?
Swing trading is when you hold positions for one day to a few weeks. This
style of forex trading is suited to people who don't like looking at charts constantly,
or can only monitor the market for about 30 minutes a day to seek out trading
opportunities.
With swing trading, you're trying to capture longer term moves and therefore
may need to hold positions through some gyrations before the market actually gets
to your profit target area. You'll often be trading with at least a 25 to 50 pip+ stop,
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and attempting to make 50 to 75 pips+ on your winning trades. If you go for bigger
gains, such as 300 pips, your trades will likely last several days or more
(depending on volatility).
If you select trades that have a 50 pip stop, the absolute minimum you can
open an account with is $500. This is because you can risk $5 per trade; trading
one micro lot (about $0.10 per pip movement) with a 50 pip stop the risk is $5.
Since trades may last a few days, you're likely only to make about $10 or $12
every couple weeks. At this rate it could take a number of years to get the account
up to several thousand dollars.
Ideally, start with $2000. With this starting balance you can take at least 1
micro lot in pretty much any swing trade setup, in any pair, that you see. A $2000
account means you can risk $20 per trade, which is 200 pips with a micro lot. Find
trades with only 50 pips of risk and you can take more lots, or open multiple
positions. With $2000 or more you start to get some flexibility.
How Much Money Do I Need to Trade Forex - Final
Thoughts
In percentage terms the figures provided above represent phenomenal
growth. But remember we're using leverage. A 1% move in the market can be
turned into a 50% gain using 50:1 leverage. Some traders make the mistake of
thinking that because it's possible to turn $500 into thousands relatively quickly,
it's just as easy to keep exponentially growing a larger account ("Why aren't good
traders trillionaires?").
Psychologically, most traders find a trading level they're comfortable with,
and they maintain that trading account balance, withdrawing any money over that
balance as their income each month, thus the account doesn't grow anymore. Once
you have a reached an account level that produces an income you're happy with
(varies from person to person), the need and desire to make more diminishes.
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Also, as the account increases to six figures or more (sometimes sooner),
brokers will typically reduce the leverage available. Whether psychological or
because of the limitations of the market, smaller accounts can be grown more
quickly than large accounts ($50,000 or more).
Be realistic about what you expect from your forex trading. How much
money you deposit plays a crucial role in how much you'll likely make when you
follow proper risk management. If you're willing to grow your account slowly, you
can begin with as little as $500, yet starting with at least $1000 is recommended no
matter what style of trading you do. If you want to make an income from your
forex trading open an account with at least $3000 for day trading, or $5000 for
swing trading.
Most unsuccessful traders risk much more than 1% of their account on a
single trade; this isn't recommended. It's possible for even great traders and great
strategies to witness a series of losses. If you risk 10% of your account and lose 6
trades in a row (which can happen) you've significantly depleted your capital and
now you have to trade flawlessly just to get back to even. If you risk only 1% of
your account on each trade, 6 losses is nothing. Almost all your capital is intact,
you're able to recoup your losses easily, and are back to making a profit in no time.
As the examples above showed, it's still possible to make great percentage returns
risking 1% of your account, or less, on each trade.
The above scenarios assume that your average profit is about 1.5 times your
risk, and that you'll win about 60 percent of the time. These statistics vary
drastically depending on the strategy being traded, although a 60% win rate is quite
common for an accomplished trader (will be lower for beginners).
Your ability to stick to a strategy, assess market conditions, decide when to
trade a strategy, and when not to, will ultimately determine your success. How
much money you trade with is where it all starts, and will set you out on the right
path, or the wrong one.
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4. Pip Potential Relative to Spread – Day
Trading Forex
In chapter 1 we looked at some currency pairs to focus on. These are
generally the most liquid currency pairs and have the tightest spreads.
Unfortunately, when you're choosing which forex pairs to day trade, it's not as
simple as picking the pair with the tightest spread, or greatest daily average
movement.
Especially when day trading, the spread has a significant impact on your
long term success. Think of it this way: if a currency pair moves on average 70
pips a day, and the spread is 4 pips to get in and out (8 pips total) you're paying
more than 11% of the daily range. That is very large obstacle to overcome.
If the price is moving 250 pips a day and the spread is 4 pips, that's better.
There's is more opportunity for the cost (spread). Yet, as volatility contracts, say
from 250 pips down to 90 pips per day, traders often continue to trade the same
way they did when the daily range was larger. This can be costly; there are times
when it's highly beneficial to not trade, or to look for different pairs which have
higher potential revenue compared to the spread.
This also means the pair with a lower spread isn't always the best for day
trading. If a pair has a 3 pip spread (6 pips to get in and out) and a 100 pip daily
average movement, 6% of the daily range is unattainable (because it's your cost). If
a pair has a 4 pips spread (8 pips to get in and out) but has a daily range of a 150
pips, 5.3% of the daily range is unattainable. The revenue potential is higher in this
case compared to the former, even though the spread is higher.
Establish a baseline for all the currency pairs you trade (method below).
Which pairs you trade is laid out in the trading plan. Also specify at what times
you'll trade each pair (this is covered in detail later on). During certain times of day
volatility is greatly reduced, so during those times the spread is too much of a
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factor and that pair shouldn't be traded. Also, due to market conditions certain
times will be volatile, and other times not. When a pair is too quiet, don’t trade. If
the spread is costing too much of the daily range, wait and save your money for
better opportunities.
This chapter mostly applies to traders using non-ECN brokers. If you're
using an ECN broker, your spread will be extremely small, and therefore the
spread isn't typically an issue. You still should be aware though of when volatility
is contracting, so you're only taking trades that have a high probability of hitting
your profit target. Even with a small spread, if a pair isn't moving, it isn't worth
trading.
If you're a swing trader, then this chapter also isn't relevant. The longer time
frame of the trades means the spread usually isn't an issue. An exception is when
volatility is very low—the spread could have an impact and it's best to avoid
trading in these low volatility pairs.
Establishing a baseline is easy:
1. Find the daily average range of each pair traded (use 10+ days of price
action). Calculate the daily average range by subtracting the low price of the
day from high price. Use a 10 day (or more) Average True Range (ATR)
indicator for a quick reference. Ideally though, I recommend you record your
own daily stats. You can also find useful forex stats for each pair at
http://vantagepointtrading.com/daily-forex-stats
2. Take note of the spread (if fixed) or the average spread (if not fixed/variable)
during the times you trade.
3. Divide the spread by the daily average to get a percentage.
If you're entering and exiting the same day, double the spread, since you'll pay
it twice.
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Quickly calculate these figures at least once a week, as these ratios will
change constantly. Be aware when volatility drops as it may be time to move to
another pair/strategy, tweak the strategy, or sit on the sidelines. Be aware of the
spread—if it drops or increases this could dramatically affect the ratio.
Day traders also don’t usually trade 24 hours a day. If you only trade the US
session—and positions are entered and exited during that session—then you should
only use statistics from the US session. This means you're only concerned with the
average spread and volatility during the US session, so track the US session high
minus US session low.
It's for this reason I recommend you keep track and record your own
statistics on the pairs that are relevant to you.
If you're allowing trades to run from one session to another, then using 24
hour data is fine. In this case one of the easiest ways to get the daily average
movement is to use an Average True Range (ATR) indicator. Set the indicator for
10 or more days and that'll tell you how much, on average, the pair moves in a day
(when viewing a daily time frame on the chart).
By regularly tracking the ratio of profit potential to spread, you'll see that
just because some pairs are very liquid and heavily traded doesn't mean they
should be traded all the time. It'll also show that some less heavily traded pairs can
be very advantageous to day trade.
Spread to Pip Potential Examples
Assume you're trading the EURUSD and aren't concerned if your order fills
during the European, US or Tokyo session, therefore using 24 hour data is fine.
Look to your ATR indicator which is set to 10 or more days. The current
reading is 0.0126, which tells you that the average movement of the EURUSD is
126 pips per day.
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You also know the spread you pay is fixed at 2 pips, for example. If the
spread you pay is variable, use an average or an estimate.
That provides you with the first two steps in the calculation. Then run the
calculation.
4 pips (2 for entering and 2 for exiting) / 126 = 4/126 = 0.0317 or 3.17%.
Looking at the spread in this way puts it in a very different context. Many
traders view the spread as costing nothing, but that's not true. Every time you pay
the spread you give up profit potential. The more profit potential you give up, the
more costly each trade becomes and the harder it is to make consistent daily
profits.
For instance, consider the USDJPY which for a chunk or 2011 and 2012,
moved only 30 to 50 pips per day. If the spread on this pair is 2 pips, that means a
single day trade is costing 4 pips. Even if the pair is moving 50 pips per day, the
cost of trade is very high in percentage terms of daily movement:
4 / 50 = 0.08 or 8%
Merely by entering and exiting, 8% of the daily range has been paid. Also,
keep in mind that the daily average movement is for a 24 period. If you only trade
during certain times of the day the pair could move far less, and your cost could be
much greater. For example, if you trade the US session, and the pair is only
moving 30 pips during that time, paying 4 pips to get in and out is costing you
13.33% of the movement you're likely to see during the US session.
You must determine in advance how much you're willing to pay and at what
level you'll stop trading a pair if there isn't enough volatility to warrant paying the
spread. When day trading, you shouldn't be trading pairs with a reading higher than
7%; less than 5% is preferred (this applies to the 24-hour period). Either there isn't
enough volatility, your spread is too high, or both.
This may seem like a lot of work simply to gain some information and
insight. It is work, and it takes discipline to stay on top of these factors. Would you
run a business without being aware of what your costs and profit potential are? Of
course not, you would drive your business into the ground in no time. That's
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exactly what happens to most traders. They forget the simple things, like
monitoring the profit potential (daily movement) in a pair, and the cost of making a
trade. Tracking this sort of data lets you know when it's worthwhile to trade and
when it isn't. It's therefore more important than any day trading strategy, because
this tells you whether you should even be day trading that pair in the first place.
It never was my thinking that made the big money for me. It always was my
sitting. Got that? My sitting tight! - Jesse Livermore
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5. Introduction to Swing Trading and Day
Trading
Before moving into the more technical aspects of the book, let's look at
swing trading and day trading. Each trader is encouraged to trade the way they're
most comfortable with. It's likely traders will classify themselves as a swing trader,
day trader...or possibly both.
For those who don't like holding positions overnight, then day trading is
pretty much the only option. Trying to force a different trading style onto a
personality that won't accept it is a sure way to burn out, or experience poor
performance. On the other hand, traders who can’t stand to stare at a screen all day,
or monitor each gyration of the market, are more likely to be swing traders.
Day trading is taking positions during the day, and exiting that position
within the same day. In the forex market, day trading needs a somewhat more
dynamic definition than a day trader in the stock market might receive. A stock day
trader will generally trade a specific market while it's open, and that is it. A forex
day trader can trade any time during a 24 hour period; he or she can trade the
European open and the US close, just the European session or just the Tokyo
session.
Day traders don't hold positions overnight though—whatever their personal
“night” may be. Positions are taken and exited within the same trading day, with
the number and duration of trades varying drastically from trader to trader. Some
day traders incorporate roll-over into their strategy, and some choose to exit before
roll-over occurs. By the end of the book you'll know what to do in different
situations.
Scalpers are a form of a day trader that trade small moves over and over
again, often with large positions since the risk (in pips) is also kept small. If you
wish to be a scalper, open an ECN-style trading account. An ECN account is
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actually recommended for all day traders. Brokers and ECN accounts will be
discussed a bit later.
Some day traders may make many trades a day, or only a few. It really
depends on what the trader enjoys, and which strategies they utilize from this book
Swing traders on the other hand, may trade each day but don't necessarily
close their positions each night. Their trades last from a single day to a week or
even months (depending on the time frame used for the trade setup).
Swing traders can be very active, trading multiple pairs and thus opening
and closing different trades throughout the week, or they may simply focus on one
or two pairs, having an entry or exit signal only once or twice every couple weeks.
While traders often compartmentalize themselves into a group—day trader
or swing trader—the strategies of one group are often applicable to the other (and
vice versa). Unless a strategy involves a particular hour or time of day, most of the
strategies that follow can be applied to any time frame.
When you decide to be a swing trade, day trader or both, make sure you
choose an approach which you enjoy, find easy to stay disciplined with and that
suits your circumstances.
Swing Trader or Day Trader?
There are some limitations and advantages for both swing trading and day
trading. While someone may wish to be a day trader or a swing trader, a few things
may stand in the way of successfully accomplishing that, and these issues must be
dealt with before trading commences.
Day trading requires the trader have very fast broker execution and fast
reflexes to catch quick moves. This becomes more pivotal as the time frame for
trades decreases. A scalper attempting to grab 7 or 10 pips can ill afford to spend
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30 seconds typing in an order. Orders need to be teed up and filled in an instant.
That means setting up the platform so it can handle quick executions. It also means
going through a broker that provides quick execution—a “no dealer desk” ECN
style broker (more on this next chapter).
The spread is more of a factor the smaller the trade time frame becomes. If
your broker is charging you a three pip fixed spread on the EUR/USD (that's very
high!) it will be hard to profit by attempting to capture small 7 to 10 pip moves.
Some brokers don't even allow scalping, and institute rules which don’t allow
traders to exit positions within two minutes of the entry, for example. Use an ECN
broker and none of this is an issue.
Prospective day traders must legitimately ask themselves if they're setup to
effectively day trade (when the times comes, after reading this book), or if their
current circumstance is likely to pose problems. Due diligence is required in
preparing to make day trades, especially if you require rapid fire execution to
capture quick moves. It should also be noted that while a demo account may
provide some idea of how a day trading system will work, the platform may
perform very differently under live conditions where slippage (orders not
executing at the price you expect), liquidity and platform latency ("lag") issues
become an actual concern.
If a day trader is well prepared for day trading, it's a lucrative endeavour.
Small accounts benefit from day trading, as day trading provides a way to
capitalize on small moves while risking less than 1%, but capturing those moves
over and over again.
Swing traders generally don't need to worry as much about execution, the
spread or latency issues. When a trade lasts a couple days or a week, a pip or two
doesn't make a big difference. That also means swing traders don't need rapid
execution, although setting the platform up so trades can be executed quickly when
needed is encouraged.
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Given the length (in time) of the trades, swing traders must always put out
profit targets and stop orders on their positions, as it's quite possible the level could
be hit while they're not watching the market. Stops and target are also used by day
traders, but since day traders are watching their screens, they can also manually
exit trades if they wish.
The major advantage of swing trading is that it doesn't have to take up a lot
of time. Once a strategy (or several) is mastered and a trading plan is in place,
charts are scanned quickly each day for trade candidates. This may only take
several minutes a day depending on how many pairs are scanned. Orders are then
set and the trader walks away.
Unfortunately, this “easy money” approach is what lures many traders into
swing trading undercapitalized, and without a proper method. Swing traders are
generally going to require a larger stop loss (in pips) than a day trader. Even
though position size can be adjusted, the swing trading account needs to have
enough capital in it to handle the larger stop losses and still not risk more than 1%
of the account on a trade.
With regard to time commitment, those starting out and those who haven't
mastered their emotions and trading plan need to put in much more time studying
charts and understanding their own tendencies than a few minutes a day. It's true
that 10 to 20 minutes a day is all it takes to manage positions and find new swing
trades, but there's work which occurs outside “analysis” time. Record keeping was
discussed in a prior chapter and the trader must stay on top of what's working and
what isn’t. Trading is a full time job during the initial stages of the learning curve,
whether swing or day trading. But most of those hours aren't spent actually trading;
they are spent practicing the strategies and exercising discipline. Once profitable
methods are established and enough internal work has been done to actually follow
through on a personal trading plan without deviation, only then does trading
become a part time job.
Personality also plays a pivotal role in whether you'll be a swing trader or a
day trader (or both). Some traders love to make lots of trades, even while swing
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trading, and may sit in front of their computer all day. Others only want to look at
the markets for 10 minutes a day.
Traders who are open to both day trading and swing trading get the best of
both worlds. Sometimes day trading strategies are employed and at other times
swing trading tactics. Having the best of both trading styles means more work is
required though. The trader must be comfortable trading on multiple time frames
and also must develop a comprehensive trading plan to account for day trades and
swing trades, potentially occurring at the same time.
Final Thoughts: Adapt Methods to Suit You
Whether swing trading, day trading, or both, the bottom line is to make sure
you're prepared (financially, technologically and emotionally) for the endeavour.
Use strategies that align with your personality and allow you to reach (eventually)
the realistic goals you have for yourself and your trading.
In that light, as you read through the rest of the book, keep an open mind.
While certain sections cater more to day traders and others to swing traders, realize
there's potential for both types of traders within these chapters. A small tweak
and/or simply a time frame change can transform a day trading strategy into a
swing trading strategy or vice versa. It won't work with all the methods outlined in
this book, though it will for many.
If a strategy doesn't initially appeal to you—for whatever reason—still read
it through. When you've read through the book, come back to that strategy as
something you learned in another chapter may help you implement that strategy
better.
Whether you swing trade or day trader (or both), the choice you make and
what you do every day should align with who you are, your resources and your
goals.
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6. Picking a Forex Broker
Once you've finished with this book you'll need a forex broker, first for your
demo account and the then hopefully your live account, once you're consistently
profitable in the demo. Choosing a forex broker is essentially the biggest trade
you'll ever make in your forex career. You're trusting all your trading capital to
these people, so don't take the choice lightly.
Below you'll find some steps for how to pick a forex broker that's right for
you. You'll also learn how to test that broker out, what you can and can’t trust, and
things to consider before handing over your money.
How to Pick a Forex Broker – ask yourself the right
questions
Have an understanding of what you need from your broker. This narrows the
field of brokers to a handful which suit your needs. Consider your resources,
trading style and how you move your money around.

One of the main factors to consider is whether you want to trade micro, mini or
standard lots. If you have under $10,000, trade with micro lots. Only look for
brokers that offer micro (1K lot or 0.01 lot) trading. Different brokers will also
have different deposit minimums—this is an easy way to narrow down brokers
based on the funds you have available for trading.
Also, some brokers impose a maximum on the amount of money you can
have in a micro or mini account. That seriously stinks if the broker bumps your
account up the next level and won’t let you trade in small increments anymore.
For instance, let’s say you open a micro account with $900. Since each pip
movement is only $0.10 (approx) you can control your risk and only risk 1%
($9) of your account on a given trade (90 pip stop). You do well and soon your
account is at $1000... and BAM, your account gets switched a mini lot trading
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account. Now each pip movement is $1 (assuming they no longer allow you to
trade micro lots). With a $1000 account there's no way you can control your
risk properly anymore. You can only risk 10 pips in order to keep your risk to
1% of your account per trade. That greatly restricts your trading style and
forces you to trade more actively. You're being forced to deviate from the very
risk management that was helping you be successful.
Make sure there's no limit on how much you can have in your micro or mini
account, or that you can trade these smaller increments even when using a
standard account. For the record, I recommend Micro lot trading for anyone
with under $10,000 to deposit. Micro lots allow risk to be fine tuned and for
position size to be managed precisely. In my opinion, $10,000 is the bare
minimum for trading mini lots. And $100,000 is the bare minimum for trading
standard lots. This is especially true for swing trading. If day trading, you may
be able to trade these bigger lot sizes with less than the recommended capital in
your account...but why? There's no upside to limiting yourself to only trading
mini or standard lots.

Some brokers don't allow scalping. If you want to scalp, make sure the broker
allows it. If unsure, email the broker before opening a demo account. If you're
day trading, this may still be an issue, since some of your trades may end up
being considered scalps. If you're going to swing trade this isn't an issue.

If you're executing a significant number of trades (or small pip movement
trades), get a broker which offers tight spreads, as the spread is a cost. Ask
yourself how many trades you expect to do per day, per week, or per month.
You'll have a good idea after you've read the book and started on your trading
plan.
The more trades you do, the more spreads you'll pay. If you only do the
occasional longer-term trade the spread isn't a significant factor. If you want to
trade a lot, and capture small gains, open an ECN account with an ECN broker.
ECN brokers have the tightest spreads but charge a small commission on each
trade. Since the commission is less than the spread, day traders benefit from
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using an ECN account. The spread offered by each broker varies; all ECN
brokers aren't equal. Shop around for the best deal, heeding the additional
criteria mentioned below.

You'll also want to consider HOW you're going to fund and withdraw from the
account. This is a big one…especially the withdrawal aspect as this is often
where traders run into problems. Learn how deposits and withdrawals are
made (methods), processing time, and if there are any limits imposed. A
common limit is that if you deposit by credit card you can only withdraw (via
credit card) the same amount (or less) as the initial deposit. Therefore, you may
wish to use a broker that will mail checks, wire funds or offers payment
services such as PayPal or Skrill, or one of the many other web payment
services out there. Ideally, you need a broker that provides a deposit and
withdrawal method that works for your personal circumstance.
Now that you've determined some of the things you want, we move to the
next step which is what the broker can offer. There are so many brokers out there,
and the market is largely unregulated (slowly changing as many brokers are now
becoming regulated). This means the trading experience varies greatly from broker
to broker. Choosing a broker is an individual process, as each broker focuses on
certain things that will appeal to some traders, but not others.
How to Pick a Forex Broker – does your broker offer
this?

Competitive Spreads: In forex trading there's often no commission. Instead,
traders pay a spread (difference between bid and ask price) when making a
trade. Some brokers offer fixed spreads, while others offer a variable spread.
For instance one broker may offer a fixed 3 pip spread on the EURUSD at all
times (this is very high!). Another broker may offer a variable spread which
fluctuates between approximately 1.0 pip during high volume times and 2.5
pips during low volume times. The spread that's paid has a huge impact on
profits, especially when day trading or doing lots of trades. The lower the
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spread the better. Sometimes that comes at a cost though…such as being
constantly re-quoted (discussed shortly).
ECN forex brokers charge you a commission on each trade, though
generally provide much lower spreads. With some ECN brokers, the spread is
almost zero. Paying the commission is typically worth it to save one pip or
more on the spread. For longer-term traders this isn’t a big deal, however for
scalpers and day traders, an ECN broker with a typical spread near zero (0.1 or
0.2 pips on major pairs) is highly advantageous.
In the "middle" are STP accounts. These are accounts which offer instant
execution, like ECN accounts, except STP accounts don't typically have
commissions. Instead the spread is slightly higher than an ECN account, but
lower than a typical forex account.
Because the conditions are more favorable in ECN and STP accounts, the
deposit minimum is typically higher than for a basic forex account. Expect to
deposit at least $1000, often $2000+, to open an STP account, and more for an
ECN account.
The accounts you can open for $50 or $100 (and this isn't recommended
anyway, based on what you've read so far), or even $1000 or less, often have
the worst trading conditions (highest spreads and day trading abilities may be
limited). Not only are you undercapitalized, but you're trading at a
disadvantage compared to better capitalized traders.
It's highly recommended all traders, day or swing, use an ECN or STP
account. ECN is best for day traders, while swing traders should use an STP
account, yet can also use an ECN account.

Few Re-quotes: A re-quote is when you place an order and the price changes
and you get “re-quoted”. A message pops up asking you if you want to proceed
at the re-quoted price. This is a big deal for day traders; the delay can ruin your
entry and the trade, or keep you in a losing position longer than you need to be,
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resulting in a bigger loss. That said, it can be annoying to anyone if it happens
a lot. Also, constant re-quotes draw the listed quotes and spread into question.
If a broker is showing a very tight spread, but constantly re-quotes, then they're
not actually giving you that spread even though they're advertising it.
Therefore, you want a broker that offers a competitive spread and actually lets
you trade at the rate you see.
ECN and STP accounts don't have re-quotes, you're simply filled at the
prevailing rate when your order gets to the market.

Safety: A major concern for traders is being able to get their money out of
their account. It doesn’t matter if you make a killing in the markets, if your
broker scams you, or your money gets caught up somewhere, it was all for
naught.
I've had issues with regulated brokers, and have had great experiences with
unregulated brokers. That said, regulated brokers are under more scrutiny than
their unregulated counter-parts, so choose regulated brokers over the
alternative. Ideally, choose brokers regulated by financial authorities in the
U.S., U.K., Canada, Australia, New Zealand or Japan, or other well established
financial markets. Many brokers are regulated in Cyprus, although when there
are problems with regulated brokers, it's usually with these ones. Stick to
opening accounts which are regulated in countries with good economies and
established financial markets.

Customer Support: If you need help with something, your broker should be
there for you. To make sure they are send a few emails to customer service
asking about something. This is just to make sure they're listening to you and
they seem to know what they're talking about. Also make sure the broker has
live chat or phone support so you have quick access to help if something goes
wrong and you need to speak with someone quickly. Test out the customer
support by sending emails and trying out chat support before you make a
deposit. Don't be coy about this, you really need to test them. The last thing
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you want is to open an account and then get no response to your queries and
questions.
How to Pick a Forex Broker – don’t always trust
reviews or other people’s opinions
While reading about forex brokers in forums, on websites and in reviews is
of value, it can also be totally inaccurate. Brokers may post their own reviews, and
what I find more often is that traders will bash brokers simply because they lost
money at trading. Since more than 90% of active traders who try trading lose
money, it's no wonder so many traders blame their broker. It's much easier to
blame someone else than accept personal responsibility.
I don’t trust reviews. The best way to test a broker is to read what you can
on the broker’s website, to make sure they offer what you need. Then, follow the
steps below to "test out" the broker.
Just like trading, avoid taking short-cuts. Do your own due diligence rather
than blindly trusting someone else’s opinion. Reviews and information on a
particular broker may be a starting point, though you need to test that broker out
for yourself.
How to Pick a Forex Broker – personally “test out”
the broker(s) you choose
Open a demo account with brokers you think you'll like–brokers that offer
what you personally require. Demo accounts aren't exactly like live-trading,
although you'll get an idea of the spreads, customer support and whether you like
the platform.
If you like the demo account and everything else is in-line (see sections
above) then proceed to open a live account, but follow these steps in doing so:
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



Always make a small initial deposit with a new broker (don't take any
bonuses or "free money").
Make several trades. These are very small orders, just to test out the software
and see how quickly orders go through. Unless your trading plan is
completed and has proven profitable over the course of a number of months,
this step is not actually about trading. Just place a few orders with very tight
stops and targets to see how the trading platform operates and how quickly
orders go through. This process shouldn't cost you more than several dollars.
Make a withdrawal for a portion of the funds you have in the account.
If everything goes smoothly, deposit more the next time and continue to
work up until you feel comfortable the process is reliable.
Nothing is limiting you to using only one broker either. Consider separating
your funds between two brokers (if you have a larger amount of capital); use one
broker for swing trading and the other for day trading, as an example.
Each broker is different, so if I like what I see and read about a broker I'll try
them out with a small amount and slowly add more capital, up to my full amount,
if things go smoothly. This process can take months sometimes. If you're following
the 5-step plan for successful trading, taking a few months for this process is fine.
During this time, practice implementing and refining your trading plan. Once you
trust the broker you're dealing with and have deposited your trading capital,
hopefully you'll be close to finalizing your trading plan and trading with real
capital.
Be sure to read all the fine print when opening an account.
Don’t Take the “Bonus”
While a bonus may seem nice upfront "Deposit $5000 and get $1000 free in
bonus capital!" don't be fooled. Accepting a bonus will complicate things down the
road when you go to withdraw funds. Nothing is really free about these bonuses.
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The broker isn't going to give you free money unless they think they can make it
back.
What happens is that you now have a $6000 balance showing in your
account, and after some profitable trading your account is now at $6500. You
decide to withdraw $500. But your broker says you can't, because $1000 in the
account is theirs (until you have met the specific trading requirements which will
make it yours). Since it's possible you could lose all the money in your account,
they don't let you withdraw any, because they want to protect their $1000.
If it sounds too good to be true, it probably is, and there's always a catch.
Send a note to the broker when you open your account that you don't want a bonus.
For more details on the type of issues you're likely to run into when taking a
forex bonus, and why it isn't worth accepting in the first place, check out the article
Why You Shouldn't Take the Forex Bonus From Brokers.
Final Word on Choosing a Broker
Don't take the decision lightly on which broker to use. You may actually opt
to try out a few brokers, and end up trading with all them. Do your research online,
but read reviews with some skepticism. Disgruntled traders may bash a broker
because they lost money, but that isn't the brokers fault. Positive reviews may also
be written by employees of the brokerage.
The best approach is to test a broker yourself, once you have come to the
conclusion that they're offering what you need. Start with a demo account, and
email support (multiple times) to see how accessible they are. If all goes well,
deposit a fraction of your trading capital. Make some live trades and attempt a
withdrawal. If the experience is positive, continue to add capital, repeating the
process above. These withdrawals and trading transactions may cost several dollars
in fees/losses, but knowing you can access your money with ease is worth the few
dollar cost.
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Stick to brokers regulated in major global financial centers, and avoid
brokers regulated in places you've never heard of, or that have volatile economies.
Finally, never take a bonus. As traders we make our own money and grow
our accounts the proper way. Accepting a bonus only complicates things down the
road.
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7. Best Time to Day Trade and Swing
Trade
Don't let the 24-hour market fool you. When it comes to day trading, not all
hours within the 24-hour period are equal. Attempt to trade a trending strategy
when major markets affecting that pair aren't open and you're trading against the
odds. Unless a strategy explicitly states otherwise, if you're going to day trade the
strategies in this book, it's recommended you do so during the hours discussed
below.
The best time to day trade the forex market is dependent on the forex pair
you're trading; certain pairs are more heavily traded at different times around the
globe based on which markets are open. For simplicity, we'll look at the best time
to day trade popular currency pairs, such as the EUR/USD, GBP/USD, USD/JPY,
USD/CAD, AUD/USD, NZD/USD and USD/CHF. I'll also show you how to find
the best times to day trade other forex pairs not covered here, as well as monitor
the above pairs for changes in their volatility, which may affect day trading.
Open Major Markets Means Increased Action
As a basic guideline, forex pairs are most active when one or both of the
markets associated with the pair are open for business. For example, the EUR/USD
is most active when European banks and/or when US banks are open for business.
Exact times of heightened volatility will be addressed shortly. If neither the
European or US banks are open, then the EUR/USD will have less transactions
occurring and will be “quieter.”
Here are the market hours for major markets around the world. Please
accommodate for day light savings time.
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Forex Market Hours in GMT
Forex Market Hours in EST (New York)
During the week there's always a market open somewhere, allowing you to
trade 24-hours a day.
If you get lost converting all the time zones and figuring out which market is
open and when, there's a great little tool which shows current times in different
time zones as well as the market hours for different time zones:
http://www.forexmarkethours.com/markethours.php.
Your Day Trading Style
If you day trade the strategies in this book, it's recommend you trade them
during the times below (unless a strategy says to do otherwise).
Below I discuss the most active and volatile trading times in each forex pair,
and the best time of day to day trade forex if you're an active trader seeking
volatility and trending opportunities.
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The
volatility
charts
below
are
updated
daily
on:
http://vantagepointtrading.com/daily-forex-stats. I recommend checking these stats
and charts at least once a week, to make sure the hours you're trading are still the
most active, and to be alerted to any significant volatility changes which may
affect the strategies you're employing.
Best Times to Day Trade Forex…
The charts below show the hourly volatility of each pair, showcasing which
times of the day are best for day trading forex. All charts below are based on a 30
week average. While volatility changes over time, the hours of the day that are
most active don't change significantly. For example, overall volatility may increase
or decrease, but 1200 to 1500 is still likely to be the most active time of day in the
EURUSD, as shown below.
Times listed are GMT. Be aware of Day Light Savings Time if it affects
you.
Best Time to Day Trade– EUR/USD, GBP/USD and
USD/CHF
These are all European currencies traded relative to USD, and are most
active at similar times.
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The EUR/USD is most active between 0700 and 1600 GMT. While this is an
active time overall, the most active time is between 1200 and 1500; if you only
have a few hours to trade, start and stop trading at these times respectively.
The GBP/USD is most active between 0700 and 1600 GMT. While this is an
active time overall, the most active time is between 1200 and 1500; if you only
have a few hours to trade, start and stop trading at these times respectively. The
hour from 0800 to 0900 GMT is also very active.
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The USD/CHF is also most active between 0700 and 1600 GMT. While this
is an active time overall, the most active time is between 1200 and 1500 GMT; if
you only have a few hours to trade, start and stop trading at these times
respectively.
Best Time to Day Trade– USD/JPY
Since Japanese and US markets are open at different times, the most active
times of the day are spread out.
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The USD/JPY is most active from 2400 to 0200 GMT, 0600 to 0800 GMT
and 1200 to 1600 GMT. The latter period is better than the former two. The entire
area has been highlighted (yellow) between 2400 and 1600 GMT as a potential
time to trade, although this isn't highly recommended. If you only have a couple
hours to trade, focus on 1200 to 1600 GMT.
Best Time to Day Trade– USD/CAD
Canada is situated above the US geographically, therefore, these country’s
markets are open at the same time.
The most active time to trade the USD/CAD is between 1200 and 1600
GMT.
Best Time to Day Trade – AUD/USD and NZD/USD
Australia and New Zealand share some economic similarities and
geographical proximity, and therefore the AUD/USD and NZD/USD experience
similar trading conditions during the day.
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The AUD/USD and NZD/USD see increased volatility between 2400 and
0200 GMT, 0600 to 0800 GMT and the most active part of the day is between
1200 and 1500/1600 GMT. The latter period is recommended over the former two.
Best Time to Day Trade – Other Forex Pairs
To figure out the best time to trade other forex pairs, go to
http://vantagepointtrading.com/daily-forex-stats. Under “Pair Volatility” click on
any forex pair to see a chart like the ones shown above.
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Locate the most active time(s) for day trading that pair, and quiet times to
avoid.
Unless a strategy directs otherwise, trade the above pairs at the times
mentioned. If trading other pairs not discussed above, then only trade the pair
during the most active time day. We want movement for our strategies.
Time of Day and Swing Trading
There are specific times you should day trade; swing trading is more
flexible. If you're using a 4 hour or daily chart, then you don't need to worry about
when you place trades. Many of my swing trade orders are placed when the US
and Europe are closed so when these market opens, and volatility increases, those
orders are filled. You can also set your swing trade orders while major markets are
open. Ultimately, it shouldn't affect your results too much when you place orders
for swing trades.
As a guideline, I recommend that you place swing trade orders at about the
same time each day. Set a bit of time aside each day where you look through your
charts and set out trades. This way you're looking at the market in the same "state"
every day when you place your trades (and can spot tendencies).
If one day you place swing trades while Europe is open and then the next
day you place trades while Europe is closed, the price bars you're looking at the far
right of your screen are likely to be quite different. Will it affect your trading?
Maybe, maybe not. Swing trading is more flexible, and you can put out trades
whenever you like, though strive for consistency. Trading is a business, and should
be treated like one.
I put my swing trade orders (entry, stop and target) out after the US has
closed but before Europe opens. If trade setups develop, I may place additional
swing trade orders at other times, yet I always check my charts and look for trades
between the US close and the European open.
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8. Introduction to Japanese Candlestick
Charts
Japanese Candlesticks are one of the most widely used chart types. The
charts show a lot of information, and do so in a highly visual way, making it easy
for traders to see potential trading signals and perform analysis with greater speed.
Here we'll look at what Japanese Candlesticks are, how the "candles" are created
and basic candlestick interpretation. Understanding these charts will be useful
going forward, as most of the chart examples in this book are candlestick charts.
Japanese Candlestick Charts
Japanese Candlesticks show the high, low, open and close price for a
currency pair, as well as highlight whether the pair finished higher or lower, over a
specific period. Candlesticks are used on all timeframes—from a 1 minute chart
right up to weekly and yearly charts.
When information is presented in such a way, it makes it relatively easy to
perform analysis and spot trade signals.
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Figure 1. Japanese Candlestick Chart - EUR/USD 5 Minute
Candlesticks use two colors, such as green and red, blue and red, or white
and black. The charts on FreeStockCharts.com use a green and red color scheme
(by default, but this can be changed) for the Japanese Candlesticks. Change the
chart type to candlesticks and the colors to red and green preferably.
Japanese Candlestick Creation
Color is important in Japanese Candlesticks. A green bar (sometimes blue or
white) indicates the price closed higher than the open price of the bar. A red bar
indicates the price closed lower than the open price of the bar. The bars can also be
colored based on how they closed relative to the prior close.
To understand how this works, let's look at how each bar is constructed.
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Figure 2. Japanese Candlestick Green and Red Candles - EUR/USD 5 Minute
Each candle provides information on the open, close, high and low of a
currency pair's price. Each candle reflects the time period you've selected for your
chart. For example, in figures 1 and 2, a 5 minute chart is used, which means each
candle shows the open, close, high and low price information for a 5 minute
period. When 5 minutes has elapsed, the bar is "complete" a new 5 minute candle
starts. The same process occurs whether you use a 1 minute chart or a weekly
chart.
The open and close are marked by the "fat" part of the candlestick. This is
called the real body, and represents the difference between the open and close. If
the close is higher than the open, the candle is green; if the close is lower than
open, the bar is red.
The open or close aren't necessarily the high or low price points of the
period though. The high and low prices for the period are marked by a "tail" or
"upper shadow" and "lower shadow." The high point of the upper shadow shows
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the highest price the currency pair went during that period, and the low point of the
lower shadow shows the lowest price the pair went during that period. Figure 3
shows the basic construction.
Figure 3. Japanese Candlestick Construction
If there are no upper or lower shadows, it means the open and close were
also the high and low for that period.
Occasionally, you'll see bars that are nearly all upper and/or lower shadow,
with very little real body.
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Figure 4. Japanese Candlestick Long Shadows - EUR/USD 1 Hour
Figure 4 shows several examples of candlesticks with long shadows. Let's
focus on the one in the blue box. The upper shadow reflects the highest price hit in
this one hour period, the lower shadow shows the lowest price hit during the hour,
and the small red real body shows that the price closed marginally lower than it
opened.
To see the exact prices of the open, close, high and low you can click on a
candlestick on FreeStockCharts.com to see a pop-up, which provides you with all
the info. Figure 5 shows information for the same bar addressed in figure 4. If
you're using MetaTrader, click your mouse wheel anywhere on your chart to pull
up a "crosshair." Place the crosshair over a price bar and the high, low, close, open
and date of the bar will appear along the bottom of the trading platform.
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Figure 5. Japanese Candlestick Info Box
For some tips and tricks on using MetaTrader 4, see MT4 Tips and Tricks—
Making MetaTrader 4 Trading and Analysis Easier:
http://vantagepointtrading.com/archives/10148
Japanese Candlestick Interpretation
Due to the highly visual construction of candlesticks, there are many
candlestick patterns which traders use for analysis and to establish trade signals.
Some of these are discussed later in the book, although for now there are general
principles that anyone new to Japanese Candlestick charts should understand.
 A long real body indicates stronger pressure than a small real body. For
example, a long green body represents stronger buying pressure than a small
green body. A long red body represents stronger selling pressure than a
small red body.
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 Shadows are used to determine what group of traders—buyers or sellers—
are strongest at the close of a candle. While not always, it's quite possible the
strongest group at the close of the prior bar will be strongest heading into the
next bar/time period.
 A long lower shadow indicates sellers tried to push the price down, but
ultimately the buyers succeeded in pushing the price back up and were
strong at the close.
 A long upper shadow indicates buyers tried to push the price up, but
ultimately the sellers succeeded in pushing the price back down and were
strong at the close.
The Secret Life of Charts
Japanese candlesticks are useful, although you should be aware of one
drawback which actually applies to pretty much every type of chart out there, not
just candlesticks.
Within each bar you see in hindsight the market was gyrating back and forth,
but the bar/candlestick only records the open, high, low and close for time period.
Much more took place within the bar than the high, low, open and close. If a trader
only looks at historical data, breakouts (discussed in the strategies that follow) may
appear clean and easy to trade, yet in real-time the market may move back and
forth over the breakout point (all within one bar). When the bar closes, it looks like
a clean breakout occurred, but in real-time maybe it wasn’t.
Price bars in hindsight are a summary of what happened, and reveal a lot,
but they don’t reveal everything. This is why practicing in a demo account is
required before you move to live trading. Looking at charts and examples isn't the
same as trading the real-time market.
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It's for this reason I don't wait for candles to complete with any of the
strategies contained in this book (unless specifically stated). Price bars/candles are
arbitrary. For instance, if there's a big down bar, and then the next bar starts to rise
dramatically, if it crosses above the open of the previous down bar, to me that's a
bullish engulfing pattern (this pattern is discussed in later chapters); if that's my
trigger, I enter the market without waiting for the candle to complete. It's possible
the market could drop right then, and in hindsight the engulfing pattern wouldn't be
seen, yet in real-time it happened—this is the secret life of charts.
This is also the reason why many back-tested methods which are optimized
on historical data do very well in theory, though crash and burn in real-time
trading. The forex market is a continuous market, and the closing prices of bars
aren't particularly useful. In the stock market, there's a definitive close each day,
which makes the closing price more important. In forex, we don't have that, so
don't give the closing price of a random bar much respect; trade in real-time, as
trade signals occur (you'll learn lots soon) and don't worry about whether a bar has
finished/completed or not.
The Bid/Ask Spread and Your Charts
The Bid/Ask Spread discussed earlier in the book explained how the spread
works in the forex market. As a trader, you can lose money without the currency
pair even moving, simply because you always pay the offer price (higher price)
when buying, and sell at the bid price (lower price).
When you first start trading the forex market you may be confused by why
some of your limit orders or stop orders get executed and others don't. When you
look at your charts it appears you should've gotten into a trade, but didn’t. Or other
times you get into a trade when the price never reached your entry price on the
charts. What’s going on???
The simple reason situations like this occur is that forex charts by default,
only show the bid price. If the current bid price is 1.5410 on a particular currency
pair, the rate on the chart will show 1.5410. At this point the offer is actually at
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1.5412 (if there's a two pip spread), but this latter level isn't shown on the chart,
only the bid price is shown. As the bid price moves up or down, so does the
“current” rate on the chart.
If you're looking to enter a long position with a buy order at 1.5412, the
order will only be “triggered” if the offer price hits 1.5412.
If the spread is three pips and the pair is currently trading at 1.5430, this
means the price on the chart needs to move down to at least 1.5409 to trigger this
buy order. If the chart (bid price) shows the price only dropped to 1.5412, your
order won't fill because the offer price as that time is 1.5415, which is still above
your buy price of 1.5412.
It's also possible that a buy order is executed at a level above where the chart
shows the rate went. Consider a chart which shows the high price of the day at
1.5400. If you bought precisely at that moment, the offer price is actually 1.5403
(assuming a three pip spread). Therefore, you'll be in a long position at 1.5403,
even though the chart shows that the pair only went to 1.5400 (bid price).
When you sell, the charts are accurate. Sell orders always go through at the
bid price, and the bid price is what you see on the chart. An entry order to sell at
1.5410 is executed if a bar on the chart shows the market moved to 1.5410.
If the low for the price bar is 1.5410, and you place an order to sell at
1.5409, the order isn't executed.
The important thing to remember is that charts, by default, almost always
reflect the bid price. Buy orders go through at the offer price, and sell orders go
through at the bid price. Factor this in when placing orders for entries and stops.
Many charting platforms allow the bid and offer to appear on the chart. This
can help you better understand how the spread works when you first start trading.
To toggle this option in MetaTrader 4 right click on an open chart, select
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Properties, click the “Common” tab, from the options check the “Show Ask Line”
and click “OK.”
Japanese Candlesticks - Final Word
Japanese Candlestick charts are the preferred choice of many traders, since
the price moves are easy to see and trade signals can be spotted quite quickly. Play
around with the free charts offered on FreeStockCharts.com to get a feel for
candlesticks and how to trade with them.
Being comfortable with the basics of candlesticks makes the rest of the book
easier to understand, and the chart examples will make more sense.
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9. Trading Chart Patterns
Chart patterns are a good introductory strategy to learn. Since many traders
have heard or read about them, let's dig a little deeper into what chart patterns are
and the various ways they're traded.
Chart patterns provide a way to spot trading opportunities, plan where to
take profits (targets) and set stop loss levels. They're a basic strategy though, so as
you progress though the book you'll realize chart patterns are just part of the ebb
and flow of market movements. Being able to spot chart patterns and having an
idea of how to trade them will aid you in effectively implementing the other
strategies in this book.
Chart patterns are geometric shapes created by connecting, or encasing,
price bars using trendlines (available via drawing tools in almost all charting
platforms). Like a “connect the dots,” chart patterns are a visual way of seeing
potentially predictable market behaviour unfold. Patterns repeat and do so very
often, although the result isn't always the same. A pattern can breakout and move
to upside one time, breakout and move lower another time and the next time the
pattern is broken the price moves right back into the pattern—a false breakout.
While chart patterns aren't a perfect predictor of future price movements—
no method is—by isolating a pattern you're given a couple of highly probably
scenarios which are likely to play out. The pattern gives you a precise way to trade
a scenario once it occurs.
There are several common patterns you'll see regularly on price charts. As
your eyes become trained, you'll see these patterns on all forex pairs and time
frames. The patterns aren't limited to forex either; chart patterns occur in stocks,
commodities, bonds and other financial markets as well.
Commonly discussed chart patterns include trading ranges (also known as
rectangles) as well as double tops/bottoms. There are others though, including an
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assortment of triangles, wedges, head and shoulders, flags and pennants. Less
well-known is the broadening wedge.
For the chart patterns that follow, I frequently refer to stop loss or entry
levels as "just above" or just below" a price or point on the chart. For entries, just
above or just below means 1 pip. In terms of stop loss orders, just above or just
below means 1 pip when day trading, and 5 pips when swing trading. In all cases,
remember to add the spread if applicable (re-read The Bid/Ask Spread and Your
Charts in the prior chapter if unclear on how the spread affects orders).
Chart Patterns to Focus On and How to Trade Them
The chart patterns outlined in this section are fairly simple to see and trade
using the methods discussed. These patterns include triangles, wedges, head and
shoulders, flags and pennants, all which provide profit potential that's greater than
the anticipated risk.
To trade a chart pattern you'll need to know how the pattern looks, how to
draw the pattern on your chart (the trendlines of the pattern), where to enter, where
to place stop loss orders (stops) and where to set profit targets (targets).
As you look at the examples given, you may notice that at times a trendline
is drawn along the extreme highs and lows of the price moves within the pattern,
and at other times the lines are drawn right through a price bar/candle. When
drawing trendlines to create chart patterns, use “lines of best fit.” Patterns don't
always form perfectly; sometimes the price will stall before reaching a trendline,
and other times it'll slightly penetrate it. That's fine. When you draw patterns,
simply try to make it the best fit to the price action you can. That's all you can do—
and it still works well for trading purposes.
All trading software has drawing tools which allow you to draw horizontal,
vertical and diagonal lines on your chart. If you're unfamiliar with drawing tools
check out TradingView.com to test out charts, tools and indicators for free. Use the
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tools to outline trading action so you can see the patterns clearly. The lines define
breakout points, and also “contain” the price until the breakout occurs.
The drawn lines signal the breakout points, that's why it's important to draw
the lines using the suggestions above—use price points running along (or near)
highs and lows which define the pattern using “lines of best fit.”
If you see several ways a pattern can be drawn, draw all the variations on
your chart. Doing so provides you with more than one profit target. If trading two
or more lots, exit one lot at each profit target. That's why I recommend traders
open micro or mini accounts, as the trade size is much more customizable. Instead
of taking one standard lot ($100,000) you can take 10 mini lots ($10,000 each), and
exit those lots at different prices if you wish—much more flexibility.
Before delving into the chart patterns, here are two guidelines for trading
them:
 Let patterns develop. Don’t assume a pattern will develop just because it
looks like the price may be starting to form a chart pattern. Later we'll
discuss head and shoulders patterns; once the left shoulder and the head
have formed, it's easy to fall into a trap of anticipating the right shoulder
and the ensuing breakout move lower. This is an unprofitable habit to get
into it. Let the market develop and don’t assume a pattern is in place until
it actually is.
 Don’t assume a breakout or the breakout direction. Certain patterns do
have tendencies, but there's no need to anticipate or guess the breakout
time or direction. When the breakout actually occurs you can trade it,
based on the direction the price is moving. Patience is a key virtue to
have in trading.

The Triangle
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Triangles are symmetrical, descending or ascending. Although, for trading
purposes it doesn't matter which one you're trading—all triangles have the same
entry criteria, stops and profit targets.
A symmetrical triangle forms when the price action is continually making
lower swing highs and higher swing lows. The trendlines along the top and bottom
of the price action are converging, creating a triangle.
The thickest part of the triangle is how our profit target is calculated. The
distance in pips between the swing high and swing low, at the thickest part of the
triangle, is added/subtracted to the breakout price. The breakout price is where the
currency pair crosses above or below the trend line.
A symmetric triangle looks like this:
The light grey lines provide a measure for the profit target. The thick part of
the triangle is projected out from the breakout point to give a potential exit price
(profit target).
Breakouts can occur along either the upper or lower trendline. The longer
the price stays within the triangle, the lower the risk on the trade. This is because
the stop loss for the trade is placed on the opposite side of the formation as the
breakout, and a triangle continually narrows. If a breakout occurs to the upside, a
stop is placed just below (1 pip when day trading, 5 pips when swing trading) the
lower trendline. If a breakout occurs on the downside, a stop is placed just above
the upper trendline.
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This method has a larger reward than risk. Our profit target is always based
off the thickest part of the triangle, yet our risk diminishes over time as the price
action moves toward the apex (where the converging lines meet) of the triangle.
Very rarely does the pattern hold all the way to the apex, a breakout normally
occurs before this happens.
The same principles apply to an ascending or descending triangle. Profit
targets are based off the swing high and low at the thickest part of the triangle, and
stop levels are placed outside the triangle on the opposite side of the breakout.
Ascending Triangle:
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Descending Triangle:
Above are images of how ascending and descending triangles look. An
ascending triangle occurs when the swing lows in price are moving higher—higher
lows—but the swing highs are reaching roughly the same price area. The
descending triangle has progressively lower swing highs, yet the swing lows reach
roughly the same price area.
Since our profit target is calculated the same for all triangles, here's an
example using some simple numbers with a symmetric triangle. The formation also
provides us with our stop level on the trade.
The widest part of our triangle is 1.50 – 1.40 = 0.10. This is added to the
breakout price when it occurs. Our breakout occurs at 1.45, so our target is 1.45 +
0.10 = 1.55. Our stop loss is placed just below 1.4300, which is the low of the
triangle at the time of the breakout.
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After you've entered the trade, if your stop is based on a sloped line, you can
adjust the stop over time to track the line. With this method, over time, much of the
risk on a trade is eliminated (other methods for reducing risk on trades are
discussed later in the book)...as long as the price continues to trade in the direction
of the breakout.
In the example above, the stop is originally placed at 1.43, though over time
could be moved to the apex of the triangle—near 1.44 to 1.45—as the line
continues to slope. If trading a daily chart, the intersecting price point of that line
will change daily, providing you with the new stop level. If trading a 5 minute
chart, the sloped trendline produces a slightly adjusted stop level every 5 minutes.
Adjusting the stop isn't required. If you like the original reward to risk ratio,
leave your original stop level as it is. Moving the stop along a sloped trendline is
one method you can use if you like, but isn't mandatory. For those who are risk
adverse, this method reduces the risk. The downside is you'll occasionally get
stopped out prematurely. That's to say, if you hadn’t adjusted the stop you would
have made money, yet because you adjusted the stop you lost money or broke
even. The reverse is also true though: adjusting the stop may save you money if the
price turns against you.
If you like to adjust the stop to limit risk, then do it; if you like using the
original stop, that's also fine. One method isn't necessarily better than the other in
my experience, although one method may be better suited to your individual
trading style and personality.
Day traders that are watching the trade can adjust the stop using this method
with greater ease than a swing trader. If you're a swing trader, you can either leave
the stop alone (no adjustment) or adjust the stop loss periodically when you do
your daily review of your trades (and look for other setups).
Let’s look at a trading example to see how a symmetric triangle could be
traded in the forex market. This example also shows how you draw the pattern
around the price swings that form.
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USD/JPY 15 Minute Chart
In the example above, notice the USD/JPY pair is forming a symmetric
triangle pattern to right of the green vertical line. The price swings are converging
as the more recent swing highs are lower than former highs, and the recent swing
lows are higher than the former lows. The highlighted blue price shows the price of
the pair at the time this snapshot was taken—98.59. The high within the pattern is
99.05, although we'll round it down to 99.00. The low occurred at 98.20. This
means our profit target is 80 pips; 99.00 - 98.20 = 0.80.
At the time this snapshot was taken, the breakout price on the upside was
98.68. If the price moves above this level the trendline is penetrated, indicating a
breakout and an entry. A downside breakout occurs if the price moves below
98.35—the lower trendline.
Since the lines are sloping, the breakout prices will change over the time. In
the case of a symmetric triangle, upside breakouts occur at a lower and lower price
over time as the line slopes down. Downside breakouts occur at a higher and
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higher price as the line slopes up. For ascending or descending triangles, the
breakout price only changes on the side of the triangle with a slope.
Add/subtract 80 pips (the height of the triangle) to the upside/downside
breakout price to determine our profit target. The price broke out of the triangle at
98.55 to the upside (a couple hours after this snapshot, so the breakout price had
changed slightly), providing a target of 98.55 + 0.80 = 99.35. This target was hit
soon after, resulting in a profit. A stop was placed at 98.40, just below the opposite
trendline at that point. 15 pips were risked to attain an 80 pip profit.
This pair actually reached a price of 99.72 before quickly falling; so the
profit target was exceeded by a significant margin. You may have noticed on the
chart example above that the lower trendline extends further down than what was
used in our profit target calculation. Often within a triangle we have multiple profit
targets.
We could use the levels discussed above for one profit target, and also use
additional levels in this chart for a “more aggressive” profit target. Since the low
at the very base of the trendline is 25 pips below the low we used in our original
calculation, we can add 25 pips to the former profit target. If we did this, we would
exit at 99.60, close to the high of the move.
If multiple profit targets are used, it's recommended that at least part of the
position is exited at the more conservative profit target. This allows for a profit to
be locked in on the trade. The more you practice, the more patterns you'll see.
Often there's two or more interpretations of the triangle (or other pattern). No
interpretation is necessarily right or wrong. Rather, mark each interpretation on
your chart, and decide which you like best (based on the information you'll attain
from this book), or simply use multiple entries or profit targets to satisfy each
interpretation of the chart pattern.
Let’s look at an ascending triangle which formed on the AUD/USD daily
chart. The formation on the daily chart provides an opportunity for swing traders,
and day traders as well, as the breakout gains momentum.
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AUD/USD Daily Chart
The AUD/USD formed a large ascending triangle formation after a period of
heightened volatility. The formation was a consolidation before another potentially
big move. The high of the formation, marked by the horizontal red line, is 1.0387
and low is 0.9667 (start of ascending red line).
The breakout occurred from the pattern in the middle of January and
proceeded to move higher from there. Calculate the profit target by taking the
difference of the high and low of the triangle and adding it to the breakout point. In
this case: 1.0387 – 0.9667 = 0.0720. This is added to the breakout point: 1.0387 +
0.0720 = 1.1107 which is the price target.
The stop for the position is placed just below the ascending trendline. When
the breakout occurred, the stop for the position would have been placed at 1.0160.
There's 227 pips of risk for a potential profit of 720 pips—the potential profit is
more than three times the risk.
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In this case, the breakout was to the upside. That won't always be the case.
Had the breakout occurred to the downside you would've entered a short trade as
the price pierced below the ascending trendline, and placed a stop just above
horizontal trendline. The profit target is calculated the same, except in the event of
a downside breakout, subtract the 0.0720 from the breakout price to get the price
target for the move lower.
If you look closely, you can also see a smaller ascending triangle within the
pattern shown above. This pattern can also be used to calculate a profit target, and
if trading multiple lots, a portion of the position can be exited at the profit target
based on the smaller pattern. The rest of the position can be unloaded at the target
indicated by the larger pattern. The smaller pattern is shown below.
AUD/USD Daily Chart
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Transaction ID: 6YD31355T17923521
In this case, the upside breakout point stays the same because the line is
horizontal, yet our profit target is smaller based on the smaller formation—the
ascending line has a higher starting point than the larger pattern discussed prior.
For the smaller pattern, the high of the formation remains 1.0387 but the low is
0.9862. These levels produce a triangle height of 1.0387 – 0.9862 = 0.0525. Add
the height to the breakout point to attain the target price: 1.0387 + 0.0525 = 1.0912.
When the breakout occurred your stop would've been placed at 1.0250.
Based on this stop price, your risk is 137 pips, with a potential target of 525 pips.
That's a good risk/reward ratio.
Ultimately this pair reached a high of 1.0856 before commencing a four
month decline. None of the targets were reached, even though the trade was
showing an almost 500 pip profit before it reversed. The example is included to
highlight an important point:

In trading you'll never be right every time. Chart patterns aren't a
flawless system. At times your profit targets won't be achieved, and
frustratingly sometimes the target will be narrowly missed. For this
reason I encourage traders to “round down” their profit targets. Take a
bit off the initial calculations in order to make the profit target more
achievable. By doing so, not only is it more likely the target will be
reached (hit), the reward to risk ratio usually remains favorable.
By the end of the book you'll have additional methods for taking profits,
or reducing risk, even when a target isn't reached.

Wedges
Wedges are traded in a similar way to triangles, though the formation is
slightly different. Let’s first look at the similarities: profit targets are based off the
swing high and low at the thickest part of the wedge; the entry is a breakout of the
formation’s trendlines; the stop loss is placed on the opposite side of the breakout,
but with a variation.
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Transaction ID: 6YD31355T17923521
Wedges are structured similar to triangles, except the entire structure of a
wedge is sloping either up or down. In the case of a descending wedge, both the
upper and lower trendlines are descending and moving towards each other. In the
case of an ascending wedge, both trendlines are rising and moving towards each
other.
Rising/Ascending Wedge:
Falling/Descending Wedge:
Below is an example of a descending wedge. Both trendlines are falling and
the price fluctuations are narrowing, resulting in the lines moving towards each
other as they fall. As mentioned near the beginning of this chapter, you may notice
the lower trend line doesn't run exactly along the lows of all the price bars. This is
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Transaction ID: 6YD31355T17923521
fine. The market doesn't always move in perfect harmony, so you must “fit” your
trendlines as best you can to the price action.
EUR/USD 15 Minute Chart
An upward break of the wedge occurred at 1.3260. 1.3261 is therefore the
entry price, and a stop loss is placed at 1.3245—just below the low price within the
wedge—resulting in a 16 pip risk. Since the lines are sloping down in this case, we
don't place our stop outside the pattern (below the lower trendline) because this
exposes us to more risk than is required (stop would be down around 1.3230).
Calculate the profit target by taking the difference between the high and low
at the thickest part of the wedge. The high is 1.3435 and the low is 1.3330
(rounded), so the difference is 105 pips. Don’t see the high and low points? Look
to where the trendlines begin. Your profit target is therefore 105 pips above the
breakout price.
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Transaction ID: 6YD31355T17923521
The profit target you'd set in your trading software is 1.3260 + 0.0105 =
1.3365. This target was hit a short time later and once again provided potential
profit many times greater than the risk.
Using the price low or high within the pattern for the stop loss works well as
wedges are usually reversal patterns. Once an upside breakout occurs from a
descending wedge, it's unlikely the price low recently witnessed will soon be revisited. When a downside breakout occurs from an ascending wedge, the price
high in the pattern also isn't likely to be re-visited for some time.
A downward sloping wedge will typically breakout to the upside, and an
upward sloping wedge will typically break to the downside. There's little need to
assume the breakout direction though. The breakout will eventually occur and
there's ample time to get in and make a profit. Also, a wedge is a trend. Until the
price breaks out of a wedge pattern, that trend is tradable (in the direction of the
trend) using trend trading methods you'll learn later.
Here's a drawn example of a wedge pattern to clarify how this pattern is
traded.
The wedge is sloping upwards, so more than likely the breakout will be to
the downside, though we don't need to assume that. The price breaks below the
ascending wedge pattern at 1.3525, providing the short entry point (1.3524). A stop
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Transaction ID: 6YD31355T17923521
is placed above the recent high in the pattern, in this case at 1.3560. The width of
the wedge at the widest part is 50 pips (1.3550 - 1.3500), so that's subtracted from
the breakout price, for a price target of 1.3475 (1.3525 - 0.0050).
As a more advanced concept, notice how the overall price trajectory was
down (on the left of the drawing) and therefore the wedge in this particular case
was just a pullback against that longer term downtrend. The overall downtrend,
and the fact the price broke below the wedge, were good reasons to take this trade.
The one poor thing about this trade is the risk to reward. We're risking about 35
pips to make 50. Ideally our reward to risk should be 1.5:1. This drawing
represents a trade that's slightly below that. The risk/reward ratio makes it a
marginal trade, yet in light of the overall trend and breakout direction, it's an
acceptable position to take.

The Head and Shoulders Pattern
A head and shoulders pattern is two higher swing highs, followed by a lower
swing high, with retracements in between each high point. The pattern is
considered complete and tradable once the price retraces (pulls back) off the lower
high and falls below the lows of one or both retracements, or falls below the
“neckline” of the formation. Later on in the book, other strategies are covered
which could potentially get you into the trade sooner.
The neckline is a small trendline which connects the two retracement lows
within the formation. This line is generally sloping, as the retracement lows won't
typically hit the exact same level. The following drawing shows a head and
shoulders pattern, with two thin pink lines representing two different entry points
based on the two possible methods.
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The head and shoulders topping pattern shows the market is losing steam;
the latest price action (right shoulder) failed to reach the level of the head, and then
fell below the retracement lows and neckline of the formation.
You can sell when the price passes below the neckline (sloped thin line),
and/or you can sell when the price passes below the low of the right retracement
(horizontal thin line).
As the drawing shows, this formation often sees a pullback. The pullback is
an upward move following the breakout. This pullback provides a third possible
entry point.
Since it's not always possible to take multiple positions because of capital
limitations, it's recommended that you take one position at either the neckline or
the retracement low of the right side. Either entry is typically fine. The neckline
gives a better entry price in some instances (such as this example); though in
different scenarios it may offer a worse entry price. If the neckline is downward
sloping, the neckline entry would be below the horizontal (right retracement low)
entry point; in that case, use the horizontal entry point.
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Take one position when the price passes through the upward sloping
neckline or passes below the right-side retracement low within the formation. You
can also take positions at both, keeping in mind the total risk for the trade shouldn't
exceed 1% of your account. This is your main position; it's taken so you have a
position to potentially profit from the likely price decline.
This position is likely to show you a relatively quick profit, but a pullback
happens quite often, erasing that profit...in the short-term. If you wish, you can add
to the position on this pullback, after it starts to head back down. If the additional
trade is taken, use the Pyramiding approach discussed in Chapter 2 so the total risk
on the trade never exceeds 1% of the account.
That's how entries are made, though you also need a stop level. Your stop
level determines your risk, and lets you know if you can take a trade at more than
one of the entry points. If the risk of having more than one position exposes you to
losses greater than 1% of your account, you shouldn't take more than one position.
If you can only take one trade, determine the stop level first, then choose which
entry—the right-side retracement low or neckline—to use. If you're comfortable
potentially missing a trade, you may also opt to wait for the pullback to occur
(after the breakout), and trade that.
The risk on the head and shoulders pattern (in pips) is the difference between
the entry price and the top of the right shoulder. Thus, your stop is placed just
above the right shoulder. It's placed there because if the price moves back above
the right shoulder, it's no longer a head and shoulders pattern.
The profit target for the formation is the height of the pattern subtracted
from the breakout point. If the distance between the head and lowest (of the two)
retracement levels is 400 pips, subtract 400 pips from the breakout point and that's
the profit target.
Since head and shoulders can take place over a long time, and cover a lot of
chart area, extreme conditions may make this profit target unlikely to be achieved.
As you'll see in the chart below, if the market moves far beyond what it normally
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does, such a move may not happen again. In such a case, you'll need to adjust your
profit target using more conservative numbers from within the formation. This is
true of all chart patterns. If an extreme event occurs which is unlikely to occur
again, yet impacts your stop, profit target or entry price, you need to adjust your
trade(s) to compensate.
If a major news event plunges a pair 400 pips in an a few hours, when in a
normal day it only moves 100 pips, you need to compensate and assume that 100
pip movements are more likely than 400 pip movements. If you use the 400 pip
move in your calculation, your profit target(s) is unlikely to get hit, and your stop
price may also be exposing you to too much risk.
The following example is used to show where stop levels are placed, as well
as go over entries and profit targets. The following example isn't a perfect
formation like the drawing. Formations aren't always "pretty," and we need to
adapt to them.
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EUR/JPY 4 Hour Chart
This is an ugly chart. The head and shoulders pattern is created by extreme
volatility, well beyond normal. After the left shoulder (which is actually a double
top formation, which we'll discuss later) there's a massive sell-off where prices
plunge more than 600 pips in a matter of days. The price surge up to the peak that
forms the head is equally spectacular. The head and shoulders pattern is visible but
when we to go to create a neckline (the trendline which connects the low at 126.50
and the low at 131.00) and extend that line upwards, it actually passes above the
right shoulder (this neckline isn't shown on the chart). The neckline isn't a viable
entry point in this case; an alternative entry point must be used.
The left side of the formation is extremely volatile and shouldn't be used in
our entry criteria or profit targets. The right side of the formation shows a return to
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Transaction ID: 6YD31355T17923521
more normal market behaviour (for this time) and is more rational to use for entries
and profit projections. In this case, use the low after the head (right retracement
low) as the entry point. This is marked on the chart as an “Entry Point.” When the
price moves below this low, after the right shoulder has occurred, enter a short
trade. The entry occurs on 04/15.
Place a stop loss just above the right shoulder. The profit target for this trade
cannot be based on the extreme lows and highs of the formation, as the low on the
left side was due to extreme volatility which we can't assume will repeat. Trades
must be based on typical market behaviour, not extremes, since most days we're
dealing with the typical.
Focus on the right side of the chart pattern to establish a profit target. First,
measure the distance from the head to the low created after the head (the right
"armpit") to find the height of the pattern: 137.50 – 131.00 = 650 pips (these
figures are rounded for ease of use). Then, take our breakout point which is 131.00
and subtract the 650 pips, giving us a price target of 124.50. On 04/26 the market
reached an ultimate low of 124.38 (not on the chart). The profit target was reached.
This trade resulted in a risk of 350 pips and a profit of 650 pips; a reward
almost two times greater than the risk. This reward to risk ratio is typical of head
and shoulders patterns. Avoid trades where the reward to risk approaches 1:1, for
example you're risking 50 pips to make 55 pips.
This example was given to show that markets don't create perfect patterns all
the time. Look at a pattern and ask yourself if the profit target and entries provided
by the pattern are rational? Was the movement within the pattern relatively normal,
or was there extreme volatility that caused price surges (or plunges) which are
unlikely to happen again?
Equally of note, there will be times of almost no volatility; possibly around a
holiday or during certain times of the day. It's not wise to assume that the lack of
volatility will continue once regular trading resumes. During times of extreme
volatility it's reasonable to assume volatility will die down as time progresses.
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Extreme lack of volatility also won't last forever, being replaced by higher
volatility.
There's also a head and shoulders bottoming pattern, called an inverse head
and shoulders. For the inverse pattern everything is reversed and the same methods
apply. This formation is a low (left shoulder), followed by a retracement up, a
lower low (the head), followed by a retracement up and another swing low which
doesn't reach the low of the head (the right shoulder). The price then breaks above
the high of the retracement, or through a trendline connecting the retracement
highs within the formation (neckline).
In the drawing below, the horizontal entry point—the right-side retracement
high—is a better entry point than the neckline. Since the neckline is sloped
upwards, if used, the trade is entered later than it needs to be. The right-side
retracement high is the prudent entry point because it provides a lower entry price
and results in fewer pips at risk. The stop is placed just below the right shoulder.
The following is an example of an inverse head and shoulders pattern.
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USD/CHF 4 Hour Chart
The inverse head and shoulders pattern can be seen developing on the left
hand side of the chart above. The bottoms of the left shoulder, head and right
shoulder are marked with small red horizontal lines.
When connecting the “armpit” highs of the pattern, the neckline is slanted
upwards to a significant degree and doesn't provide a useful entry point. The
horizontal line drawn along the top of the right armpit is of value, signaling the
breakout and completion of the bottoming process (horizontal white line)—this is
the entry point.
The entry is made at 0.8959, as the price crosses above the white horizontal
line. The stop loss is placed below the right shoulder, at 0.8755. The target is the
height of the formation added to the breakout price. The high of the formation is
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Transaction ID: 6YD31355T17923521
0.8958 and the low is 0.8568, for a difference of 390 pips (the height of the
formation). Add the height to the breakout price of 0.8958 (entry is at 0.8959) to
provide a target of 0.9348.
The risk was 205 pips for 390 pips in potential profit. This is close to a 2:1
reward to risk ratio; a respectable trade.

Flags and Pennants
Flags and pennants are excellent trade candidates, as they're generally small
patterns meaning relatively small stops (in pips) and quick profits. Flags and
pennants are formed when the market consolidates in a narrow range after a sharp
move (the flag/pennant “pole”). They're seen on all time frames and consist of
about 7 to 20 bars. Let’s look at flags first, then pennants.
A flag is a narrow trading range which occurs after a large price move.
Here's an example of a flag formation.
AUD/USD 15 Minute Chart
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The flag is marked on the chart with horizontal green lines as the market
consolidates after a run up. In this case, both the lines are horizontal. It's also
common to see flags that slant upwards or downwards.
Enter long when the price moves above the highs of the flag (upper
horizontal line). Enter short when the price moves below the lows of the flag
(lower horizontal line). Stops are placed just outside the flag on the opposite side
of the breakout. If the lines are sloping, stop levels and entries will change slightly
over time.
Profit targets are established using two different methods. One method is
conservative, likely resulting in a quick profit. The other method is more
aggressive and seeks a larger gain.
The first profit target is based off of the height of the flag consolidation. If
the distance between the parallel lines which form the flag is 30 pips, then the
profit target is the breakout price +/- 30 pips. Because the market is tightly wound
after a strong move, these profit targets are often hit quickly, then exceeded.
To capture larger profits, base your profit target off of the “pole.” In doing
so, you're estimating the breakout will result in a move of similar magnitude to the
move that preceded the consolidation.
Look at the example for the flag pattern and you’ll see that the flag
(consolidation part) is roughly 40 pips high. An initial profit target is placed 40
pips from the breakout price, on either the upside or downside. This targets are
marked by the green lines along the very right hand-side of the chart.
The second profit target is based on the preceding move (pole) into the flag
consolidation. From the very start of the preceding move at 0.6980 to the high at
0.7130 the move measures 150 pips. If the price breaks higher, our profit target is
150 pips from the low of the flag consolidation. The profit target is 0.7090 (low of
the flag) + 150 pips = 0.7240.
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Transaction ID: 6YD31355T17923521
If the breakout is downward, our target is 0.7130 (the high of the flag) – 150
pips = 0.6980.
Flags are considered continuation patterns, as the breakout is often in the
direction of the preceding move. In my own trading I haven't found this to be the
case, and have abolished the notion from my mind.
With that said, a breakout in the opposite direction of the preceding move
deserves special attention. If a break occurs in the opposite direction of the
preceding move, knock off the height of the flag consolidation from the profit
target. For the chart example above, move the second target up by 40 pips. Recall
the consolidation was 40 pips, so we knock that off of the profit target. This makes
for an adjusted profit target of 0.7020. This only occurs if the breakout is in the
opposite direction of the preceding move (pole).
Why we alter the profit target for reversal moves is discussed further in the
pennant patterns section below.
If the breakout occurs in the same direction as the preceding move (the
pole), no alterations are made to profit targets and you’ll simply use the methods
outlined prior.
Below is another example of a flag formation, using a 30 minute chart.
Notice the aggressive move higher in the USD/CHF, with the pole measuring 91
pips. A flag then develops as the pair moves sideways within an 18 pip range. The
pair then breaks higher, providing us with an 18 pip target above the breakout
price—the conservative target—and another target 91 pips from the low of the
flag—the second target.
The 18 pip target is quickly hit. The second target is missed by a few pips
later that day, though is hit the following day as the pair continues to rise. Ellipses
mark when the targets were hit.
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Transaction ID: 6YD31355T17923521
USD/CHF 30 Minute Chart
Pennants are similar to triangles, except much smaller. Pennants, like flags,
follow a large swift move (the pole), whereas triangles don't have this prerequisite.
A pennant is a consolidation in which the price action continually narrows. Flags
seem to be more common than pennants
To trade a pennant, enter when the price moves beyond the pennant
boundaries outlined on your chart. Place a stop loss just outside the opposite side
of the pennant. Because the lines are sloping towards each other, your entry price
and stop price will change over time. Risk diminishes the longer a breakout takes,
as your entry price and stop level are moving closer together as time elapses.
Pennant profit targets are calculated the same way they are for flags. The
only difference with a pennant is that your initial profit target (or conservative
target) is based off the price highs and lows at the thickest part of the pennant. The
second profit target is calculated the same way it is for flags—based on the length
of the move preceding the pennant formation.
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Transaction ID: 6YD31355T17923521
Here's an example of a pennant formation.
USD/CHF 15 Minute Chart
Notice the sharp decline followed by the pennant formation—a
consolidation in which the price begins to converge with higher lows and lower
highs.
The highlighted blue number shows the current price of 1.0939. At this point
in time, the breakout price is 1.0950 on the upside and 1.0925 on the downside.
The high point of the pennant is 1.0960 and the low is 1.0910. If a break were to
occur at this point in time, the initial profit target would be 50 pips (calculated by
1.0960-1.0910) plus or minus the breakout price.
If the prices were to breakout right now, the initial targets are 1.0950+50
pips =1.1000 on the upside and 1.0910- 50 pips = 1.0860 on the downside.
The second profit target is calculated the same as it was for flags. The start
of the move is 1.1045. Why 1.1045? 1.1045 is where the price starts to fall and
doesn't retrace. Many traders may use 1.1055 because that's the very top, yet you
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can see the price fell from there then rallied a bit, and the fell again from 1.1045.
Using this type of logic to discern what levels to use in your profit calculations will
give you more accurate results.
1.1045 is the high and 1.0910 is the low, which means the pole is 135 pips in
height. Based on breakout direction your targets are 1.0925 + 135 pips = 1.1060 in
the event of an upside breakout, and 1.0950 – 135 pips = 1.0815 in the event of a
downside breakout. Remember the target is projected from the top of the pattern
(at the time of the breakout) in the case of a downside breakout, and projected form
the bottom of the pattern (at the time of the breakout) for an upside breakout.
Since both lines of the pennant are sloping, your target will slightly change
as each new bar forms within the pennant, just as the breakout level also changes.
In this example the preceding move (pole) into the pennant was down. If the
breakout is upwards, you’ll want to alter the second profit target by deducting the
height of the pennant (50 pips) from the profit target. If an upside breakout occurs,
our adjusted upward target is 1.1010. If the breakout is to the downside, make no
alterations to the profit target.
Why adjust the second target when the price breaks out in the opposite
direction of the preceding move? If you don’t adjust the price target, the price has
to move all the way back to starting point of the formation (the beginning of the
pole) in order for your profit target to be hit. Why's that a problem? The start of the
formation is likely a support/resistance area, which could prevent the target from
being hit. By adjusting the target, you move it out of that resistance/support zone,
making it easier for the price to reach the target and increasing your chances at a
profitable trade. The chapter "Strong" Support and Resistance and the Crotch
Strategy digs deeper into why this adjustment is made.
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
Trading with Multiple Profit Targets, Stops and Positions
With chart patterns, as well as other strategies outlined in this book, at times
you'll have multiple profit targets, potentially have more than one stop loss to
choose from, or may be trading multiple positions.
You may be wondering how to juggle or manage multiple profits targets or
stop levels. The easiest way to utilize multiple targets and stops is open two (or
more) positions. To keep things flexible, instead of buying one lot of the
EUR/USD for $100,000, buy two mini lots of $10,000 each, five times. Instead of
one position for $100,000, you have five positions for $20,000, and can attach a
profit target to each position (various stop aren't recommended, pick one, and stick
to it). Since these positions are essentially the same trade, they still fall under the
guideline that no more than 1% of capital should be risked on a given trade.
Each position has its own profit target (if desired). In this way you can exit
at different profit targets, locking in profits along the way as the market
movements unfold.
If you only trade one lot due to capital limitations, or to maintain risk
exposure, choose beforehand which profit target calculation you'll use and stick to
it.
With any pattern, if you're unsure of which prices to use in your profit target
calculations, always opt for those that provide a more conservative profit target.
It's far better to make 100 pips on a trade, then to try to make 120 pips and end up
with nothing. Always ask yourself whether the profit target is based on reasonable
price movements, and try to avoid using extreme or uncharacteristic price
fluctuations in your calculations.
Be smart, not greedy.
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Additional Chart Patterns
Below are patterns which can be more difficult to trade because the methods
required to effectively trade them are more subjective and will take (more) practice
to master.
There are traditional ways of trading these patterns, which are briefly
addressed and will work on occasion, though the alternative methods discussed are
superior to the traditional methods.

Double Top/Bottom, Triple Top/Bottom
Double and triple tops occur when a pair is topping out and the pair is
expected to fall, if the pattern completes. A double top is when two swing highs
reach approximately the same price high, with a retracement in the middle. The
pattern is complete, and traditionally a sell trade is entered, when the currency pair
falls below the low price of the retracement between the two highs.
A triple top is similar to a double top, except there are three peaks with
retracements in between them. The pattern is complete when the price falls below
the retracements (like a head and shoulders pattern we can draw a neckline, or use
just the right-side retracement low as our breakout level); a sell order is
traditionally entered when this occurs.
Here is an example of a double top.
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USD/CAD 1 Hour Chart
The example shows a double top in the USD/CAD, making two highs into
the same price area. The pattern is confirmed when the price drops below the low
of the formation. The highs in this case are very near 0.9960; the retracement low
after the first high is at 0.9805—your entry price if the rate moves below it (which
it does). Place a stop 5 pips above the high (for a swing trade, 1 pip for a day trade)
plus the spread after you enter the trade. Such is the traditional method.
The height of formation used to determine your profit target is 0.99600.9805 = 155 pips (figures rounded). The profit target is the entry price minus the
height of the formation (since you're going short) 0.9805-0.0155=0.9650. If the
tops don't occur at the exact same price, always use the lower high in your
calculations for determining the profit target.
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To recap, the traditional stop order for a double or triple top formation is
placed just above the highs of the pattern. Your profit target for the trade is the
height of the formation (high-low) subtracted from the entry price (retracement
low).
For double and triple tops (and bottoms, which are addressed shortly) the
risk and potential reward for a trade are the same because both are based on the
height of the pattern. This makes trading double tops and bottoms in the traditional
way both unattractive and not recommended.
An alternative method, which I prefer, is to watch for a false breakout to the
upside on the second (or third) top. If the second top moves just above the first
high and then back below it both quickly and aggressively, enter short. Why? It's
quite possible this could be a false upside breakout, leading to a double top
formation.
Place a stop just above the recent high (what we expect is the false
breakout). Usually this trade has a very low risk, because the entry price is very
close to the stop level. For example, if the original high(s) occurred at 1.5050, the
price retraces to 1.4960, and then rallies to 1.5062 before falling back below
1.5050, the risk on the trade is only about 19 pips. You enter as the price drops
back below 1.5050—so 1.5049 or 1.5048—and place a stop at 1.5068 which is 5
pips (plus the spread) above the new high at 1.5062. Place an initial profit target
just above the retracement low of 1.4960—say 1.4970 (The Crotch Strategy
discussed later in the book gives you more information on where to place orders in
the context of recent highs and lows).
If the price continues to fall below the low of the formation (1.4960), place
another profit target using the traditional breakout method described prior. The
height of the formation is 1.5050 - 1.4960 = 90 pips (remember, we use the lower
of the highs for our calculation). Subtract 90 pips from 1.4960 to get a second price
target of 1.4870. To be safe, round the target up to about 1.4885 to increase the
chances of the target being hit. It's recommended you take some profit off the table
at the initial target price.
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The AUD/USD provides a real-world example of this false upside breakout,
leading to a double top scenario. A high was made at 1.0844 (first top), the pair
corrects down to the 1.0598 (retracement low) and then rallies back above the first
high to 1.0856 (second top)—highlighted in grey. This was a false breakout and
quickly moved back below the high of the first top.
AUDUSD Daily Chart
As the market dropped back below the former high (1.0844), a short trade is
taken, a stop placed just above 1.0856 and an initial target placed near the
retracement low. I used an initial target of 1.0615 for trade, which is just above the
retracement low. Some of the profits should be locked in at this level.
Since the pair continued to fall below the retracement low of 1.0598, it's
now a confirmed double top. Calculate another profit target based on the traditional
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method of taking the high(s) minus the retracement low and then subtracting that
from the breakout price (retracement low).
In this case, the target is 1.0844 (our lower high) – 1.0598 (our retracement
low) = 246 pips. This amount is subtracted from 1.0598 to produce the target of
1.0352.
Since you’re entering near the top (or at least what we believe at the time to
be a top) as the pair turns back lower, the risk is small and profit potential large—a
good combination. Unfortunately, it's not as perfect a situation as it sounds. The
pair could drop a little and then keep rallying. What looks like a potential double
top will often just end up being a blip within the uptrend. When trading this type of
false breakout strategy, it's quite possible you'll see a number of small losses before
catching a big winner.
A big winner could result in a profit of 10 times our risk or more. In the
example above, our risk is about 18 pips to make about 225 pips on the first chunk
of our position, and more than 470 pips on the second chunk.
Double and triple bottoms are traded in the same way, except you’ll be
buying when there's a breakout to the upside using the traditional method, or
buying when there's a false breakout to the downside on the second or third bottom
(alternative method).
It's possible that the second (or third) low moves slightly below the first (or
second) and then quickly moves higher again. This indicates a potentially false
downside breakout and that a rally is forthcoming. A long entry is taken with a
stop just below the most recent false-breakout-low. The first target is near the
retracement high(s). If the pair continues to rally, causing an upside breakout of the
double/triple top pattern, the traditional target calculation provides an additional
target price for the remainder of the position.
The example below is a typical double bottom. The traditional profit target is
established by taking the breakout point (retracement), minus the highest low
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(bottom). This number is then added to the breakout price to attain our profit
target.
EUR/USD 1 Hour Chart
The highest low is at 1.3870. The retracement high between the lows is
1.4010. The height is therefore 140 pips. This is added to the breakout price of
1.4010, providing a traditional target of 1.4150. That target was surpassed the
following session.
In the above chart example, the second low didn't move slightly below the
first, therefore, the false breakout entry method couldn't be used. If the second
bottom had dropped below the first, rallying quickly and aggressively back above,
a long position would be taken. A stop would be placed below the recent falsebreakout low, and an initial target placed just below the retracement high—1.3990
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for example. Exit part of the position at the initial target and if the price continues
to rally above 1.4010, use 1.4150 as the next target (traditional).

Rectangle (Ranges)
Rectangle breakouts are traded in a similar fashion to the double
tops/bottoms and triple tops/bottoms just discussed. The only difference is that a
rectangle can occur anywhere in the price history and not just at turning points like
double/triple tops and bottoms. Rectangles are consolidation periods where the
market is deciding which way to go. The price moves up and down between a
resistance and a support area. As long as the price remains inside those bounds, the
pair is moving in an overall sideways direction until a breakout occurs.
A range is easy to spot and the pattern is well known by most traders. The
sideways movement of the rectangle draws in both buyers and sellers, trying to
make an easy buck (rarely occurs) on the "easy to see" pattern. This results in a
tug-of-war which can last for a long time and result in many false breakouts. The
fact there are many people trading for a breakout, and others making trades based
on the range continuing, means when a breakout does occur, it can be significant.
Ranges have the potential to be profitable. You can capture profits while the
range is in effect, moving up and down between support and resistance, or wait till
the breakout occurs. Sounds easy enough, although in real time it's difficult to
know when an actual breakout will occur, or if the range will continue. If you want
to produce more consistent profits trading rectangles, you need an alternative
approach.
The following example shows a range.
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USD/CAD Daily Chart
If you decide to trade a range, it can be traded in several ways. You can buy
at the bottom of the range, in the hope the range will continue. Place a stop several
pips below the lowest price of the range. Place your profit target just inside the top
of the range (you're attempting to capture most of the price range as profit). A
more conservative profit target is just beyond the half way point (mid-way point)
of the range.
As the range continues, go short at the top of the range, with a profit target
just inside the bottom of the range, or alternatively just beyond the midpoint for a
more conservative target. The stop loss is placed just above the high of the range.
The problem with this method is that ranges are dynamic. If you look at the
chart above, and this often occurs in the real world, each peak and trough occurs at
a slightly different price. While the price is swinging back and forth and reversing
at similar areas, rarely does the price move to the exact same spot as before. The
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profit targets are also based on the idea the price will move to the opposite side of
the formation, though it may not. The price may not make it all the way to range
extreme(s), as the chart shows on several occasions.
Trading this method isn't advised, though if you do decide to trade ranges in
this traditional manner, here are some pointers which will maximize your odds:
 When you buy at the bottom wait for the price to start moving higher
again before going long. Don't buy while the price is still falling.
You'll learn specific entry techniques later in the book which can be
applied to trading ranges in this manner (or trend channels).
 Sell your long position near the middle of the range, as this gives you
the best chance of getting out of the trade with a profit.
 When you go short near the top of the range, wait for the price to start
moving lower again before going short. Don't short while the price is
still rising.
The traditional breakout method for ranges is another strategy. When the
price moves beyond the previous high or low point of the rectangle, a trade is
entered in that direction. A stop is placed just outside the opposite side of the
range. If the price breaks above the high of the rectangle (upside breakout), the
stop is placed a few pips below the low price of the rectangle. If the price breaks
below the low price of the rectangle (downside breakout), the stop is placed a few
pips above the high of the rectangle. The profit target is the height of the range,
added to the breakout point if the breakout is higher, or subtracted from the
breakout point if the breakout is down.
This method provides a reward to risk ratio that's roughly 1:1, because the
stop and profit target are both based off the height of the range. If you trade this
method, you'll need to be right more often than not in order to make a profit.
Unlikely.
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The allure of the breakout is the possibility that the pair breaks out of the
range and surges in one direction, reaping you massive a profit. This does
occasionally happen. A range develops—say 100 pips in height—and when the
pair breaks out it surges 500 pips over the next several days before pausing again.
Unfortunately, this doesn’t occur often. If you study your charts, you'll see many,
many, many ranges. The vast majority of those ranges will not end with a massive
move after the breakout. You're more likely to find that if the height of the pattern
was 100 pips, the next move is approximately 100 pips—sometimes less,
sometimes more. Trading breakouts in an attempt to hit that homerun trade will
likely wipe out your capital before that massive move comes along.
Trade based on the norm, not the exception.
The reward to risk ratio on a traditional breakout is improved by reducing
the risk which is taken on the trade. If you see a breakout occurring to the upside of
the range, buy, then place a stop within the range just below a recent swing low. If
you can’t find a swing low close at hand, skip the trade.
Let’s look at another example in the USD/CAD.
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USD/CAD Daily Chart
First, notice how choppy and staggered the range is. While the overall
direction is sideways, rarely do the price swings move to the exact levels seen
prior. Also, if you look closely you’ll notice there are a number of false breakouts.
I've marked on the chart a prominent one which occurred to the downside.
Where I have placed the main support and resistance lines of the rectangle
are also somewhat subjective—you may look at the chart and think I should've put
the lines at slightly different levels. Most ranges I've encountered in the forex
market have these qualities.
Try to put the reward to risk in your favor...when the upside breakout occurs,
enter long, then spot an area within the range which is suitable for a stop. I've
drawn two small lines and labelled them “Alternative Stops”. These lines mark
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swing lows within the range and a stop could be placed beneath either one. Placing
a stop below the higher swing low is favorable, since it results in the lowest pip
risk (difference between entry price and stop price).
The height of the formation is 210 pips (1.0051 – 0.9841). The breakout and
long entry occur as the price moves above 1.0051. Traditionally, a stop is placed
below 0.9841, exposing you to slightly more than 210 pips of risk. Using the
alternative stops at 0.9915 or 0.9950 reduces the risk to approximately 136 or 101
pips respectively. This moves the reward to risk ratio closer to 2:1, as your profit
target remains 210 pips above the breakout price: 1.0051 + 210 pips = 1.0261.
If you see a downside range breakout, sell and place a stop within the range
just above a recent swing high. There may not always be one of these
support/resistance levels close by; if a stop level can’t be found that makes the
reward to risk ratio more attractive, skip the trade.
The potential reward should always be greater than the risk; take trades
where the potential profit is 1.5 times greater, or more, than the risk.
Even though the alternate-stop-breakout-method improves the reward to risk
ratio on the trade, there's still the problem of false breakouts. Luckily, false
breakouts are scenarios which present decent range trade opportunities once your
mind is open to trading them. When the range highs and lows are well defined, a
false breakout is likely to trap a lot of traders, and this presents a low risk, high
reward trade (like double/triple tops/bottoms false breakouts).
In a ranging environment, watch for the price to move slightly above former
highs, and then move back below, preferably quickly and aggressively. Go short
when the price passes back below the former high. Place a stop just above the
recent false breakout high, and a target near the range low.
"Near the range low" means the target is placed 25% of the range distance
away from the range low. Confusing sentence, I know. If the range is 100 pips
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wide, and you go short at the top, your target is for 75 pips, or placed 25 pips from
the range low.
Also, watch for the price to drop slightly below former lows, and then rally
back above, preferably quickly and aggressively. Go long when the price pushes
back above the prior lows. Place a stop just below the recent false breakout low
and a profit target near the top of the range.
"Near the top of the range" means the target is placed 25% of the range
distance away from the top of the range. If the range is 100 pips wide, and you go
long at the bottom, your target is 75 pips, or placed 25 pips from the range high.
I have relabeled the same chart from above to show how the false-breakout
strategy could have been used on this pair.
USD/CAD Daily Chart
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In April of 2012, after moving sideways for the last several months the
USD/CAD dropped below the prior low of the range. If the pair quickly move back
into the range, it's a possible false breakout and we want to go long.
The day after the downside breakout occurs (first red bar that drops through
the red horizontal line), a green bar appears and price moves back above the
horizontal red line (former range low). Enter long, just above 0.9841 (former low),
labelled “Entry one” on the chart and place a stop below the recent low. In this
case, it's the low of the same green bar at 0.9805. Our profit target is near the top of
the range, right near 1.000 which captures 75% of the range.
The next day the price drops again and you're stopped out for a loss of about
36 pips as the price moves to a new low of 0.9799.
A couple days later though, the price surges back above 0.9841 and you can
enter long again—labeled “Entry two” on the chart. The stop is placed below the
recent low, now at 0.9799, so I would put the stop at 0.9794. Risk is approximately
47 pips.
If you have multiple lots exit part of the position at the initial profit target
(make 59 pips while risking 47 pips) and hold onto a portion of the position to see
if an upside breakout occurs. If it does, place a target using the calculation from the
traditional breakout method. Recall that the height of the formation is 210 pips
(1.0051 – 0.9841, don't include the height of the false breakouts) and this is added
to the upside breakout price of the entire range. Your next target is 1.0051 + 210
pips = 1.0261. With an entry point near 0.9841, you potentially reap a massive
return for the 47 pips in risk.
The point of the strategy is to capitalize on potential false breakouts—which
occur more often than actual breakouts. If another false breakout occurs in the
direction opposite to a position you're holding, consider getting out. If you look
closely at the USD/CAD chart, as the price moves through the upper red horizontal
line in May, it moves above it and then drops below it on multiple occasions. The
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target of 1.00261 wouldn't have been achieved (if exiting the long based on the
false upside breakouts). It's even possible, one or two short positions could have
been taken, resulting in small losses, as the price action over several session made
it appear the upside breakout may also be false.
Even on this chart example (which looks great in hindsight at first glance),
upon closer scrutiny isn't all it's cracked up to be. Even using the alternative
methods, trading ranges can be difficult.
Of the range trading strategies available, I believe the false breakout strategy
is one of the better ones. The price is already reversing before we enter, indicating
the range is continuing. Also, the false breakout likely trapped traders who now
need to exit their positions, pushing the price in our direction. What I really like is
that usually the risk is very small on these types of trades relative to the potential
reward. You can be wrong quite a few times, and one winner more than makes up
for it.
As you progress through the book, and learn more about trends and price
action, you'll get better at discerning which false breakouts you want to trade. For
example, if the overall trend is up, you may only watch for false breakouts along
the bottom of a rectangle to buy, because the longer-term momentum is moving in
that direction. When the trend is up, breakouts to the downside are more likely to
be false, and upside breakouts are more likely to be legitimate. The reverse is true
for downtrends. When the trend is down, focus on false breakout along the top of
the rectangle. This provides an advantageous entry if the price continues to fall, as
the overall trend dictates.

Broadening Wedge
The broadening wedge is a hard pattern to trade and should be avoided. The
reason it causes so many problems is that by the very nature of the pattern, it's
composed of false breakouts. New highs are created, then quickly reverse creating
new lows...and back and forth it goes.
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Like the (converging) wedges discussed earlier, broadening wedges may be
sloping or sideways. Below is an example of a sideways broadening wedge. This
formation is also be called a broadening triangle
EUR/USD Daily
These patterns usually make several swings back and forth, before making a
more sustained move in one direction. It's best to wait for the pattern to cease and
make a more sustained move, then trade the ensuing trend. Broadening wedges
show that volatility has increased and there's very little in the way of any trending
activity to take advantage of. Trying to pick tops and bottoms can be difficult. The
price will usually not align perfectly with the trendlines originally drawn (similar
to the problem with rectangles). In other words, most traders would be wise to
avoid trading in a currency pair that has this type of action occurring on the time
frame they're trading.
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This pattern is mentioned only so you can spot it and avoid taking trades in
pairs and on time frames where the pattern is occurring.
Finding Patterns
Some chart patterns (and ways or trading them) provide better opportunities
than others, letting you enter the market in a way that offers greater potential
reward than risk.
When you’re starting out it’s not always easy to spot chart patterns, or trade
them. This is why it's important to practice (before using real money) if you opt to
incorporate these trades setups into your trading plan. You may find you spot the
odd chart pattern, though not enough to provide regular trades. While lulls occur
and you may not see a chart pattern for some time—especially on daily charts—
usually chart patterns appear quite often, providing you with multiple trades in a
single day, or several trade signals a week when swing trading multiple pairs on
hourly or 4-hour charts.
Chart patterns occur all the time and work equally well across different time
frames, such as the 15 and 30 minute charts, hourly charts and daily charts (and all
other times frames as well). If you're not finding chart patterns, it may simply be
because you’re focusing too narrowly on one time frame, or one currency pair.
In order to find chart patterns and trade them, here are some guidelines to
follow:
 Follow more than one currency pair. Some trading methods are meant for
trading only one pair, trading chart patterns requires you trade more than
one. Scan through at least several currency pairs to find patterns, and don't
be afraid to trade them.
Good day trading pairs for patterns include the EUR/USD, GBP/USD,
USD/JPY, AUD/USD, USD/CAD, NZD/USD, EUR/JPY and GBP/JPY.
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Trade the patterns during the ideal times for day trading discussed in
Chapter 7.
If swing trading, you have all the other combinations of the EUR, GBP,
AUD, NZD, JPY, CAD, CHF and USD. When swing trading, I flip through
28 pairs each night looking for trades.
Always be aware of what type of trading environment a currency pair is in.
If a pair is very quiet and has very little movement, even if it's a major pair,
avoid trading the chart pattern until volatility increases enough to make it
worth your while. This means during times of low volatility, you may drop a
currency pair from your “watch list” and possibly add another pair which
does have some movement.
 Search multiple time frames. Day traders can scan all time frames 30
minutes or less; swing traders can scan all time frames 30 minutes or higher.
Once you're aware of what patterns look like, this should take no more than
10 to 30 minutes total to scan through all the pairs and all the time frames
(depending on how many you monitor). When you find a pattern, decide if
it's tradable. Tradable means the stop level you place is within your risk
tolerance, and the profit target for the pattern gives you more reward than
risk.
 If using a non-ECN broker, look for patterns on a 5 minute chart or longer.
Patterns occur on all time frames, although when dealing with patterns on 1
minute charts, the profit targets may not be large enough to compensate for
the pip spread over the long run. This only applies if you're using a non-ECN
broker. If you're using an ECN broker then the spread likely isn't a major
factor, so smaller patterns and time frames can be traded. You still should
have at least a 4 pip stop though—don't trade patterns smaller than that.
The above guidelines will help you find chart patterns and also decide which
ones are worth trading.
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Chart Pattern Summary
Chart patterns are a complete trading system because the formations provide
you with visible entries, stops and a profit target(s). While the formations provide
this for you, it's up to you to determine which patterns are within your risk
tolerance to trade. No more than 1% of your account should be risked—the amount
you'll lose if your stop loss is hit—on any one trade.
Risk is controlled by your stop levels and position size. Take a position size
that allows the proper stop to be used and doesn't expose the account to more than
a 1% potential loss.
Write down a trading plan and record your trades. If you decide to include
chart patterns in your trading plan, review the methods described for the particular
pattern and create a plan for how you'll trade them and how you'll filter trades
(Only certain time frames? Only certain pairs? Only certain patterns?). As you
progress through the book, you'll learn more about market movements, which will
also help you assess when you should trade a pattern and when you shouldn't.
The market is dynamic and patterns won't always appear perfectly. "Nonperfect" patterns are still tradable, but make adjustments for the pattern's
anomalies. Trade based on what normally happens. Use stop loss orders to protect
yourself against disaster. When possible trade multiple lots, so you can use
multiple targets (if applicable) and lock in profits as a trade moves in your favor.
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10. Trendlines, Horizontals and Shifting
Markets
Trendlines and horizontal support/resistance lines are related to the chart
patterns discussed prior. These lines offer us a context for the market we're trading,
and are used in conjunction with other strategies. Combined with other strategies,
these lines are powerful in providing confirmation of trade signals or indicating
that a move lacks conviction.
Understand this chapter and practice using these tools before applying the
other strategies discussed. Understanding price action is the most important
concept you'll learn as a trader. It'll save you from applying your strategies at the
wrong time and tell you when to take trading signals for high probability trades.
This isn't all there is to know; you'll learn more about reading price action as you
progress through the book.
Before going in-depth on the use of trendlines and horizontals (horizontal
support and resistance) these terms should be understood. An upward sloping
trendline is drawn along price swing lows, which are progressively moving higher.
A downward sloping trendline is drawn along price swing highs, which are
progressively moving lower. Examples are shown in the following chart.
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EUR/USD Daily Chart
The upward sloping trendline marks an uptrend, which is simply defined as a
series of higher swing highs and higher swing lows in price. If one of these
conditions isn't present, it's possible a reversal may be starting. The downward
sloping trendline marks a downtrend, defined as a series of lower swing highs and
lower swing lows in price. Once again, if one of these conditions isn't present in
the downtrend it may be undergoing a reversal—we'll get to that later.
When you hear “support” or “resistance,” often the person speaking/writing
is referring to a “horizontal” level. Horizontal levels are areas where the price
previously stalled. If the price is in a range (rectangle), then the top of the range is
a horizontal resistance level (market resists higher movement), and the bottom of
the range would be a horizontal support area (market supports the price at that
level).
I differentiate between “horizontals” and support/resistance because
support/resistance can be determined by many different methods. The price may
not be anywhere near a former swing high or low, yet the price may still hit
resistance or support respectively. Support and resistance areas are created all the
time and old support and resistance levels are constantly being broken. Trendlines
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and horizontals are two ways of pinpointing support and resistance. The following
chart shows examples where important horizontal areas are marked.
EUR/USD Daily Chart
By drawing rectangles, we can easily see when a trend has moved into a
more ranging type of environment. The rectangles clearly show the horizontal
support and resistance levels.
Anyone who has traded knows that making money isn't as simple as trusting
support and resistance levels. Markets are constantly shifting. Where price had
stalled before may not be where it stalls the next time it moves into that area. The
EURUSD stops falling near 1.3750 on a number of occasions, though finally drops
below it. A downtrend ensues, followed by another range.
During trends, horizontal support and resistance don’t matter much, as we
expect these levels to be broken. In a downtrend we expect recent lows to be
penetrated—this must occur for the downtrend to continue. In ranging
environments we expect support and resistance to have more of an impact, thus
keeping price within the range. The following chart shows the transition from
range, to trend and back to range.
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EUR/USD Daily
A trendline may not provide the exact level at which price stops, or the price
may move just beyond a horizontal or trendline level. Just as the market shifts, you
too must shift and adapt with it. Adapting to current conditions means you
understand that just because you draw lines on your chart doesn't mean the price
has to respect those lines. From time to time, you'll need to make adjustments to
your drawings or place additional information on your charts as the market moves.
Always draw both horizontal and trendline support/resistance levels, as it'll
be easier to see how the market is shifting from phase to phase—range to trend to
range, etc. Do it in real-time as the price fluctuates; you'll see the moves develop
and be able to determine when a small range is likely just a pause in a larger trend,
or when a small trend is just a part of a larger range. You'll also see when a
downtrend is transitioning to an uptrend, or vice versa, since the direction of the
trendlines you draw will change.
At any given time you'll have "micro" and "macro" factors affecting your
chart, even when day trading. The macro factor is the dominant trend, range or
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market environment affecting the trading session or time frame you're monitoring.
The micro factors are the short-term gyrations within the larger environment.
If swing trading, the daily and 4-hour chart show the macro factors. Micro
factors show up on the hourly and 30-minute chart. For day traders, the 30-minute
or 15-minute charts reflect the macro picture, while the smaller time frame charts
show the micro picture. Both the micro and macro are needed to trade effectively.
Look back at the EUR/USD daily chart above. We can see that once the
price broke below the first support/resistance zone (top white box) the overall trend
is down. We then enter another consolidation phase (bottom white box); if you're
not aware of the overall trend—macro picture—you may make some potential
mistakes while trading in this region (bottom white box).
In the bottom box, note how the price makes a higher swing low (near the
middle) then a higher swing high (as it pushes slightly above the box). Based on
the guidelines that follow shortly, this is generally a bullish signal—an indication
that the market is going up.
When we consider the macro trend, which is strong down, we don't want to
buy based on that bullish signal, since doing so goes against the dominant down
trend. Whenever you're considering which direction the trend is in, or in which
direction you should trade, ideally you want to align yourself with the dominant
trend, and use the short-term trends or ranges to get in to trades. The other
strategies in the book provide the signals needed to do this. In this case, since the
macro trend is down, favor looking for short entry signals, and filtering out buy
signals.
As mentioned, always draw lines on your chart to help you more clearly see
the direction of the market. You may have a small uptrend, yet if it goes against a
bigger downtrend, the small uptrend is not a signal to buy. More likely, depending
on whether a valid trade signal develops, you're going to be looking to go short
with the dominant trend.
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Take for example the downtrend between the two white boxes in the chart
above. There's a small upward move, consisting of 4 green bars, which occurs
during this downtrend. If you only focus on this and buy, you'll likely lose as the
larger trend re-emerges to the downside shortly after. You'll learn how to use those
little counter-trend moves as entry points later in the book.
Look at the overall trend, as it tells you the trade direction you should favor.
The micro trends and ranges provide the opportunity to enter trades in your favored
direction.
The following is a guide on how horizontals can be used, followed by a
guide for trendlines.
Horizontal Support and Resistance Guide
Commonly referred to as support or resistance, it's a price level on a chart that
has stopped the price from advancing in the case of resistance, and stopped further
declines in the case of support. Support is a floor and resistance is a ceiling to the
rate of the currency pair.
 A horizontal line is drawn across the top of resistance points, and along the
bottom of the support points. The more times the price moves to that area
and bounces off of it, the stronger the support/resistance is. The harder and
faster the price approaches and the harder/faster it bounces off a level, the
stronger the level is.
If the price has little clear direction and is trickling lower, then trickles back
higher, the low that was just created isn't likely a strong support level. It may
become one if it's tested multiple times, though currently there's no evidence
that a lot of buying was present at that level. On the other hand, if the price
is plummeting at a steep angle, hits a level and reverses very hard in the
opposite direction, that's likely a strong level since it stopped a big decline.
The buyers at this level were tested by strong selling and the buyers won.
Going forward we need to at least respect the fact those strong buyers may
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still be at that level. It doesn't mean it'll always hold when the market moves
back down to that support level. You should be aware that there are buyers
there though, so taking a short position right above this level isn't wise. The
same scenarios apply to resistance levels as well; don't take a long position
right below a strong resistance level—one which caused a hard and fast price
reversal.
A strategy related to "strong" support and resistance is revealed later in the
book.
 The stronger and longer a support or resistance level lasts, generally the
greater the velocity of the eventual breakout.
 Support and resistance levels aren't exact. Often each attempt to reach or
breakthrough the level will leave the price slightly short of, or slightly
beyond (false breakout), what appeared to be the support/resistance level.
When this occurs, draw a “support/resistance area.” This area isn't a specific
price, but rather an area where prices move into and out of. This is very
common once a level has been “tested” multiple times. Support and
resistance areas are rarely exact, making it difficult to determine when a
breakout is actually occurring (recall the chart patterns Rectangles section).
 Support which is broken will often become resistance, and resistance which
is broken will often become support. It's common after a breakout for the
market to move back toward the original breakout point. That point will
often push the currency back in the breakout direction. The "Goodbye Kiss
Strategy" capitalizes on this tendency, which you'll learn later. If the old
breakout point offers no support/resistance, it's a sign the breakout may be a
“false breakout.”
A false breakout is simply a move which fails to follow through after a
breakout. If the price breaks out of a triangle pattern moving higher, and
then quickly retreats back inside the triangle, it's a false breakout—the price
failed to follow through in the breakout direction.
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 Failure to move beyond support and resistance levels shows the currency
pair is within a range. Even within ranges there may be small trends, as the
price moves back and forth towards the high and then the low of the range.
If the range is large you can trade the trends within the range, as long as your
profit targets compensate you for the risk. Always trade in the direction of
the macro trend, unless a specific strategy indicates otherwise.
Trendlines Guide
Trendlines connect price swing bottoms in an uptrend, and connect price
swing tops in a downtrend. These provide us with an indication of where the price
is likely to move back to on retracements (pullbacks).
 When a trendline is broken (price drops through an uptrend line, or rallies
above a downtrend line), it's an indication a reversal is possible. More
evidence is needed though, as the trend may be just weakening, though not
reversing. If an upward trendline is broken but the price stays above the
prior swing low, then draw a new trendline. If the price breaks the upward
trendline and also drops below the prior swing low, then a reversal is likely
underway.
If a downward trendline is broken but the price stays below a prior swing
high, then draw a new trendline. If the price breaks the downward trendline
and also rallies above the prior swing high, then a reversal is likely
underway.
 Since the market can be chaotic and doesn't usually move in harmony with
previous moves, you may have to draw multiple trendlines reflecting the
various trends which are underway. These trendlines will likely have
different angles and may even go in different directions.
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 Often there are one or two (maybe more) major moves in a pair each day
(for day traders). These provide you with your main trend(s) of the day.
Your focus should be to trade in the direction of the main trend when
possible. Shorter term intraday trendlines can be used to place entry and exit
orders, stops, profit targets, as well as gauge when the main trend may be
losing its momentum.
Using Trendlines and Horizontals in Shifting
Markets
By combining horizontal support and resistance with trendlines you’ll see
when a trend is ending and may be moving into a range or vice-versa. A broken
trendline doesn't always mean a complete reversal of the trend, rather it could
mean a transition into a more ranging environment. After all, a trendline accounts
for both price and time. If the time it takes for price swings to occur slows down,
the trendline will be broken. This doesn't mean a reversal is imminent, but rather
momentum is slowing. This slowing can take the form of sideways movement, or a
pullback. We don’t know which it'll be—a viscous pullback or just lateral
movement— so draw trendlines when you can connect two higher lows (uptrend)
or two lower highs (downtrend). When one of these lines is broken, draw
horizontal lines at recent horizontal support and resistance levels. Similarly, if the
pair is in a range, start drawing trendlines as soon as the pair breaks out.
The following chart shows the end result of what a chart may look like at the
end of the day (if day trading), though the concepts are applicable on all time
frames. You want to know where support and resistance is likely to be. I have left
all levels on this chart. In your own trading, you'll find that some lines can be
deleted as time passes and they're no longer needed.
This chart is of the SP-500 index and is used to show that this technique can
also be used in other asset classes as well. I've used long horizontal lines to mark
highs and lows. Some may find this beneficial for seeing minor and strong support
and resistance levels, while others may find it distracting. After I'll show another
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chart where small horizontal lines are used which only extended until the price
moves through them. This latter approach keeps the chart looking "cleaner."
SP-500 2 Minute Chart
Notice that the uptrend was dominant in the morning; while I did draw some
horizontal lines along swing highs, the price would pierce right though those lines
on the next rally—this is expected in a trend. When the price stops piercing
resistance in an uptrend, or stops piercing support in a downtrend, that's a sign the
market is likely entering a consolidation phase (more sideways movement) or
going to pullback, which could result in a reversal.
After about 10:30, the price moved mostly sideways through the afternoon.
As the day progressed, I put multiple support and resistance levels on the screen
(horizontal white lines). The inability of the market to move beyond those levels
with any momentum showed us the market was in a range.
Just before 3PM, the market broke above resistance and sustained the move.
This allows us to draw another trendline, again showing a main upward trend. The
retracement which occurred at approximately 3:30 PM came very close to the
trendline, which would've already been drawn, providing us with a good entry for
the move higher which occurred into the close. Strategies for this type of situation
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are discussed later in the book. Right now, the main thing to focus on is seeing
how trends and ranges work and how this relates to support and/or resistance being
broken or respected.
If that trendline would've broken, it would provide a signal that the market
was losing steam. In that case, a drop below a prior support level would be needed
to confirm the reversal signal.
 During the day trendlines may need to be adjusted slightly or redrawn. Take
for instance the sharp rise in the morning. Notice the trendline doesn't touch
the first pullback just after the open (it should in real-time). This is because
the line has been redrawn to accommodate later price action (remember we
must draw these and adjust them in real-time for them to be of use). Just
after 10 AM, the market moves sideways for several minutes. At no point
was the uptrend in danger, as the market barely pulled back and came
nowhere near a former price swing low. The line was redrawn to make it
more accurate for future price action. Update the lines in real-time and
redraw them to accommodate pauses in action or sideways movements.
Here's another example, which shows how crucial marking the charts with
trendlines and horizontal levels can be.
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EUR/USD - 5 Minute
From the EUR/USD 5 minute chart, we can see that the London session
(highlighted in yellow) begins with an uptrend, marked by the upward trendline as
well as the progressively higher lows (horizontal lines).
Later in the day, the price drops below the trendline (the more steeply angled
trendline), which is a warning signal but not a clear sign of a reversal. The price
continues to fall below the recent low (small horizontal lines on left), making it
quite likely we're into a full reversal. Confirmation comes when the price also
makes a lower high than the former swing high, allowing us to draw a new
downward trendline, and new horizontal levels at the progressively lower highs.
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These lines—trendlines and horizontals—helped during the trend, letting us
know it was still to the upside. The lines then notified us when a reversal was
occurring, and then once against helped us see the new trend to the downside.
Practice, practice, practice. Mark up as many charts as you can like this. You
may think you have a handle on it. Mark up a whole bunch of charts anyway.
Learn to tell when the market is potentially shifting, when it's in a strong trend, and
when it's reversing. This skill won't come from trading, it'll come practicing.
Anytime there are swing highs or lows to connect, connect them. Then do it in
real-time. Only when you have a firm grasp of this should you advance to the
strategies that follow.
Most of the following strategies require skill in assessing trends and trend
reversals. This skill helps determine when a strategy should be used and when it
shouldn't.
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11. Combining Engulfing Candles with
Trends
The engulfing candle trading strategy is easy to spot and provides a way to
enter a trend at an opportune time. Using the trend and the engulfing candle as a
trade trigger provides a powerful combination.
This strategy can be applied to any time frame or pair which is trending well.
Avoid using it in pairs which are choppy or lack a trend.
Recognizing Engulfing Candles
There are two types of engulfing candles, a bullish engulfing candle and
a bearish engulfing candle.
A bullish engulfing candle occurs when the “fat” part of an Up candle
completely envelopes the fat part of a prior Down candle. The fat part of the candle
marks the distance between the open and close of that bar, while the “tails” mark
the high and low. While there's no specific size requirement for an engulfing
candle, typically both candles in the pattern should be substantial. For a bullish
engulfing pattern, the down bar/candle should show strong selling and the
following up bar should show strong buying.
Figure 1 shows an example of a bullish engulfing pattern in the AUDUSD.
On my charts, up candles are green–the close is higher than the open. Down
candles are red–the close of the candle is lower than the open of the candle.
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Figure 1. Bullish Engulfing Pattern: AUDUSD 1-Hour Chart
A bearish engulfing candle occurs when the “fat” part of a Down candle
completely envelopes the fat part of a prior Up candle. Figure 2 shows an example
of a bearish engulfing pattern in the EURUSD.
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Figure 2. Bearish Engulfing Pattern: EURUSD 5-Minute Chart
If you look back at figure 1, you’ll notice that right before the bullish
engulfing candle pattern, there was a bearish engulfing pattern as well...and just
before that another bullish engulfing pattern, all within four price bars. Engulfing
candles occur often, which is why we need to add some sort of other filter to trade
them. Use the trend as the filter.
Using the Trend with Engulfing Patterns
Engulfing candles occur often. While its appearance signifies a sharp shortterm change in direction, many of these patterns aren’t of concern. In a trend
there are impulse waves (strong waves moving in the trending direction) and
corrective waves (smaller waves moving against the trend). Ideally, we want to
enter trades during corrective waves, or pullbacks (preferably when they're
ending), and then “ride” the next impulse wave for a profit.
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The engulfing candle signals the pullback is over and the trend is about to
resume. In the case of an uptrend, the bullish engulfing pattern signals the selling
which occurs during a pullback is over and the buying is resuming. The trend
doesn’t always resume right away. We may simply get a small push in the trending
direction before the pullback resumes. Losing trades occur, and that's okay as all
losing trades can’t be avoided.
Figure 3. Bullish Engulfing Candle Trading Strategy in Uptrend
For a bullish engulfing candle in an uptrend, place a stop loss 1 pip below
the low of the engulfing candle.
In the case of a downtrend, the bearish engulfing pattern signals the buying
which occurs during a pullback is over, and the selling is resuming.
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Figure 4. Bearish Engulfing Candle Trading Strategy in Downtrend
For a bearish engulfing candle in a downtrend, place a stop loss 1 pip (plus
the spread) above the high of the engulfing candle.
Engulfing candles are simply an entry technique and don’t provide a profit
target. For this entry technique, I typically use a 1.6:1 or 2:1 reward to risk ratio, in
rare circumstances it can be extended to a 3:1 ratio.
If you opt to use a 1.6:1 ratio and your risk is 10 pips on a trade, your target
is 16. If you use a 2:1 ratio your target is 20 pips from your entry point; 3:1 is 30
pips from your entry point.
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Which ratio to use is decided just before you make the trade, based on
current market conditions. For a downtrend, choose the ratio which puts your
target just past the prior low. In figure five, we have a bearish engulfing pattern in
the NZDUSD. We enter short as soon as the pattern appears (white box) because it
occurs during a correction higher within an overall downtrend. We place a stop
above the engulfing pattern high and that gives us our risk—50 pips. Based on this,
we should use the 1:6:1 ratio for the trade because that'll put our target (small
circled area) just beyond the prior low (dashed white line).
Figure 5. Bearish Engulfing with Entry, Stop and Target
The same goes for an uptrend. Look for a bullish engulfing candle during a
pullback lower within an overall uptrend. Place your stop so you know what your
risk is. Then use the ratio which puts your target just a touch higher than the last
high of the uptrend. Usually this will be 1:6 or 2:1, but occasionally it could be
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more based on the dynamics of that particular trend and the size of the engulfing
candle.
Zeroing In on the Entry Point
The traditional method of trading engulfing candles is to let candles
complete before entering. That means once the engulfing candle finishes and a new
one begins we enter the trade. But price bars are arbitrary. There's no relevance to
the open or close of a 1, 5 or 15-minute candle. Watch for these signals in real-time
and as soon as you see an engulfing pattern with the proper setup, trade it without
letting the bar complete.
For a downtrend, enter when the (potential) engulfing down candle moves
below the low of the prior up candle (during a pullback).
For an uptrend, enter when the (potential) engulfing up candle moves above
the high of the prior down candle.
This is a bit different than the traditional engulfing pattern, which only
requires the fat part of one candle to engulf the fat part of the other.
Figure six shows how this works in a downtrend.
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Figure 6. Forex Engulfing Candle Trading Strategy Entry Point
In the figure 6 the small horizontal red lines mark the entry point for short
positions.
There are a number of reasons for doing this. Mainly, a timed price bar is
arbitrary in the forex market. There's nothing special about a 5-minute bar closing
and the next one starting.
Also, this entry reduces risk (in pips). Engulfing candles show a powerful
change in direction. If we wait for a bar to complete, it may have already run
significantly, which means our stop is bigger and our profit potential is diminished.
Look back at figure 6. If short trades were entered at the close of the bearish
engulfing patterns the trader would've received worse prices than entering at the
prior candle low.
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Finally, we’re trading with the trend, so probability is already on our side.
Getting in before a bar closes doesn’t change our odds of success.
It's possible that when we look back at our trades, an engulfing pattern may
not be present. By entering early there's a possibility that by the time the bar closes
it's no longer a traditional engulfing pattern. Yet in real-time, the price exhibited
the shift in momentum we were looking for and that's all that matters.
The engulfing signal doesn’t necessarily have to come from one bar, either.
Assume there's a downtrend and a pullback moving higher. Then a down (red) bar
appears, but isn’t quite an engulfing candle. A few seconds after, another down
(red) candle drops below the low of the up (green) candle. To me, this is a still a
valid entry. Even though it was over a number of candles, it still shows the change
in direction. Once again, traders need to rid themselves of the notion that there's
something magic about the close of an intraday price bar, especially when forex
day trading.
Incorporate elements from prior chapters to enhance the odds of these
engulfing trend trades. Draw trendlines, and trade signals when the price pulls back
to the proximity of the trendline. This helps filter many signals which occur when
there isn't a trend present, or a pullback hasn't occurred.
Figure 5 is a good example of this trendline approach. The trend is down and
the price pulls back into the vicinity of the trendline marking that downtrend.
That's when to be watching for a bearish engulfing pattern. By using the trendline
as a guide, we're assured of the trend direction (and the direction we should be
trading) and that a pullback has occurred which is of significant magnitude.
Engulfing Candle Trading Strategy – Final Word
The goal of the strategy is to isolate a trend and use engulfing patterns to
signal the pullback is ending and the trend is resuming. We can also use multiple
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bars to signal the end of a pullback. There's no need to wait for the engulfing
candle to complete. Once it has engulfed the prior candle, take the trade.
Engulfing patterns don’t have a specific profit target. Use a fixed reward to
risk ratio. Which ratio you use is determined by the market conditions. Stops are
placed above the high of a bearish engulfing pattern, or below the low of a bullish
engulfing pattern.
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12. Trading the News
News events can be extremely volatile and result in irrational price
movements, triggering orders placed way outside the pre-news price. Exercise
extreme caution around the release times of major economic data. Most economic
calendars show which events are significant and which ones aren't. Here's a good
economic calendar: http://www.dailyfx.com/calendar. Be sure to set it to your time
zone, so you know when events are scheduled.
It's recommended that you don't trade for 5 minutes before or after high
impact news releases. New releases can result in slippage: being filled at a worse
price than an order was set for.
News events provide opportunity, but enter trades after the volatility has
subsided and the market has chosen its direction. Determining when to enter is the
basis of this strategy. Other strategies in the book can also be used following a
news release, though wait at least 5 minutes after the news release before
deploying them.
There are a few news announcements which cause big moves in the market.
Interest rate decisions are one of those announcements. The Non-Farm Payrolls
report (NFP) out of the US is another one. Other high impact news announcements
are listed on the economic calendar, usually marked with red, "High" or 3 stars.
These ratings indicate the news release often has a large impact on the price of
pairs related to that currency, like in the figure below.
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Set the calendar to your own time zone. Otherwise, you may end trading
right through one of these announcements, which could be disastrous for a shortterm trader.
These events provide opportunity but a trader shouldn't enter in the first
couple minutes after the news is released. If no real volatility is generated, then no
opportunities were missed anyway. If there is volatility, you can look to implement
the news trading strategy detailed below.
This strategy is geared towards the NFP report, although it's also applicable
to other news events which cause a lot of volatility. The NFP report is released the
first Friday of each month at 8:30 AM EST. The GBP/USD is the recommended
trading pair for this event as it's very liquid (significant daily volume) and responds
to the event with volatility.
Below I discuss a simple strategy and an advanced strategy. I call the first
strategy “simple” because there is little discretion or subjectively involved in
taking the trade. If we get a valid signal (based on the rules), we take it. This is
fine, but my personal performance is better with the more advanced strategies
discussed later on. That said, the advanced strategies are more subjective and may
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be harder for some people to implement. Therefore, practice each strategy and
utilize the one you trade best with.
Rules of the Strategy:
 Using a 5, 10 or 15 minute chart, wait for the first bar after the news
event to elapse. A 15 minute chart is recommended. After 8:45, using
the 15 minute chart (8:35 if using a 5-minute chart), watch for the
following criteria:
 After this wide ranging first bar occurs (usually covers a large price
area), wait for an inside bar to develop before doing anything. An
inside bar is a candle where the low and high are completely “inside”
the price range of the prior bar. This may take several bars to develop
or may occur right way.
The appearance of the inside bar shows volatility has dropped and it's
now safer to enter the market. Also, the volatility right at the news
announcement doesn’t always tell you much. That movement is based
on panic and loads of orders being triggered. Let the market digest the
information for a few minutes. The calmer, more rational movements
that follow provide much better clues as to the future direction of the
pair.
If the first bar following the news announcement isn't big (it should be
at least 50 pips or more using a 15-minute cart), don't use this
strategy.
 Once you've isolated an inside bar, mark the high and low of that
inside bar. If the price moves above the high of the inside bar, enter a
long position. If the price moves below the low of the inside bar, enter
a short position.
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 Place a 30 pip stop. Alternatively, you can use the opposite side of the
inside bar as your stop. For instance, if you enter long, put a stop 1 pip
below the low of the inside bar. If you enter short, place a stop 1 pip
(plus the spread) above the inside bar high. Make sure the stop is at
least 15 pips, regardless of where the inside bar high or low is. If you
use a stop smaller than this, you stand a very high chance of being
stopped out, as the market is still likely to have some volatility.
 Take up to a maximum of two trades. If both get stopped out, don’t
trade any further signals using this method.
 The profit target is a timed target, not a price target. Since some news
events can cause the market to move 300 pips and others will cause it
to move 70 pips (or less), just as examples, we use a time target to
attempt to capture the bulk of the move. Once a trend develops it'll
commonly last till the lunch hour, or early afternoon. Therefore, exit
the trade 4 hours after the entry. Cap the exit at 2:00 PM EST—by this
time other factors may begin to shape the direction as the US market
heads into the close.
Examples of the timed exit: If you enter at 9:00 AM EST you'll exit at
1:00 PM EST. If you enter at 10:00 AM (normally entries occur
before this if using a 5 minute chart, though if using a 15 minute chart,
this is not unreasonable), you'll exit at 2:00 PM EST. If you enter after
10:00 AM, exit at 2:00 PM EST.
 As with all strategies in this book, this strategy must be practiced.
Watch several major news events and take notes first. Understand how
the news affects the market and how much the pair typically moves
over a series of at least 5 news events. This process helps you
determine if the strategy is working in current (recent) conditions, or if
another strategy in this book would be more suited to trading a certain
news event.
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This strategy typically doesn't do well when overall volatility is low.

Trade Example
The chart below shows how this strategy is executed. The inside bar is
marked with a box. When the price moves above the inside bar make a trade in that
direction. The time on the chart is GMT, therefore the 13:30 represents the 8:30
AM EST news announcement and is marked by a vertical line.
GBP/USD – 15 Minute, Time is GMT
Stop is placed 30 pips below the entry price, marked by the horizontal black
line. Alternatively, place a stop 1 pip below the low of the inside bar, if this makes
the stop smaller than 30 pips.
Exit the trade 4 hours after entry time: 1430 + 0400 = 1830.
Trades won't work out this well all the time, but this trade resulted in a 160
gain, with a 30 pip risk: entry=1.4660, stop=1.4630 and exit=1.4820.
There are potentially many ways to trade the news (other strategies in this
book), this is one way. It's relatively conservative in that not a lot is risked, but still
can capture large returns in a short time.
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As with all strategies in this book proper money management still applies.
Don't risk more than 1% of your account on a single trade.
This strategy is always being refined. For updates to the strategy, please see
Simple and Advanced Non-Farm Payroll Forex Strategies on
VantagePointTrading. Some of the refinements or upgrades to the strategy may
require knowledge of concepts discussed later in this book.
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13. The Carry Trade
The traditional carry trade—which as day and swing traders we have no real
interest in—is when you borrow money in a low interest rate currency and buy an
interest rate bearing asset in a high interest rate currency.
For instance, as of November 2014 the Bank Rate in Japan is 0.1%, and the
bank rate in New Zealand is 3.5%. Theoretically you could borrow in Japan at
0.1% and then buy treasuries or another interest bearing note in New Zealand and
collect an approximate 3% return. Factor in 4:1 leverage (or greater) and you have
a 12% (or greater) return for doing nothing...theoretically.
Reality as we know is a little different. For starters, consumers don't get the
interbank rate on a loan from their bank. We're also assuming interest rates will
stay the same, and we're assuming that the currency rate (the price) will stay the
same. Neither will stay fixed for long, especially the currency rate (price of the
currency pair).
If the value of the Japanese Yen rises in this case, it will cost more New
Zealand dollars (NZD) to pay it back, thus eating into your profit or causing a loss.
On the other hand, if the NZD rises relative to the Yen (JPY), you have a win-win.
You get the interest on your investment and because you're holding an appreciating
currency it costs less to pay back the loan. You make interest and capital gains.
That is the snapshot of the traditional carry trade, played predominantly by
banks and major corporations, but generally not individuals. Individual traders can
play it by taking advantage of the rollover credit they receive from holding a
higher-interest currency, but more on that shortly though.
This background is given because there's an opportunity created by this
phenomenon for day traders and swing traders.
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Since the higher interest rates are attractive to investors/corporations/banks
(for the reason discussed above) the high yielding currency does often get bought
up, resulting in an interest gain and capital gain as the higher interest rate currency
appreciates.
The higher yielding currency involved in these trades is pushed higher, and
the low yielding currency is pushed lower. It becomes very attractive because as
long as people feel they can get out in time, or that the bubble won't burst, they
collect the interest and capital gains. Remember, such transactions are often
leveraged and involve hundreds of millions or billions of dollars when major
banks, funds and investors around the globe are doing this.
All good things must come to end. Carry trades can be huge, with billions of
dollars bet on being able to make an easy profit and get out before it collapses.
When that trend turns though, all hell can break loose and all these participants are
forced to get out of their positions, or face big losses. That means an often sharp
and quick reversal of the currency pair's price as investors clamor for the exits.
What to Watch For
Unfortunately, finding a carry trade isn't as simple as it may appear. Just
because a country has a high(er) interest rate than another doesn't mean there will
be a large carry trade taking place. For instance at the time of this writing Japan
has the lowest interest, but other currencies such as the USD or CHF also have low
interest rates near 0.25% and 0% respectively. These may also be candidates of
carry trades. There are also many other currencies and countries which may see
carry trades, but because they are less heavily traded they slip under the radar.
Ultimately we're watching for currency pairs which contain a high interest
country/zone AND a low interest rate country/zone. So as mentioned in the
example prior, the NZD/JPY where NZD is 3.5% and JPY is 0.1% is a prime
example. This is a currency pair to watch closely given these market conditions (all
rates subject to change). There are also other things going on in the world, and in
these pairs, so simply because a high currency pair rises doesn't mean a carry trade
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is going on. We're looking for sustained buying in a high-interest rate currency,
relative to a low-interest rate currency that generally lasts for years.
Interest rates may change periodically throughout the year. Those changes in
interest rates have a profound effect on the current carry trades, and could also
potentially start brand new carry trades involving other currency pairs. As with all
methods in trading, carry trades are dynamic. Watching charts and paying attention
to shifts in price trends and interest rates is important.
In 2002 AUD interest rates started to rise and did so until 2008, when we
saw the financial meltdown. At this point rates fell from 7.25% to 3% within a
year. For a day trader, a year is a long time. When the meltdown hit towards the
end of 2008, and AUD interest rates began to drop, it took only 3 months for the
previous 8 years of gains to be erased. It was fast, vicious and enormously
profitable for short-term traders who watched this unfold, realized what was
happening and acted on it, by shorting the AUD vs. the JPY.
These are trends like any other, except there's usually much higher volatility
as these carry trades unwind. Utilize any of the trend trading methods in this book
to take advantage of these opportunities.
AUD/JPY, Monthly Chart
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Other factors come into play and the carry trade isn't the only input at work
within a currency pair. The important take away is that when a carry trade is taking
place the reversals are likely to be quick and aggressive, due to the large amount of
money at stake.
The crash in 2008 was due to a global issue, yet it's a great example of the
power of the carry trade. There are also a few other things which need to be
addressed.
It may be questioned why in a time of panic money flooded into the Yen
(chart above) and USD (chart below), both currencies that paid lower interest rates.
During times of trouble wouldn't investors want higher interest to help protect
themselves?
The chart below shows the AUD/USD and we can see the sharp selloff of
the AUD, or sharp rise in the USD, in 2008. The Yen and USD were both weak
currencies heading into this meltdown, and the US was vulnerable to the financial
crisis. So why did money flow so aggressively to these currencies?
AUD/USD, Monthly Chart
The answer is found in the carry trade. Higher yielding currencies are
considered “risk on” trades. Many traders are willing to speculate so they can
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potentially make the interest gains and capital gains. Low yielding currencies are
considered “risk off” currency trades, meaning if you're in the low yielding you're
giving up on the potential to make the higher interest rate.
Therefore, when troubles were brewing, and interest rates were in question
traders begin converting back to their lower yielding currencies forcing a high
yielding currency sell-off. They want to be “risk off.” Similarly, if the high
yielding currency moves against someone holding a high yielding asset in that
currency, they may be forced out of that trade or face big losses. Basically, there's
a rush for the exits. Traders want to hold the higher interest currency, but can't.
How You Make Money
Carry trades have been a factor in many of the major trends which have
shaped the forex market in our time, and will continue to play a role in the future.
Likely some of your best days and months as a trader will come from the
opportunities presented when a carry trade unwinds. Not understanding what's
occurring and/or fighting it, could mean you have some of your worst trading days
or months. This type of unwinding doesn't happen often, yet when it does, you
want to capitalize on it and not be frozen on the sidelines.
The information is provided to give you a glimpse of the big picture. For day
traders and swing traders taking advantage of this phenomenon is quite simple,
both on the way up and the way down.
Retail forex trading accounts generally give/take from the traders the
difference between the prevailing interest rate of the currency pairs they're holding.
This was discussed in “Rollover” in Chapter 1. A trader takes advantage of the
higher yielding currency simply by purchasing it relative to a low yielding
currency. If the Euro interest rate is 1% and the USD rate is 0.25%, by buying the
EUR/USD currency pair you'll be credited with a small amount of interest, if you
are holding that currency pair at 5 PM EST (a small interest rate differential like
this isn't usually enough to cause a carry trade).
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Since banks/markets are closed on Saturday and Sunday, the interest for
these days is made up on Wednesday. Positions held on Wednesday at 5 PM EST
are subject to the extra days of interest credits or debits.
Alternatively, if a person is short the EUR/USD (assuming prior mentioned
interest rates) they'll be debited a small amount of interest at 5 PM EST for holding
that position.
By watching trends and also paying attention to the difference in interest
rates, traders can ratchet up big returns. Taking part in the carry trade doesn't need
to be a long-term commitment. Rather, commence with regular day (or swing)
trading activities, and by taking a long position in a high yielding currency relative
to a low yielding currency you can capture mini-trends and collect interest. Don't
rely on the carry trade though...you're still only taking valid trade signals based on
a sound strategy. If you can take trades in a pair that's trending, and collect
interest as well, that's a bonus you should capitalize on.
Leverage was discussed early in this book. Leverage in the retail market is
often 20 to 100 times the capital in the account. If you can capture a 1% return
from interest a year and you're leveraged at 50:1, effectively you'll make a 50%
yearly return. Combine this with being aware of the major trends in these pairs and
you can create a very profitable strategy.
At no point do you want to try to capture the interest rate differential but lose
on capital gains. Your ultimate goal is always to be on the right side of the actual
trade and trend, the interest is only ever a “sweetener” for a trade, not the reason
for it.
Capital gains are your first goal. Capturing some interest may be a secondary
goal. When that trend begins to break, forget about interest. As you can see from
the chart examples above, when a carry trade breaks you can profit handsomely
from the capital gains by trading the reversal, so don’t even think about trying to
capture the interest. Always trade with the trend. Realize a large group of traders
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are caught on the carry trade, seeking small interest payments, yet will eventually
be forced out by large capital losses. The biggest money comes when a high
yielding currency breaks to the downside, as the carry trade unwinds.
In this way you make money on the way up and the way down. How to be
on the right side of the trade is the focus of this book, so hopefully you'll feel
empowered with the tools provided in order to profit from this situation when it
occurs.
The purpose of this chapter is to provide a potential secondary income in
your trading from interest, in addition to capital gains. Realize this is a popular
strategy—and when things are popular there's even bigger money to be made when
they go out of style and the carry trade breaks.
When the carry trade does break, you'll be shorting the higher interest rate
currency, which means you'll be debited the interest rate for holding that short
position overnight. Depending on the interest rate differential, the debit could be
significant. Plan your trades with this in mind. Try to capture explosive moves that
allow you collect your profit before 5PM EST. If you need to hold a short trade for
a few days and pay the debit each night that's fine, though be aware of it. Be
selective about taking swing trades you're going to be debited for. These debits
erode capital gains.
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14. Statistics and Averages Every Trader
Should Track
One of my day trading students stated that his profit target was at such-andsuch a level. I asked why he had chosen this level, and he gave some reasons—
good ones in fact. I then him asked what the probability was that he'd be able to get
out at that price before the market closed? The markets were a couple hours from
closing and while technically it did look like the rate was going to go there at some
point, would the rate do it on the time frame he desired?
He looked at me and shrugged his shoulders. I then asked “Do you want to
be type of the traders that shrugs your shoulders, or do you want a method to
answer that question?” He wanted the method, and hopefully you do too.
Everything in life has a probability attached to it. It's not romantic and it isn't
pretty, but almost everything can be reduced to numbers.
Some of you may be saying "The forex market is open 24 hours during the
week, so who cares if the profit target is hit now, an hour from now, or while I'm
asleep?" Good point. Let me digress for a moment and point out that some traders
will enjoy implementing strategies which last several days, while other traders will
pull their hair out and lose sleep over a position or order that's left out over night.
If you're strictly a day trader and want out of your positions, and your orders
canceled, before significant markets close, you'll find this chapter especially
helpful. If you're a swing trader, not minding trades that last several days or weeks,
with orders pending all over the place, you'll still benefit from this chapter as it
provides a reference for how long your orders may take to fill and how long your
positions last. For both day and swing traders, the statistics discussed in this
chapter allow you to pick better entry and exit points, as well as fine tune stop
losses and profit targets (or filter out trades which are unlikely to complete on your
timeframe).
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Understanding “daily average movements” and statistics is valuable
information for a trader to possess. Here are some seemingly simple statistics that
you should track, no matter if you sit at your computer all day, or set orders and
walk away.
Daily Range
The daily range is one of the simplest indicators. It's the high price of the
day minus the low price of the day. It's the entire span that a currency pair covers
in a 24-hour period. When we take the daily range and then average it over time,
we can get a good indication of what a typical day should be like, in terms of
volatility. For instance, if the average daily range of the EUR/USD for the last 100
trading days is 120 pips, we can reasonably assume that a typical day will involve
movement of approximately 120 pips +/- a certain margin of error.
Why is this important? Let’s say you see trade—it looks perfect. The
EUR/USD has been moving up all day; it's already up 140 pips! There was no
news out and you're about to go long. You then ask yourself “What is my profit
potential on this trade?” An average is only an average, but on a typical day how
much room is left for you to profit? Not much, if any.
Since probabilistically there's not much (if any) profit to be had, the day
trade isn’t taken, or if it is, the risk on the trade should be very small to
accommodate for the low profit potential.
Another scenario may be that the market has moved 80 pips, though the
profit target requires the pair move another 100 pips. Is it likely the profit target
will get hit? On a typical day—and most days are typical—the answer is NO. In
order for the target to be hit, the pair would need to move 180 pips in a day. Sure it
could happen, but the odds are against it since the average in this case is 120 pips.
There are atypical days, which are out of the norm. The prior chapter
discussed carry trades, and if a major trend unwinds, you may see moves that are
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three, four, or even five times their average daily movement (until the average
begins to fully account for the increase in volatility, at which point the average will
reflect current volatility). Such events do occur, yet on most days when you trade
massive moves won't arise, and you're better off trading based on the statistical
averages.
By tracking daily ranges constantly, you'll also be aware when volatility is
expanding or contracting. Thus you'll be able to adjust your trading methods to
accommodate. If volatility is trending down (meaning daily ranges are getting
smaller and smaller), you need to accommodate for it. Anticipate that tomorrow
you may need to pull in your profit targets in order for it to be hit, you may also be
able to decrease your stop because with reduced volatility. Using the strategies in
this book, the adaptation should happen automatically, since targets and stops are
based on price action. Price action is what determines volatility in the first place.
Take the information the market provides, and adapt to it. That doesn't mean
you adjust your strategies per se, it means you adapt the strategy to the market
conditions.
The Average True Range (ATR) indicator is quite good at providing a
snapshot of daily average movement. Using the indicator is the quick way, though
I highly recommend you also keep track of the high, low, open and close of each
session, so you can manipulate the data in a spreadsheet and get much better
information out of it. This diligence (including looking at the charts and recording
numbers yourself), over time, will help you to see market dynamics more clearly
and potentially spot additional strategies, or trade-setups you otherwise would
miss. Daily and hourly volatility stats are also available at
http://vantagepointtrading.com/daily-forex-stats.
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Inner-Daily Range
The forex market is open 24 hours a day, yet you're not trading 24 hours a
day. This is extremely important; it's also why I recommend you record your own
data that's relevant to you, instead of relying on an indicator to provide a snapshot.
I used to trade between 11 PM and 2 AM (my local time), which is when the
European markets were opening. The daily range provided by an indicator or by
news service providers wouldn't provide any insight into what I would be facing
during this three hours of trading. Since my day only consisted of three hours of
trading, I recorded my own open, high, low and close for every session, starting at
11 PM and ending at 2 PM. After all, this was my trading day (for that particular
strategy I used at that time of the day).
This is what I call the “inner-daily range.” It's the part of the day you trade.
You must know what the typical tendencies are of the pairs you're trading during
this time. If you don’t, you've unnecessarily disadvantaged yourself.
I know what typically happens during the time I trade, yet there may be
times when I want to leave an order out after my typical trading session is finished.
This is where the daily range data discussed in the prior section comes in handy. I
need to know what's within the realm of likely possibility for the rest of the day,
while my order is out in the market. If I want that order to fill, I need to place it
within a price range that's likely to be hit.
By breaking down the day into its tendencies, you gain a lot of insight and a
huge advantage. There are many potential applications which can be drawn from
this data, and I recommend that you play with different calculations in a
spreadsheet. Uncover some insights of your own for the pairs you’re trading and
the strategies you’re using.
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Day of Week Averages
On a certain pair you may find your 50 pip target is easily hit on Thursday,
yet you're hard pressed to make 30 pips on a Monday. Each pair has different day
of the week tendencies; some days have half the volatility of others. If you're
trading each day the exact same way, you may find a pattern of better or worse
performance on certain days.
If you look at average volatility over the last 100 days, for example, you'll see that
each day of the week has its own average.
EURUSD Volatility by Weekday (in pips) - 20 week average, November 2014
Adjust expectations based on the day of the week. During this 20-week
period for the EUR/USD a day trader could expect to make much more (due to the
larger moves and more opportunity) Monday to Thursday, than they could expect
to make on Friday or Sunday. Expectations also need to be tempered on a Monday,
when compared to a Wednesday.
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The day trading the strategies in this book—based on price action—should
automatically adapt to higher or lower volatility. Be aware of it anyway, especially
on low volatility days. The average weekday volatility is a more precise measure
than average daily volatility. Avoid trades which require the price to move
significantly outside its typically price range in order to reach your target. This
topic was already addressed in the Daily Range section above, though now that
you know each day of the week has its own tendencies, you can zero in further.
If the price has already moved 40 pips when you take a trade on a
Wednesday, you have lots room to potentially profit outside the already established
daily range. On a Friday, the price is more likely to stay within the 40 pip range
already established, unless there's a major news release scheduled.
Like any other statistic, weekday volatility fluctuates over time. Visit
http://vantagepointtrading.com/daily-forex-stats for current stats, or record your
own in a spreadsheet.
Homework
I recommend that all students of the market have some knowledge of
statistics. Standard Deviation, Variance, and an understanding of how averages are
calculated should be the bare minimum a trader knows.
It's also extremely beneficial to understand how the standard deviation and
the variance relate to the average (mean). Whether the data is pulled from a
significant or useful source is also extremely important. For instance, incorporating
data from a very volatile time isn't prudent to day trading when volatility is low.
Use data that's relevant to current conditions, and use that same data to determine
when market conditions are changing.
By understanding these concepts, you'll be better able to adapt the strategies
described in this chapter to your own trading. I recommend picking up a college
level statistics book, going through it and doing the exercises. Without doing so,
you may miss what's between the lines; often the simplest things can create success
or failure.
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For a "palatable" introduction to statistics, check out the book The
Drunkards Walk - How Randomness Rules Our Lives by Leonard Mlodinow.
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15. European Open Strategy
The European Open Strategy is really a full day strategy, yet trade signals
usually appear within a few hours of the European open. It's based on the daily
average movement discussed in the prior chapter, and attempts to capture a
significant portion of the daily average range.
A similar idea could be adapted in other pairs, but I've only used it on the
EURUSD or GBPUSD. Only implement the strategy in one pair at a time, as the
EURUSD and GBPUSD are often positively correlated and implementing the
strategy on both pairs is overkill. Use the strategy on the pair that has the largest
average daily range. At times this will be EURUSD but usually it'll be the
GBPUSD. Check http://vantagepointtrading.com/daily-forex-stats to see the daily
average movement of forex pairs.
These pairs are used as little trading activity takes place leading up to the
European open. As Europe opens for business, traders and banks rush in and the
pairs are actively traded for the next 14 hours.
Most of the daily action in these pairs occurs during the New York and
London sessions. The European open gives us our first glimpse at how the day is
setting up, and will hopefully provide a good entry point for taking advantage of
the rest of the European and US session price movement.
The Trade Set-up
The logic for our trade is based on the fact that we know most daily price
candles have an upper tail and lower tail, and in-between we have the open and
close.
If we can enter a trade in the right direction on one of those tails, then we
have the fat portion of the bar and the other tail as potential profit. For instance, the
market opens and then begins to move higher for the next 45 minutes. It then
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reverses, after putting in a high 30 pips above the open. It has been about an hour
since the market opened and the price just dropped back below the open price.
Could the upper tail of the day have just been created?
If we know the pair moves on average 120 pips per day (subject to change),
and we assume the upper tail was created (30 pips), that means we're likely to
move about 90 pips outside of the current 30 pip range during the rest of the day.
Since we're assuming the upper tail is already in place, we want to enter a short
trade to capture the rest of the daily range.
The strategy is based on some assumptions. In this example we can’t know
for sure if the high of the day (upper tail) is actually in place. The market could
reverse course and make a new high, losing us money on the trade. Losing trades
happen, which is why this strategy tends to work over a large number of trades—
our winners are bigger than our losers. We also make the assumption the market
will move 120 pips today. 120 pips is just an average, not what the market will
actually move on a particular day.
In light of the assumptions, we improve our odds by using more specific
data. First, different days have different volatility. Thursdays may be less volatile
than Tuesdays for example. This may change over time, which is why keeping
daily statistics is so important—many strategies are built off such information. The
following chart shows EURUSD Volatility by Weekday and you can see the
weekday volatility difference. On Tuesday we'll try to extract more profit than on a
Thursday.
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EURUSD Volatility by Weekday (in pips) - 20 week average, February, 2012
Going back to our example, we can see that on Monday, Wednesday and
Friday the average movement is about 120 pips. On Tuesday, it's higher so we'll try
to extract a bit more, and on Thursday we'll settle for less potential profit. From the
chart we can see that on average there's an upper tail, a lower tail and the middle
potion (open-close). By isolating one of the tails we can enter a position and try to
take advantage of the rest of the daily range—there's usually about 2/3 or more of
the daily range left to capture following the entry.
Don't use this strategy on US or European holidays, as volatility is likely to
be low and average daily statistics won't be relevant. If there's a lot of volatility
prior to the European open, be sure to account for that when projecting profit
targets as discussed below. If the GBP/USD moves on average 120 pips per day,
and it's already moved 90 pips prior to the open, then activity wasn't low heading
into the European session and this violates the whole premise of the strategy.
Movement in the GBPUSD or EURUSD should be relatively calm for the few
hours before the Europe market opens.
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Trade Rules
The rules of the European Open Strategy are simple once the concept is
understood, but requires regular monitoring of the daily statistics (especially
volatility by weekday) so you can adjust the strategy to current market tendencies.
1. Mark the open of the London session on your chart with a horizontal line.
Use 15 minute charts
2. The first two bars are of no concern. After the first two bars (30 minutes) the
market must stay on one side of the Open price for at least another 30
minutes. If the market is see-sawing back and forth across the Open price
during the first hour, avoid this strategy.
3. After staying on one side of the Open price for at least 30 minutes (after the
first two bars) the pair must move back through the open price.
4. Enter as the price moves back through the open price by one pip. For
instance, if the market opened and the price moved higher, then moves back
down through the Open, go short when it moves below the Open price by
one pip. If the market moved down after the Open, buy when the price
rallies back above the Open price, assuming all other rules above have been
met.
5. Put out a stop loss order a couple pips outside the recent high or low which
was just established. The stop (in pips) shouldn't be much more than 1/3 of
the average daily range (for that weekday). If the price moves more than 1/3
of the daily average range in one direction after the Open, don’t use this
strategy. If the pair on average moves 120 pips in a day, but rallies 60 pips
after the open before falling back through the open price, don't take the
trade. Too much of the daily movement has been exhausted, and your risk
(60 pips) doesn't warrant taking a trade that's only likely to yield about 60
pips. If the daily average range is 100 pips, your stop shouldn't be much
more than 33 pips; if the daily average range is 120 pips, your stop shouldn't
be more than 40 pips.
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6. Calculate a reasonable profit target. You're attempting to capture a large part
of the rest of the daily range. Assume your upper tail is 30 pips after the
Open, you just went short as the price moved below the Open, and the daily
range is 120 pips. There's about 90 pips of profit potential available. Reduce
this by about 20%, leaving you with a profit target of 70 pips. Put out an
order for the 70 pip profit target. Here's a scenario: the market opens at
1.3000, goes up to 1.3030, drops below 1.3000, you go short at 1.2999,
placing a stop loss at 1.3032 and a price target at 1.2930.
7. Make sure the profit potential warrants the risk. If the target is much less
than two times the risk, avoid the trade. Absolute minimum reward to risk is
1.5 to 1.
8. If target or stop isn't hit, exit the trade at 23:15 GMT. You'll have incurred a
roll-over, as this is 1 hour and 15 minutes after the US session ends.
This may seem complicated at first, but once you become familiar with the
trade setup it becomes second nature. Let’s look at an example.
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EURUSD 15 Minute
Using the EURUSD 15 minute chart above we'll go through the steps of the
European Open Strategy. On the chart I've marked the European session in Yellow
and US session in blue (overlap period appears as light yellow).
1. When London opens at 8:00 GMT, draw a horizontal line which marks
the open price. On this day the pair opened at 1.32514.
2. The price moves higher, during and after the first two bars, and stays
above the Open price for at least another 30 minutes. All good so far—
there's a potential trade set-up if it drops back through the open.
3. The pair then moves down and drops below the open price.
4. Enter short at 1.32504 (a pip below the Open).
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5. Place a stop at 1.32847, two pips above the high that was just established.
Our risk is therefore 1.32847 - 1.32504=34.3 pips. The high is marked on
the chart by a horizontal line.
6. This is a Monday, and from the weekday volatility statistics we know our
daily range is about 120 pips (this will change over time). If the upper tail
is in place there's 120 pips - 34.3 pips = 85.7 pips of profit potential
remaining. We take about 20% off to improve the odds of our target
being hit, which provides a target of 70 pips. Our target price is thus,
1.32504 - 0.0070= 1.31804. This level is marked on the chart by a
horizontal line.
7. The potential profit is about two times our risk. All orders are locked in.
8. Our target is hit just after the end of the US session. Rollover is incurred
on this trade since the position is exited after 5:00 PM ET.
As with all strategies you opt to include in your trading plan, paper trade the
strategy first to get a feel for it, and see if it's profitable. If it doesn't work in
paper/demo trading it, it may not be a good time for the strategy. Don't use real
capital until you have a firm handle on the concept and it's showing consistent
profits.
Since the entry doesn't occur till at least an hour after the Open, it's easy to
determine beforehand if there's a valid trade setup. After the hour (could be more),
as the price approaches the Open you'll know what the stop level is. Subtract the
stop (in pips) from the daily range leaving you with your estimated profit potential.
As long as the profit potential outweighs the risk (1.5:1 reward to risk absolute
minimum), take the trade and set your stop loss and profit target immediately
according to the rules of the strategy.
Your stop or profit target may be hit in a matter of hours, or it may take all
day. The profit target is based on the daily average range, which includes the
whole 24 hour period. While most of the action takes place inside the European
and US sessions, occasionally the target is filled after the US session ends. Exit at
23:15 GMT if your target or stop isn't hit within the European or US sessions.
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Through trading this strategy I've found exiting at 23:15 GMT to be
favorable relative to holding on to the position longer, or exiting earlier if the stop
or target hasn't been reached. This exact exit time is subject to change though—
continually monitor statistics and see if you find a better time that works for you
when this situation occurs.
Next is a trade which may look like a signal, but isn’t. Under the following
conditions, no trade is taken.
EURUSD 15 Minute Chart
The Open is marked with a black horizontal line (the dots aren't relevant).
The first two 15 minute bars are of no concern, but overall the movement is lower.
We then have a full 15 minute bar completely below the open (third bar inside the
yellow highlighted area). If another 15 minute bar were to follow, completely
below the open, then we'd have a signal. This doesn't occur. The bar with an “x”
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below it violates the rule. It pushes up through the Open too soon, nullifying the
trade.
There's a temptation to say "It's only a couple of minutes, so I should take
the trade." I don’t recommend it. As you can see from this example, the market
didn't have the opportunity to build up any steam for a reversal. It's more likely to
chop back and forth, which it did for quite a while before dropping eventually. The
time frame is only a guide—a minimum guide. After the first 2 bars (30 mins) we
want the market to have picked a side and then stay there for at least another 30
minutes. As long as the price doesn't move too far on that one side of the Open, the
market is potentially gaining momentum for a move in the opposite direction.
Let’s look at another problem, using the chart below, which could trap
traders with this strategy: the risk/reward.
EURUSD 15 minute Chart
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The market moves lower off the open and stays down there for some time.
The thick black line marks the open price, and on this day it took a long time
to receive a signal. It took about 6.5 hours for the price to move back above the
open.
February 16 was a Thursday, and from our data we know that on Thursday
the pair usually moves about 100 pips (subject to change, check for new stats). The
pair opened at 1.3020 and made a low of 1.2973. Our stop is 1.3021 – 1.2971=50
pips. Deduct this from 100 pips to get 50 pips as a potential target. To be
conservative we reduce this value by 20%, giving us a target of 40 pips.
Our risk is more than our reward, so the trade isn't taken!
The target would've been reached and exceeded. It would've been a winner,
and could make a trader question why they didn’t take the trade. This strategy is
based on averages and probabilities. On this particular Thursday the market
moved close to 180 pips, much more than a typical Thursday. It's better to miss a
trade, especially when the odds of the trade are against you, than to catch the odd
winner but lose on the high probability trades. If the risk is too big for the likely
profit, don’t take the trade.
Here's another “good” signal, and is the type of trade we're looking for.
February 10 was a Friday; based on our statistics expect the pair to move about 135
pips.
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EURUSD 15 Minute Chart
The EURUSD opens the session at 1.32535 (black horizontal line), drops
and then rallies above the open during the second bar (we're not concerned with
these first two bars). After the price stays above the Open for more than an hour
you can anticipate a potential short trade...assuming the pair doesn’t move too high
above the Open, and that it eventually drops back below the Open.
As the pair moves back towards the open, note the high was 1.3283. As the
pair moves back below the Open we go short at 1.32525 and place a stop at 1.3285,
making our risk on the trade 32.5 pips. Since we know the pair moves about 135
pips, without even calculating our profit target we know we'll be taking the trade.
Our profit target is 135 pips minus the 32.5 pips the pair has already moved,
leaving us with 102.5 pips of potential profit left. Reduce this by 20%, leaving 82
pips. Subtract 82 pips from the Open price and generate a target price of 1.31715.
Our profit target is well in excess of two times our risk.
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This particular trade moved down aggressively and hit the profit target,
resulting in an 82 pip profit for 32.5 pips of risk.
Considerations and Performance
When the rules are followed the strategy performs fairly well. However,
results are "streaky." Once the trade is "on," set the orders and forget about it. The
strategy isn't time intensive, but the strategy does have a few pitfalls.
The main issue with the strategy is the lack of signals. While it's possible to
get four signals in a week, it's also quite possible a signal won't occur for a couple
weeks. There are three main reasons why signals don't occur:
1. Choppy trading, moving back and forth across the Open price, in the first
hour immediately lets you know you won't be implementing the strategy.
2. The market runs too far in one direction before correcting back across the
open. The stop should be about 1/3 of the daily range or less, if it's more (as
a result of a big directional move in the morning), don’t take the trade.
3. The pair never crosses back through the Open. On very strong days the
market moves in one direction and doesn’t pull back.
The third point we don’t need to worry about: if the market doesn’t cross back
through the Open, there's no chance of getting a false signal. These very strong or
very weak days are favorable for other strategies as well, so missing out on this
strategy isn't a concern.
Around the time I considered writing this chapter, and then actually writing it,
there were 32 trading sessions (there were also two holidays which aren't included
in this number). A valid signal was produced in 11 of those sessions, with the other
21 sessions producing no signals based on the reasons mentioned above.
Of the 11 signals, 8 were winners resulting in an overall profit of 437 pips.
Average winner was 66.69 pips, and average loser was 32 pips. Three of the
winners didn't hit the target in the European or US session and were exited at 23:15
GMT. Since I don't usually stay up to watch for this signal (I live in Mountain
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Time...the other side of the world) I've sporadically checked it over the years and
the results are similar to those above, but fluctuate. At times the win rate over a
couple month period will drop below 50%, and at other times be above 60%.
Making sure the winners are bigger than the losers is crucial.
Other market conditions, such as whether the market is ranging or trending
doesn’t seem to matter. When a strong trend is occurring we often won't get signals
because the market moves in one direction, or the signals occur in-line with the
trend, resulting in a profit.
What you'll mostly need to monitor is the daily average range; continually
update your statistics, at least once a week, to stay on top of current average
movements. If the daily average range begins to decrease below 100 pips per day
the pair is likely not volatile enough to warrant the strategy.
Beware when the daily average range is shrinking continually. If you pull up an
Average True Range indicator and it's trending down strongly, this strategy will be
hard to implement. Targets will rarely be hit because volatility is contracting day to
day. In this type of environment, don't trade the strategy, or, be sure to reduce your
profit target by several percentage points in order to accommodate for volatility
being lower than it was in the past.
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16. Truncated Price Swing Strategy
This day trading strategy can be used on its own, though should really be
used in conjunction with other strategies. This strategy gets you looking at trends
and reversals, and also introduces an entry technique—the "consolidation
breakout"—that's incorporated into many of the strategies that follow as well.
The strategy gets you into a move early, risk is relatively small and it aligns
your trades with the trend (or with the potentially emerging trend). It's used to take
advantage of the swings which occur every single day, so the strategy provides
ample trade signals.
While no system is perfect, this trading strategy often provides high rewards
for the risk and shows you quite quickly if you're on the right side of the market or
not—saving you time so you can get out and move on to the next trade if it doesn't
work out. Some potential flaws of this trading method are discussed at the end of
the chapter.
A truncated move, the basis of this strategy, is a price move that doesn't
reach the previous price move extreme. There are truncated moves that indicate a
trend is continuing, and those that indicate a reversal.
In a downtrend, if a rally fails to reach the previous high, it's a truncated
price move. In an uptrend if a pullback fails to reach the prior swing low, it's a
truncated price move. In both these cases, the truncated price move indicates the
overall trend is continuing.
If the overall trend is up and a wave higher fails to reach the last swing high,
it's a truncated price move and indicates a possible reversal, or a consolidation in
price. If the trend is down and a wave lower fails to reach the low of the last swing
low, it's a truncated price move and indicates a possible reversal higher, or a price
consolidation. The truncated price moves in these last two cases violate the basic
tenants of trends—higher highs and higher lows for uptrends, and lower highs and
lower lows for downtrends—indicating the trend is in jeopardy.
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I especially like this strategy near the open—the European open, or during
the European/US overlap period—but it can be used during any of the
recommended day trading times (see Best Times to Day Trade, Chapter 7)
Assume the EURUSD opens at 1.3000 and drops 20 pips near the start of the
European session, moves higher and then starts heading back to test the low at
1.2980. But this current price swing fails to reach that low before heading higher
again. Simply put, we have a higher low—a truncated move—and a potential trade.
It provides a low risk opportunity to get long.
The chart below shows the EURUSD on a 1 minute chart. This example
took place not long after the London open.
EURUSD 1 Minute Chart
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Focusing on the yellow area, which highlights the London session, the
EURUSD moves lower, higher, makes a new low and then rallies back toward the
former high...but it doesn’t make it there. That's what we're watching for.
The price stalls below the former high, and I've marked that area with a
white rectangle. We know a short trade could be forthcoming, because if the price
can’t push through the former high, it's likely to head lower, even if temporarily.
A potential trade needs a "trigger." The trigger indicates exactly when a
trade should be taken. This is where drawing a little rectangle around the price
action helps.
In this example a small range (rectangle) is created below the old high. A
break below the rectangle (very short-term support) signals the truncation is in
place and a short trade can be taken. While not all trades are this successful, the
market moved aggressively lower after that small range was broken.
To summarize, for an entry we're watching for any move that's heading to
test a high or low, but doesn’t make it there. Once the price stalls and starts to
reverse away from the high or low, we're watching for a trigger which initiates our
trade— this could be a candlestick pattern (such as an engulfing pattern, discussed
earlier in the book), or a collection of bars and then a breakout from those bars
(consolidation breakout).
My preferred method entry is the consolidation breakout—I use it for many
different strategies. In order to get a trade trigger, the price needs to pause just
below a prior high or just above a prior low so some very short-term support and
resistance can form. Draw a rectangle similar to the one on the chart and await a
breakout from it.
Stops are placed just above (1 pip plus the spread for day trading, 5 pips plus
spread for swing trading) the truncated high or just below (1 pip for day trading, 5
pips for swing trading) the truncated low which keeps the risk in pips usually fairly
small (relative to the surrounding price action).
In the example above, we enter short at 1.3020 and our stop is 1.3026. Add a
couple pips, so the stop in this case is closer to 1.3028.
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The profit target for this strategy can be based on multiple factors. One
option is to set the profit target at a location which presents a 2:1 reward to risk
ratio. In the case above, our stop is 8 pips, so our target would be 16 pips from our
entry price. If the price movement is a little sluggish, use a 1.75:1 target. If your
stop is 8 pips, your target is 14 pips with this reward:risk ratio.
Using a larger reward:risk ratio may result in a bigger profit, but the trades
last longer and the target is less likely to be hit. Since signals for this strategy occur
frequently throughout the day, getting in and out swiftly with a 2:1 (or 1.75:1)
reward to risk is beneficial since you can quickly begin looking for another trade.
Making two or three trades with a 2:1 reward to risk is better than making one
trade with a 3:1 ratio. Take a quick profit and move on.
I've used many other methods for exiting this trade, but often find that no
matter what profit target method is used, the ratio normally ends up near 1:75 to
2:1, therefore, to keep things simple just use the 2:1 (reward:risk) ratio under most
market conditions. In times when volatility is decreasing, use a slightly smaller
target.
The 2:1 reward to risk assumes the entry is actually attained near the actual
price trigger (consolidation breakout or engulfing pattern). Regardless of where the
actual entry takes place (the price you get the position at) the stop should always be
placed above the truncated high or below the truncated low and the profit target is
then placed at a distance which is equal to two times the risk from the
trigger/breakout point. Hopefully this is the same as your trade price, but if you
happen to miss the entry point by five pips to due slippage or slow reflexes, the
originally calculated stop and profit target shouldn't be adjusted for this 5 pips.
If you get a lot of slippage on your order, don’t adjust the stop and profit
target to reflect it, keep the original stop and profit target. Just because you missed
your entry point by five pips doesn't mean the strategy should be altered to suit
your predicament. If you miss a trade, let it go. There will be others. We don't want
to start chasing the price, as this increases our risk (based on where the stop should
be placed) and decreases the profit potential.
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On the same day as the example above, three more signals pop-up (see chart
below). For these, the trade triggers were engulfing patterns. Engulfing patterns, in
addition to the “consolidation breakouts” method discussed prior, are a reliable
trade trigger when using the truncated price swing strategy.
A bullish engulfing pattern is when an up-bar completely envelops the prior
down-bar after a downward move. A bearish engulfing pattern is when a down-bar
completely envelops the prior up-bar after an up move. The set-ups and patterns
are marked on the chart below—the engulfing patterns are our entry signals and are
marked by arrows on the chart.
EURUSD 1 Minute Chart
Trade 2 is a lower high, and the trade signal is a bearish engulfing pattern.
Enter short as the pair moves below the low of the former green bar. This gives a
short entry price of 1.3012 (1 pip below the low of the green bar). The recent high
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is at 1.3016 and our stop goes just above it, making it 1.3018 (6 pips of risk). The
target is therefore, 12 pips below our entry price or at 1.3000. The market reaches
1.2997 so the trade is profitable.
Trade 3 appears right after exiting Trade 2. An aggressive bullish engulfing
pattern triggers a long trade, on a higher low (truncated price swing). Enter long at
1.3006, which is one pip above the former red bar. Stop is below the recent low
(low of the bullish engulfing bar in this case) at 1.2997. Subtract one pip to make it
1.2996. The stop is therefore 10 pips and our target is 20 pips. Add the target to the
entry price of 1.3006, giving a price target of 1.3026. The market reaches 1.30267
so the trade is profitable.
Trades 4 and 5 happen quickly. For trade 4 we get a bullish engulfing
pattern, but the market then moves lower losing us 6 pips. We're still watching for
a higher low, as we remain well above the prior low (trade 3 in this case) at this
time. Another bullish engulfing pattern occurs and we enter long for trade 5. We
go long at 1.3010, stop is 1.3005 and our target is therefore at 1.3020. The market
moves up to 1.30236 so this trade is profitable.
This strategy worked well on this day using a one minute chart. You don’t
need to use a one minute chart though; use a 5 minute or even a daily chart. The
trade setups are still the same, as shown on the daily chart below.
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EURUSD Daily Chart
Regardless of the time frame, the rules are the same. You're looking for a
higher low or a lower high and you want either a collection of bars which provide
you with a trade trigger (consolidation breakout) or an engulfing pattern.
In the case of the daily EURUSD chart above, the trigger is an engulfing
pattern. The bullish engulfing pattern appeared right above the prior low,
indicating a truncated move. Our entry point is 1.3090 as the “bullish” day
surpasses the high of the former down day. Our stop is placed just below the recent
low (5 pips below, since it's a swing trade) at 1.3000 (90 pips risk). The target is
therefore 180 pips added to our entry price, to get 1.3270. This target is reached
several days later.
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The chart below is a daily AUDUSD chart. I've highlighted the trend with a
white line to show the simple structure of truncated price moves—in this case
there's a low, a move higher, a move down which creates a higher low and then a
move back higher. Once you see the higher low, you want to trade the next move
higher.
AUDUSD Daily Chart
If you can get a good entry into this wave higher you stand a very good
chance of capturing a profit. In this example, many novice traders will wait till the
price moves above the major high at approximately 1.04 to enter, but this entry
gets you into the move too late.
As long as the price remains above the former lower (a potential higher low)
look for a trigger which signals a move back higher; the primary triggers are a
consolidation breakout or an engulfing pattern.
The chart below shows the zoomed-in version of the turning point on the
AUD/USD daily chart above. I've drawn a blue box around the consolidating price
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action where the market stopped dropping for several sessions. Since the price is
still above the former low we're looking for entry signals to go long (buy).
In order to catch an up move we want to see some sort of bottoming process
first. When the market moves sideways for at least three bars and then begins to
move higher, that's the type of pattern we're looking for.
AUDUSD Daily Chart
Our entry candle is marked by the small arrow and our entry price is marked
by the horizontal green line. On December 20 there's a big green bar which moves
higher than the highest point in the consolidation—the entry occurred at 1.0027.
Remember signals are traded in real-time; don't wait for bars to close. On
December 20th, as soon as the price rose above the highest price in the
consolidation, a long trade is initiated.
Our stop loss goes below the recent 0.9862 low, marked by the horizontal
red line, making the stop 0.9857 (5 pips below the low). The risk is (1.00270.9857) 170 pips; our target is 2 x 170 pips = 340 pips, added to the breakout price,
giving 1.0367. This target was hit a couple weeks later.
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Truncation Strategy Considerations
The main down side of this strategy is that you don’t know for sure if the
pair is actually going to reverse. An uptrend is defined as “higher highs and higher
lows” or in the case of a downtrend “lower lows and lower highs.” This strategy
jumps the gun in that it only requires a higher low to be present into order to jump
into a long position, or only requires a lower high to enter a short position. That
said, the trade set-up presents evidence the trend may be reversing (or continuing
as the case may be) and the risk/reward indicates we can be wrong more often than
we are right and still make a profit.
I advise focusing on short trades where the last swing low was lower than
the former swing low, and the price is making a lower high. I advise focusing on
long trades where the last swing high was higher than the former swing high and
the price is making a higher low. In other words, trade in the overall trending
direction. For example, in an uptrend when the price pulls back but stays above the
former low. That's a signal I feel good about trading, and the target is likely to get
hit. If the trend is up and then I get a lower-high and a trigger, that's a reversal
signal (not a trend following signal). I may still trade it, but I'll often use a lower
reward:risk such as 1.5:1 instead of the usual 2:1, because I want to get out quicker
in case the uptrend re-establishes itself.
Day trade the strategy only during the recommended day trading times for
the specific pair you're trading.
This pattern is very common. You'll see it a lot, which potentially means lots
of trades. You may opt to filter some trades out. Applying a filter with this strategy
can be useful. For instance, choose to only take long trades when there's a
dominant up trend, or to only take short trades when an overall downtrend is
present. This is where understanding the other chapters will help you, especially
being able to gauge shifting markets.
DON'T TRADE EVERY SIGNAL THAT COMES ALONG. Be selective
and look at overall momentum. Be aware of the pair's daily statistics when day
trading. If you get a trigger to go long when the EUR/USD is already up 130 pips
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on the day (and it usually moves 100) then the odds of your target being hit even
further outside the daily range isn't very likely.
Trade triggers and profit targets can also be customized based on the pairs
you trade and patterns you notice. For example you may find a 2:1 reward: risk is
just out of reach, so a 1.75:1 or 1.5:1 is more favorable. Alternatively, a pair may
be trending strongly, and 3:1 ratios are easily attainable for a time. Monitor
conditions and adjust the strategy accordingly, typically though 2:1 reward to risk
works quite well.
In hindsight it's easy to see the market made a higher low and that a long
position should've been taken, or a lower high was made so a short position
should've been taken. In real-time it'll be unknown whether the market is going to
reverse or just pause before continuing on its current course. For this reason the
trade triggers are extremely important.
From my experience the best trade trigger is when the market pauses for
several bars, moving predominately sideways, creating a consolidation as shown in
the examples above. We then wait for a consolidation breakout and pounce.
Though, often there's no pause. The price simply snaps back the other way leaving
you without a trade. The engulfing pattern allows you to capture some of those
trades that the “consolidation breakout” trigger doesn't.
Both these patterns (consolidation breakout and engulfing pattern) need to
be watched for in real-time. If the trend in the AUD/USD is up, you'll want to
watch for pullbacks in price in order to buy into that uptrend. As long as the rate is
above the prior low you have a potentially higher low. If the trigger develops, then
you'll enter into a long trade. Seeing the trigger developed several bars ago may
provide some analytical insight, but it's too late to be used for trading purposes.
Learning when to watch for triggers, being able to see the trigger develop
and then pouncing on those opportunities will eventually become second-nature to
you. At first though, it may be hard to spot the patterns in real-time; with patience
and practice it'll happen.
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17. Channel Breakout Strategy
This strategy is based on trend trading. By using the corrections (countertrend moves) to signal the entry, this strategy gets you into the next trending move
early. When you get in early your risk is limited and your profit potential is
maximized.
Watch a trend develop and you'll see pullbacks along the way—brief
counter-trend moves that quickly disappear as the trend re-emerges. Entering on
these pullbacks can be lucrative, yet most traders go about it the wrong way. They
either enter too early when the pullback is still occurring—and then have
to hope the pullback soon reverses–or they wait till the trend has clearly reestablished itself, but by then much of the trending move may already be over.
The following strategy attempts to solve these issues. While it won’t win
every time, this simple correction breakout strategy will help you get into trending
moves early, and with a level of safety, since the breakout signals the pullback is
likely over and the trend is re-emerging.
Trade signals are only taken in a strongly trending pairs. Incorporate your
knowledge of trends to isolate when a trend is strong or when it's in jeopardy (more
on this later in the book as well).
There are two types of corrections we look for. One is called the minichannel and the other is the correction channel. A mini-channel is a very tight and
relatively small channel which moves against the dominant trend. The correction
channel is a larger structure. It's a pullback that's contained between trendlines
forming a channel, and often has multiple price waves. Even though this is a larger
structure on our charts, it should be smaller than the prior trending moves.
Our goal is to trade with the trend, and wait for a breakout of the channel,
signaling the price is moving back in the trending direction. Mini-channels are
discussed first, because mini-channels can occur within correction channels. By
knowing about both we can fine-tune our entry.
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The Nature of Trends
A trend isn't a relentless move in one direction. A trend is a series of strong
impulse waves in one direction, separated by pauses or smaller reversals
(corrections) in the opposite direction. A trend is composed of both impulse waves
and corrections. No matter which time frame you trade on, you'll see the market
move in 3, 5, 7… wave patterns.
A three wave pattern consists of an impulse, a correction, followed by
another impulse. A five wave pattern is an impulse, correction, impulse, correction
then an impulse. Tack on another correction and impulse for the seven wave
pattern.
Look at a chart, and with a bit of practice you'll see every trend takes this
configuration (figures below). Upon this little insight you can base a powerful
strategy. Each correction—which often appears as a mini-channel or correction
channel—provides a potential entry signal into the next impulse wave of the trend.
Corrections can take forms other than the channels discussed above. This
strategy is only used if the correction takes the form of a channel. This method can
be used for day trading or swing trading.
Mini-Channel Breakouts
The chart below shows the EUR/USD from the open of the US session.
From just after 8:00 AM EST till 10:00 AM EST a five wave pattern develops. I've
highlighted it in black for demonstration purposes. The labeling with the numbers
isn't important, but is used to show how trends develop in patterns of impulse,
correction, impulse, correction, and so on.
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Figure 1. EUR/USD 5 Minute Chart
Since we know that most of the time a correction is followed by a move
back in the trending direction, we can look for corrections to provide potential
entry points. Lines 2 and 4 are corrections against the dominant trend (lines 1, 3,
5). We know that line 2 is a correction because it covered less ground than line 1.
In order for a trend to occur, a correction must be smaller than the prior impulse
(trending) wave, otherwise the price doesn't progress. Wave 3 is much bigger than
2, which progresses the price to the downside. Wave 4 is much smaller than wave
3. Wave 5 is bigger than wave 4, but only marginally, which shows this trend is
weakening, and the price did indeed reverse direction after that.
We need higher-highs and higher-lows to create an uptrend, and lower-highs
and lower-lows to create a downtrend. When one of those conditions isn't satisfied
it warns of a trend reversal. Had a short-trade signal (discussed shortly) developed
right after wave 5, the trade wouldn't be taken since wave 5 was very weak, barely
making progress relative to wave 4 (the correction). Recall from the Chart Patterns
chapter that this type of price structure is called a double bottom.
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Once the correction is found we draw lines along the highs and lows of the
correction to create a mini-channel (see next chart).
As the day continues an uptrend develops (multiple waves), interspersed
with mini-channels. I've marked some of these mini-channels on the chart in black.
Figure 2. EUR/USD 5 Minute Chart
By drawing the mini-channels on the chart, we provide ourselves with
potential entry signals. In the chart above there are strong moves higher, followed
by moves lower (mini-channels). When the price breaks back above the minichannel a long trade is taken. In a downtrend we'll have strong moves lower,
followed by corrections (mini-channels) higher. A short trade is taken when the
price breaks below the mini-channel.
Unfortunately, not every breakout results in a sharp move in the direction of
the former trend, and it's very possible to get false breakouts since the channels are
small and we must draw them in real-time.
Drawing the channels is also subjective. Comparing charts with another
trader at the end of the day, it's unlikely all the mini-channels would be marked the
same. Corrections may not always take the form of well-defined channels;
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corrections may be erratic, and not easily contained between lines. If the correction
is more complex than a simple mini-channel like what's shown above, then don't
use this strategy.
Stops and Profit Targets
To enter a trade using mini-channels look for a strong move in one direction
(impulse), wait for a pullback, draw a mini-channel around it, then wait for the
breakout to occur in the direction of the impulse. A chapter later in the book about
Velocity and Magnitude will greatly aid in the profitable implementation of this
strategy.
Getting in is only part of the battle; you also need to control risk and plan for
a profitable exit.
To control risk, place a stop loss 1 pip below the most recent swing low
which occurred just prior to a mini-channel breakout in an overall uptrend. Place a
stop 1 pip (plus the spread) above the most recent swing high which occurred just
prior to the mini-channel breakout in a downtrend. Your risk is the difference
between the entry price and your stop price. Set your profit target at 1.5 to 3 times
your risk.
In an uptrend, if your risk is 15 pips, place a profit target at 30 to 45 (2:1 and
3:1 respectively) pips above your entry price. 2:1 usually works well for a quick
profitable trade. The next chart shows an example with stops and profit targets.
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Figure 3. EUR/USD 5 Minute Chart
The trade had a 5 pip risk, and therefore a profit target was placed 15 pips
above the entry price. If you pay more than 2 pips on the spread then opt to trade
slightly larger patterns, using a minimum of 6 pips or more for your stop.
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Figure 4. AUDUSD 5 Minute Chart
The chart above shows another trade in the AUD/USD, which is in a strong
overall uptrend. Draw lines around the mini-channel, and enter when the price
moves higher out of that mini-channel. For this trade, the risk was near 7 pips and I
used a target of 12 pips; a 1.7:1 reward:risk ratio, based on the volatility and
tendencies of the pair at that time.
There are four other corrections on the AUDUSD chart above where this
correction strategy could have been used.
This strategy provides many signals, and as trends end and new ones begin
is where losses typically occur. When a trend reversal occurs though, often a
truncated price swing will appear, providing a warning. Combine the strategy
discussed in this chapter with the Truncated Price Swing Strategy and you have a
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powerful combination for trading trends and reversals, and identifying them as
they occur.
Grasping these concepts will take time. Reading about them isn't enough. Go
through charts; put all your trend lines and horizontals on them, as well drawing
lines around mini-channels. See how the market reacts to these lines, so you can
eventually start determining which of these signals to take and which ones to leave
alone.
If the trend is choppy and not moving aggressively, then use a 1.5:1 reward
to risk ratio, or avoid using this strategy all together. If the trend is moving
strongly, then use a 2:1 ratio. 3:1 can be used in very strong trends, but use it
sparingly. Better to lock in a profit than end up with nothing.
Day traders using this strategy should only trade it during the Best Times to
Day Trade (chapter 7).
For a mini-channel we ideally want three bars or more in the mini-channel.
But this is subjective based on the timeframe being monitored. In figure 3 above
the channel is only 2 bars, but that's on a 5-minute chart. If viewing a 1-minute
chart the mini-channel is 10 bars, which is more than adequate for drawing a minichannel. Pick a time frame you're going to find signals on, and practice on.
Develop rules for how many price bars a mini-channel needs. Once a mini-channel
has formed with enough bars, it provides a potential trade signal. If there aren't
enough bars to form a mini-channel, there's no signal, because the mini-channel is
incomplete.
Also, because different pairs are more or less volatile at different times of
the day, a 3-bar channel may work well on a 4-hour chart in one pair, but for
another pair waiting for 5 or 6 bars to create a mini-channel on a 4-hour chart
works better. As with all strategies, some work is required for fine-tuning the
method based on the pairs you're going to trade, and what time frame you're going
to use.
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Correction Channels
Correction channels are larger versions of the mini-channels discussed
above. Mini-channels are a collection of bars, but don't contain any significant
price swings. Correction channels do have swings, and while they can be seen and
traded intra-day, usually these patterns are seen and traded on hourly, 4-hour and
daily charts. The reason these appear on longer-term charts is because there must
be a strong longer-term trend present.
Corrections against the trend won't always be as simple as the mini-channels
described above. The price may have multiple waves which move against the
trend. This is where things get a bit more complicated; marking up the chart with
trendlines and understanding the previous chapters will help.
When there's an uptrend, it's possible to have a lower low, followed by a
lower high, and then another lower low, but the uptrend still isn't over. Looking at
overall price action we see that even though the price entered a short-term
downtrend, given the overall longer-term picture, the trend is still up. Confused?
Here's a chart showing this concept.
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Figure 5. GBPUSD Daily - Correction Channel in Larger Uptrend
During this uptrend we have a number of corrections which create lower
lows and lower highs. In this case, the upward sloping green trendline shows the
progress is still higher, despite a number of these more complex
corrections/pullbacks.
Let's focus on the channel correction which occurs between the white lines.
From the high point there is a lower low then a lower high. Connecting the two
high points allows us to draw the top line of the channel. When the price creates
another lower low, we connect the two lows to form the bottom of the channel.
From this point on, if the price continues to make price swings that are moving
lower, this channel gives us an idea of the potential price trajectory.
Based on this correction channel though, we're ultimately watching for a
breakout higher because the overall trend is still up. If the price were to continue to
drop and move below the long-term green trendline then we'd need to question that
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assumption, but while the price remains in that correction channel the overall trend
is still up.
The entry occurs when the price breaks above the correction channel, back
in the trending direction. If the overall trend had been down, then the correction
channel would be angled upwards, and we'd enter when the price breaks below the
channel back in the trending direction.
The chart below shows this. Our stop is placed 5 pips below a recent swing
low; usually this is somewhere within the correction channel. Our profit is twice
our risk, added to the breakout price. This ratio can be adjusted slightly based on
market conditions. Ideally the target should be just beyond the former high when
the price is in an uptrend, and just below the former low when trading an overall
downtrend.
Alternatively, take the width of the correction channel and add it to the
breakout point of the channel. This is another way to establish a profit target, and
can result in a very favorable reward:risk ratio when the risk on the trade is small
(2:1 reward:risk ratio may leave a lot of profit on the table in this case). Adding the
height of a pattern to the breakout point is a method you should be familiar with
from the Chart Patterns chapter.
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Figure 6. Correction Channel Strategy
In hindsight this looks very simple, but in real-time when the price moves
lower for the first time (inside the white lines) you don't know if the price is going
to plummet or form a correction channel like this.
Therefore, on that first move lower, since the overall trend is up, you could
buy using the mini-channel breakout strategy (when the price breaks above the
mini-channel).
The second time the price falls, the upper trendline of the channel is drawn.
On the second decline another mini-channel breakout trade could have been taken.
That one would've gotten you into the long-term trending move higher.
There are mini-channels within correction channels; both are tradable. This
correction channel in the GBPUSD actually presented three opportunities to get
long, given the overall uptrend in the pair.
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Figure 7. Multiple Entry Points if Mini-Channel and Correction Channel
Entries are Considered
If trading a mini-channel breakout within a correction channel, you can base
a profit target on the larger correction channel. If you took the second mini-channel
entry, you would've gotten a better price than if you waited for a breakout above
the correction channel (third potential long entry). If the price breaks out of the
correction channel, then the target can be extended to what the target would be for
the actual channel breakout. This would be near 1.70; the target shown in figure 6.
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Mini-Channel and Correction Channel Breakout
Summary
Markets move in a continual pattern of impulse, correction, impulse, and so
on.
Corrections against the trend can be simple or more complex. Simple onewave corrections are called mini-channels, and present an opportunity when the
price breaks out of the mini-channel in the trending direction. A correction channel
is more complex because there are multiple waves involved. With this pattern the
key is to look at the bigger picture. Even though a correction may result in multiple
waves moving against the trend, can that trend still be considered in effect? In the
correction channel figures above, the answer is yes.
When trends reverse, the impulse, correction, impulse pattern begins in the
new direction. While the strategy appears simple in theory, in the real world it's
more difficult to implement since you must constantly determine the direction of
the trend. Draw the mini-channel lines on the corrections and attempt to profit
from the impulse waves that follow.
Mini-channels occur frequently on intra-day charts. Correction channels
occur frequently on longer-term charts, and will often have mini-channels within
them.
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18. Scalping Round Numbers
There are price points which cause little pops or drops in currencies (and
stocks, commodities, etc). These types of trades aren't based on fundamental or
technically driven events; rather these quick “dashes” in price are due to order
flow.
Order flow is buy and sell orders coming into the market. Certain conditions
create an imbalance in the order flow. Imbalances never actually exist, since for
each buy someone must sell. An imbalance just means buyers or sellers become
more aggressive, clearing out most opposing orders causing a quick move in price.
Often this occurs due to stop or limit orders being triggered, at highly visible
spots on the chart. If a price is reached which has a high concentration of sell stops,
a flood of sell orders will hit the market as all those sell orders execute
simultaneously. This causes a quick price move, which may or may not reverse just
as quickly.
Scalping Round Numbers
Round numbers have an almost gravitation pull to them. 1.3300 is an
example of a round number, as is 98.00. Each currency pair has round numbers
which often come into play each day, or every couple days, depending on
volatility.
The price often see-saws through these round numbers. If the USD/CAD is
moving higher, approaching 0.99, it's likely it'll move above 0.99 by at least
several pips. The same concept applies if the pair is moving lower, and
approaching 0.98; it's likely the pair will move lower than 0.98, even if only
slightly.
This phenomenon provides a scalping opportunity for any currency pair that
has intra-day volatility of greater than 80 pips (100+ pips recommended) per day.
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Trading this scalping strategy in pairs with less volatility than this usually isn't
fruitful.
As the price moves higher toward a round number, go long 10 pips before
the round number and exit 5 pips after the round number. As the price moves lower
toward a round number, go short 10 pips before the round number, and exit 5 pips
below the round number. Your goal is to make 15 pips. This why you want to trade
pairs which move at least 80 to 100+ pips intra-day; without that movement it's
hard to attain 15 pips.
These numbers can be adjusted slightly, but for liquid and moving currency
pairs the 15 pip target should work fine. Since this is a day trading strategy, use it
during the Best Times to Day Trade (Chapter 7) for the pair you're trading.
Trade with momentum. Buy as the price is moving up towards a round
number. Short as the price is moving down towards a round number.
Scalping is almost an art form. Since profits are small (in pips), risk must be
controlled. This is mostly accomplished by waiting for price to begin moving in
the direction you want before entering. If you always do this, you should only be
showing a loss for several seconds and then immediately be in the money. If you're
scalping and your trades are showing a loss, or your loss isn't diminishing within
about thirty seconds, your timing is off or there wasn't enough momentum present.
The key to scalping is to get in and out with a gain on a quick movement in
price, while never really showing a loss on the screen (or only very briefly). Since
gains are small, one big loss can be devastating. Get in quick with momentum and
have an order already set to get out on the quick price surge. The easiest way to do
this is through market buy and sell orders. Some traders don't like these types of
orders because they think their broker will rip them off. On the contrary, I use
market orders all the time as I like knowing that I'll for sure get in and out.
When you go through the broker selection process, choose a broker that
gives you the tools to get in and out quickly, set up trades quickly and trade how
you need to trade. The Resources section at the end of the book discusses a plug-in
for MetaTrader4 which makes placing (and adjusting) orders, stops, targets and
trade volume very easy.
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Don't get greedy and try to make more than the scalping strategy dictates. If
you become greedy, you're changing the strategy mid-trade. If you wish to hold a
trade for a bigger gain, plan the trade beforehand and have the method for doing so
written down in your trading plan.
If the trade is showing a profit, but doesn't reach your target, and your profit
is evaporating, exit before it turns into a loss. Scalping is about quick profits; take
any profit the market gives you.
The USD/CAD 15 minute chart displays price action from September 13 to
September 19, 2011. During this period there were many times the price see-sawed
around 0.99, and also around 0.98. There were 22 occurrences where the price got
within 10 pips of the round number (after being further away than 10 pips prior).
20 out of 22 times the price made it to the round number. Only twice did the rate
move to within 10 pips and then not proceed to hit the round number. Those two
instances are circled on the chart. All other trades would have at least resulted in a
small profit.
USDCAD 15 Minute Chart
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Here are the main points of the strategy:
 Buy within 10 pips of a round number as the price approaches, with
momentum, from below.
 Short within 10 pips of a round number as the price approaches from above,
with momentum.
 Target is 5 pips beyond the round number.
 Use a market order to get in. If the target isn't hit, use a market order to get
out.
 Don't let a profit turn into a loss.
 Enter as price is moving towards the round number—in scalping you should
never be showing a negative position for more than about 20 to 30 seconds.
 Exit if the position starts to move several pips against you (at any point).
 Place a worst case scenario stop loss on the position of 10 pips, but this
should never be allowed to get hit, it's only a safety precaution.
This is a less structured strategy than some of the others mentioned in this
book. Mainly, there's no particular stop (except the worst case scenario stop of 10
pips, but it should never get hit). Since you'll only ever enter this trade with
momentum going in your favor, you should be showing a profit quickly. If you
aren't, get out!
If you are showing a profit, then it starts to disappear and you're about to go
negative on the trade, get out! This may mean you make a couple pips, or lose a
couple pips on a few trades, but I've generally found that as long as I only enter
when the price is moving with momentum in the direction I want—according to
the strategy—10 to 15 pips profit isn't uncommon.
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19. The "Good-Bye Kiss" Strategy
The "good-bye kiss" is a great trade setup where risk can be kept quite
minimal, there's a good probability of success and the pattern is fairly easy to spot.
It takes a lot of patience but we avoid a plethora of bad trades.
The good-bye kiss strategy is based on the premise that a legitimate breakout
will often "re-test" the old breakout point. This provides an opportunity to get into
a trade, and participate as the price likely moves back in the breakout direction.
This strategy can be applied to any pattern from which a breakout occurs,
such as ranges/rectangles, triangles, head and shoulders, wedges, etc. This strategy
was briefly addressed when we discussed the head and shoulders pattern (pullback
after the breakout).
1. Isolate a price range (or other chart pattern).
Price ranges/rectangles work quite well for strategy. Isolate a price range (or
other chart pattern) on any time frame. The range should include several "price
swings," meaning the price is oscillating back and forth within a contained area.
The swings don't need to create the same highs or lows, although when this occurs
the range is easier to spot. Figure 1 shows a daily chart price range in the
AUDUSD.
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Figure 1. AUDUSD Daily Range
2. Wait for the price to breakout and stay outside the
pattern for at least 3 or 4 bars.
The real goal here is to make sure the price has actually broken out. In order
for a breakout to be legitimate it needs to actually move out of the range a decent
distance (this is subjective, and the actual pip amount it needs to breakout will vary
by time frame and volatility) and stay outside for several bars. Figure 2 shows the
type of move outside the range we're looking for.
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Figure 2. Likely Legitimate Range Break
On false breakouts the price usually only moves out of a range by a small
amount, and then retreats back into the range. In figure 2 there's a very strong
breakout and the price moves well beyond the high of the range. This indicates the
breakout is likley legitimate. The price also stays outside the range for a number of
bars before pulling back toward the high of the old range.
3. Wait for a pullback to the breakout area and enter a
trade.
In figure 2 the breakout was to the upside, therefore we're waiting for a
pullback to the former resistance area of the range. This pullback is our "goodbye
kiss," as the market is coming back to say goodbye to this area one last time. While
occasionally the price will pull all the way back to the resistance area (or support in
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the case of a downside breakout), often it'll come up a bit shy (as in figure 2)—it
gives it a kiss from a small distance away.
Place an order in advance near the breakout point, or watch for a manual
entry using the consolidation breakout entry or the engulfing pattern entry. The
manual entry is best; let the price pullback toward the former range, consolidate,
and then trade a breakout of the consolidation back in the trending direction (entry
method is outlined in the Truncated Price Swing Strategy). If a consolidation
doesn't form on the pullback, an engulfing pattern can also provide an entry signal.
Engulfing patterns were covered in Chapter 11.
Figure 3 shows how you can use the consolidation breakout method for
entering a good bye kiss trade. The price pulls back to our expected entry area and
then stalls. The price then moves above the high of the small consolidation (white
box), triggering a long position entry.
Figure 3. Upside Breakout in Expected Area
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4. Place stops and targets.
If you don't wait for the manual entry, and instead place an order just above
the old resistance level (upside breakout), or just below the old support level
(downside breakout), place a stop loss about 1/4 of the way into the old range. For
example, if the range is 100 pips wide, your stop is placed about 25 pips from the
breakout point.
If using the consolidation breakout or the engulfing pattern to enter a good
bye kiss trade, then you should already know where to place the stop (discussed in
those chapters). If buying, place a stop below the consolidation or engulfing
pattern low (1 pip below if day trading, 5 pips below if swing trading). If shorting,
place a stop loss above the consolidation or engulfing pattern (1 pip above plus the
spread if day trading, or 5 pips plus the spread if swing trading).
The overall target is roughly equal to the range distance (reduce it slightly).
If the range is 100 pips, look for a target between 75 and 100 pips above/below the
breakout point of the range. This often results in a 3 or 4 to 1 reward to risk. If
using this approach on a different type of chart pattern, calculate the profit target
based on that pattern, as discussed in Trading Chart Patterns, chapter 9.
If using a consolidation breakout or engulfing pattern entry you can also use
a fixed reward to risk ratio for your target. If going long, choose a fixed reward to
risk ratio which results in your target being placed just above the previous swing
high. If going short, choose a fixed reward to risk ratio which results in your target
being placed just below the previous swing low.
For this strategy we're using the same tools you learned before, but applying
them to a different trade setup.
Good-Bye Kiss Considerations
This strategy is most useful when a breakout has already occurred and you
want to get in. Don't chase the price, let it come to you when it re-tests the old
range/pattern.
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A potential pitfall is that the strategy can be subjective. How far the breakout
must travel depends on factors such as how big the range is, the time frame and
how much confirmation you want.
Entries can be manual or set in advance near the breakout point. I prefer the
manual approach as the stop, target and reward:risk can be fine-tuned when the
trade is taken. Also, with a manual entry (consolidation breakout or engulfing) the
price is already starting to move in the anticipated direction when we take the
trade.
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20. Always Weigh the Probabilities
This chapter is a break from strategy. There isn't much to learn, just a few
things to remind yourself of while trading.
As you've read through this book you've been exposed to trading strategies
and a number of different methods for attempting to extract a profit from the
market (and there are still more methods to learn). There's an endless number of
trades to take, and near infinite ways to plan and execute a trading plan. But when
it's all said and done, each trade must be looked at and the following determination
must be made: Are the odds in my favor?
A well executed trading plan should put the odds in your favor, but spotcheck your trades to make sure the market hasn't changed, and that the potential
reward from the trade outweighs the risk.
Assume for a moment you wish to trade a triangle breakout. The triangle has
formed inside of a larger range on a bigger time-frame. If a breakout from the
triangle occurs, the range's support and resistance levels are close at hand. This
may prevent the profit target from being hit, if it rests outside support or resistance.
How do you proceed? Assuming support/resistance will break just so our
target can be reached is wishful thinking. It may happen, but what's the probability
that it will happen? It's not like flipping a coin (I win or I lose) as many like to
believe. That's like saying the lottery gives you a 50% chance—I win or I lose.
In trading there are many variables, and there's no way to calculate or even
consider them all. This is why losing trades happen, and they also happen because
there's a completely random element to the markets.
So what do you do with that potential trade; take it or pass on it and look for
better opportunities? Consider the following example in the AUD/USD.
The daily chart shows an ascending triangle, highlighted by the box. The
profit target for this pattern, based on the method described in Trading Chart
Patterns (chapter 9), is 723 pips or a rate of 1.1113. If a breakout occurs to the
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upside we can see two recent swing highs in price right near the 1.07095 area (look
toward top of chart of the left). Since our breakout price is at 1.0390 this means
that significant resistance will occur before we're half way to our target.
AUD/USD – Daily Chart
The same occurs on a downside breakout. A longer-term trendline line
crosses just under the triangle, indicating potential immediate support.
How are questions like this handled? How likely is it our profit target will be
hit?
It's an important question to ask, and should be asked in order to avoid those
trades that make you smack your palm against your forehead. Yet, there are always
reasons not to take a trade. That's why we always try to make more on our winners
than we lose on our losers. In this way we can lose about half the time and still
make money; although if we're being selective with our trades and strategies then
our win rate should be higher than this. Even pushing our win rate from 54% to
56% over a great many trades makes a huge difference.
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A problem occurs when we're taking trades where there's almost no
possibility that our target will be hit. This is a common novice mistake. Consider
someone who plays the lottery. In defining a strategy they stipulate that they'll
gamble all their savings, $30,000, by buying lottery tickets. $30,000 is equivalent
to a stop loss, and they're willing to risk it because if they win they get
$1,000,000—the profit target. Based on pure numbers that's a fantastic risk/reward
ratio. If they win they'll make more than 33 times their money back. Yet logically
we know this isn't a good plan, as the odds of winning the $1,000,000 are
staggeringly high. So we stand a much greater chance of losing everything than
making any money...even though the risk/reward ratio theoretically is great. The
odds of losing are much higher than the odds of winning.
This is why I use rather small reward:risk ratios (1.5:1, 2:1, 3:1 etc) in my
trades. Under certain conditions a trade may end up with a much larger
reward:risk, but only if price action and the information within this book tells me
it's feasible. I would rather take a trade that has a good chance of hitting my target,
than place a much larger target which almost never gets hit.
Traders make this mistake all this time. They create outlandish profit targets
and expect, or simply want, the target to get hit. If the probability that a target is hit
is miniscule it doesn't matter what the risk/reward ratio is, because you'll always
lose and your capital will dry up long before a big score is made.
Profit targets must be feasible and probable. That doesn't mean we need to
make all sorts of calculations (because we can’t compute all the variables anyway)
but it does mean we need to look at the market realistically. If the price is going to
have to surge more than it has before, or “crash through the floor” to hit our target
we're going to end up disappointed more often than not.
Big moves do occur, yet it's better to use reasonable profit targets, and then
re-enter if the market is offering lots of opportunity. There's always another trade;
take profits when your realistic target is hit, as you can always re-enter to make
more when the time is right.
Based on this information, should the AUD/USD trade be taken? The
following is a small check-list you'll want to run through when you first start
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placing trades. Eventually these will become second nature, but at the beginning
it's a good idea to check your trading plan, and trades, for these criteria:
 Is the target based on reasonable criteria?
 Did any abnormal events occur on this timeframe that aren't likely to occur
again during the timeframe of my trade (such as a financial crisis,
earthquake, economic news announcement etc)? If so, have I adjusted for
this by basing my outlook on more “normal” market movements?
 Is my risk under 1%?
 Is my stop at a price that's reasonable and not just arbitrarily picked?
 Does it seem feasible, that based on normal market movements (such as
daily average pip movements) my target will be hit before my stop?
 If there's a time limit on this trade (for example, the target needs to be hit
before the US session ends), is it likely my target will be hit within that time
frame based on the usual volatility of the pair? (See Chapter 14 on Statistics)
Based on these criteria, I'll take the trade. It may lose money, or it may make
money—that's trading—but since the pattern seems reasonable and all the above
questions check out, the trade can be taken. Assuming my trading plan indicates I
can take the trade, and that the trade doesn't conflict with other strategies in my
trading plan.
Ultimately, you need to control risk, but you can't become gun-shy either.
When there's a good set up, as long as your stops and profit targets are reasonable,
take the trade. No matter what you do, you'll lose about half the time (maybe a bit
less or a bit more). Trade good set ups when they come along. Just be sure to keep
your risk on each trade to less than 1% of your total trading capital, and your
winners bigger than your losers.
What are Realistic and Reasonable Criteria?
With so much information being given and received by the market, traders
often fall into the trap of making things very complicated. The checklist is meant to
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keep things simple and reasonable. Avoiding impulsive trades keeps things much
simpler than constantly having to figure out how to get out of ill-thought-out
trades. Run through the checklist to see how reasonable a trade is. It only takes a
few seconds and keeps your trading simple. It may just slow you down enough to
stay out of the bad trade which isn't part of your trading plan.
Eventually you won't need this checklist because everything on the list will
become second nature. Later in the book there's a more advanced technical
checklist which you'll use while trading. For now though, read over the checklist
above several times so when you start trading you'll already be incorporating those
reminders into your trading.
Realistic and reasonable are subjective terms, and vary from trader to trader.
We each see the markets in a slightly (or vastly) different way, yet this book has
attempted to provide ways to trade based on how the market is actually moving,
and not on illusions or wishful thinking.
A realistic and probable trade takes everything into account that you've
learned so far. For example, you may see a great trade set-up, but if you have to
place the stop loss at such a distance that it exposes you to more than a 1% loss,
you can't take the trade. You may see a great trade setup, but the potential on the
trade isn't enough to warrant the risk—don't take the trade. You may see a day
trade setup but it occurs at a very dull time of the day where day trading isn't
recommended—don't take the trade.
Each trade is a microcosm of your ultimate success. If you're diligent about
your overall trading plan, and you're diligent in assessing each trade, then you'll
eventually succeed. If you take random trades and aren't focused on every single
trade you take, the failure at executing these details will result in an overall failure
of not making money. Be precise, weigh the probabilities on every trade (based on
what you've learned so far, and what you'll learn in the rest of the book), and
execute each trade according to your trading plan with awareness and focus.
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21. Anticipating Chart Pattern Breakout
Direction
When I originally addressed chart patterns in Chapter 9, I told you not to
anticipate the chart pattern breakout direction. Since you were just starting out your
forex journey that was good advice. If you've gotten to this point though you know
a lot more now than you did back then.
Trading chart pattern breakouts is one of the first strategies I learned when I
began trading nearly a decade ago. Always looking for ways to improve on trading
methods, anticipating chart pattern breakout direction—I call it “front-running”—
is an advanced technique for trading chart patterns.
The next chapter on Velocity and Magnitude will help you determine trend
strength, and assess whether you want to "front-run" breakouts. When the price is
moving with velocity and magnitude in a particular direction, the conditions are
more suitable to anticipate a breakout in that direction. Trends, trend channels and
support and resistance levels will also help you determine in which direction a
breakout is likely.
What is Front-Running a Chart Pattern Breakout?
While there are a number of chart patterns, there are only a few I consider
good front-running candidates: triangles, ranges, head and shoulders patterns and
consolidations. A flag or pennant is also fine, and for our purposes both these
patterns are considered consolidations. Through the examples below you’ll get a
good feel for how to trade triangles and head and shoulders in a traditional way, as
well as “front-running” the breakouts. You can then use this knowledge for trading
other chart patterns.
Instead of waiting for a breakout—which is the traditional approach for
trading chart patterns (and is still a good method)—if we're able to read the price
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action and come up with an expectation for the direction of the breakout, we can
greatly reduce risk and increase potential profit by getting a better entry price.
The method applies to all markets and time frames. I've included some stock
examples, once again showing that many strategies have universal application.
Anticipating a Chart Pattern Breakout
Figure 1 shows a triangle chart pattern in Apple (AAPL) stock, along with
the traditional way to trade it.
Figure 1. Traditional Way to Trade Triangle in Apple Stock, Daily Chart
Once the pattern is drawn, the traditional method requires waiting for a
breakout. In this case we enter when the price breaks below the lower band of the
triangle. A stop is placed just outside the opposite side of the triangle, and a target
is attained by taking the height of the triangle and subtracting it from the breakout
price (add it in the case of an upside breakout).
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This method is fine—it worked here—but we don’t always need to wait for
the breakout. Figure 2 shows another triangle in Apple. The stock was in an
uptrend, and the price was rallying aggressively prior to the triangle forming. We
can anticipate the trend will continue, and that the breakout of the triangle will be
to the upside.
Figure 2. Anticipating Chart Pattern Breakout Direction Strategy
Based on the prior rally, as soon as a support line can be drawn we have an
approximate entry area. Since we're anticipating an upside breakout, and the price
isn’t moving below support, we go long near the bottom of the triangle. Our stop is
placed just below the triangle–although give a bit of a room. Using this method we
get a better price than if we waited for the breakout.
Our risk is reduced, because the stop is in the same spot as using the
traditional method, and our profit potential has also increased because the target is
still based on the breakout point. Less risk more profit. Good combination. In
figure 2 the "front-running" entry price is about $10 better than the traditional
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breakout price. That's $10 less in risk, and $10 more in profit (per share). That's
huge.
Figure 3 shows a head and shoulders on a 1-minute EURUSD chart. Once
again there's a strong price run leading into the head and shoulders pattern. The
head and shoulders pattern is commonly considered a reversal pattern, but if you
look closely, you'll often see small head and shoulder patterns that act as
continuation patterns. Don't get trapped into conventional ways of thinking. The
market is dynamic; read the price action, and use the various entry, stop and target
methods outlined throughout this book to pounce on opportunities.
Figure 3. Anticipating Upside Breakout on Head and Shoulders Continuation
Pattern, 1-Minute Chart
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Given the prior move higher, the expectation is that the price will continue
to rally. Although, we can’t be sure. Once the right shoulder forms, and then makes
a higher low (truncated price swing), it’s an indication that our expectation is
correct. Following that higher low, we're looking for any opportunity to get long.
The price drops a little again than starts to move higher–that’s the entry
The entry is like the mini-channel entry discussed in chapter 17. Notice the
downward channel which ends with yet another higher low—more confirmation
we want to go long. The price then breaks above the top of the channel signaling
an entry.
A stop is placed below the lows of the head and shoulders pattern, or below
the recent low of the mini-channel. In this case, our entry is slightly better than
waiting for an actual breakout higher, reducing risk and increasing profit potential.
When trading a head and shoulders "continuation" pattern in this way, make
sure it hasn't actually signaled a top is in place. Had the price dropped below the
neckline or the second pullback of the pattern, this long trade would've been
avoided. In this case, the head and shoulders started to form, but never broke
lower. Instead, the price crept higher (higher lows)—this is why the long was taken
in this case.
Since this is a head and shoulders pattern, add the height of the pattern to the
breakout point to get a price target. In this case, our entry point and the breakout
point are different. Figure 3 shows the entry which occurs in the small rectangle.
The breakout point of this pattern would be slightly higher, when the price breaks
above a descending trendline connecting the top of the head to the top of the right
shoulder.
Another "pattern" front-running works well on is consolidations (could be a
small range, flag, pennant, or really any pause following a trending move). After a
strong trending move it's common to see the price “drift,” either sideways or
slightly against the trend with little movement. The price is wiggling back and
forth within a small area (relative to the trend) and most importantly the price isn’t
showing any aggressive movement against the trend to indicate the trend is over.
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The oval in Figure 4 marks a consolidation. The trend is up, and then the
price drifts sideways. In hindsight it's easy to spot the whole consolidation, but in
real-time you wouldn’t be able to tell the price is moving sideways until several
waves have formed and the price is no longer moving to the downside.
Figure 4. Good Consolidation for Front-Running – EURUSD 1 Minute Chart
The consolidation is less than half the size of the last thrust higher; if the
consolidation becomes bigger than this then it's not ideal for front-running. If the
price is moving sideways, but making big swings, it could be a reversal pattern
(double top or triple top), in which case the price is unlikely to break above the
consolidation and keep running higher.
Once you notice the consolidation, buy near the lows of the consolidation
(for an uptrend like in Figure 4 and 5) and then hold it until an upside breakout
actually occurs. Place a stop a bit below the consolidation. To establish a profit
target, like other patterns, add the height of the consolidation to the breakout price.
If the price ends up breaking lower, since you bought near the low of the
consolidation (in an uptrend) your stop loss is nearby and your risk is extremely
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small. On the other hand, if the price breaks higher, which often it will, you have
one of the best prices and will maximize your profit.
Figure 5. Front-Running Consolidations: Entry and Stop
If the trend is down, watch for a similar looking consolidation and enter a
short position near the top of the consolidation, expecting the price to trend lower
once the consolidation is over.
By front running chart patterns and consolidations, we get a much better
price, which means our risk is smaller and profit potential larger, when compared
to traditional chart pattern entries. By front running we can often make almost
double what we would trading the traditional way, and our risk is also a fraction of
the traditional way. With front-running, reward:risk ratios of 5:1 or even 10:1
aren't uncommon.
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Guidelines for Anticipating Chart Pattern Breakout
Direction
In order to anticipate chart pattern or consolidation breakout direction, there
needs to be a strong move prior to the formation of the pattern. We expect that the
breakout will occur in the direction of that prior move. As a general rule, I want to
see strong price movement prior to any chart pattern, whether I end up trading it
in a traditional way, or front-running it. Without a strong move prior to the pattern
there’s no evidence that traders care about the price, and therefore, breakouts are
more likely to fail or not reach the target(s).
For a front-running entry we want some confirmation of our expectation. In
the event of an upside breakout, we want to see the price hold above the support of
the pattern, as it did in the examples above. In the event of a downside breakout,
we want the price to hold below resistance of the pattern.
This sometimes means we won’t be able to front-run; the market simply
doesn’t give us the opportunity. Refer back to figure 1. By the time we can actually
draw the triangle (we need at least two price swings) the price breaks lower before
pulling back to the top of the triangle. Therefore, sometimes trading chart patterns
in the traditional way is the only option.
Pay attention to larger price structures. The price may be rallying higher in
the short-term, but the longer-term trend is down. The most likely breakout
direction isn't always the direction of the last price move. If the price rallied into a
resistance area, front-running a breakout lower may be a better trade than frontrunning a breakout higher. Consider the micro and macro price action when
deciding in which direction to front-run. The Crotch Strategy and Trend Channel
Strategy discussed later provide more details on times when you will expect the
breakout to occur in the opposite direction of the recent price wave.
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Anticipating Chart Pattern Breakout Direction – Final
Considerations
No matter what or how we trade, losing trades occur. While some may argue
that waiting for a breakout is safer, breakouts can fail and result in losses as well.
Anticipating the breakout direction reduces risk. Profit potential is also increased.
Learning how to read the market, and account for all sorts of other factors—such
as near-by major support and resistance levels, tendencies and short and long-term
trends—will take time.
If you find your expectations are wrong quite often, or you’re unable to
capitalize on the opportunities that come along, you’ll likely do better by waiting
for the actual breakout to occur. This is only a strategy, and like any strategy, must
be combined in your overall trading plan and practiced (a lot!) for it to be
successful. It’s your trading plan that'll help you determine which trades to take,
leave alone, front-run or trade in the traditional way.
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22. Interpreting Price Action: Velocity and
Magnitude
This chapter is what I call an "odds enhancer." You know a lot of strategies
now (and there are more to come), and many of those strategies provide guidelines
for when you should trade and when you shouldn't. This chapter, on two of the
crucial elements you should analyze when determining when and how to trade, will
help you with implementing those guidelines.
A trend following strategy has a better chance of success when the price is
moving with both velocity and magnitude in the direction of the trend. When
velocity and magnitude are both present in a trend, the odds the trend will continue
are improved. With greater insight into the trend, decisions become clearer, such as
deciding whether to front-run chart pattern breakouts.
Velocity and Magnitude: Why They’re Important
Every price wave within a trend can be judged based on velocity and
magnitude. Throughout the trend, assessments are made about the probability of
trades in regards to that trend.
If a trend is strong, based on velocity and magnitude, we know we want to
take the next valid trade signal (based on our trading plan) that'll get us into that
trend. If velocity and magnitude are weakening, the trend may be ending and the
next trade signal may be filtered out, or our expectation/target for the trade
lowered.
Analyzing Price Action: Magnitude
Magnitude, in regards to analyzing price action, refers to the length of price
waves, relative to other price waves of consequence. If the price runs for a long
way in one direction without a significant pullback, that run/wave has strong/large
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magnitude. During a trend we want to see waves of larger magnitude in the
trending direction (called "impulses").
Short waves have small or weak magnitude. The price isn't moving
aggressively. During a trend, pullbacks should have weak magnitude relative to the
impulse waves of the trend. When pullbacks become as strong as the impulse
waves, the trend is in jeopardy of reversing (or has already).
Figure 1. Analyzing Price Action using Magnitude: GBPYJPY 1 Minute Chart
Magnitude isn't measured in absolutes, it's always relative. Waves are
measured against recent waves, as well as the overall outlook. In figure 1 the trend
is down, as the impulse waves are larger than the smaller pullbacks. Toward the
middle of the chart there are some stronger pullbacks, relative to recent down
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waves. While this may deter us from taking a short position for a period of time,
looking at the overall outlook the pullback isn't big enough to rival the major down
waves.
Here are some basic guidelines for analyzing price action with magnitude:

The trend is confirmed by waves of large magnitude in the trending direction.

A reversal has begun, or a deeper pullback is underway, when a wave of large
magnitude (relative) occurs against the prior trend.

A trend may be losing momentum if small waves start to occur in the trending
direction. The trend isn’t over yet though, it's just weakening. It’s possible to
have several slow waves in the direction of the trend, only to be followed by
another strong wave renewing the strength of the trend—this is why we don’t
assume the trend is over just because there are small waves in the trending
direction.

Pullbacks of small magnitude, relative to the larger impulse waves of the trend,
confirm the trend.
Compare a pullback to other pullbacks, impulse waves and the overall trend.
Do the same for impulse waves; comparing them to other recent impulse waves,
recent pullbacks and the overall trend.
View another time frame as well. If trading off a 1-minute chart (figure 1),
view a 5 minute chart also. Doing so provides a broader perspective, and you may
notice some relative strengths or weaknesses in waves that you hadn’t noticed on
the shorter time frame chart.
Analyzing Price Action: Velocity
Velocity is how fast price covers distance. Use velocity in conjunction with
magnitude.
A very fast price move, that covers a significant distance (relative), shows
greater conviction than a move that progresses very slowly.
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Figure 2 shows the same chart as above, yet we can also use velocity to
analyze this chart in conjunction with magnitude. Moves down (trend direction)
aren't only larger than pullbacks, but they occur faster than the pullbacks—the
impulse waves down cover more distance in less time.
Having magnitude and velocity on the side of the market you're trading is
ideal (ie. taking short positions when strong velocity and magnitude are to the
downside).
Figure 2. Analyzing Price Action using Magnitude and Velocity: GBPYJPY 1
Minute Chart
Velocity is most applicable when combined with magnitude. A short burst of
velocity isn’t particularly important, since it could just be one or two big orders
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being filled in the market. A move of large magnitude which also has velocity
shows a lot of power and conviction, and may either confirm the trend (if in the
trending direction) or indicate a reversal (if moving against the trend).
Extremely large moves with substantial velocity (relative to recent price
action) usually indicate a news announcement or unusual event. In such cases,
technical analysis is generally useless, and it's recommended traders step aside
until valid signals based on more stable market conditions emerge.
Analyzing Price Action – How to Use This Information
Analyzing price action is the constant task of adjusting to new information.
Develop some guidelines or rules about velocity and magnitude in your
trading plan. While these concepts are relatively simple to understand in theory, I
consider them advanced trading techniques. Analyzing velocity and magnitude
requires strong focus to stay on top of changing market conditions.
Agreeing that something works is very different than actually being able to
use it in real time trading. Practice, practice, practice. Go through historical charts
and analyze velocity and magnitude and how it impacted the trend, as well as how
these factors could be used in conjunction with other strategies. Then proceed to
marking up charts in real-time, noting changes in velocity and magnitude, and how
those changes affect the price waves that follow. Note how velocity and magnitude
could be used to find and filter trading opportunities.
Velocity and magnitude are constantly in flux. Look at an overall picture of
what's occurring, as well as note details about each wave. This is the study of
current price waves relative to recent price waves. Even though studying velocity
and magnitude gives us an edge, there's still an element of uncertainty. Everything
can look great and you can still lose. By analyzing price action based velocity and
magnitude—and being able to effectively act on the information you interpret—
hopefully those losing trades will happen slightly less often.
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23. "Strong" Support and Resistance and
the Crotch Strategy
Support and resistance are words that get tossed around a lot, and traders and
analysts will mark up their charts with all sorts of supposed support and resistance
levels. Most of these levels have minimal impact on the price. Understanding what
a STRONG (important) support or resistance level is helps you isolate better
trading opportunities and avoid likely losers.
Minor (inaccurate) Support and Resistance
When most people mention support or resistance they're often looking at a
recent swing high or swing low on the chart. Do these highs and lows provide any
useful trading information at all?
In Figure 1, an indicator has been added to the chart which marks short-term
high and low points with red (resistance) and blue (support) lines.
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Figure 1. EUR/USD 1 Minute Chart
The first thing to realize is support and resistance levels, especially these
minor ones based on short-term highs and lows, are likely to be broken relatively
easily. During an uptrend we expect the recent highs to be broken as the price
moves to a higher high (definition of uptrend). During a downtrend we expect the
price to move below recent lows (definition of downtrend).
While minor highs and lows may provide trend confirmation (per above),
they do little to actually stop price from advancing or declining. Just because the
price recently stopped rising or falling at a certain point doesn't mean that point is
likely to stop the price from rising or falling in the future. For that we need more
stringent criteria.
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STRONG Support and Resistance
Certain levels are more likely to stop the price from rallying or falling—
these are called important or STRONG support and resistance levels.
While we expect these levels to also break at some point, they deserve more
respect.
Show these levels respect by:
 Not taking a short position when the price is right above STRONG support.
 Not taking a long position when the price is right below STRONG
resistance.
 Going long very close to STRONG support (crotch strategy, discussed
below).
 Going short very close to STRONG resistance (crotch strategy, discussed
below).
Those are a few of the trading guidelines I follow when trading around an
important support or resistance level.
Important/strong support and resistance levels are price regions that
changed the direction of the market in a significant way.
In figure 2, regions that caused reversals are marked on the chart with white
boxes.
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Figure 2. EURUSD 5 Minute Chart with Important Support and Resistance
As soon as the price significantly reverses direction the area is marked with
a box (or lines), such as those in figure 2. The box is extended out to the right until
broken (could be a very long or very short time). Learning to utilize this method
will take time and practice.
In order for a bounce off support to be important, the price must make at
least two higher swing lows and two higher swing highs (on whichever timeframe
is being traded). The move away from support shows the price reversed off the
level.
In order for a bounce off resistance to be important, the price must make at
least two lower swing lows and two lower swing highs (on whichever timeframe is
being traded). The move away from resistance shows the price reversed of the
level.
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This guideline is subjective though. In order for an area to be strong it must
reverse the price. Two waves in the opposite direction is just a rough guide. A very
big one wave reversal (relative to surrounding price waves) is also fine. Look at
figure 2. Each of those boxes changed the overall direction of the market...that's
what we're looking for, and what we want to mark on our charts. Don't get too
caught up in whether a reversal is one, two or three waves etc, just ask yourself if
the trend reversed off a level. If it did, the level is strong.
Moving from left to right on the chart, the price is moving higher and then
witnesses a significant drop. Since this area caused a significant reversal it's
marked on the chart (1). While there's no guarantee this area will stop the price
from rising in the future, it's quite possible the price will struggle to get through the
area.
After the sharp drop the price bounces aggressively and makes two higher
swing highs and two higher swing lows. The area that started that bounce is
marked as strong (2). The price then drops again—which you'll soon learn to use as
an entry point—and then bounces aggressively.
Before breaking through (1) the price moves lower and then rallies
aggressively off (3). Level (3) also proves important toward the left of the chart as
the price bounces off it again.
(4) marks where an aggressive rally died and reversed (at least two lower
swings highs and two lower swing lows). In the future, when the price approaches
this area, it should be treated with respect.
If a level is drawn and the price moves aggressively through it ("breaking"
it), it can be deleted as it's no longer relevant. Resistance marked (1) was broken by
an aggressive move higher; once that occurs it can be deleted. The exception is if
the strong levels are marking a chart pattern, such as a range. In that case you may
wish to leave the levels on the chart to remind you of the potential for a Good Bye
Kiss Trade (chapter 19).
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How big a support or resistance area is depends on the size of the crotch—
sounds bad, I know. The crotch is simply the bars/candlesticks which compose the
reversal point.
Figure 3. AUDCAD Daily Chart - Crotch Marking Strong Resistance Area
On the left the price is trending higher, but as it reaches the 1.02420 area it
stalls out and declines. We don't know this area is strong until we see the price fall,
making two lower swing lows and two lower swing highs. As soon as we see that
we can mark the area as strong with the two horizontal lines or a box.
The spacing of these horizontal lines—showing how big the strong
resistance area is—is determined by the "crotch" size which caused the reversal.
This area is highlighted blue. It doesn't need to be exact; you just need to
encompass the highs and lows of several candles which were present at the turning
point. Notice how the blue box encompasses the majority of the price action at the
turning point? The box determines the size of the resistance area (or support area in
the event the price was falling and then reversed higher). Sometimes this will be
multiple price bars, as in this example, other times it may only encompass one
price bar if the price very quickly reversed off the area.
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Since this area caused a trend reversal (two lower highs and two lower lows
on our time frame) when the price moves back to that area it's likely to struggle.
We can see this occurring when the price rallies back into the strong resistance
area in the following months.
This information presents both a trade filter for other strategies, and also
provides its own trading strategy (discussed below). As a filter it helps you avoid
taking short trades right above strong support, or taking long trades right below
strong resistance. We know that the price is likely to struggle to get through these
areas, therefore, buying near strong resistance or shorting near strong support isn't
a high probability trade.
Review of STRONG Support and Resistance
These types of levels deserve respect, so alter your trading around them.
Isolating strong support and resistance areas is much cleaner, and provides more
relevant information, than drawing tons of unimportant high and lows on the chart.
How big you draw the areas will depend on volatility and the timeframe you
are trading on. Every strong support or resistance area will be different based on
the "crotch" size that caused the reversal.
The Crotch Strategy
You now know where strong support and resistance areas are; next you need
to leverage that knowledge into a trading strategy. This strategy is simple, and
highly effective.
A nice thing about this strategy is that we can see strong support and
resistance areas before the price comes back to "test" them. That means we can set
our entry orders (along with stops and targets) near the strong support or resistance
area and forget about them. It's a non-time-consuming strategy.
The entry, stop loss and target rules are as follows:
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 Mark strong support or resistance levels on the chart with a rectangle. The
support/resistance area is as wide as the "crotch" which caused the reversal.
 For a strong resistance area, place an order to go short at the bottom of the
strong resistance area (bottom of the crotch). Place a stop loss 5 pips above
(plus the spread) the high of the strong resistance area. Place a target at 2x
the risk. If the entry point is 1.2150 and stop is at 1.2250 (100 pips of risk)
then the target is at 1.1950 (200 pips below entry point).
 For a strong support area, place an order to go long at the top of the strong
resistance area (top of crotch). Place a stop loss 5 pips below the low of the
strong support area. Place a target at 2x the risk.
 Once a strong resistance area has been established, and used for a short
entry, the price must make a lower major swing low in order for the
resistance area to be used again. For example, if you go short, and the price
hits your target but doesn't make a new major swing low, if the price rallies
back to the strong resistance area, don't enter another short trade at that area.
If the price does make a new major low, and then rallies back to the strong
resistance, you can use the same area and method described earlier to make a
second short trade at the strong resistance area. You can make a maximum
of 2 trades at a strong resistance level; avoid taking a third.
 Once a strong support has been established, and used for a long entry, the
price must make a higher major swing high in order for the support area to
be used again. For example if you go long, and the price hits your target but
doesn't make a new major swing high, if the price falls back to the strong
support area, don't enter another long trade at that area. If the price does
make a new major high, and then falls back to the strong support, you can
use the same area and method described earlier to make a second long trade
at the strong support area. You can make a maximum of 2 trades at a strong
support level; avoid taking a third.
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Figure 4. EURNZD Daily Chart - Crotch Strategy Entries and Stops
In figure 4, the price is trending higher then falls. The initial decline sees a
quick spike back into the strong resistance area. Since we hadn't had two lower
swing highs and two lower swing lows at this point, this wouldn't have been a trade
(the price hadn't fallen enough to even alert us that there's a strong resistance area
there). But we still must make note of it, because it was a "test" of the strong area,
even though we wouldn't have traded it.
The price then continues lower, creating the lower lows and lower highs
needed to confirm that this is indeed a strong resistance area which caused a
reversal. With this information we then set our short entry order at the bottom of
the crotch (red entry line) and our stop 5 pips, plus the spread, above the crotch
high (red stop loss line).
The price rallies into our order, but the price ultimately can't get through the
strong resistance area. The price falls, hitting our target (shown on chart below).
The price rallies again, but we don't put out any orders to go short again. The area
has already been tested twice (even though we only took one trade off of it), and
we don't assume a strong area will hold for more than two tests. It may, but all
strong areas eventually break, and by the third re-test the odds on the trade are
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reduced. When the price rallies to the strong resistance area a third time it blows
right through it...that's why we don't trade a third test of a strong area.
Figure 5. Crotch Strategy with Entry, Stop and Target
A 2:1 reward to risk ratio is used on this trade because that's what seems to
be the most effective ratio in my experience. The 2:1 ratio will usually get you out
of the trade before the price encounters another strong level. Don't take a trade if
your target is beyond another strong level.
Also, the 2:1 ratio gives us a profit, and if the price does continue to run,
then we can always use one of the trending strategies in this book to capitalize on
that. This strategy captures a bounce off strong support or resistance, warns us
when trends may halt (filters trades), but isn't meant to capture major trends. That's
what trend following strategies are for.
In Figure 5, our target is near a potential strong support area. Off to the left
there's an area that caused the price to reverse higher. So the target is in a good
spot; we still capitalize on the short position, yet we're respecting the fact there's a
potentially strong level near the target price. The price ultimately fell right through
this strong support area, but at the time of the trade we couldn't have known that
would happen.
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Usually there's a directional bias that tells you in which direction to trade.
When this snapshot of figure 5 was taken the pair was in an overall downtrend, so
going short at resistance is more logical than going long at support. Whenever
possible take trades that align you with the overall trend, if there is one. In this
case, only the short trade was taken at strong resistance, and no longs were taken at
strong support, yet you still need to respect that strong support area.
The Crotch Strategy and "Rangey" Pairs
Currency pairs can be split into two broad groups—those that contain the
USD, and those that don’t. As the world’s reserve currency the USD has a
tendency to trend, so pairs containing it also tend to trend. Even when a pair such
as the EUR/USD enters a ranging environment, that range is unlikely to last for
long. Time is better spent focusing on trends in USD pairs, than attempting to
profit from ranges which may occur. Trying to range trade a pair that has a strong
tendency to trend can be very frustrating.
Moving to the opposite spectrum, pairs that don't contain the USD are
generally more ranging in nature. This doesn't mean trends don't occur in such
pairs, they will, but often you'll see the trends are within the context of a larger
range, or the ranges will last a long time.
Ultimately you want to put yourself in the highest probability trades. That
means employing strategies in pairs which are more statistically suited to the
strategies you're using. The crotch strategy is ideally suited to "rangey" pairs.
Each currency pair has its own “personality.” Whether you're a swing trader
or a day trader, it's important to look at how a pair acts on multiple timeframes.
Even a day trader will benefit from seeing how a pair acts over a five or ten year
period. Why? The trader can see where the tendencies lie. One pair may range over
a 10 year period, but on a shorter time frame appears to trend. Another pair may
appear to range on a short-time frame but is actually a trending currency most of
the time.
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Ranges in Similar Economies
Range trades and ranging strategies are more likely to work out in currency
pairs that involve countries/economies that are similar.
Australia and Canada for example have similar commodity-based
economies. Pulling up a chart of the pair reveals that over the long term the
currency rate between these two countries is fluctuating in a range. Trends do
occur, but within a broader ranging context.
Figure 6. AUDCAD Monthly Chart
The EURGBP is another pair susceptible to ranging behaviour. Closely
linked economies mean the price of the currency pair will bounce around in a
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choppy range, until such a time as either the EUR or GBP moves into favor based
on fundamental conditions. A breakout and trend occurs, followed by another
generally long-term range.
Figure 7. EUR/GBP Daily Chart
If a trader can seamlessly move from a trending to ranging strategy, it won't
matter what pairs they trade. Yet this is what many traders find frustrating about
trading. They lose money when the market shifts, assuming what happened before,
whether it's a trend or a range, will continue. If you struggle with this, refer back to
the Trendlines, Horizontals and Shifting Markets chapter, which will help you to
identify when markets are shifting.
The "Crotch" trading strategy is especially effective in trading these types of
"rangey" pairs—in my experience the AUD/CAD and EUR/GBP have provided
some of the best trades using it.
The crotch strategy isn't as effective in trending pairs (trends that aren't
within the context of a range).
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For trending pairs use the trending strategies, although you may find
elements of the crotch strategy still useful in trend trading. Strong support and
resistance areas still exist in trending pairs, and should be respected.
Time of Day
Note: All times in EST (may need to adjust for day light savings)
While the EUR/GBP and AUD/CAD (as examples) are often ranging pairs
overall, intra-day this tendency may not always be apparent. Depending on the
time of the day the pair can be quite erractic, and at other times move more
rythemically within a range. From the chart below, which shows two days of price
action on a 5 minute chart (London session in yellow and US session in blue), you
can see that typically the pair is quite calm and range bound during the US session,
but can be more "trendy" or erratic during the early part of the London session
(subject to change).
One problem with the EUR/GBP is that typically these ranges that develop
in the latter part of the London session and the US session are only 7 to 10 pips
wide (subject to change). Unless you trade through an ECN broker with low
commissions and very tight spreads, trying to trade such a range isn't worth the
risk.
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Figure 8. EUR/GBP 5 Minute Chart
Another alternative is the AUD/CAD. It typically has a more ranging
environment throughout much of the 24 hour period, although I always
recommend trading when a major market is open. From the 15 minute chart below,
even when this pair is trending, the movement is typically choppy and confined to
channels. While that dynamic isn't present all the time, and may change for periods
of time, quite often this intra-day channeling can be found in the AUD/CAD which
works well for the crotch strategy.
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Figure 9. AUD/CAD 15 Minute Chart
Just because these pairs have more of a tendency to range, doesn't mean they
don't experience trends or sharp price changes—they do. Just probabilistically pairs
like these are more likely to experience ranging behaviour than a pair like the
EURUSD, for example. This is why pairs that move like the EURGBP and
AUDCAD typically work best with the Crotch strategy, and pairs that move like
the EURUSD work better with the trending strategies in the book.
Remember that pairs which include the USD have a higher probability of
trending, and pairs without the USD have a higher tendency to move in a more
ranging fashion. Also, countries that have similar economies are also more likely
to range (move between strong support and resistance). Unless something drastic
occurs which changes the dynamic between countries, the rate between the two
economies should stay within a band of activity reflecting the economic
correlation. The time of day is also very important to short-term traders. If day
trading the crotch strategy make sure there is enough movement to warrant taking a
trade.
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At the time of writing, pairs which favor the crotch trading strategy include
the EUR/GBP, AUDCAD, EURNZD, EURCHF, GBPCHF, AUDNZD, CHFJPY,
GBPCAD and NZDCHF. Some of the time the GBPNZD, EURJPY, AUDCHF,
GBPAUD and GBPJPY are also good for this strategy, but only if the price is
moving within the context of a larger range or channel. If there's a longer-term
direction bias, always favor trades that align with the directional bias.
Final Word on the Crotch Strategy
The crotch strategy requires an understanding of strong support and
resistance. A strong area is one which caused a significant price reversal. I've
loosely described a trend reversal as two waves in the opposite direction of the
prior trend. This is somewhat subjective since it's possible to get two waves
without the price really reversing, or you could get a big one wave reversal. This is
why you must practice this technique (and all other techniques in this book).
Combined with what you have learned about trends, and with a bit study, you'll be
able to apply this strategy quite effectively.
Be more stringent than lenient with this strategy. Look for major reversals
off price levels. The bigger the reversal, the stronger that level is, and the more
likely it's going to hold next time it's tested. Figure 10 below shows an example of
this. This is a "good look" for this strategy. When the chart looks like this, trade the
strategy without hesitation.
It'll be difficult to condition yourself to buy when the price is falling toward
you, or sell when the price is rallying into you, but when you see how effective this
strategy can be, those doubts should melt away. This is why you start out in a
demo account, so you can condition your mind without risking real capital. Until
you can effectively and consistently profit from this strategy in a demo account,
don't trade it with real capital. This also allows you time to compile your own list
of pairs which have the "rangey" movement we want for this strategy.
Another trade entry option is to let the price enter the support or resistance
zone, then wait for a consolidation and trade the breakout from the consolidation
(only if the breakout occurs in the anticipated direction). This entry method
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incorporates elements of other strategies you've learned so far. This alternative is a
fine approach, yet may result in missed trade signals since the price often spends
very little time in the support or resistance zone (see figure 10) and doesn't have
time to form a proper consolidation.
Figure 10. Big Reversals and Moves, Strong Level Still Holds
Don't become too attached to a strong level. Once it's been tested twice,
don't use it anymore. Even if you didn't end up trading the tests, they still count.
Once a level has been tested twice, the chances of that level breaking increase.
Once a level is broken, if another strong zone develops in that same area
again, we can use it for another two tests. Since we're using rangey pairs for this
strategy, strong support and resistance will often develop in similar areas as before.
The Crotch strategy is best used on the rangey pairs discussed in this
chapter, and isn't ideal for trending pairs even though some of the elements from
this strategy may help you with trading trends. Use the trend following strategies in
this book for trading trending pairs.
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24. The Trend Channel Trading Strategy
Earlier in the book mini-channels and corrections channels were discussed.
There are also trend channels. You'll find that markets move in trend channels
quite often.
The trend channel trading strategy isn't complex, yet it'll draw on all you've
learned so far and help you incorporate it. The simplicity of the strategy makes it
highly effective.
The key to a trend channel trade is isolating trend channels on the chart.
Each night, I go through 1-hour and 4-hour charts (occasionally daily charts as
well) of the pairs I trade and place trendlines wherever I can. This allows me to see
where channels are. Some of these may be correction channels, and others may be
trend channels.
A trend channel is when the bulk of the trend on your screen is represented
by angled parallel lines, either up or down. The trendlines don't need to perfectly
match the highs and lows in price, in fact, trying to draw trendlines this way is
discouraged.
Instead, the trendlines should be lines of best fit, running through the
majority of the highs on the top of the channel and the majority of the lows near
the bottom of the channel. The trendlines only act as a guide for—or an
approximation of—the channel.
In a downward trend channel, when the price is near the top of the trend
channel, be on high alert for shorting opportunities. In an upward trend channel,
when the price is near the low of the trend channel, be on high alert for buying
opportunities.
When the price is near the middle of the channel avoid trading.
If the trend channel is down, avoid going long, even at the bottom of the
channel. If the trend channel is up, avoid going short, even at the top of the
channel.
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The trend channels acts as an excellent filter, helping you stay out of the
market when probabilities don't favor a position. The trendlines also provide a
rough guide for when it's time to act.
You already know the basic entries for this strategy; it can be a number of
the entry methods already discussed in this book: engulfing pattern, consolidation
breakout, mini-channel breakout or even a correction channel breakout (if the
correction channel occurs within a larger trend channel).
The stop loss placement is also the same as most of the strategies addressed
so far. If day trading a downward trend channel, place the stop loss 1 pip (plus the
spread) above the recent high, which is near the top of the channel. If day trading
an upward trend channel, place the stop loss 1 pip below the recent low, which is
near the bottom of the trend channel. The same goes for swing trades, except the
stop is placed 5 pips away from the recent high (plus the spread) and low.
Targets vary based on the pattern, although typically 2:1 to 3:1 will end up
being used. The target is placed on the opposite side of the channel at the time the
trade is made. If the risk is very small and channel large, reward to risk ratios can
be up to 5:1 (or even slightly more), although most channels yield trades in the 2:1
region. This is not because we force that reward to risk ratio on the market, rather,
the price movements which indicate where to place our entries, stops and targets
yield this ratio.
Here are a few examples of potential entries in a rising trend channel. The
entries all occur near the lower trendline, and utilize engulfing patterns or
consolidation breakouts.
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Figure 1. Trend Channel Entries
It's quite possible that if you took the second trade, you wouldn't have taken
the third, since you'd still be in a trade. The price didn't reach the top of the channel
between the second and third trade, so the target wouldn't have been reached on the
second trade. It did reach it a short time later though.
Figure 2 shows the second trade in more detail. The stop loss goes below the
recent low. The entry occurs as the price crosses above the high of the recent
candle. The target is near the top of the channel—the top of the channel at the time
of entry that is.
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Figure 2. Trend Channel With Entry, Stop and Target
This trade resulted in a more than 3:1 reward to risk. Notice how the target
(thin blue box) is based on the high of the channel at the time of the trade. It isn't
altered as the channel progresses. Remember, we draw channel trendlines as rough
guidelines, not exact targets. If we keep adjusting the target to match the trendline
it may never get hit. Leave it where it is. If the trade provides 2:1 to 5:1 reward to
risk, that's more than sufficient. Greed usually results in ending up with nothing.
Remember Figure 3 below from the mini-channel and correction channel
chapter? It's the same chart, except now we can see the correction channel is within
an even larger trend channel.
The trend channel helps refine our entry. Where there were originally three
entry points using mini-channel and correction channel breakouts, by only taking a
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long trade near the lower trendline of the trend channel, we're left with only one
entry...the best one in this case.
Figure 3. Trading a Correction Channel Within a Trend Channel
The consolidation breakout works well for this trade, as the price forms a
consolidation above the lower trend channel trendline and above the lower
trendline of the correction channel. A stop is placed 5 pips below the consolidation
low once the trader is triggered (breakout above the consolidation) and a target is
placed at the top of the trend channel. The top of the channel at the time of the
trade, that is. This trade resulted in a more than 3:1 reward to risk.
Another nice thing about trading with trend channels is that they'll usually
let you know when the overall trend is over. Look at the chart above. We assumed
that the overall uptrend would remain in place, that's why we look for a long
position in the corrective channel near the bottom of the longer-term trend channel.
What if the price broke lower, instead of higher? That would alert us that the trend
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channel either needs to be adjusted, or it very well could be broken and no longer
relevant.
If the corrective channel just keeps dropping, in this case, below the trend
channel, a new trend has likely emerged (down) or at minimum the trend is in
question and we should step back and avoid trading.
Trend Channel Trading Strategy Summary
This strategy combines many prior elements you've learnt about, and
combines them. Using trend channels is a great way to eliminate a lot of confusion
from trading, as it simplifies the process. Once a large trend channel has been
found, only take long trades near the lower trendline if the trend channel is up, and
only take short trades near the upper trendline if the channel is down.
Use other techniques you've already learnt: place stops in the same place
we've used for a number of strategies, and targets go on the opposite side of the
channel at the time of the trade.
The reward to risk on this trade should be at least 2:1, and typically that isn't
difficult to attain if the entry is executed effectively and the stop placed in the
proper location.
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25. Psychological Pitfalls You Need to
Understand
People can spend their entire life looking for something, not realizing the
answer was looking back at them every morning in the mirror. All the work put in
to understanding the market won't matter if you don’t understand yourself.
Approaching trading with the right psychology is paramount to your success. Each
trader must take a personal inventory and find a way to accommodate their
personality, tendencies and habits and make it all fit with their trading.
What follows are some key points on trading psychology. Psychology plays
a huge role in trading success. You can have the best strategies in the world, but if
you get fearful in trades, greedy, hopeful or angry, you're going to deviate from
that strategy and it'll cost you.
A great trading psychology book is Trading in the Zone by Mark Douglas
(listed in the resources section at the end of the book). It covers more advanced
psychological topics, and is a recommended read once you've been trading with
real capital for several months. Trading real capital should be at least several
months away if following the five step plan laid out at the beginning of the book,
so you have time to absorb the content in this book before reading that one.
Articles on specific trading psychology issues—such as trading not to lose,
loss aversion, biological factors, trading anxiety, availability bias, building the
right mindset, etc—can be found at:
http://vantagepointtrading.com/tutorials/trading-tutorials-trading-psychologyarticles
How Not Losing Keeps You From Winning
Losing is inseparable from trading. Losses do occur, and trying to avoid
losses leads to ruin. Whether you're a day or swing trader, not accepting losses is a
recipe for disaster. Great traders know losses occur, but they plan for losses and
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have an exit strategy. This exit plan is critical, and failing to have one is where
most traders end up going wrong in their trading careers.

Avoiding Losses
Humans have a tendency to avoid loss. In terms of trading this often results
in a delayed reaction to realizing a loss. Losses are allowed to "fester" and the
trader shifts into “hope” mode. The “hope” mode results from the trader wanting to
get back to breakeven on the losing trade. If you find yourself in this mode, where
you're praying just to get back to breakeven, it's already too late. Get out now. At
best you'll only breakeven, but you could lose your entire account trying to do so.
It also shows a trading plan wasn't implemented or followed.
In Beyond Greed and Fear, Hersh Shefrin discusses a study where people
generally view a loss as having 2.5 times the impact of a gain of similar magnitude.
In other words, a $1000 gain is one thing, but a $1000 loss in psychological terms
feels more like a $2500 loss. Being wrong has an impact on the ego, not to
mention, losing money means we have to forgo an opportunity to use it for
something else. Profit is money you didn’t have any way, but money you lose is
money you already had and no longer have. This stings, and is a psychological
reason why traders don’t want to realize their losses when they should.
Admit right now that losing is part of the game. Even if you become a great
trader you'll probably lose 40% to 50% of the time. That's just trading. Plan now
how you'll handle your losses, so you aren't faced with a "hope" situation.
By following the five step plan laid out at the beginning of the book, you'll
see that by making and following a trading plan even when you lose 50% of the
time you can still make money.
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
Losing Means Winning?
Successful traders don’t let losses get out of hand. They're not afraid to take
a loss, and in fact they'll likely realize many losing trades because they have a low
tolerance for trades that don’t react or move how they expect (more on this in
upcoming chapters).
In this way, taking losses actually means a trader is more likely to be
profitable. “Realizing” a loss simply means the trader closes out the position and
the loss (or profit) is booked in the account. Not realizing a loss or profit means the
position remains open and is susceptible to further movement.
If a trader exits when they're supposed to, it shows the currency didn't react
how they anticipated and there was no reason to remain in the position. A trader
who allows losses to mount is no longer in control of their trading, they've entered
a gambling mentality. The market has shown them they're wrong but they're not
listening to the warnings. There are psychological reasons why this occurs, but
regardless of the reasons, not accepting a loss and letting it mount will most
certainly result in frustration and a lack of profits over the long run.
Don't change your strategy mid-trade in an attempt to avoid a loss. I use
many strategies that are only accurate a little more than 50% of the time. That
means I KNOW I will lose about 50% of my trades with it, and that has to be okay;
my profits are bigger than my losses so over a number of trades I'll still make a
consistent profit.
A Psychological Trick
Those who are struggling with their trading often have a hard time admitting
that they're to blame...."It's the markets fault!” There are endless excuses for why
losing trades occur, but ultimately the blame lies with the person executing the
trades. The faster you accept this the quicker you'll learn to minimize losses, and
the more profitable trades you'll likely participate in.
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This is where a psychological trick comes in. Not only are losing trades
losing you money, but the longer you hold onto those trades (and tie up capital) the
more opportunities you give up to get into profitable trades. Thus losing trades deal
you a double blow, and should be realized as quickly as possible so you can move
onto other opportunities. Realize losses quickly by laying out in your trading plan
how you'll exit losing trades, and then stick to that plan.
Stock brokers, are often taught not to tell their clients to “Exit that losing
position.” Rather, the broker is taught to tell their client something like “We need
to transfer your funds into something which has more opportunity.” Avoiding the
“loss” discussion and instead using words like “transfer” and "opportunity" makes
closing out an unprofitable trade much more palatable.
You want to be in the best opportunity trades, and a trade that keeps going
against you (losing) isn't a best opportunity trade.
Just as a stock broker may convince a client to get out of a losing trade by
changing their language, individual traders should also do this. Try not to think in
terms of winning and losing on trades, because both will occur regardless of belief
or trading system. Avoid win/loss thinking; instead, as a trader your job is to
continually transfer money from one opportunity to the next....and to execute your
trading plan to the letter.
This doesn't mean someone has to continually be trading (referred to as
"over-trading"). It simply means that any time a trade is made you know when and
how you'll exit. When a losing situation develops, the loss is booked and you can
focus on moving funds into other opportunities. This transfer is what matters,
getting out of a trade simply allows that transfer of capital to occur.
Losing trades not only strip you of capital, but if a trade is held longer than
needed other opportunities may be missed. Ultimately it's your responsibility to be
in control of how you take profits and control risk. You can benefit by not thinking
in terms of losses or profits, but rather in terms of “transferring” funds from one
opportunity to another....and by viewing success as following your trading plan. If
you think this way, consistent profits are more likely to be generated.
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Wanting to Be First In and Last Out
You may feel that in order to make money you must be the first one into a
move, and the last one out. In other words, you want to pick the exact top and
bottom. Don't attempt this; it's a suckers bet. When you try to be one of the first
people into a move, normally there's very little evidence to confirm the trend
reversal. Basing trades on little evidence, or a whim, is simply gambling, and good
traders don't gamble. Instead, they take trades based on evidence and probabilities.
Normally, capturing the bulk—or even a chunk—of a move will provide
ample profit. There's no need to be first in. Be patient and wait for good trades.
Wait for them to develop, instead of jumping the gun and assuming the market will
turn right when you expect it to.
Exits are no different. Many people like to try to scrape every last bit of
profit out of a trade. In doing so, they normally get greedy and end up giving all
the profits back because they wait too long to get out. Take your profits according
to your trading plan. You won't get the exact top or bottom, so aim for capturing
the bulk of the profit from the move (use the reward:risk ratios discussed). Besides,
you don't need to make all your profit on one trade; there are countless other trades
to profit from as well. If a trend is really moving, book your profit and then look
for another entry.
Protecting the Ego
Throughout life we do many things to protect our egos. One of the main
things we do is fight for the idea that we're “right,” or that someone else is
“wrong.” Right and wrong have no place in trading; simply watch price movement,
as it's the only thing that matters. If a currency plummets and you think it should
go up, being “right” will bring you nothing but an empty trading account.
When trading, forget about concepts such as right or wrong. By focusing on
price (and not your ego) you'll pay attention to what the market is saying. You'll
identify and accept potential winning and losing trades. The markets aren't
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personal. The price doesn't care what you think, nor what your entry price or stop
level is. Don't become emotionally invested in your trades. As soon as you do, you
lose your perspective and you'll likely deviate from your plan.
Just as you can't let the ego creep in while you're losing, you can't let it creep
in while you're winning. Traders often experience a bad week or month of trading
after setting a new best day, or hitting a lofty goal. They become arrogant and
begin to deviate from their plan. They assume they have “trading invincibility,” but
forget what it was that actually got them to that point: following their plan!
Conditions in the market change and the successful trader must navigate
these constantly shifting waters, both physically and mentally. After a string of
losing or winning trades don't get trapped into thinking you'll always be right, or
always be wrong. Rather, simply trade according to your plan, and ego never even
enters into it.
On and Off Discipline
Discipline can't be something you turn off and on; you must be disciplined
every time you sit down in front of your trading screen(s). One slip up in your
trading can cost more than you ever bargained for. At all times you must be
vigilant and every trade must be thought of as a business decision. Successful
traders are disciplined and stick to their trading plan. They shun any trading
behaviour that isn't disciplined, such as trading at times that are unlikely to be
profitable, or taking a trade which isn't outlined in their trading plan.
Lack of discipline in other areas of life is tolerable in small doses, in trading
it isn't. In trading the full consequence of lacking discipline can be experienced
immediately and fully. While someone on a diet can occasionally lack discipline
(“cheat”) and not notice a difference (if it's infrequent), the trader can witness the
full brunt of his lack of discipline very quickly in the form of a massive loss.
Probabilities dictate that even making undisciplined decisions will work out
sometimes, but in the long-run—like the dieter who constantly cheats—the full
consequence of this lack of discipline becomes evident.
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If you struggle with discipline that doesn't mean you can't be a good trader,
but you'll have to plan for your weaknesses. Keep detailed notes of your trades. At
the end of the day analyze what you did, and write down your mistakes. Mistakes
never have to do with making or losing money; mistakes are when you don't do
what we were supposed to, or did something we weren't supposed to do. This
exercise may be enough for some people; others may need even more discipline. If
so, get yourself a trading referee.
A trading referee is someone you trust who questions you on whether you're
following your plan. Have them check in on you (periodically or regularly), or
submit your trading journals to them. Take screenshots of the days you trade, and
tell them exactly why you did or didn't take certain trades. This person may be
another trader, just a friend or a partner. This person is there to make you feel more
accountable for what you're doing.
At trading firms, risk managers and other traders are always watching out for
each other. Most stay-at-home traders don't have that luxury, so re-create it. Find a
way to make yourself accountable to trading the way you are supposed to (your
trading plan).
Don’t be Arrogant. Develop Confidence and Selfcontrol
Don't mistake confidence for an arrogant “I'm right!” attitude. Confidence
comes from doing something difficult in spite of that difficulty, pushing through
and sticking to your plan. By making a trading plan and sticking to it, you'll
develop confidence and self-control. Confidence and self-control allow you to pull
the trigger on a trade when you need to, and hold back when the signals don’t
quite line up.
Master traders make a plan and stick to it. This is how they make it look
easy and effortless. Don't be fooled though into thinking it is easy and you can do
whatever you want when you trade. This easy confidence and self-control comes
from discipline and practice, and exercising these traits relentlessly.
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Losing Objectivity
It's very easy to get distracted or caught up in the emotion of a trade.
Successful traders find the discipline and mental focus to stay objective and not be
swayed by their emotions. Find a healthy, constructive and positive way to deal
with any emotions which could negatively impact your trading or reduce your
objectivity. Take small breaks, go for a walk, exit a trade if you feel you can’t
execute your plan, or don't trade at all if you're feeling particularity emotional
(angry, fearful, agitated, nervous, etc) that day.
One exercise very helpful for keeping emotions at bay, and staying focused
on pertinent market movements, is to talk to yourself while you trade. Say out
loud what's happening with the price action, and how it relates to your trading
plan. The "checklist for while you're trading" provided later in the book gives you
a list of things to watch for and focus on. Keeping your attention on what
matters—price movement—and off of your emotions is a crucial skill to learn.
The “All In” Mentality/Revenge
Anyone serious about making money from the markets over the long run
must avoid the “all in mentality” and “revenge trading.” It may work once, but it's
an impossible strategy to win with over the long run.
Imagine entering a casino with $100. You play for a bit and get up to $150,
but then you start to lose. Soon you're down to $50. You're upset that you didn't
walk away with the $150 and now you only have $50 and it'll take a long time to
get back to $150. What do you do? If you have a revenge/all in mentality you
throw down the $50 and say "All I need to do is win a couple of times and I will be
back to where I was." You gamble everything, in an attempt to gain quickly.
Additionally, you may tell yourself "I will walk away if I get back to $150." But in
trading you don't just walk away. There's always another trade. If you start going
all in (revenge trading) eventually you WILL lose everything.
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This is losing behavior. Say you do win the money back, and you leave.
Next time you go to the casino you'll do the same thing, and the next time. Before
you know it, everything is gone. When you continually risk everything, eventually
you'll lose everything. Don’t put it all on the line on one trade, or even several
trades. The maximum risk on a signal trade is 1% of account equity.
Don't abandon your trading plan, or lose your discipline. The times when
you want to get revenge on the market are the times you must fight these urges the
most. By not yielding to it you strengthen your discipline, hone your mind and
create a true trader mentality.
The worst thing is that often these tendencies come up when we're already
down or on a losing streak, hitting you right when you're already at your breaking
point. Stay disciplined and realize profits are accumulated over many trades, and
several losses (even in a row) are inconsequential if proper money management
rules are used. If you're mad, get away from your trading screen. Drink some
water, take a walk or even take the day off.
Random Reinforcement
I introduced the topic of random reinforcement in an Investopedia article
entitled Random Reinforcement: Why Most Traders Fail. Random Reinforcement
is a term used in psychology, but I've adapted the ideas of random reinforcement to
trading, providing the following definitions:
Random Reinforcement: Using arbitrary events to qualify (or disqualify) a
hypothesis or idea; attributing skill or lack of skill to an outcome which
is unsystematic in nature; finding support for positive or negative behaviors
from outcomes which are inconsistent in nature - like the financial markets.
That may sound rather complex, yet the idea is simple. Assume you like one
of the strategies mentioned in this book. You see a trade setup based on the
information provided for the strategy and you make a trade—you lose money. You
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tell yourself the strategy sucks and you go buy another book...repeating the same
process over and over again.
You're succumbing to random reinforcement; you're forming an opinion that
a strategy doesn't work simply because it failed you on a few occasions. In other
words, you're basing your opinion on a very limited data sample and therefore the
opinion has no substantial evidence backing it up.
Another scenario may occur. You try out a strategy and the money starts
piling in. You have several winners in a row and you feel on top of the world.
You're a fantastic trader! This too is random reinforcement. You may actually be
doing the wrong thing, and for a short time you get rewarded for it because
randomness allows for even someone with no skill to have a winning streak.
Randomness is present everywhere. You can have a long winning streak
with almost no skill whatsoever, and you can have a long losing streak with great
skill and an abundance of market knowledge and experience. If your strategy is
sound, stick to it; even the best systems have losers, and even horrible trading
habits can produce strings of profitable trades.
Random reinforcement is a tricky trap and as the title of my article states, I
do believe it's one of the main reasons traders fail. Judging a strategy or your
trading skill based on very little data is a dangerous game to play, whether you're
losing or winning.
This is the why the five step plan outlined at the beginning of the book must
be followed. It assures you're consistently successful with a strategy before you
start trading it with real capital. You'll also have a large number of trades recorded,
so you know how that strategy performs.
Continually changing methods based on short-term results is a sure way to
join the ranks of the massive group of traders that lose everything. If you only risk
1% (or less) of your account per trade, even if you lose 10 trades in a row you'll
still have most of your capital intact.
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26. Active Trade Management
So far you've been presented with strategies that give you entry, stop loss
and profit points. Whether it was stated or not, the inference was that once you take
a trade you either let it hit your stop or your target. In other words, once you've
placed the trade based on your strategy, you leave it alone and go look for other
trades. Your trade will eventually hit your stop or target. This is a good option, and
this is how you should trade when you're starting out.
As you progress though, and your chart reading skills get better, you'll be
able to interpret when your stop is likely to get hit. For example, your trade is
onside (making money), but you can see a trend reversal is taking shape. Do you
have to let the trade go all the way against you and stop you out for a losing trade?
No, you don't have to let big winning trades turn into losing trades.
Intervening in a trade once you've initiated it is called active management. It
allows you to take profits, increase profit targets or cut losses by adapting to new
information which may come available.
Active management isn't required, but if done correctly will improve overall
profitability. Active management doesn't give you the right to throw your trading
plan out the window. On the contrary, active management requires you to make
your trading plan more extensive, as you'll now need to add an Active
Management section to it.
How and under what conditions are you allowed to move stops closer to the
entry price (reducing risk), or when can you take profits before your target is
reached? This is a personal decision, yet I suggest implementing a few simple to
follow guidelines in your trading plan.
For example, if you are long the EURUSD at 1.3550 and your target price is
1.3650, you have a 100 pip target. A simple guideline would be if the price is more
than half way to the target (you're 50+ pips to good on the trade), drop down 1 time
frame on your chart. If you took a trade based on your 4-hour chart, drop to a 1hour chart. Once on the 1-hour chart reduce your stop to 5 pips below the most
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recent low or consolidation. Sometimes this results in locking in a profit (stop loss
above entry price) and other times it will simply reduce the risk on the trade (stop
still below entry).
If you're in a short trade, and the price is more than 50% of the way to target,
drop down a time frame and move the stop loss to 5 pips (plus the spread) above
any newly formed swing high or consolidation.
Do the same for a day trade. If a trade was generated on the 5-minute chart,
drop down to a 1-minute chart once the trade is 50% of the way to the target. Place
the stop 1 pip below a recent low if long, or 1 pip (plus the spread) above a recent
high if short. If already trading on a 1 minute chart, then go through the same
process, but without dropping down a time frame.
If the price is more than half way to your target there's no reason to take a
full loss on the trade. That trade moved as anticipated, so just because it didn't
reach our target doesn't mean we need to take a full 1% hit (or whatever our
original risk was on the trade). Risk should be reduced if the price is more than half
way to the target (move stop closer to entry point, according to methods described
above and below).
If the price is 75% of the way to target (target is 100 pips and you're 75 pips
onside) on a short trade, draw a trendline on the declining price action. Move the
stop loss to 5 pips (plus the spread) above the trendline and continue to trail the
stop down with the trendline until you're stopped out (price breaks the trendline),
or the target is reached. If you can't draw a trendline, continue to move the stop 5
pips (plus the spread) above the high of the most recently completed price bar.
If the price is 75% of the way to the target on a long trade, draw a trendline
on the rising price action. Place a stop loss 5 pips below the trendline and continue
to trail the stop up with the trendline until you're stopped out, or the target is
reached. If you can't draw a trendline, continue to move the stop 5 pips below the
low of the most recently completed price bar.
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Once a trade is 75% of the way to the target we put a strangle hold on the
position. The stop moves closer to the current price while the price gets closer to
our target. It's emotionally rattling when the market misses your target by one or
two pips, and then reverses course stopping you out for a loss. By actively
managing positions in this way that situation is avoided.
As the price approaches your target your stop loss works to lock in profit, so
even if the price reverses you still make a profit on the trade. Also, since that stop
is moving closer to the target price, if the price is moving very strongly in your
favor you can keep edging your profit target up. Eventually your stop will be
where your original target was, locking in the originally anticipated gain.
Here's my rule for expanding my profit target and trying to squeeze a bit
more profit out of a trade. I only move it once the price is very close to the original
target. For day trading I want the price to be within about 2 to 3 pips and for swing
trades within about 6 or 7 pips. My stop needs to be protecting at least 90% of the
gain. That means the price must really be moving and be expected to blow through
my profit target if I'm going to adjust it. Re-read the chapter on velocity and
magnitude (chapter 22) if you're not sure what strong momentum looks like.
I keep adjusting my target about 3 or 4 pips higher on day trades, and about
10 pips higher on swing trades (may vary slightly base on pair-specific volatility). I
continue to do this until either my stop is hit, which is continually being moved as
well (based on methods discussed earlier) or a price spike hits the target. As long
as the price is ticking in our favor we hold the trade, but if at any point it starts to
go back against us by about 3 pips on a day trade or about 7 pips on a swing trade,
we exit. When expanding the profit target we become very active traders, trying to
squeeze a few more pips out of our trade as it runs in our direction.
An alternative to extending the target in this very active style is to just make
one alteration. If you're long via the trend channel strategy and the price is surging
toward your profit target, move it up slightly to allow for a bit more profit. How
much you move it depends on the trend channel. For this strategy we placed our
target based on the top of the channel at the time of the trade. Since the trend
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channel is sloping, you can adjust the target to where the top of the channel is
currently. Make sure your stop locks in at least 75% of the original profit target
though. Trail the stop behind recently completed bars, or use the short-term
trendline approach.
For a day trader, managing trades is fairly straightforward since they're
sitting in front of their screens while their trades are on. For a swing trader
managing trades may be a bit more difficult to do consistently. If you're trading off
a 4-hour chart though, price swings take time to develop. Therefore, you can
simply manage trades during your allotted time for swing trading each day. Ideally
this is after the U.S. session and before the London session, when the market is
quieter and you can reduce risk on trades that have moved in your favor. If the
price is close to your target during this time, analyze the situation and assess
whether moving your profit target is worthwhile. If you choose to expand your
profit target, use trendlines and support and resistance levels as a guide on where to
put it. Then, if you do opt to expand the profit target, make sure your stop loss is
locking in at least 75% of the profit target.
Decide if you're going to actively manage trades. If you can't do it all the
time, then don't do it any of the time. Choose the set-and-forget approach for all
your trades or choose to actively manage all your trades, don't switch back and
forth.
Add a section into your trading which addresses precisely how you'll
actively manage trades. You may wish to use the guidelines above, or develop your
own. I use the guidelines above but I'm not a stickler for the exact percentage. If
the trade is about half way to my target I reduce my risk, it doesn't have to be
exactly 50%.
My basic rule of thumb is this: if I am long/short and a trade is showing me a
profit, I'll drop down one time frame and seek to reduce my risk by moving my
stop to just below/above a recent swing low/high that formed. I continue to move
my stop below/above recent swing lows/highs until either I'm stopped out or my
target is hit. Adjusting my target is a rare occurrence.
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I have one other active management trading method which I share a bit later
in False Breakouts - A GIFT to Active Traders (chapter 30). It's a more advanced
technique and won't suit all traders, so I've opted to cover it separately.
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27. How to Incorporate All This
Information
There's been a lot of information provided in this book, possibly too much.
The human mind loves the idea of having choices, but often becomes paralyzed by
too much information and too many choices. It's called the paradox of choice.
If you're a new trader you may be facing this problem now. You have lots of
information, and while the strategies are defined, you realize you can't incorporate
them all (and some strategies actually conflict, which I'll explain in a moment) and
so you may be wondering what to do next.
Here, once again, are the 5 steps to start incorporating what you've learned.
1. Pick one or two strategies that you like or that you think you can implement
effectively, based on reading this entire book.
2. Write a trading plan for how you'll trade these strategies. Define the strategy
in your own words. How does the market have to behave in order for you to
take the trade signals the strategy provides? When won't you take trade
signals? What's your maximum percentage risk on each trade (1%, or less)?
By reading the whole book you should have a good idea how to answer
these questions, even though you're only going to use one or two strategies
for now.
3. Practice trading the one or two strategies in a demo account, according to
your trading plan. Don't deviate. If you make a trade that isn't based on your
strategies then your profit/loss will be inaccurate. Your only goal in the
demo account is to consistently implement those one or two strategies. That
is it. Profits don't matter at this point.
4. Practice a strategy for at least a month in your demo account. After the one
month period, if you notice a few small changes could be made to the
trading plan, write them down as new guidelines, and proceed to practice
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implementing the strategy in the new way. Practice implementing this new
method for another month.
5. If you're seeing a profit in the demo account, then you can consider opening
a live account, but only trade those strategies you've been practicing.
Don't attempt to incorporate more strategies until you're profitable in live
trading with the one or two strategies you're already using. If you can't handle one
or two, trying to juggle more strategies isn't going to help. If and when you're able
to add new strategies to your trading plan, go through the same process as above—
practice the new strategies in a demo account until they show you a consistent
profit. Only then is the new strategy used in your live trading account.
We're all a bit different and "see" things a bit differently. When you read
about some of these strategies it may have been like a light bulb went off in your
head, and when you look at your charts you can see the strategy playing out, it
makes sense to you. Other strategies may seem awkward to you, hard to implement
and you just don't see it happening when you look at your charts.
That's fine. You don't want to incorporate all these strategies at the same
time. But maybe you take pieces you like, and incorporate it into you trading plan
for another strategy.
For example, in the next chapter I discuss how you can incorporate two of
my favorite strategies into a swing trading plan. It provides an example of how you
can combine elements and strategies into a cohesive plan that makes sense, and
that works.
No matter which strategies you choose, if you read the book carefully you
may realize that certain strategies conflict with one another. As an example:
assume a downward trend channel. Based on the strategy we are waiting for a rise
to near the top of the channel and then a consolidation. If the rise happened
quickly, this could very well look like a flag/pennant formation. The targets for this
pattern are different than what we use for the trend channel strategy.
The trend channel strategy is based on a larger price structure and more price
information than just the flag/pennant pattern. If you decide on a particular
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strategy, don't be swayed by other strategies in the book. Don't allow yourself to
become overloaded. Just focus on your one or two strategies, work on finding the
setups and then implementing the strategy.
Take small steps and practice a strategy before using it with real capital.
Practice is rarely talked about in trading, yet it is a critical. A high school
basketball player and an NBA player both know the mechanics of taking a shot, so
why is the pro a pro if they both have the same information? Practice! Information
isn't the key to success, practice is.
In hindsight it looks easy to spot a trade signal, and tell yourself you
would've traded it. Seeing a trade signal in real time, and having the reflexes and
guts to act on it, is entirely different.
Trading is tough; practice is the only thing that results in improvement. Start
practicing in a demo account, just one or two strategies. Refine your approach with
those, and when you're consistently profitable make the transition to a live account.
From my experience, and the experience of hundreds of other traders I know
and work with, it'll take at least 6 months until you start to see some consistent
trading profits in your live account. Several months will be spent building your
trading plan and practicing implementation in your demo account. Upon switching
to a live account it'll likely be another few months before you develop consistency.
Expect about a six month to one year time span between when you start this
journey, as defined above, and when you start to generate some income.
How much income you generate will depend on how many trades you make,
how you're implementing the strategy (affecting reward-to-risk ratio and win rate)
and how much capital you started with.
Many traders become discouraged several months into their journey, quitting
just before they're about to have a breakthrough. Don't be one of those people.
Follow the process described in this book; starting with practicing in a demo
account so you don't diminish your real capital during the learning phase. Then
when you switch to a live account, risk 1% of your capital or less on each trade.
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That way even if you have a losing streak as you're get used to trading with a real
account, it won't significantly drawdown your capital.
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28. Bringing Everything Together into
Your First Trading Plan
A trading plan is a personal thing. I know guys who have a stack of paper
representing their trading plan, and others, who have several bullet points on a
page. Like a "while you are trading checklist" (next chapter) your trading plan can
eventually be reduced to several bullet points, but when first writing it down, make
sure to explain (to yourself, for later reference) exactly what you mean by those
bullet points.
Below is a sample trading plan, and is basically what I use most of the time
when I'm swing trading. My two preferred strategies are the "crotch" and "trend
channel" methods, and I use the two together to help filter or confirm trades. Even
chart patterns, and front-running breakouts can be used in alignment with these
strategies. If you construct a trading plan with these two strategies, then that's all
you trade, just these two strategies, nothing else. With just these two strategies
you'll always have lots of trades, so it should be enough to keep you busy.
The point you really need to drive home to yourself is that you're only
looking for the setups and conditions which are laid out in your plan. If the setup
isn't there, or the conditions aren't right, don't start trading other strategies. You
need to practice the plan you lay out for yourself down to the letter. The trading
journey/career is a relentless pursuit of finding well defined trade setups, within a
well defined context, trading them when they occur, and not being distracted by all
the other price information which isn't relevant to the trading plan.
My notes are in brackets explaining each point. This plan assumes that you
know the basics of the strategies being employed, so reread the relevant chapters if
needed. This is a sample plan. Alter it based on your circumstances and the
strategies you wish to use.
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Swing Trading Plan
Basics
This plan applies to swing trades which occur based on 1-hour, 4-hour or daily
charts (define which time frames you will trade, here).
Ideally trades should last several days maximum. If a trade is going to last longer
than a week, based on daily average volatility, then avoid the trade, or zoom in the
time frame to reduce the risk and profit target so the trade can likely be completed
within a week. (For example, if looking at a 4-hour chart, drop down to an hourly
chart and see if that provides a similar trade setup, but with a shorter likely
duration.)
Trades are limited to pairs which are a mix of the following: USD, EUR, GBP,
CAD, NZD, AUD, CHF, JPY (I monitor 28 pairs).
"Actively manage" trades on a chart one timeframe lower than the trade setup
timeframe. If the trade setup occurred on a 4-hour chart, active management is
completed on a 1-hour chart. If the setup is based on a 1-hour chart, active
management occurs on a 30-minute chart.
Have the chart zoomed out to the maximum, but only enough that all bars are still
clearly visible (high, low close, open). The daily time frame is the largest time
frame looked at. Don't zoom out further than what's visible on the screen; scrolling
back (or zooming) through years of price data isn't relevant or useful to us as swing
traders. Don't factor anything that happened more than 15 months ago into your
trading decisions. (It's easy to get information overload, and looking at very old
data isn't likely to improve trading performance, and could very well harm it.)
All swing trade orders are placed after the US session closes, and before London
opens.
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Every order I place includes a stop and a target.
Don't take swing trades within several hours of the close on Friday, or within the
first couple hours of trading on Sunday night/Monday morning. Trades are only
placed at the usual time—within a few hours before the European open.
Note tendencies in the pair. If you see that recent trades (based on the strategies
below) in the pair would've been unprofitable, don't trade that pair until the pair
begins performing in alignment with the strategy. If a pair has a history of poor
performance (based on what you see or actual performance numbers), don't trade it
and delete it from your watch list.
TRADE ALL SIGNALS THAT MEET THE CONDITIONS LAID OUT BY THE
STRATEGIES BELOW (considering all other guidelines). (If you try to guess
which trades will be profitable, and skip trades you think will be unprofitable, you
randomize your results and will have no idea if the strategy actually works.)
Record all swing trade results in a trade journal, noting the strategy used (1 or 2
below) for each trade. For actively managed trades (optional) be sure to note
whether you exited the trade based on a trailing stop (note which type), or via the
target.
Risk Management
Never risk more than 1% of the account on a single trade. (If taking the smallest
position size results in more than 1% risk based on the entry, stop and account
balance, then don't take the trade.)
The 1% is calculated based on the current real-time account equity (the equity
number fluctuates based on current positions).
Never take more than 2 long or short trades in the same currency, at the same time.
(This makes it easy, you never have to look at the correlation tables or worry about
being overexposed. For example you can be long the EURAUD and EURJPY, but
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if another EURXXX long trade comes up, you can't take it. Same goes for being
long USDJPY and short EURUSD, both are long USD, so if another trade comes
up which requires you going long the USD, skip it.)
Entries with Stops and Targets
Use pending orders whenever possible. If you miss an entry point, then you missed
it, don't ever chase the price if you missed a trade. Instead, place a pending order at
the original entry point and see if the market retraces to fill it.
The pending orders mean the trade is entered when the price reaches the price of
your order; there's no need to wait for bars to complete.
Entry 1 - The Crotch
Can enter in the crotch of strong support or resistance. [Assume support or
resistance will hold. In order for it to be a strong support area the price must
have previously fallen into it, and then had a full trend reversal higher (two
higher swing lows and two higher swing highs)]. Place a buy order in the
crotch of strong support, with a stop loss 5 pips below the low of the strong
support area. [In order for it to be a strong resistance area the price must
have trended higher into it, then had a full trend reversal lower (two lower
swing highs and two lower swing lows)]. Place a short-sell order in the
crotch of the strong resistance, with a stop loss 5 pips (plus the spread)
above the high of that strong resistance area.
If the price bounces off strong support as anticipated, unless it makes a new
major high (based on the time frame you're trading on) that level can't be
used again. If the price makes a new high, the area is still considered strong
and it can be used again (once more), using the most recent crotch as an
entry point.
If the price declines off strong resistance as anticipated, unless it makes a
new major low (based on the time frame you're trading on) that level can't be
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used again. If the price makes a new low, the area is still considered strong
and it can be used again (once), using the most recent crotch as an entry
point.
The same price area can never be used for more than two crotch trades in a
row in the same direction; two is ok, but don't take a third.
Only takes trades in the direction of the longer-term directional bias (if there
is a longer-term trend, trade in the direction of the trend.
Place a target at a 2:1 reward-to-risk ratio.
Entry 2 - Trend Channel
If a short trade develops using the Trend Channel method, but there's a long
trade (or strong support) based on the Crotch method in close proximity to
where the target would be, skip the Trend Channel trade.
If a long trade develops using the Trend Channel method, but there's a short
trade (or strong resistance) based on the Crotch method in close proximity to
where the target would be, skip the Trend Channel trade.
Draw the channel, don't just envision it. Drawing it helps you with
identifying the entry area and the target area.
If a Trend Channel is down, wait for a consolidation of at least 3+ 4-hour
bars (1-hour bars are also fine) near the top of the channel. Enter an order to
go short a pip below the low of the 3+ bar consolidation. Place a stop loss
above the consolidation.
Target goes near the prior low, near the bottom of the descending trend
channel. (Placing it below the prior low is what I consider aggressive, and
can be used when there's very strong overall momentum down; when
momentum is "average" place the target just a tiny bit above the prior low).
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If a Channel is up, wait for a consolidation of at least 3+ 4-hour (1-hour also
fine) bars near the bottom of the channel. Enter an order to go long a couple
pips above the high of the 3+ bar consolidation. Place a stop loss below the
consolidation.
Target goes near the prior high, near the top of the ascending trend channel.
(Placing it above the prior high is what I consider aggressive, and can be
used when there's very strong overall momentum up; when momentum is
"average" place the target just a tiny bit below the prior high).
Never take a long trade in a downward trend channel (even at the bottom), or
a short trade in an upward trend channel (even at the top)...unless it's because
you're taking a Crotch trade.
Target should be at least twice as big as the stop; typically these trades yield
2:1 reward to risk ratios, or more.
When a consolidation forms near the top of a downward trend channel for a
short trade, or near the bottom of an upward trend channel for a long trade,
there's always the option to "front-run" the breakout and buy near the bottom
of the consolidation of the long or sell near the top of the consolidation for a
short. For this to occur, the consolidation needs to be "neat" and clearly
defined so an entry can be made near the appropriate edge of the
consolidation.
Active Management
(This is an optional section based on how active you intend to be. If you only have
20 minutes a day, you may opt to include this, yet it is usually intended for traders
who can monitor their positions throughout the day.)
If a trade is more than half way to the target, then implement active management,
not before.
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If the price is more than half way to the target, drop down one time frame (from 4hour to 1-hour, from 1-hour to 30-minute, etc).
If short and onside (currently making money) move the stop loss to 5 pips (plus the
spread) above any newly formed swing high, or 5 pips (plus the spread) above a
consolidation from which the price has now broken below.
If long and onside move the stop loss to 5 pips below any newly formed swing
low, or 5 pips below a consolidation from which the price has now broken higher.
If the price is more than half way to your target, never, ever, take a full loss on the
trade. Risk must be reduced if the price is more than half to the target (move stop
closer to entry point, according to methods described above and below).
If the price is 75% (approximate) of the way to the target (target is 100 pips and
you're 75 pips onside) on a short trade, draw a trendline on the declining price
action. Place a stop 5 pips (plus the spread) above the trendline and continue to
trail it down with the trendline until you're stopped out (price breaks the trendline)
or the target is reached. If you can't draw a trendline, continue to move the stop 5
pips (plus the spread) above the high of the most recently completed price bar.
If the price is 75% of the way to the target on a long trade, draw a trendline on the
rising price action. Place a stop loss 5 pips below the trendline and continue to trail
it up with the trendline until you're stopped out or the target is reached. If you can't
draw a trendline, continue to move the stop 5 pips below the low of the most
recently completed price bar.
Specificity Matters
If you're going to follow a plan, it needs to be clear enough to follow. I think
these two strategies are good to start with. There are a number of reasons for this.
The main reason is that you'll get a lot of trade signals, in lots of pairs, and they
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don't take a long time to find, place orders in or analyze. This is especially true
since I publish forex swing trading signals on VantagePointTrading.com at least
once a week (usually) which provide you with a few examples of these trades.
The two strategies also work in synergy with one another. One lets you
know when the price is approaching a major resistance or support level. The other
works to capitalize on trending moves when there isn't major support or resistance
nearby. The Crotch strategy can also be used during the start of a ranging
environment (for two swings). Therefore, you can capitalize on both ranges and
trends.
The plan also forces the market to come to us; we enter on our own terms,
only under certain conditions. Nowhere does the plan say "If the setup doesn't
occur, make a trade anyway." No, we ONLY trade if the market produces our
setup. We trade those setups (the setups you include in your plan) every time they
appear (unless the plan provides conditions under which we don't), and we never
take trades which are based on setups not included in our plan.
Create your own plan, but use this one as a base model if you like, if you're
swing trading. If you're day trading you'll need to add in details like what hours
you will trade certain pairs. Then begin trading a demo account with the plan. As
you trade with the plan, note any questions you're asking of yourself while you
trade. Then try to fill in those "holes" by inputting a guideline into your trading
plan. For example, what if the market is in an uptrend on the daily chart and a
downtrend on the hourly chart? If you're confused about which signals you should
take under these conditions, create guidelines that tell you when you trade and
when you don't, then test the guidelines in a demo account.
It takes time to work out all the kinks; that's why you must follow the 5-step
plan. Once you've read the book (multiple readings of some chapters may be
required), build your plan. Then practice the plan, and tweak it as you notice
issues. Eventually you'll end up with a plan that's perfect for you, and you'll begin
to see consistent results. It's then, and only then, you can move on to live trading
using that plan.
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Once you've been profitable with live trading for several months using your
trading plan, add another strategy to it if you wish (not required). Be sure to
practice using the new strategy in a demo account first. If it's profitable, work it
into your live trading plan. Accommodate for your other strategies though...could
the strategies conflict? Be sure to rectify this in your plan and account for
contingencies before trading the new strategy with real capital.
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29. Checklist For While You Are Trading
You have a lot to think about! It'll be impossible to attempt to implement all
these strategies; ultimately you should choose one, two or a few and get very good
at them. Practice them often and make a checklist to memorize which keeps you on
track while you trade. In the psychology chapter, you learned that trading isn't as
simple as it seems, and the mind can play tricks on us, even experienced traders.
To keep the mind focused, compose a checklist that you'll run through
during the day to monitor market conditions and assess which trades to take.
Your checklist must be personal to you. Since I don't know which strategies
you're going to use, I can't prescribe a checklist that'll work for you or your
temperament. What I can do is give you an example so you can build your own.
Your actual checklist should be about 4 to 7 statements or questions. Here's
an example:
What times are the economic news events scheduled at?
What is the long-term and short-term trend?
Is the market exhibiting some sort of pattern?
Is there strong support or resistance anywhere?
In which direction are the strong and weak moves?
How volatile is it?
Would the strategy have worked already?
Are there repeating tendencies?
The above is a checklist that I continually run through my head throughout
the day while day trading (for swing trading my checklist is slightly different, but
the general idea is the same). While I only have the statements written down, each
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of those statements means something to me. How I answer each question gives me
a definitive course of action for my next trade.
 What times are the economic news events scheduled at? Avoid making any
trades for about 5 minutes before, and a couple minutes after, news is
released.
 What is the long-term and short-term trend? For me long-term, when day
trading, is basically the overnight session, maybe a bit of the prior day and
the current session. Short-term is the last 30 minutes to an hour or so.
Ideally, I like trades where there's a shift in momentum on the short-term
that aligns with the long-term. The question to ask is "What's the overall
expectation, and what's the immediate expectation?" I take trades based on
immediate expectations, but if that goes against the overall expectation then
I am much quicker to bail on the trade at any sign of trouble. If I'm trading
with the overall expectation, I am more inclined to "give the trade some
room."
 Is the market exhibiting some sort of pattern? What may look like a trend
may just be a piece of a larger wedge pattern or range. Drawing lines on the
chart along highs and lows will highlight any patterns that are present. Pay
attention to these.
 Is there strong support or resistance anywhere? These are areas that have
caused the price to shift very strongly in the opposite direction. Be careful of
strong bounces off these levels. These strong levels filter trades as well
provide trading opportunities.
 In which direction are the strong and weak moves? If all the really strong
sharp moves are up, and all the weak moves are down, probably best to be
trading on the long side until that changes.
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 How volatile is it? On a very slow day your profit expectations will be less
than on a very volatile day. Base your targets and stops on the price action
you've seen so far. You can only trade what the market is willing to give.
 Would the strategy have worked already? If a few signals already occurred
before you started trading, would those have worked out? If the market
doesn't seem to be respecting your strategy parameters, wait till it does. This
may mean missing one trade, but it's better than trying to impose a strategy
on a non-complying market.
 Are there repeating tendencies? This one takes quite a bit of focus because
you need to realize it in real-time, but are there repeating price movements?
For example, the price moves higher, stalls, and then makes three attempts to
move higher before finally breaking out. Next time the price moves higher,
the same thing starts occurring. Finding certain tendencies can give you a
little extra confidence for a trade, but don't expect these patterns to always
repeat. They may repeat 2, 3, maybe 4 times and then disappear. Use them
for information while you can, but don't rely on them too heavily
When I look at each of those statements it lets me know what to look for, as
described in the paragraphs above. The goal of the checklist is to keep me focused
on the trading day and trades at hand, and not let my mind wander. When the mind
wanders you may start to deviate from your trading plan, miss trades, or make
impulsive unplanned trades. Create a checklist and check it continually while you
trade. This is a very simple thing you can do to improve your results dramatically.
While trading, talk to yourself. Repeat the checklist and describe what it
means for the trades you're in, or the trade you're about to take.
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30. False Breakouts - A GIFT to Active
Traders
Think of this chapter as an addendum. You can read it now, but it's probably
best to start implementing these practices later on, after you have some actual
trading experience. The technique also requires—and is a form of—active trade
management.
For many traders a false breakout is the most frustrating thing in the world.
They find a great trade setup, set their stop loss according to the guidelines of a
strategy, then watch in horror as the price touches their stop then proceeds in the
intended direction without them. Read forums and you'll hear traders rage about
how brokers stop hunt their order and how it's impossible to win because little
traders always get stopped out before the big move.
That's one way—the wrong way—to look at it. Another is to look at it as a
MAJOR opportunity. Consider the consolidation breakout entry which can be
implemented in many of the strategies in this book. You'll find that often a
breakout will occur from the consolidation you've defined, but then the price
proceeds right back into consolidation and out the other side, losing you money. It
may do this a number of times, and other times the initial breakout is the legitimate
one.
So traders face a dilemma. How do you know which breakouts are likely to
be fake, and which will be real? The answer is you don't, but you actually don't
have to know. Having read this book so far, which emphasizes trading with the
trend when a trade setup occurs, you should have a good idea of whether you want
to be buying or selling when the consolidation forms.
Assume the price is consolidating at the bottom of an upward trend channel.
In this case, our bias is to go long. We want to buy, and you've learned a couple
ways to do it:
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 Buy when the price breaks above the small consolidation, with a stop just
below the consolidation.
 Buy near the low of the consolidation (front-running) with a stop just below
the consolidation, because we're anticipating the price is going to proceed
higher anyway.
If you're willing to sit in front of your computer (swing traders and day
traders) and monitor the market when the price is around your entry points, then
there's another option.
If you notice that the price is constantly stopping you out just before it
moves in the anticipated direction, then you're getting stopped out on false
breakouts. Instead of playing the victim, accept it's happening and alter your entry
approach. Don't increase your stop loss level, instead, wait for the false breakout.
In the scenario above, if the price drops below the consolidation at the
bottom of the upward trend channel, let it happen. If the price then rallies back into
the consolidation, that's a false downside breakout; buy immediately. The quick
drop below the consolidation that usually stops you out just became your new
catalyst for entry, but only if the drop fails and the price moves back into the
consolidation.
You end up with a price similar to what you would get front running (near
the bottom of the consolidation), but you avoided being stopped out on the false
breakout lower. Also, since the price had a false breakout lower, as it heads back
higher it's more likely to have a legitimate breakout to the upside.
This method works great if you aren't front-running, or a break above the
consolidation hasn't occurred yet. With those two approaches you're already long
when the drop (false downside breakout) occurs, likely stopping you out.
If you're anticipating the price to move higher, and you buy when the price
breaks above a consolidation, but then the price quickly reverts back into
consolidation, exit the trade (don't let it reach your original stop). You can always
get back in if it starts rising again, but since you just got caught in a false upside
breakout the price is now likely to head back toward the low of the consolidation,
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putting your stop loss in jeopardy. Cut the loss quick. That way, you can watch for
an entry near the bottom of the consolidation, or wait to see if the price has a false
breakout on the downside, which presents another buying opportunity.
If the price keeps falling you saved yourself some money. If there's a false
breakout to the downside, then you get your long position back at a better price,
which will probably offset the small loss you just took. If the price bobbles around
in the consolidation, and then breaks higher again, you can go long again.
This mindset is completely adaptive to what the market is doing, and
completely detached from the outcome of the trade. Earlier in the book I warned
about commissions and paying the spread, and many traders get scared away from
actively managing trades because of this. Yet paying a 1 or 2 pip spread is much
better than losing 20 or 30 pips when you don't have to.
If you monitor your chart, you'll notice that pairs very frequently have a
false move in the opposite direction before a big move in the other direction. This
stops out a lot of traders, but it isn't a problem, it's an opportunity!
Switch out of victim thinking and capitalize on this tendency. If the price
breaks out in the direction you expect, but then quickly fails and moves back inside
the breakout point (give it a bit of room, so you aren't constantly punching in and
out of trades) then get out. You can see the price is consolidating which means if it
continues to consolidate your stop just outside the consolidation could easily be
triggered. You were trading the breakout, but the breakout failed, so get out, now!
The loss is a fraction of what it would be with the set-and-forget approach.
The benefit of doing this is that you make more money. Your win ratio will
likely creep up slightly. The main advantage though is that the dollar amount of
your losing trades decreases. You may originally wager $100 dollars on a trade,
but if conditions change and you cut losses early, you may only end up losing $20
or $30. Since you're actively managing trades, some of your winners may also end
up the same way: you're expecting to make $300 but the price altered course so
you take a $100 profit instead. You still end up with some big winners though, so
you keep the upside, but reduce the downside.
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If you need to set-and-forget trades, that's fine. You don't need to actively
trade in this manner all the time. The point is, if you're getting constantly stopped
out right before a big move you've been anticipating, don't keep standing there and
getting punched. Move your buy entry to below the consolidation (if the
consolidation is at the bottom of an upward trend channel), and move your short
entries to above the consolidation (if the consolidation is at the top of a downward
trend channel). This way your entry occurs during the false breakout that normally
stops you out.
Adapt to what the market gives you. Turn weakness into strength. If you feel
like you're constantly "being tricked," ask yourself what the trickster is doing and
mirror his actions.
This type of trading brings together everything you've learned and takes it to
the next level. You form expectations about what the market should do (which
direction you want to trade in), and if it doesn't do it, you cut losses quickly. You
notice market tendencies and act on them to get advantageous pricing. This often
requires patience, but when the time comes there's no pause, immediate action is
taken to either get into a position or get out of one.
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31. Create Your Own Trading Strategies
There are many great strategies available to you, and even though they may
work there may come a time when you wish to develop your own. Creating your
own strategies is an important skill to have, and one which is rarely addressed.
Creating your own strategy takes time and patience, but the rewards are
significant. While rewards may come in the form of monetary gain, there are other
substantial advantages of going through the process to create your own strategies.
Mainly, building a strategy from scratch will give you a much greater
understanding of price movements, the markets and yourself.
You'll also truly understand how the strategy works, and what could make it
stop working. When you use someone else’s strategy you may rely on it without
really understanding how it works. On the other hand, if you build it and
understand it you're more likely to be able to implement it properly and at the right
times.
Creating Strategies
To create a strategy, look at your charts—historical and in real-time—to find
points where there was profit potential. Usually this means seeing a trend, a range
which could be traded multiple times or finding turning points. Glance through
your charts and make note of the obvious "profit potential" times, and then note
any commonalities between the different scenarios. Wherever you see profit that
you think you can extract is where you want to focus your attention.
Once you've found a pattern or movement that could have made you money,
it needs to be scrutinized for tradability.

What initiated the Move?
Profits are great, but sometimes a profit is hard to capture. While it's
tempting to think we could have captured a big move, it's not always possible and
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quite often there's no reliable way of getting into every move (big or otherwise)
which occurs.
By looking at the move(s) you've isolated, was there anything that signaled
the move, or indicated it may occur?
Was there a chart pattern or a candlestick pattern that initiated the move? A
breakout through resistance or support? A consolidation breakout? A bounce off a
trendline? Did a news event trigger it, and or did it occur at a certain time of day?
Is there a correlation to the global sessions (such as the European, Australian,
Tokyo or US session) opening or closing?
Consider adding an indicator (these are technical analysis tools which I
rarely use but some traders find helpful): did the indicator(s) give any signal of
what was about to happen? Be careful with this one. Indicators often act like
"Chicken Little;" they spot turning points, but how many times did they signal a
turning point that didn't occur?
Is there an overall trend present, or is the market in a range? This is relevant
as it may provide a context for the strategy. For instance, the strategy is only
implemented during trends, or is only implemented when a range is present.
Next, consider where you could have entered the move? If the move was
very fast it may not be possible to get in, and thus is an unreasonable trade to
assume you could make. As you ponder where you could enter the trade, consider
any factors you mentioned prior that could have initiated the move.
Ultimately, you must define something tangible, so that if the specific move
occurs again you can isolate it and then trade it. This is called your "trade trigger"
and is a required element for any strategy. Knowing you want to buy (or short) is
only one part of the entry puzzle. You also need a precise event that tells you to
enter the trade. Many of the trade triggers in this book have revolved around the
price breaking above another price bar or out of a small pattern. That's the trigger.
The moment the breakout occurs you know it's time to act.
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
Look For an Exit
Every entry requires an exit at some point, in order to take profits or losses.
Find something that signals your exit from the trade. It may come from an
indicator, a price moving above/below resistance/support, breaking a trendline or
your entry criteria disappearing.
By "entry criteria disappearing" you're watching for what got you in the
trade no longer being there. For example, if you got into a long trade because of a
price break coupled with a rising indicator, when that rising indicator levels off or
starts to decline that could signal your exit. What kept you in the trade—the rising
indicator—is no longer rising, so your reason for the trade is no longer there and
you can exit. This is the logic behind chapter 30, False Breakouts - A GIFT to
Active Traders. If a breakout occurs but then immediately fails, the reason for the
trade is gone, so exit the trade.
You want to capture as much of the move as possible, but at the same time
you don’t want to give back all your profits when the market reverses. Ask
yourself how this can be accomplished? Just as you looked for a trigger to get into
the trade, you need to find a trigger for your exit that lets you know it's time to get
out.
Consider whether a trailing stop would be effective, or if stops could be
raised manually as the trade moves in your favor.
Would a fixed reward:risk ratio work? Would a fixed target work, such as 40
pips or 100 pips? This requires some knowledge of how far the pair moves in a day
(or week, etc.) but is an effective statistical method for exiting trades. After going
through the chapters of this book, you should have a grasp of how to come up with
reasonable profit targets.

Money Management – What’s the Risk?
So far, on your chart you've found a price move, or series of price moves,
that would've produced a profit had you captured it. In order to extract a profit you
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need to first find a way to enter the trade based on a signal you can identify and
trade, and then you must also find a way to exit the trade at a profit using an
identifiable signal.
Not every trade goes our way. While you may find a pattern that often
precedes a big move, it won't always work out. Determine where to place a stop
loss.
Look at the moves again. You know where to enter and also know how
you're going to exit with a profit. In order to control the risk, where does your stop
loss go? The stop should be at a price, which if triggered, signals the trade setup
isn't going to work out.
Now consider what your risk/reward looks like. Is the profit potential worth
the risk?
If the profit is too small, is there any way to get into the move earlier, or
make a larger profit by exiting at a slightly different time or with a different signal?
If the risk is too large, is there a way to reduce the risk, possibly by actively
managing the trade, like discussed in chapter 30 (False Breakouts - A GIFT...)?

See if it's Reliable
So far you've completed the easy part. You've looked at price moves and
considered them for money making purposes. Then, you thought about different
ways you could enter into the move, exit that move at a profit and control your
risk.
Unfortunately, only looking at a few price moves isn't going to provide a
reliable trading strategy. You now need to go back and see how your strategy
faired in the past, and also watch in real-time to see if you can actually implement
your plan in the heat of the moment when the market is moving.
First, make sure you have your strategy ideas written down...precise and
well defined. This includes what initiated the move and how you'll enter and exit it.
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Scroll back your charts and see if you can find your entry trigger in the past. If you
can’t, your strategy may still be valid but the signals will be infrequent, thus it'll be
hard to gauge if it's actually effective or not until more signals come along and you
can test your theory.
When you do find an entry trigger, see if your entry, profit extraction and
risk control methods produced a profit or loss on the subsequent price moves.
Continue to move back through charts testing every signal you see against your
criteria. Write down how many signals you find, along with what your profit or
loss would've been. Include both losing and winning trades. Just because there are
losing trades doesn't mean it's a bad strategy, every strategy will have losses.
Once you have found at least 10 setups, tally up your results. 10 signals isn't
a lot and won't indicate whether your strategy is likely to win or lose over the long
run, but it's a start. Ideally, find about 50 signals and tally up the results. If the
strategy is profitable on historical data, then watch for new signals in real-time.
When the price is moving, and you can’t see the future (like we can when we
are looking through historical charts), can you still implement the strategy? If you
can’t, something has gone wrong and you need to adjust your criteria so they are
objective and tradable, or you may need to start all over again.
If your strategy is indicator based and involves nothing subjective (it's rule
based), you may be able to run it through back-testing software. This will provide
you with a much longer history of how the strategy has performed, and give you
some inkling of how it may perform in the future.
Some strategies are hard to run through back testing software as the signals
are based on a price pattern or chart pattern which the back testing software may
have a hard time recognizing, and thus won't provide accurate results. Most of the
strategies in this book fall in this "hard to test" category, because they rely on hand
drawn trendlines and consolidations (for example) which are subject to
interpretation and may vary slightly from trader to trader.
Ultimately, if you've gone through the charts and found many examples of
the signal you're looking for, the risk is controlled and more often than not you can
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exit at a profit (or at least profits outweigh losses) then you have a strategy which
you'll want to start monitoring in real-time.
Open a demo account and trade the strategy without risking any real money.
If it works on the demo and you have a track record of positive results, only then
move to trading real money with your new found strategy.
You created your strategy so you should be aware of how it works. Make
sure the strategy is formalized and simple to implement. Then incorporate the
strategy into your complete trading plan so that it fits within the context of your
other strategies and overall risk tolerance.
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32. Meditation for Traders
Meditation, visualization and hypnosis have been used by athletes and in
many other professions to improve performance and reach goals, but can
meditation help traders? The short answer is, yes. There are many misconceptions
about what meditation actually is, and this chapter will discuss that as well as how
it can help your trading.
We've all visualized a scene playing out perfectly in our mind, which means
you've already practiced a form of meditation. If you learn to focus this attention,
you can harness its power and apply it to your trading.
What Meditation Is, and How it Relates to Trading
Meditation is focusing your attention on a specific idea, thought, picture,
sound, etc, or even focusing on nothing at all. Our minds are constantly accepting
data, interpreting it, reacting to it or filtering it out. When we slow down and
meditate we can start to make profound changes within ourselves because our
energy is focused on a limited number of things. The world is widdled down and
we can work with precision on one thing, instead of being bombarded by loads of
everyday trivialities.
Meditation helps you progress; it helps you get used to taking larger
positions as your account grows, implementing an alternative form of trading, or
overcoming obstacles such as exiting earlier than a trading plan dictates.
Using Meditation For Improved Trading
Within the trading field there are many potential uses for meditation.
Almost every problem we face as traders can be aided by meditation. Adapt the
meditation, which is just a visualization exercise, to address other issues, but for
the purposes of this book we'll look strictly at how to improve performance in
general.
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Just as learning to trade effectively isn't going to happen overnight—even
with the strategies outlined in this book—meditation isn't instantly going to change
your life. It changes your habits slowly, and takes work. You need to meditate
regularly if you want to see the positive aspects of the practice. This chapter is just
a start. If you're interested in this area I suggest picking up a book on the subject or
doing more research. Your mind is the main tool you need to trade, and meditation
improves it, and that's a big trading advantage.
The following exercise can be done anywhere and requires no prep work.
While going through this exercise in the evening and spending 15-20 minutes will
be of great benefit, it can also be done quite quickly. Use a quick version before
the trading day begins, taking 5 minutes before the first trade is placed. Run
through the exercise to get yourself in the right frame of mind to start trading.
The following method is very adaptable. Use it to become more selective
about trades, focused on price instead of internal thoughts, increase trading volume
or move up the pecking order in an institutional environment.
For the meditation we'll use the following situational context: a trader is
struggling to meet his/her potential. He has created a trading plan and has several
strategies that he wants to implement. When he goes to do it, he has a hard time
pulling the trigger on trades, and when he does he often deviates from the plan,
exiting too early or letting losses get out of hand.
This is just a context. If you deal with a different issue, read through the
meditation a few times to get the general idea, and then alter it to suit your
individual situation.
The words in the dialogue below don't matter; they're just used to create a
visual scene in the mind. Once you're familiar with the general concept, go sit
somewhere quiet, close your eyes and visualize what I'm describing below. Create
the scene in your mind. The object isn't to focus on profits. The object is to focus
on you and how you handle yourself when you trade.
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
Improving Performance Meditation
Close your eyes and find yourself outside a downtown skyscraper (or
whatever tall structure you prefer). Straining to see the top, you can’t, as it
disappears into the clouds. Walking towards the front entrance of the
building, you see that it's your name above the door. This is your building,
and it represents your life and your success. You enter the building and see
yourself in a familiar trading environment (your home office most likely),
doing what you have always done. If you make a couple trades a day, you
see yourself executing those trades as you have been doing with the same
results you have always gotten. This first floor represents where you are as a
trader right now.
As you look around the room you notice an elevator. If you're going to be
successful in your trading you know that you need to step up your trading
and to do so you must go into that elevator. As you get into the elevator, you
notice there are hundreds of buttons representing each floor of the building,
but right now only the second floor is lit up, so you press it and feel yourself
moving higher. You're leaving behind your old behavioural patterns and
moving towards a more successful you.
As you get out of the elevator you once again see your trading environment,
but this time your trading post is empty. As you take your place at the helm
you feel empowered. You see yourself taking advantage of more trading
opportunities as dictated by your plan. Everything seems clearer.
You see a trade setup based on one your strategies. You wait for the trigger,
and then execute the trade. No hesitation, no fear, just calm, assertive
action. You've done all the prep work, and even if the trade doesn't work out,
you will only lose 1% of your capital—an easy amount to make back on
another trade.
You realize that one trade will never make or break you; so you set a stop
and profit target and let the trade play out according to the plan. You sit
back satisfied, knowing that no matter what happens the market will either
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hit your stop or profit target, and there's nothing you can do about it. So you
relax. You let the trade play out. You don't care if you win or lose, because it
doesn't matter. If you're using a good strategy profits will come, and you
know you don't need to force it. You're satisfied that you followed your plan
and let your profit or stop be hit. Regardless of the result, by doing this you
know you're becoming a better trader.
You stay at this level in the building until you're comfortable and until you
are actually implementing this action in your real-life trading. You know
that once you are comfortable at this level the elevator will allow you to
move to the next floor, where once again you'll be able to take your trading
to the next level.
At each level you hone in on a particular issue and work though it. See
yourself doing what you need to do to be successful.
Repeat this process several times. Picture yourself executing trades, maybe
one you know you have difficulty executing, multiple times. Each time,
you're calm and composed and follow the exact strategy your plan has laid
out. The result of the trade doesn't matter to you anymore. One trade never
matters, because you know great traders are built over many trades, and you
are going to be one. You're going to bring this confidence and calm state of
mind to your real-life trading.
Bring your thoughts back to the current moment, remembering you're about
to start trading for the day. You feel refreshed and confident that it'll be a
good day—you'll follow your trading plan, control your risk, and by doing
so, over the long-run you're very likely to be successful.
Altering the Meditation
With all the potential pitfalls traders face, maybe the context used above
doesn't fit your situation. The method can still be used. As you move up floors
within the exercise, see yourself doing what it is you want to do in the real world.
Maybe you overtrade, so in the visualization see yourself allowing trades to pass
by that don’t fit your trade criteria. Feel the urge you have to trade, then subdue it.
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Use your meditation to come up with solutions or ways to curb your behaviour. In
your visualization, feel satisfied and happy that you overcame this issue.
Maybe you take too much risk on your trades. In this case see yourself
setting a stop and profit target and letting the trade ride out. You risk no more than
1% of your capital on the trade. Within the mediation you feel happy because you
know that these are traits of profitable traders and if you follow them you can also
be successful.
The potentials uses are virtually endless, so use the exercise to help with
your individual struggles. As you improve, keep moving up floors. Push yourself
and see yourself improving at each new level.
Final Thoughts on Meditation
Meditative visualization is a powerful catalyst for change. Contrary to
popular belief, this process requires no strange postures and is no different than
daydreaming except you're directing that daydream in a certain direction to give
you a tangible result. Just like an actor rehearsing for a play, or a golfer visualizing
a shot before they hit it, you're mentally rehearsing what you'll do in trading
situations.
Adapt the above mediation to suit your individual needs; change the focus of
the exercise to help you with a particular problem. Do the meditation in your down
time, or before you begin your day, to condition yourself to be disciplined and
implement proper trading practices. The more you do the exercise the more
anchored the beneficial aspects of the exercise will become in your mind.
Meditation is only useful though if you bring the feelings and traits back into
the real world—such as confidence, calmness, assertiveness, patience and
discipline. When you're sitting at your computer ready to trade, bring back the
sense of confidence you had during the meditation, and then follow-through; do in
the real world exactly what you visualized in the mediation. At first you may have
to pretend you're confident, happy, calm, etc. Do it anyway. Recreate how you felt
in the visualization, in the real world. You can't control the market. You may lose
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on this trade, but it doesn't matter. You do control yourself, and by acting with the
same disciplined confidence you did in your meditation, you're working on
becoming a better trader overall.
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33. Trading Resources
 Forex Session Highlighter (MetaTrader 4) - A tool that marks the different
global trading sessions: http://vantagepointtrading.com/archives/8072
 Forex statistics and tools: http://vantagepointtrading.com/daily-forex-stats
and https://www.mataf.net/en/tools/home (only really need forex correlation
and forex volatility stats).
 Hook up your account and analyze your trading stats:
http://www.myfxbook.com/ . This site also has volatility and correlation
stats, as well as an economic calendar.
 Customizable economic calendar: http://www.dailyfx.com/calendar
 See when major markets open and convert time zones:
http://www.forexmarkethours.com/markethours.php.
 Best Book on Trading Psychology: Trading in the Zone by Mark Douglas
 A palatable introduction to statistics: A Drunkards Walk—How Randomness
Rules Our Lives by Leonard Mlodinow.
 An ECN/STP trading tool that makes it easy to get in and out of positions.
Set stop losses, targets and limits orders, as well as change position size with
ease: https://www.fxopen.com/en/traders-tools/.
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Best Wishes.
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