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FOREX STRATEGY

Seeing the Music of the Market

An approach to viewing the markets and constructing trades

forex strategy constructing trades

Forex markets can be very volatile. Such volatility offers both greater opportunity and added risk to the trader.  

A good trade is one that offers a return that justifies the risk. It is quite easy to describe a good trade – particularly after the fact – but to “see” a potentially good trade before it happens is not easy.  

In rapidly moving markets, analysis must be done very quickly. By the time it takes to calculate the risk/reward t\ratio of a trade it can be no longer valid due to rapidly changing price. A trader needs a system that can give them this critical data as quickly as possible. 

We have been using a method for some time that seems to work very well – better than anything else we have ever seen or heard about. We call it “seeing the music of the market”. 

Music is an extraordinarily complex subject and we do not profess to be a musician, but we do like to think of the markets as having a rhythm, a tempo and an intensity – as does music. We listen to music with our ears and detect its rhythm, tempo and intensity. For the markets, we must use our eyes, observe our price charts and “see the music”.

What makes up a good trade

Let us digress just a bit and describe what makes up a good trade. First we want a point of entry value and an expected exit value that provide a sufficient profit to justify the risk we are taking. Our risk is the difference between our entry value and our stop/exit value. Since most traders, ourselves included, have difficulty performing all that math in an instant, a visual method of “seeing” a potentially good trade is an advantage in rapidly changing markets.  

That is where “seeing the music of the market” can help you select potential trades almost instantly. A trader who learns to “see the music of the markets” can visualize on the chart the potential trade entry point, his exit/stop and his profit target as points on the chart. With practice, the trader can connect those points in his mind with lines – instantly compare the length of the lines thereby completing his trade analysis almost instantly. With practice, it really is just that easy. 

Okay, there is a bit of work to be done before getting to that level of proficiency. First we have to learn to “see the music” of our selected market. Fortunately, we have developed a method that makes it much easier to “see the music” of most any market. It provides a “sheet music” look on the price chart, which should make “seeing the music” a bit easier.

How can we see the music of the market?

There are probably many other ways to arrive at the ability to “see the music of the market”. We are going to tell you how we do it, because it works for us. It is our hope that you will be able to do something along the same lines and make it work for you. It is well worth the effort – and let us be honest – it does take some effort to learn.

We begin with our price chart. This is the basic tool of the technical trader. We use a particular type of chart and our results are based on using that particular type of chart. First, we use tick bars rather than minute bars. We consider the use of tick bars an essential part of our system because they respond to market tempo automatically – providing more bars as trading accelerates (sometimes by a factor of ten or more). Since almost all indicators are calculated on a bar by bar basis, tick bar indicators react to tempo changes quicker than minute bars.

Our first step is to create a chart from which our trading decisions will be made. This chart is usually an intra-day chart with somewhere between 12 and 20 bars per day. This will vary greatly market to market and we select the tick value visually – changing the ticks per bar until we can best “see the music”.

What we are looking for is a chart in which the movement of price is such that we can see potential trades.  A potential trade would be one that provides a price difference between the high and low of the movement of sufficient size that capturing 70 to 80% of that move would provide an acceptable profit. Generally, we want to see at least 500 or more pips (preferably more) in a potential Forex trade.

To assist us in this endeavor we prepare our chart as follows:

1. We create a weekly chart and add our primary SRVs (SRVs are horizontal lines of support and resistance).

2. We copy that chart, change data to daily and add additional SRVs (the daily chart SRVs we call secondary and the weekly SRVs we call primary).

3. We copy the daily chart, and start the process of selecting various tick bar settings until we are happy with the way the music of the market looks. Once we have our trading chart, we copy it and create one other chart with about 1/10th the number of ticks per bar – this chart is used in trade management.

Let’s look at a chart of the EUR/JPY for the first week of November, 2011.

forex strategy constructing trades EUR-JPY

This chart is interesting for several reasons, not the least of which it shows the market immediately after an intervention by the Bank of Japan.  Note the drop from the Sunday evening high to the low on Tuesday morning - a truly breathtaking ride down. And of course, the ride up early Sunday had been just as breathtaking. Such fundamental events can have a profound effect on the market - temporarily.

But notice how quickly the market stabilized into a pattern of movements more suited to trading. Note in particular how the movement of price over the remainder of the week seemed to be affected by the horizontal lines (SRVs). It should be noted here that we placed these lines Sunday afternoon, a couple of hours before the market opened for trading. We had no SRVs in the upper reaches of this huge move – typically we place 4 to 5 primary SRVs above and below the price at the time we create the chart. Huge moves like that of Sunday evening usually blow past the many SRVs.

But huge moves in one direction often are followed by significant moves in the opposite direction – such as in this case.

Smart traders stand aside when these events hit the market and wait for the market to return to its normal music. In this case it did not take long. By Monday the market intensity was back to near its launching point of the huge move up and by Tuesday the music was looking normal again.

A quick visual analysis on Tuesday morning revealed that the primary SRV at 106.656 was the turning point for the large down move. The primary SRV at 107.736 is a reasonable target for the move up assuming the SRVs in the mid-range of the Bollinger Bands can be breached. The difference in price value for these two SRVs is about 1100 pips so 70 to 80% of that value is a good profit margin.

Later we saw that the SRVs in the middle of the move, a primary at 107.242, a secondary at 107.156 and another primary at 107.053 slowed the move considerably but were eventually breached. The move indeed went to our target SRV of 107.736.

forex strategy constructing trades good trades

We see at least two good trades for the conservative trader (that’s us) - and others possible for an aggressive trader - in the above chart:      

1.  Enter the market at about 9.23 Tuesday morning, 11-1, when price has failed to close below 106.656. Our stop is just below 106.656 and our initial goal is to penetrate the primary at 107.026, which happens in about 30 minutes. Our other indicators (trend, over-bought/ over-sold, and momentum tell us to stay in the trade – and by 2:30 we get our exit signal when the price fails to close above the primary SRV at 107.736. A nice trade netting about 800 or so pips.     

2.  Our momentum indicators keep us from shorting at this point but a new long trade presents itself Thursday morning, 11-3. Price has twice failed to break below 106.656. We get our entry at about 9:30 at around 106.850. The move took us all the way back to the primary SRV at 107.736 and we would exit here because the time is 2:41 and we don’t want any part of holding into the late afternoon or early evening hours. Another nice trade of about 900 pips.

3. An aggressive trader could have shorted off the primary SRV at 107.736 on Tuesday, Wednesday and Thursday with acceptable risk to reward.

How we can use the SRVs

A few words about how we use the SRVs are in order here. First, we use a proprietary method of calculating SRVs – it is unique and we find it accurate. Traditional methods of SRV calculation may or may not yield the same results. SRVs near the upper or lower Bollinger Bands are considered more powerful than those in the middle. Primary SRVs are considered more powerful than secondary SRVs. Multiple SRVs close together are considered more powerful than a single SRV.

It should also be noted that we try to always enter and exit our trades during the day in our time zone. Because Forex trades virtually 24 hours a day, other good trades can be found using the same methodology at hours we choose not work.

We construct a trade off the SRVs in two ways. One method is much more aggressive than the other.

First, the conservative way is to wait for an SRV to actually act upon the price move, as in the above trades. We use this most often when trading Forex.

Secondly, a more aggressive approach, which we have often used in trading futures contracts, is to place an entry order to buy or sell “if touched” - with the “if touched” price being the same as the SRV on which we are basing our trade. This method is only for the experienced, confident and aggressive trader that has great confidence in their SRVs.

The SRVs are an essential part of our seeing the music of the market and they provide specific values on the chart from which we can visually see a potential trade. Being able to see the trade before it happens also means that we can see a trade that does not go our way quickly, enabling us to exit the market with a small loss.

Not all trades will be profitable – so it is important to set up your trades to accept no more than 50% risk – preferably much less (we try to only make trades with a risk of only 20 to 30%). That way a trader can remain profitable with a winning average of only 50%. And the higher your winning percentage the more money you can make. When we are doing our best work we achieve a winning percentage much higher than 50%.

Along with our other indicators, some of which are also proprietary, we trade with a confidence that only a small percentage of traders enjoy.

We have never seen a market that does not exhibit a rhythm, tempo and intensity – just like music. Learn to “see the music” and be a better trader.

One final note: our trading methodology is based on technical trading alone. However, we encourage each trader to learn the basic fundamentals that affect their market. Fundamental data can be intimidating by virtue of the sheer volume available, but the basics are essential because they can have a profound effect on the market – such as the EUR/JPY in our chart above. We knew that the BOJ was going to intervene in the market to attempt to stop the fall of the yen – they had actually told the world they were going to do so – we just did not know when. But knowing that it would come sooner or later we used our technical system to establish a long position in the USD/JPY – and just waited for the intervention to come. Needless to say the wait was worthwhile!

Phil Elrod
Author and Trader
Trading Between The Lines