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FOREX STRATEGY

Minding Our Ps and Qs

While we watch the music of the market

trading strategy trade opportunities

This article is a follow-up to a previous article, published in the January-March issue of FX Trader Magazine. If you have not read that article you might want to do so before reading this one. In the previous article we discussed the concept of “Seeing the music of the market” – and a trading methodology based on visual analysis.

To briefly recap: our trading methodology is not based on typical pattern recognition, but on price action relative to SRVs (horizontal lines of support and resistance), which we place on our charts at the beginning of our trading week. These SRVs on our charts remind us of a sheet of music.

In this article we will discuss several things that a trader can do while “watching the music of the market”, in other words, waiting for a good trading opportunity to develop. Good trades are not always available in any market; but, good trades happen from time to time in all markets. Traders do not make good trades – good trades are executed by the trader when the trade develops, meaning that traders must learn to wait for the good trades to come to them.

It is well to remember that profitable FOREX trading is not easy. Traders must exercise mental discipline and patience. The time waiting for trades can be difficult to manage. We are generally considered to be very impatient (just ask our dear wife!). However, over the years we have developed a means of controlling impatience and maintaining perspective - so that when a good trade presents itself we are ready to execute it.

Concentration consumes considerable mental energy in most people – it can be very difficult to maintain your concentration unless you prepare yourself. Part of our preparation was to develop a method of trading based on visual analysis that can be executed very quickly. We know what setup we are looking for – we just have to patiently maintain our concentration until it appears.

Over the years we developed our method of managing the waiting time between trades; we call it, “Minding our Ps and Qs”.

Growing up, as we did, in the Southern Appalachian Mountains, (an USA bastion of the original English language brought to the colonies) we often heard the term “Mind your Ps and Qs”. There are several theories on the origin of the term, but we prefer to believe the one that attributes the origin of the term to British pubs. Patrons ordered their ales in pints – the “Ps” – and quarts – the “Qs”. The inn keepers would admonish their patrons to “Mind your Ps and Qs” as a reminder to, as we say today, “drink responsibly”. Or, as the term came down to mean today, “Be careful”.

As a youngster, we generally took it to mean “be good”.

If you expect to make money trading forex, you had better be good – and you surely must be careful.

So minding your Ps and Qs is appropriate behavior for a forex trader. We like to think that following formula, along with our trading system, is the key successful forex trading:

PATIENCE + QUALITY + QUICKNESS = PROFIT

Stated another way, “Waiting (PATIENCE) for the right trade conditions to develop (QUALITY) then acting immediately (QUICKNESS) leads to great trades (PROFIT)”.

We try to always remember the above formula when we trade.

Almost all markets are experiencing significant volatility these days. As previously stated, good trades are not always available in all markets at all times – they develop in their own time. Traders must have the PATIENCE to wait for a good trade to develop. We have lost many dollars on trades that we should not have made in the first place.

The reason was that we sat down with the attitude that “we are going to trade”. What we should have done, is sat down with the attitude that we were going to wait for a good trade to develop. The music of the market has its own rhythm and we traders must learn to watch it, and only act when we see the right conditions developing.

As previously stated, patience is not our personal long suit – we have learned that simple lesson the hard way – good trading requires patience.

Our personal trading methodology, which is based on “seeing the music of the market”,  is to do trades that can be concluded in a day or less. However, the method can be adjusted to almost any trading time frame. Generally, this adjustment is done by simply changing the time frame on our trading chart – but always making sure that our primary trading chart – the one on which our trade in constructed, allows us to “see the music of the market”.

The elements of a good trade are not significantly different from our shortest-term to our longest-term trading method. That is the beauty of the visual analysis system we use – we are always looking for the essentially same set-up, regardless of the chart time frame being used.

Personally, we like to take trades that have a risk to reward ratio (RRR) of at least two – that is, we want a potential profit of at least twice our risk in the trade. Actually, we prefer that number be higher 3, 4 or even 5, is so much better. The higher RRR values are only achievable by “cherry picking” your trades (taking only the very best trades). It is easier said than done - and in order to do it patience is a prime requisite.

Generally, the faster the time frame you trade the smaller the available RRR. Our preferred forex trading chart is usually set to about 12 to 18 tick bars per day. The number of ticks per bar will vary greatly depending upon the market we are trading. We often use as many as 10,000 ticks per bar and sometimes as few as 2,500 ticks per bar for our primary trading chart. The number of ticks per bar is unimportant – being able to “see the music of the market’ is what is important.

We cannot over emphasize the importance of patience – it is what we use while watching for a good trade to develop. Trading is exciting – but waiting for that trade can be boring. Boredom can lead to mental lapses – and a mental lapse when a trade is developing can cause the trader to miss the trade completely – or make their execution late, increasing risk, and possibly giving away much (or all) of the potential trading profit.

A good trade will have the qualities we are waiting for – an SRV on which to start the trade, an SRV upon which to base our stop loss and an SRV to base our potentially profitable exit upon. Often a single SRV serves as both our entry point and our stop loss basis – another SRV provides our exit target. That is why we call our method, “trading between the lines”.

PATIENCE + QUALITY + QUICKNESS = PROFIT

A QUALITY trade will provide the trader with the highest probability of success. The qualities we look for in a potential trade were discussed in detail in our previous article, “Seeing the music of the market”. Simply stated, we want to “see” a potential trade that offers the probability of a good profit (more” Ps” to mind!) with an acceptable risk level.

We had just finished placing our SRVs for the coming week (late afternoon, Sunday, February 12, 2012) when we noticed that the EUR/USD pair had produced a sell signal from our system.  We do not trade all of these signals but we look at each one carefully, and we really liked this one very much.

We noted on our trading chart (shown below) that the euro had made a strong move up against the US dollar. The EUR/USD pair had moved well beyond the top Bollinger Band. In addition, it had been rejected by a secondary SRV at 1.32349. This looks like a classic shorting opportunity. We enter an order to sell the EUR/USD, placed our stop a little above the SRV at 1.32349 and let it ride over night. We do not usually make these trades, but the technical setup was especially good and the fundamentals favored the trade (the Eurozone leaders still groping with the Greek problem). The profit potential of this trade was just to great to resist.

Note the chart below – the music of the market played out just as the SRVs indicated it should.

The trade we constructed worked out the way it was supposed to. We collected a very nice profit on this trade (about 50% on our margin requirement). As price neared our primary SRV at 1.30791, with two secondary SRVs just below, it was time to take our profit.

Unfortunately we had an outside appointment to fulfill Monday morning, or we would have likely considered going long off the SRV at 1.03791 – with two primary SRVs just below it, and the next SRV above it at 1.31160, a pretty decent trade could have been made between those lines. And later, as you can see on the chart, it would have been a really good trade, as the SRV at 1.31160 was eventually breached and price moved right on up.

We usually try to be very short-term traders when we trade forex because of the volatility of the currency markets these days. Exceptions, like the example above, do come along from time to time and a good trader always takes what the market offers him.

Volatility is generally considered good for traders – up to a point. We love a good level of volatility because of the opportunities for profit it provides. However, with rapidly moving markets the trader must be prepared to act quickly when a quality trade develops.

PATIENCE + QUALITY + QUICKNESS = PROFIT

Likewise, the exit trade may need to be done with quickness as well to collect maximum profit – or to avoid or mitigate a trading loss.

Thus “QUICKNESS”, our second “Q”, can enhance the level of profit from the trade – sometimes significantly.

In the above trade, the entry had to be made quickly to avoid significant loss of potential profit. Likewise the exit should have been made quickly to maximize profit. Actually, because of our outside appointment, we had to close the trade a bit early – foregoing a bit of profit – but it was still a very good trade.

We should stress again that the above trade involved several unusual factors and we reacted a bit differently from our usual routine. But traders have to be adaptable to what the market is actually doing.

Our routine trading method has been changed by the recent increase in market volatility. First, we try to avoid holding positions overnight – except for special situations, such as the trade just discussed. To hold a trade overnight, and sleep well, we would have to have a stop loss in place. Today’s market volatility would dictate a very large stop value, so only trades with a large RRR would be acceptable to hold overnight.

Secondly, we seldom use hard stop losses – that is a stop loss order placed after entering the trade. This adds risk to the trade, but we consider it essential due to market volatility. The good thing about using soft (mental) stops is that we avoid getting whipsawed out of a trade with a small stop loss value. It is also good not have to place a stop loss value of substantial size- it can significantly reduce our RRR.

The bad thing about using mental stops is that it requires constant attention. We must confess that this method of stop losses has caused us to leave many trades earlier than desired – because, for some reason, we could not be there to monitor the trade. Good trading techniques seem to frequently require some form of compromise

PATIENCE + QUALITY + QUICKNESS = PROFIT

PROFIT is the result of minding our other Ps and Qs. A small PROFIT is preferable to a loss of any size. We love to make a profit – not just because of the money we make – it is succeeding at something that is not easy. We would probably trade even if we did not make so much money – simply because we love to trade.

Profit, however, is wonderful, - it is necessary for another important “P” – “PAYDAY”! Payday is a “P” which we mind with great pleasure. It is a marvelous feeling to write your own paycheck, knowing that you earned it the hard way – you worked for it!

We could talk all day about our trading method, but we must save a bit for later.

However, there is one additional set of Ps and Qs we would like to bring to your attention. One of the nice things about forex trading is that most companies providing forex trading accounts do not charge a commission for each trade – instead the trader pays the difference between the bid and the ask on each entry and exit. So our final “P” and “Q” set to watch is, “PIPS” and “QUOTES”.

The forex trader must learn to quickly assess the cost of the trade by noting the difference between the bid price and the asking price for the currency pair they are trading. It is not as easy as futures trading, where the difference is usually only a tick or two.

The number of pips it will cost to enter (or exit) the trade is, of course, the difference between the bid and the ask price. The cost of a trade would be generally double that amount - to account for entry and exit.

The difference between bid and ask is called the spread. In forex the spread may be significantly different between entry and exit, complicating a precise estimate of RRR.

Also, the spread can vary widely from market to market and from time to time. Generally, when the market is at its most liquid, the spread will be at its lowest – and vice versa.

A good trader will only enter the market when the number of pips they expect to make is at least twice the number pips it will cost to enter and exit the trade. You must have the potential to make at least as much as you risk – preferably double or triple your risk. A forex trader must develop the ability to estimate his spread as accurately as possible.

Good money management is crucial to making a profit in trading. Only your broker makes money when you breakeven (and yes, they make money even when you lose). It is up to the individual trader to mind the “P” for PROFIT.

PATIENCE + QUALITY + QUICKNESS = PROFIT

So while you are watching “the music of the market”, mind your Ps and Qs - it will help you to become a better trader!

Phil Elrod
Author and Trader
Trading Between The Lines