Traders & Investors Club

I’m a one-trick pony.  After several years of trading stocks on both the US and UK exchanges and an often turbulent, but affectionate, romance with options trading, I have come home to the instrument that best suits my trading style.  That instrument is Foreign Exchange, aka FOREX or FX, and more specifically in my case, the Cable, or the exchange rate relationship between the UK Pound and the US Dollar.

I only trade reversals using five-minute and one-minute charts.  I know exactly what my profit objective is and how much I will risk on every trade.

This month, I shall discuss why I think that trend following is a flawed strategy and why it does not pay to tarry too long in a trade.  We shall also take a brief look at the FX Market and I shall illustrate why a trade lasting less than an hour can be more profitable than having capital tied up in a trade for two months or more.  Next month, I shall describe how I endeavour to identify price reversals several times during a trading day and predict the times at which these reversals are likely to occur. 

Why Not Trend Following?

We are all familiar with the saying ‘Top pickers and bottom pickers become cotton pickers’.  I disagree completely with this tired old cliché and I shall explain why. 

As trend followers know, the main challenge when designing a trend-following strategy is how to detect when the trend has been established in a timely fashion.  By the time a ‘real’ trend has been identified, the move is usually well underway and much of the potential profit is no longer on the table.  Other decisions that have to be made are a) when should the trade be entered and b) where should the initial protective stop be placed.  

One of the most popular methods of entering a long trade is on the price break above a previous high.  However, in my experience, a breakout is normally followed by a pullback, usually the result of profit taking, and very often one is sitting on a losing position almost immediately after entering the trade.  I hate that!  Of course, it is possible that the price will bounce back.  Or, maybe it won’t. 

Perhaps we plan to enter the trade on the pullback?  But then we are, in effect, buying into a falling market.  Will the moving average provide support?  Let’s hope so.  Or have we already seen the top of the move and we are about to be whipsawed yet again? 

The second problem with this type of strategy is deciding where the initial protective stop should be placed.  We are all using protective stops, right?  Should it be a volatility-based stop, which could place it a long way below the entry price, thereby exposing a relatively large chunk of trading capital if the trade moves decisively against us, or should it be placed around a recent swing low where it becomes an attractive target for the market makers? 

Furthermore, as anybody who has back-tested a trend-following strategy will know, incorporating a reliable method to reduce whipsawing provides an interesting challenge.  With a trend-following strategy, the majority of trades will be losers; most of the profit comes from a relatively small number of trades.  In the real world, if you miss any of these trades, your strategy will lose money.  Are you feeling lucky? 

When trading tops and bottoms, we don’t have to worry about any of this.  The point of entry is obvious; go long at the price low (in practice, a little above it) and short at the price high.  The placing of the initial protective stop is also obvious; just below the low for a long trade and just above the high for a short trade.  Very tight.  If the stop is hit, then, by definition, we have not picked the low or high and, because the strategy has failed on this occasion, we want to exit the position right away.  We take a small loss and watch for the next signal to re-enter the market. 

By the way, this approach should be used in all trading strategies.  As soon as the reason for entering the trade no longer exists, exit stage-left immediately.  Holding on to a losing position represents the triumph of hope over intelligence. 

More easily said than done?  How can we identify these tops and bottoms?  We will come to that in due course.  

The FOREX Market 

FX is the best market in the world for technical traders. 

The FX Market as we know it today came into being in the early 1970s with floating exchange rates.  FX trading involves buying or selling one currency with the use of another.  The two currencies involved in the transaction are known as a Pair.  The largest traded Pair in the FX Market is the Euro v. the US Dollar (EURUSD).  Other major Pairs include the UK Pound v. the US Dollar (GBPUSD) and the Swiss Franc v. the US Dollar (CHFUSD).  The relationship between the two currencies is known as the Exchange Rate and is always changing, depending upon supply and demand. 

FX is an OTC (Over-The-Counter) market, which means that transactions are conducted directly between any counter parties that agree to trade. There is no centralised exchange such as the LSE or the NYSE.  It is the largest financial market in the world by far with a daily turnover exceeding $1.5 trillion, which is thirty times larger than the average daily turnover of the NYSE.  Therefore, it provides a truly level playing field for the individual trader as the market is very liquid and attempts at market manipulation are extremely difficult.  Unless, of course, you happen to be the Bank Of Japan. 

It is possible to open a FX trading account with $2000 or even less.  FX is traded in Lots.  A Lot represents $100,000 worth of currency although there are brokers that offer mini-lots worth $10,000 for smaller trading accounts.  Like Futures, FX contracts are highly leveraged.  Depending upon the broker, leverage can be as high as 400/1. So, for example, with leverage of 100/1, you would need $1000 in your trading account to buy or sell a contract consisting of one Lot. 

Currency movements are measured in pips, one of which is the equivalent of one hundredth of a cent.  If the Exchange Rate moves a fifth of a cent, or twenty pips, you will have made, or lost, $200 per contract.  Because of the leverage, a modest move of this size equates to a 20% profit or loss against your initial stake.  During a ‘normal’ trading day, the Cable will move 200  pips or more. 

What makes FX even more eminently suitable for frequent trading is the fact that transaction costs are very small.  The typical bid/offer spread on the Cable is around five pips but can be as low as three.  Furthermore, most FX brokers offer commission-free trading facilities.  If yours doesn’t, find one that does. 

The FX market is open twenty-four hours a day, excluding weekends, which means that anybody can trade it no matter what their lifestyle or where in the world they happen to be based. 

Why Intraday? 

To make money trading, we need movement or volatility.  The volatility of a financial instrument, and the size of the resulting moves, determines how much potential profit is on the table?   So, how do we calculate what that potential is? 

It all depends upon your timeframe.  Like a coastline, a price series is fractal in nature.  On a large scale map, the coastline of Spain is generally accepted to be a little less than 5000 kilometres in length.  However, if we zoom into a part of that coastline, a number of bays and outcrops become visible that could not be seen in the larger scale map and if we now trace the length of that coastline using the smaller scale, we find that it is much longer than 5000 kilometres.  Now, if we attempt to walk the length of the shoreline, the actual distance that we will have to travel will be much larger than that again. 

I took a random two-month sample of intraday Cable data, which just happened to cover August and September 2004, and by running system tests using the Metastock Maximum Profit System, measured the potential for profit that was on the table during that period. 

As we know, this is purely a hypothetical measurement, as the MPS could never be traded, but I just want to illustrate the relative profit potentials of trading different timeframes. 

The opening price on August 2^nd was 1.8211 and the closing price on September 30^th was 1.8124.  Let’s assume that we were on the right side of the market and short GBPUSD throughout this period.  We would have been in the money to the tune of 87 pips. However, to have remained in the trade, our stops would have had to have been above 1.8466 and below 1.7743. This represents a very large overhead.  Too large, in my opinion. 

On the daily bar chart, the Cable travelled just over $30, upwards and downwards, during this two-month period, which represented a trading opportunity of around 300,000 pips. However, by drilling down to the hourly chart, our potential opportunity increased to 1,200,000 pips.  On the five-minute chart, the opportunity increased to 4,950,000 pips!  We are looking to capture as many small packets of this move as we can.

Whereas end-of-day traders tend to ignore short-term volatility, when trading intraday, volatility, or noise, is our greatest friend.  There is exactly the same amount of profit to be earned from a 50-pip move that occurs in less than five minutes as there is to be gained from waiting for a 50-pip move to develop over several days or weeks.  The main difference is that, in the first scenario, your cash is safely tucked away in your brokerage account for most of the time. 

The Method 

We are going to be using three technical indicators as well as paying close attention to our watches and our calendars. 

Our three technical indicators are: 

Pivot Levels

(n.b. The formula for calculating daily pivot levels is appended at the end of this article) 

We do not have the space here to explore Pivot Levels at length.   If your interest is piqued by this article, you will find a lot of material about them on the web.   They provide us with a predictive indicator of likely reversal points in the market during the trading session ahead. 

Pivot Levels have been used by floor traders for many years to forecast the current day's support and resistance levels.  The calculations are based upon on the previous day’s high, low and close. The central pivot level, know as the Pivot, or P, is the equilibrium point around which trading is expected to occur. Above the Pivot are three resistance levels, known as R1, R2 and R3.   Below the Pivot are three support levels; S1, S2 and S3. 

If the range of the high/low of the previous day was  large, the seven Pivot Levels described above will be a long way apart from each other.   In this case, I plot a further six pivot levels, each of which is halfway between the main Pivot Levels.  I have called them S23, S12, S1P, PR1, R12 and R23.    Although a total of thirteen Pivot Levels might appear somewhat excessive, the fact is that the plot will encompass several hundred pips on your chart and the current session's trading action will be confined to a relatively small part of it. 

The formula for calculating Pivot Levels is shown at note 1 below.   Although it is pretty straightforward to create a MS formula to calculate them, I find that plotting them dynamically on intraday charts slows my system down considerably.   Furthermore, you don't want to see all the levels plotted on your chart at one time because it results in the price plot becoming condensed, which makes it a lot more difficult to see the price movements.   Therefore, I calculate them first thing in the morning, using an Excel spreadsheet, and manually draw them as colour-coded horizontal lines on my intraday charts.   After all, the Pivot Levels will remain the same throughout the trading session. 

Binary Bollinger Band Indicator 

In order to identify tradable reversals, we need an indicator that will alert us to any sudden increase in volatility, as well as identifying overbought and oversold conditions, of which we shall have more to say later.   Bollinger Bands provides us with just such an indicator.

In order to generate clearer signals and to declutter my chart, I have modified the BB formula a little in order to provide me with an easier-to-read binary-type indicator.   You can see the MS code for the modified indicator at note 2 below. 

MACD 

MACD is a momentum indicator based upon two moving averages that we shall use ONLY to identify divergence at the turning points identified by our Pivot Levels.   Negative divergence occurs when the price reaches a higher high but the indicator makes a lower high.   Positive divergence occurs when the price makes a lower low but the indicator makes a higher low.   Divergence is very often the precursor to a price reversal; just what we are looking for! 

We are not interested in any trend indicating properties that the MACD might possess as the use of moving averages per se has no place in an intraday FX trading system. 

The beauty of using the MACD as a divergence indicator is that, unlike some other indicators, you can see exactly why it does the job that it does. The MACD will begin to revert to zero as the longer and shorter term MAs start to converge and momentum is slowing.   Perfectly logical. 

And as we're on the subject, I would also caution against betting your hard-earned cash on any wiggly line unless you fully understand exactly what that wiggly line is telling you.   If you don't know how, say, Stochastics is calculated and what it's actually telling you and you're using it in your trading system, it's time for the MS manual and a torch under the bedclothes.  

What Exactly Is An Oscillator Attempting To Measure? 

We are all familiar with the expressions 'overbought' and 'oversold'.   What exactly do we mean? 

An oscillator is an indicator that is used to identify turning points in the market by highlighting the emotional extremes of bulls and bears. These extremes are fleeting and indicate unsustainable levels of optimism or pessimism.   We know that these extreme conditions will not last long so we are looking to bet against them.   When the price hits a high, and everybody is brimming with optimism, we will be looking to sell short and when the price is at its short-term low, and fear predominates, we will be looking to enter long. 

In the stock market, a security can remain overbought or oversold for a long time and the strategy that we are currently discussing may not be suitable for that market.   In the FX market, however, identifying these temporary market extremes will usually provide us with profitable opportunities on a regular basis. 

What Does Trading Volatility Feel Like? 

A curious question? 

Imagine that you are taking your dog for a pleasant stroll thorough the park.   The path is winding gently and your dog is happily trotting alongside you, sometimes going a little to the left of you, sometimes to the right, but always aware of the leash by which you are holding him. 

Sometimes he might stray a little further to the left or to the right, at which point you gently tug his leash to bring him back into line.   Now, supposing he spies a rabbit some distance off in the grass.   He attempts to lunge towards the rabbit but because he is tethered to you by the leash, he exerts a sudden and powerful force on your arm.   Immediately, you yank him back very hard until he accepts that he must again fall in with your footsteps. 

Your dog is the price movement and you are the moving average. 

The Strategy 

OK, now to catch the falling knife…… 

The Setup 

We are looking for the following three conditions to develop on the five-minute or 15-minute chart: 

1) An increase in volatility that will cause a sharp price move in either direction that culminates in an overbought or oversold condition.   We're looking for a nice punch through the Bollinger Bands, the strength of which will be indicated by the value of the Binary Bollinger Band indicator.   I would suggest that a value of 0.002 or above (or -0.002 or below) represents a significant move. 

2) The price must find solid support or resistance at one of the Pivot Levels described above.   If the price has not reached, or has passed through, the Pivot Level, it does NOT constitute part of the setup. 

3) There must be confirmation from the MACD in the shape of a positive or negative divergence.

The Trade 

The three setup conditions MUST all be satisfied on the five-minute chart.   We now switch to the one-minute chart in order to fine-tune our trade entry in order to keep our protective stop as tight as possible.   For example, within a five-minute bar, you may see a double-top on the one-minute chart complete with negative divergence.   Poetry in motion; bet the ranch. 

Because we are only interested in trading the reversal, a long trade is placed on the bounce off the support at a Pivot Level and a short trade is placed upon a bounce off resistance at a Pivot Level.   To put it another way, we are fading the previous price move.

 Stops And Profit Targets 

The placement of the protective stop is not an exact science but is as near as damn it.  

After a burst of volatility, such as will have occurred if the setup conditions were satisfied, the bid/offer spread often widens.   Your stop should be placed as close underneath the Pivot Level at which the signal was generated as your Broker's bid/offer spread allows for a long trade and as close above the relevant Pivot Level as possible for a short trade.   Your maximum risk on any trade should never be more than fifteen pips. 

If the price happens to resume its previous direction and push through the Pivot Level, and what we took to be a reversal was actually just a pullback, we were wrong on this occasion and so we want to be out of the trade as quickly as possible with the minimum of damage to our trading capital. 

Our profit objective is four Pivot Levels away from the Pivot Level at which the trade was placed.   For example, referring to the formula below, if a long trade was triggered at S1, our profit target is R1; if a short trade is triggered at R23, the profit target is PR1.   I have decided upon these levels through my own experience.   In the beginning, you may prefer to set yourself a profit target of, say, two Pivot Levels.   That's absolutely fine; whatever works for you. 

An OCO (One Cancels Other) order should be placed as soon as you enter the trade, which will include both your stop and your limit order to take profits.   The OCO order should remain in place until either the stop is hit or our profit objective is met.   The exception to this rule is if another setup occurs in the other direction, i.e. you are long and a short signal is triggered.   At this point, we shall close the long trade for partial profits and immediately initiate a short trade. 

We are looking for trades with a reward/risk ratio of at least 5/1. 

To Trade or Not To Trade 

Although the FX market trades 24 hours a day, most FX trading action takes place during the London session, especially between 07.00 and 10.00 London time.   The market then usually settles down until just before 08.30 EST marking the start of  the New York session where you can enjoy the action until around 16.00 EST. 

The FX market is not driven by Pivot Levels, BBs and MACD divergence although they will provide you with the framework that you will need in order to trade the price movements successfully.  There are many fundamental factors that can, and do, move the market dramatically in a short period of time such as interest rate decisions, major economic reports, significant speeches, etc.

You must be aware of when these events are going to occur.   But how? 

Fortunately, this information is widely available.   Several websites publish an economic calendar a week, or a month, in advance.   Take a look at www.dailyfx.com for a good example.   There is also a very useful daily newsletter published by www.forexnews.com that will tell you what is coming up in the session ahead complete with analyst's expectations. 

Most significant UK economic data is released at 09.00 London time.   However, US data that can really move the market is usually released at 08.30 EST. 

For example, one of the main market-moving events is the release of the monthly US Non-Farm Payroll Report.   If these figures do not meet expectations, hang on to your hat.  I have seen the Cable move more than three hundred pips in less than a minute on figures that the market was not expecting. 

Can you trade these moves?   You might be able to but, personally, I wouldn't wish to try.   You could be lucky, but then again…..

You know in advance when the train is coming so why stand on the line?

I suggest that any open positions are closed in advance of the release of major economic data or whenever Ben Bernanke is due to make a speech after a good dinner. 

When the market settles down, you can just slip right back in there with your trading capital still intact. 

A Different Mindset 

When starting out in FX trading, I strongly suggest that you specialise in one Pair and get to know it well.   Each Pair has it's own personality whose movements are dictated by factors with which you will soon become familiar.   I like to trade the Cable (GBPUSD).  However, if you would like even more action, give the Swissie (CHFUSD) a try.

We are not looking to trade trends so you should resist the temptation to hop on to a move that's already in progress whatever your moving averages are telling you.  The FX market is characterised by frequent changes of direction so you must train yourself to see a short-lived trend for what it is; a developing setup that will enable you to get into the next trade at the start of a move. 

Of the indicators described above, the Pivot Levels are by far the most important. Pivots Levels are used for our stops as well as our profit target so trades MUST only be entered on, or very close to, a Pivot Level.   Take no notice of that little gremlin on your shoulder who is telling you otherwise; he is working for your broker. 

Do not take a market view; allow the market tell you what it's going to do, not the other way round. 

Remember that the setup has occurred when your dog has yanked your arm so hard that you can feel the pain. 

And, finally, never allow yourself to feel regret at missing a trading opportunity.   There will be another one along very shortly. 

Enjoy the ride.

Formula for The Pivot Levels: 

R3 = (P - S1) + R2         
R2 = (P - S1) + R1
R1 = 2P - L
P = (H + L + C)/3
S1 = 2P - H
S2 = P - (R1 - S1)
S3 = P - ( R1 - S2)

Where P = Pivot H = High L = Low C = Close

R = Resistance Levels 1,2,3
S = Support Levels 1,2,3