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FOREX STRATEGY

To Trade, or not to Trade, That is the Question

We barely passed English Literature in college, so quoting (almost) Shakespeare is really stretching our credibility, but the temptation was just too great. Whether or not to trade is a constant and important question confronting all Forex traders.

Forex markets today are as nervous as we have ever seen them. The situation in Europe seems to be a never ending roller coaster ride. The western world’s growing mountain of debt (and we must include Japan as well), combined with central banks rampage of printing of money, hangs over Forex markets like the sword of Damocles. Toss in the fact that BOTS (robot trading systems) are so active and you have a situation that seriously challenges those of us who love to trade Forex.

Although trading Forex is not easy, it is truly a lot of fun - and can be profitable for those that have a good trading method/system and a good work ethic.

Based on our many years of learning to be a trader (and that process is still an ongoing endeavor) and talking with traders from all over the world, we are convinced that far too many of them concentrate on learning when to trade  - and spend far too little time learning when not to trade. It is further our contention that knowing when not to trade is at least as important, and possibly the more important, of the two.

Our general trading rule is quite simple: “If we see a potentially profitable trade that fits our trading parameters, we trade – if not, we do not trade.”

We agree that trading is being in the market – however, being in the market at the right time is more important than always being in the market. Being in the market at the wrong time can produce losses – and losses are bad!

The frequency with which we trade is both related to the number of potential trades that occur in our selected time frame, and the selected time frame itself. The shorter the time frame in which we trade, the more frequently we trade. We like to trade our primary trading chart whenever possible. However, we often move to our secondary trading chart when the primary trading chart is not producing promising trades.

You only make money when you trade successfully. So traders need to control that eagerness to make a trade. We submit, it is more important to make a successful trade and profit from it, than to trade frequently and take numerous losses.

After all these years, and innumerable trade analyses, we still have to fight the “urge to trade”. Let’s face it – as a trader, we like to trade – sitting there waiting for the next trade can be boring and stressful.

So what is the trader to do to control this “urge to trade”?

First and foremost, have a good trading method and follow it. A good trading method should not only indicate when you should consider making a trade – it should also indicate to you when you should not consider making a trade. A good trading method provides consistency to a trader’s actions.

The simple fact of the matter is that good trades are not always available – particularly in any one market. We wrote an article in FX Trader Magazine April-June edition about patiently waiting for the good trades, “Minding Your Ps and Qs” – and one of the most important “Ps” in that article is “patience”.

The hallmark of a really successful trading method is that it will indicate to you when a high probability of a good trade is developing; and then tell you when to enter the trade. It is up to you, the trader, to have the patience to wait for that entry signal. Personally, we find that when we are trading at our best, we are out of the market more often than we are in the market.

IDENTIFYNG A GOOD TRADE

There are many ways to identify a prospective trade. We are going to describe our method briefly. We have found it to be very effective, especially for the rapidly moving FOREX markets. The principal reason that our method is so fast is that it is visually interpreted. Once the trader has learned to visualize the setup for a potentially good trade, a good trade can be recognized almost instantly.

Our trading method/system (we call it trading between the lines, or “TBL”) employs some unique proprietary elements for determining SRVs and near term momentum. However, TBL uses traditional technical indicators, somewhat customized, to determine overbought/oversold, trading range and trend. The indicators we use are:

MACD – plotted both as traditional moving average lines and as a histogram, with the histogram representing the difference between the MACD average lines. The histogram makes it much easier to see an impending change of direction in trend. The purpose of the MACD is to monitor trend and alert to a potential change in the trend.

Stochastic oscillators – plotted as three Stochastic lines, of 7, 28 and 84 periods respectively. We do not plot the usual signal line - we prefer to use the 7 line crossing the 28 line as a potential trading signal. The Stochastic oscillators are our primary over-bought, over-sold indicators.

Bollinger Bands – plotted as 21 period exponential moving averages (the standard method). We use the Bollinger bands as both a trend indicator and a trading range indicator. Many, actually, most, of our trades are entered very close to a Bollinger Band.

Relative Strength Index (RSI) and momentum technical indicators - these two widely used and well respected indicators are used in a unique way. The techniques we use with RSI and momentum were learned from an exceptional trader many years ago. We know of no other traders - except those who have adopted our TBL method - who use these indicators as we do.

Horizontal Lines: Finally we plot many horizontal lines representing support and resistance values. These lines, we call them SRVs, are a key part of our trading system.

Our trading method is often referred to as “Seeing the music of the market” – perhaps, because the SRV lines make our charts somewhat resemble a sheet of music (see our article in FX Trader Magazine January-March edition).

We use, for the FOREX markets, a workspace consisting of 6 charts, a quote windowpane and a time and sales windowpane. The six charts are:

A weekly chart.

A daily chart.

Three intra-day charts - named and constructed as follows:

• Primary trading chart – a tick bar chart typically set to display 12 – 15 bars per day – the ticks per bar will vary with the market being traded.

• Secondary trading chart – a tick bar chart set to display 1/10th the number ticks per bar as the primary trading chart.

• Scalping chart – a tick bar chart set to display 1/10th the number of ticks per bar as the secondary trading chart.

A single tick bar chart.

The weekly and daily charts are used primarily to construct the intra-day charts. The single tick chart is used to monitor the momentum of trading.

All of the charts are set to display 100 bars of data when fully expanded.

All of these charts are arranged in a workspace in a manner making it easy to quickly select any one chart. The usual display shows a partial chart of both our primary trading chart and secondary trading chart. These partial charts are configured to show the right side of the chart, the active trading area. We like to monitor both of these when in a trade.

We can easily expand the chart to full width with a click of the mouse and then back again, with another click of the mouse.

The following picture shows a typical TBL workspace arrangement. The tick chart to the lower left and the time and sales windowpane above it are used primarily to monitor current market momentum. The quote window along the bottom of the workspace allows us to easily see the current spread as well as observe changes in bid and ask prices. The primary and secondary trading charts are shown in reduced view. The weekly, daily and scalping charts are mostly covered but are available with a single click of the mouse.

forex strategy to trade or not to trade when to trade eur usd

There is a lot to look at here. However, once learned, the trader can glance at the primary trading chart and immediately see if a trade is available – or imminent.

What we look for is:

Price is currently oversold or overbought.

Trend has just changed direction - or is about to do so.

Near term momentum is in the direction of our desired trade entry.

There is sufficient potential profit to justify the risk – we like at least 2 to 1 profit/risk potential – preferably more in the primary chart time frame.

We also like to see an SRV that can be used for entry and stop loss – usually we wait to see that the SRV affects price as expected - and then enter the market.

An example of our primary trading chart (fully expanded) is shown below. All chart analysis work is done with the chart fully expanded.

All of the above information can be seen quickly once the trader learns to use the TBL visual analysis system.

forex strategy to trade or not to trade when to trade eur usd 500

What we look for when searching for a trade:

First, we “look” at the music the market is making. Market oscillations tend to move from support and resistance over time - trending up down or sideways. We like to see that the historical oscillations are behaving as expected as they approach the SRVs. If the market is being affected as expected by the SRVs – then we are confident that future price movement will also be affected by our SRVs. Further, our SRVs give us specific numeric values with which to analyze and construct our potential trades.

Notice in the chart above, a 5000 tick per bar chart of the EURUSD, the primary SRV lines (the light blue horizontal lines) at 1.24995 and the one above at 1.25918 – a spacing of more than 1000 pips. That is a very good range in which to trade – even though we have a couple of secondary SRVs about 200 pips above the lower primary SRV and another couple of secondary SRVs about 200 pips below the upper primary SRV.

Generally, a trader can only expect to capture about 75-8% of a potential move. We must risk at least 100 to 150 pips for a trade of this type; therefore, our potential must be several times larger to really entice us to trade.

It takes many words to describe this scenario, but when a trader learns to visualize the prospective trade it can be assessed almost instantly. We just project a vertical line onto the chart at the potential entry price, extending it to the trade potential target – that is our maximum potential profit. Then we reduce the length by risk (stop loss) and we have our potential profit. The length of the potential profit line is then divided mentally by the length of the stop loss and we have our risk to reward ratio (RRR).

In the scenario described on the above chart our imaginary vertical line is 1000 pips X 75%, which equals 750 pips. With a 150 pip stop removed our line is now 600 pips; therefore, our maximum potential gain is 4 times our risk. We love this type of trade!

Monday, August 27, was a day to sit out this market for this time frame.

Tuesday, however, presented a trading opportunity. As price bounced off the primary SRV at 1.24663 overnight, it broke above the primary at 1.24995 and our technical indicators pointed to a strong upward move developing. Visualizing the vertical line scenario described above, we would enter this trade in anticipation of breaking through the secondary SRV lines just above our entry – if not we would exit quickly.

Price did move above as expected and after five attempts to break above the two secondary lines in the 1.25700 range, began retreating. We would have exited our trade at this point. This trade could have netted about 400 pips – not the full 600 pips potential, but still a very good trade.

If we had traded this primary chart all week we would have found only two trades. The TBL near term momentum indicators would have kept us out of a trade until Friday, August 31, where once again our technical indicators indicate a strong move and the SRVS around the 1.25200 area are finally penetrated.

So, for the week, we would have only found two worthy trades for this time frame.

But we can often trade other time frames – after all - the trend in the primary chart time frame is meandering sideways. Let’s look at the secondary chart for the same symbol and time.

The following chart, of the EURUSD, starts on Monday morning, August 27th.

forex strategy to trade or not to trade when to trade eur usd 3

After breaking a bit below the primary SRV at 1.24995 for several bars, the price briefly moved back above that value, then began a move back down. Our near term momentum indicators indicate a strong move downward. The next primary SRV line is at 1.24663 – giving us a potential trade of about 330 pips of which 75% is almost 250 pips. We plan to risk no more than about 50 pips, so our risk to reward ratio is very good for this trade. We would exit as price hits the primary SRV at 1.24663 – probably netting more than 250 pips on the trade.

Because of the strong indication of a reversal of momentum, a trade reversal would seem reasonable here with the potential at least to the previous primary SRV at 1.24995. Trading this faster time frame often produces opportunities to “switch sides” on a trade – but we are careful because it is not always the case. It seems like the only rule that is always true in trading is that no rule is always true.

Our method of selecting trades is exactly the same between the two time frames – only the values of entry, potential and risk change – and they are visually evaluated.

Incidentally, in this volatile market environment, we usually assess risk as the average bar height in the vicinity of current price for the time frame we are trading.

We also use the entry SRV as a stop – preferring to not allow price to reverse and break that SRV in the direction opposite the trade. When no SRV is available we just use our entry plus a small amount extra as our stop value.

By always looking for the same things – whatever the time frame we are trading, it simplifies the system and makes it easier to move smoothly from one time frame to another.

Our third chart is the fastest time frame we use, and we call it our scalping chart – the term associated with very short-term trading. Trades done on this chart must be assessed quickly and executed with haste. The potential is usually not nearly as great as other charts and the risk is often high. The pace of the trading is often frenetic and can tire one quickly. However, once in a while it is great fun. Our same system is used and we are looking for the same setup – a potential price movement that is great enough to justify the risk. The potential of such trades is often less than 100 pips and the risk is often as much as 25 pips, so you have to get it right pretty often to make money scalping. Often, SRVs are not available in the price ranges of these trades, so we have to rely on the other components of our system for entry, exit and stop calculations. In such situations we use the Bollinger Bands and our near term momentum indicators for entry and exit signals. Generally, our stop is only mental and is very tight. The trading in this time frame is too fast for limit orders and hard stops.

The EURUSD scalping chart for this week in August just did not look good to us – the Bollinger Bands were not spaced far enough apart most of the time and we had few SRVs within the trading range. That situation usually only makes money for the broker.

A personal opinion, not backed by anything other than our own observations, is that the BOTS (software trading robots) are working furiously in this very fast time frame. When we do trade this time frame, we pay particular heed to the Bollinger Bands (particularly when there is a dearth of SRVs) – not only the upper and lower bands, but the middle band as well. We can just sense the rapid and sometimes violent movements of price in these areas as the BOTS kick up their trading activity. Beware of the often rapid movement away from the averages as the BOTS trade furiously with the changes in trend.

If we are constructing a trade on our primary trading chart, we will always use the secondary trading chart to try to improve our entries and exits. The shorter time frame charts react to price at a faster pace and can often alert us to a more favorable entry price and/or alert us to exit because momentum has reversed or is about to reverse.

Our preference is to trade from the primary trading chart; however, considering the extent of volatility of current FOREX markets, we find ourselves trading from the secondary chart more and more these days. When we construct a trade from the secondary trading chart, we use the scalping chart to select entry value and for monitoring the trade progress.

When we cannot find a trade imminent on either the primary or secondary chart: there is always the scalping chart. We can always count on the scalping chart to have some real fast moving action. But be careful of the trading range – you can work hard in this time frame and not make much profit due to tight range and price spreads

Our system is based on technical trading but we must watch the music of the market for aberrations of tempo caused by fundamental events – and these events can be anticipated (such as central bank meetings, or unexpected (such as some banker or politico making a statement that riles the markets).

Price oscillations are somewhat rhythmic, but the rhythm can change abruptly – often due to some fundamental event affecting the market being traded. These fundamental events can frustrate technical traders but we must be aware of them and must anticipate them whenever possible. Incidentally, a free daily newsletter that is truly worth a FOREX trader’s time to read is the Daily Pfenning, written by Everbank President of World Markets, Chuck Butler. We refer to Chuck as “Mr. Fundamentals”, and we love to start our day reading his latest comments on the currencies. His analysis is spot on and he often reminds us of an upcoming fundamental event we might otherwise not have anticipated.

Forex markets, like all markets, are moved by the mass psychology of all market participants. Sometimes, to a rational person (and we hope that includes us) the reaction of the market to a fundamental event is hard to understand. Sometimes we wonder if “those people are stupid”. At such times we always remember a quote from Dr. Alexander Elder, from his excellent book Trading for a Living: “The crowd may be stupid, but they are stronger than you are.”

We hope that this article has given you a little insight into how we decide “To Trade, or Not to Trade”.

We wish you great success and much fun with your trading.

Phil Elrod
Author and Trader
Trading Between The Lines