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FOREX STRATEGY

FOREX IS A TUG OF WAR

And we all want to be on the winning side.

Which side to join?

When to join?

Those are the two critical decisions FOREX traders must make

trading strategy fake and reversal

Growing up in rural NE Alabama in the post depression/World War II era we did not have the extensive recreation facilities so common today. Our parks were mostly cow pastures and our equipment was whatever we could get our hands on at the moment. A large rope was not too hard to come by so “Tug of War” became popular game for our occasional gatherings.

The rules of the game were pretty simple: participants formed into two groups that were evenly matched in number the number of members and the relative strength on the individuals. Each group grabbed one end of the rope and a line was drawn in the middle between them. The “Tug of War” began – the objective of which was to drag the opposing group past the center line.

As simple as seemed at first, psychology soon entered the picture. We soon learned that “faking” a quick loss of a little bit ground, followed by a sudden “reversal” of tugging could sometimes catch the some other group off guard - and the reversal would often not only quickly gain the intentionally lost ground but a sizeable chunk of additional ground as well.

This “fake and reversal” soon became a major part of the “Tug of War” game psychology.

Sitting in front of my computer today and watching the Forex markets reminds me of those “Tug of War” games. I often see similar scenarios taking place in Forex

markets. Yes, Forex trading is a “Tug of War” – the bears forming one group and the bulls forming the other group. As the “Tug of War” progresses a trend usually takes hold as the relative strength of one group exerts itself over the other group. Over time this trend changes directions as the relative strength of each group rises and falls. Sometimes, the trend change happens as a “fake and reversal” – and some of those reversals can be quite significant.

This “Tug of War” between the bears and the bulls is what a trader watches – waiting for an opportunity to join the game – preferably on the winning side.

So “which side” to join – and “when” to join it – become the critical questions?

There are many ways of picking the winning side and the time to join. In this article I am going to describe my particular method – which I obviously think is a good one. However, my method is optimized and tuned to short term trading – usually less than a day in a position – sometimes only minutes. Longer term trading involves considerations that I do not address in my short term trading method – however, my method is adaptable to longer term trading if desired. The big differences between short term trading and longer term trading are the risk versus reward considerations.

IDENTIFYING THE TREND

The first thing I look for in assessing a potential short term Forex trade is the current trend. Is the market trending up, down or simply moving sideways? Actually, I look for multiple trends; observing the trend on each of my three intra-day charts. It is not uncommon for all three trends to be in the same direction – or not. The type of trade I will watch for is determined by this assessment of the several trends. Forex markets are prone to follow trends tenaciously – until they finally reverse – and the faster charts always indicate a reversal first.

The three intra-charts typically I use for Forex trading are configured as follows:

1. Primary intra-day trading chart of a few thousand ticks per bar – usually about 12 to 18 bars per day.

2. Secondary intra-day of 1/10th the ticks per bar of the primary intra-day chart.

3. Fast intra-day chart of 1/100th the ticks per bar of the primary intra-day chart.

The GBPUSD currency pair used in the examples for this article are intra-day charts set to 4000 ticks per bar, 400 ticks per bar and 40 ticks per bar, respectively (I have addressed the issue of my use of ticks per bar versus minute bars in previous FX Trader Magazine articles).

trading strategy fake and reversal gbp usd

Note the primary intra-day chart for GBPUSD on August 1, as shown in Figure 1, that the trend (Middle Bollinger Band – dotted white line) is strongly down. Price has dropped almost 2 and ½ cents in the past two days – a huge move for a Forex pair in such a short time. Such moves are often followed by a retracement of a significant portion of that move (remember the 50% retracement rule).

Stochastic oscillators (the red, green and blue lines) show the market to be extremely oversold.

The MACD Histogram (the topmost red and green vertical bars) indicates that the trend, although strongly down, may be weakening.

Looking at the secondary intra-day chart, as shown in Figure 2, I note that the trend is also still strongly to the downward side, but the red stochastic (the fastest) has moved slightly out of the oversold area.

The MACD Histogram (the topmost red and green vertical bars) indicates that the trend may be reaching a possible reversal point.

The blue and yellow lines (the RMI - a proprietary indicator) also indicates a possible trend reversal.

trading strategy fake and reversal gbp usd

Turning my attention to the fast intra-day chart, shown in Figure 3, I note that the trend has reversed and headed upward briefly - but appears to be leveling out – or starting a turn back down.

On this very fast chart I seldom pay much attention to anything other than current price position and trend - and the relative size of the price oscillations – everything else on this chart changes too fast to be very useful.

trading strategy fake and reversal gbp usd

Now, in the short time it takes to view the three charts I have assessed the trend situation and have decided that a long trade is favored, for the following reasons:

Price has just made a very large move to the down side.

Although the trend is still down on both my primary and secondary intra-day charts, a short trade at this point would not be desirable because we see a possible change in trend in the near term as the most probable price action.

ENTERING A TRADE

Knowing which side of the “Tug of War” I want to join – I now only have to decide “when” to join. With the trend still strongly downward - in both the primary and secondary intra-day charts - I will be watching for an opportunity to join the bulls only when I see signals that the trend change on the secondary and primary charts is probable.

Of the two decisions I have to make to enter a trade, “when” is by far the hardest to make with confidence. Getting the “when” right is where a good trading system becomes a must.  The “when” is where we separate the aggressive and conservative traders - as well as the short term and longer term traders.

I want to go long this market, but, at the current time of day, it is too late for me to enter a trade without all the overnight implications and risks - which I prefer to avoid. I will have to wait for tomorrow morning to watch for a long trading entry opportunity in this market.

What we will be looking for starting at 6:30 tomorrow morning is confirmation of the expected move to the upside – and the relative strength of that move.

My trading system tells me that if price can break above the two primary SRVs at 1.51437 and 1.51491 there is a very large area with scant resistance until price reaches the 1.52200 area. Such a move would result in an excellent long trade. But the move has to happen within the time frame of my trading day – usually between 6:30 to 14:00 most days.

However, if I was interested in a longer term trade – and probably holding the position overnight, I could enter a long trade right here and set a stop about 100 to 150 pips below our SRV at 1.51078. My profit target would be in the area of 1.52200, so even the larger risk might be justified by the substantial profit potential.

The volatility in current markets is such that I personally would rather not take the larger risk required by holding overnight. I prefer to leave such aggressive trading strategy to the young tigers in the market. I prefer to sleep without concern for what the market is doing overnight.

trading strategy fake and reversal gbp usd

The next morning, opening our primary intra-day trading chart, shown in Figure 4, I note that price has broken above both the Primary SRVs at 1.51437 and 1.51491, but has subsequently retreated back to the area near those two SRVs.

Before going on to my conservative trade, I note that the aggressive trader who jumped in yesterday might have been taken out of the market if they had used a trailing stop of less than 400 pips. Market volatility today is really a problem for long term traders.

I see a long trade opportunity if price breaks out of its channel - and moves above the SRV at 1.51491, as there is no visible resistance from there up to the secondary SRV at 1.52224. Reaching a target at 1.52224 would give us a trade of about 700 or so pips. With a soft stop just below the SRV at 1.51437 – risk would then be in the area of 100 150 pips depending on actual entry price. That’s a reward versus risk of almost 5 – I love such trades.

For this type of trade I use my secondary chart to construct the trade. My secondary chart for Friday, August 2, is shown in Figure 5.

 trading strategy fake and reversal gbp usd

Note that at 6:30, our starting time, price has broken above both the SRV at 1.51437 and the SRV at 1.51491 and is trading in a narrowing range just above those two SRVs.

What I am watching for is a potential breakout of this narrowing trading channel to the upside.

For a substantial time prior to 7:30, price had just wallowed around in the area of the two SRVs. The bears and the bulls were jockeying for a position from which they might move price out of the tight channel and in their desired direction.

At the beginning of the 7:30 bar – just like in our old time “Tug of War” – price moved downward below the SRV at 1.51437 only to quickly reverse and move upward – breaking back above the SRV at 1.51437 and the SRV at 1.51491 as well. I would enter this market immediately after price breaks above the SRV at 1.51491.

This is one of those “fake and reversal” moves I remember from our “Tug of War” days as a youth. And such moves happen frequently in Forex trading. A trader must be ready to react quickly to enter this market as the move after the fake is usually very swift – as was the case here.

To make the most of this trade you would have to have had your plan in place to react immediately at a specific price - or lose a substantial portion of the move. That is why a system that provides the trader with a specific entry point is so important to short term trading. Our specific value of 1.51491 gives us such an entry point and our soft stop loss would be a reversal of price that broke below that SRV.

I tend to think that the “fake and reversal” moves I see in Forex, such as the one just described, are a result of so many computer trading programs that are trend following. When a move suddenly reverses sufficiently the trend following traders must adjust their positions quickly – and that can cause a significant reversal move to accelerate in the opposite direction. That was the case in this GBPUSD pair move – more than 700 pips in little more than a minute – and it took only about 50 trades to do it!

Although this trade happened very fast, you must remember that I took a considerable time in constructing this trade. Also, I waited patiently – even overnight - for the specific conditions required for entry to occur.

This “fake and reversal” is easier to see on the fastest chart, shown in Figure 6. However, it is very difficult to configure a trade on this fast chart – it is best to configure your trades on the primary, or secondary, intra-day charts. The fast chart is used primarily to fine tune entries and exits – and occasionally for scalping a market.

 trading strategy fake and reversal gbp usd

I am always quite happy to take a 700 pip trade with relative low risk - and let the aggressive traders take the greater risk - and possibly a greater reward.

The aggressive trader could have gotten into this trade at a much lower price than our entry - and could have ridden the move to a much higher price than that of our exit. This is the difference it can make in the “when” a trader elects to take a side in the tug of war. But, the real difference in the two entries is aggressiveness of the trader – and I prefer the conservative trading mode. Without a very large trailing stop – or no trailing stop at all – a long trade would have gotten stopped out overnight.

The conservative strategy we employed netted less than half as much profit. However, the risk was far less as well - and there was no overnight exposure.

The conservative strategy resulted in the same decision as the aggressive trader as to “which side” to join – it just made a different decision on “when” to join.

Watch for the ‘fake and reversal” any time price is near a potential trend reversal and starts moving sideways in a tight trading range. Remember such “Tug of Wars” conditions often result in a “fake and reversal” – and that reversal can be quite large.

Forex trading is a Tug of War; “which side will you choose” – and more importantly, “when” will you make your move? Understanding the psychology of the “fake and reversal” move may occasionally help you decide.

I wish you great success in your trading.

Phil Elrod
Author and Trader
Trading Between The Lines