D day chart was in an upward channel, and sentiment for the strengthening EURis confirmed by the bull sentiment histogram, especially when it turned positive.
CARRY TRADERThe carry trader is interested in playing the interest rate differentials for receiving income by buying the pairs that pay income to the account. The goal of a carry trade
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account is to get a superior return on the equity through interest. The carry trade willalmost always be part of forex as long as interest rates around the world differ. Moneytends to flow where it is perceived to get the best return. The most famous of the carrytrade pairs is buying the New Zealand dollar–Japanese yen (NZDJPY). The NZD offers8.0 percent interest, while the JPY offers 0.50 percent. This means that the gap between them is 6.75 percent paid to the trader if done right. Another part of any carrytrade portfolio has been the AUDJPY playing off the 6.25 percent interest rates behindthe aussie. A third pair common to carry traders has been the British pound–Japaneseyen (GBPJPY) using the high rates of the pound at 5.75 percent. Carry trades havebeen the domain of very large institutional trading, but they are available to newtraders.Carry trading has become extremely popular. A sure sign that the success of thatstrategy was coming to an end was a taxi driver’s asking about carry trades. The risksof carry trades need to be recognized. The risks of large drawdowns while one waits forinterest to be paid is substantial. Let’s first take a closer look at the mechanics of thecarry trade for the retail trader.The first concept that needs to be learned is how a carry trade account works differently from a regular forex account. The account is the same, but the trader has twoimportant focuses. The first is the balance of the account. As interest payments comein, the balance totals will increase. The second is the equity of the account. This is theliquid value of the account if everything was sold. There will be volatility in the equitybecause the value of the pair bought will vary. The concept is that even though thereis risk of losing equity, ultimately, if you hold on, the interest rate will reimburse theaccount. This is a tricky trade because there can be substantial volatility in the equityvalues.Figure 14.10 shows the weekly NZDJPY and GBPJPY. These are the two major carrytrade currency pairs. We can see that for a substantial period of time those buying thesepairs and holding them not only got high interest rates but also benefited from the fallof the yen. But as interest rates in Japan increase, the carry trade becomes less attractive and holds greater risk of losses as the yen rises against the other pairs. A carrytrade portfolio looks to capture interest rates, but the equity value of the account will bevolatile.A real-world example shows this very well. The trader trading a $30,000 accounthad on a mix of pairs. Until a major sell-off of the yen on February 27, this account performed approximately 5 percent per month. But it incurred a loss of equity of $6000, or 20percent, in one day. Those who held on to the carry trade positions the week after February 27 suffered further losses. But the carry trade was not eliminated. The difference ininterest rates in the carry trade pairs continued to appeal, and the prices recovered weekslater. It’s important to keep leverage low in carry trade accounts to enable sudden large
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FIGURE 14.10 NZDJPY and GBPJPY Are Popular Carry Trade Instruments.Source: www.tradesignal.com.
moves to be sustained. Jes Black, a forex trader and money manager at Black Flag Capital, observed that:Typically, the carry trade is leveraged. With a $10,000 account, and trading minis, you should not exceed 10 times leverage. If you have more trading capital,you should look to diversify the various carry trades to reduce your risk. You couldalso look to do hedging strategies whereby you equalize your U.S. dollar exposureto net zero. Example: long USDCHF and short USDMEX. Both collect a carry, andyou have effectively brought your dollar exposure to zero, much like a long/shortequity manager attempts to do.
NEWS TRADERThe news trader focuses on trading economic news releases. A great advantage is thatthe strategy offers effective trading in a short period of time. News trades should beconsidered seriously by those who cannot do forex trading on a full-time basis.
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The market patterns relating to the news trade display three distance phases (Figure14.11). First, the price patterns go into a sideways pattern. This is because there is hesitation about the outcome. Then the news release occurs. A surprise result causes a sharpmove in one direction or the other through the formed support or resistance levels. Afterthe initial impulse, the market will sell off and try to retrace. It may succeed in returningto the original sideways range, or simply go to a point of retracement and then pause andresume the move in the direction of the break. These phases are part of every economicnews release responses by the market.
Tactics for News TradingThere are three essential tactics traders can use:1. The Hedger. Put on a hedge trade by buying and selling the currency pair at the same
time right before the news. When the news is released, the trader gets out of thelosing position and stays with the winner.
FIGURE 14.11 Phases in News Trades.Source: www.tradesignal.com.
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2. The Bull Ride. Trade on the break of the news by entering the market in the direction
of the break and trying to ride out the move.3. Post-News Retracement. Wait for the economic data to be released and allow the
market to move and complete its first wave. Once the move is over, the traderwill wait for a post-news Fibonacci retracement and enter the trade after thisretracement.Each tactic has its advantages and disadvantages. Trading the news is a very efficientway to trade forex because the trader knows in advance that the market will move. Let’slook at the strategies in greater detail.Riding the Bull or Bear—Anticipating Results (Most Aggressive Strategy)The trader has an intuitive feeling (a hunch) for the outcome of the economic data. It isnot a wise strategy to put on a trade before an economic news announcement. But if thetrader has an informed point of view, putting on the trade before the news announcementis an aggressive play that can be very profitable if correct. The key risk of being wrongand having the price move against you is important to minimize.Tactics for the aggressive strategy are as follows: About 15 minutes before the economic data release, locate the 5-minute or 15-minute chart. Locate support and resistancelevels. Use the average true range (ATR) at the default setting of 14 periods. Place a market order in the direction you desire. Place a stop loss order at 2 times the ATR. Shouldyou put on a limit order? In trading the news, the idea is to be ready for a big move Butwe don’t know if a big move will come. So a small limit order targeting 10 to 15 pipswould be like eating cake with artificial sweeteners. If you’re going to trade the news,focus on controlling the risk. The idea is to take a ride on the bull or bear, get on beforethe break of the news, and then try to stay on to get the most out of the move. So I don’trecommend a small limit. You might want to put on a larger limit of 75 pips.Getting off the trade in a news event requires a high level of skills in identifying shiftsin sentiment. Renko charts are a powerful tool for this. Remember, riding a bull or bearrepresents high risk. But if you want to try it out, do it with small lots on and test yourskills.Trading on the Break (the Bull Ride) In this version of the news trade, the ideais to get into the trade as soon as the data release breaks. The trader needs to have theticket ready to go and jump in. The risk here is of a whipsaw, where the price reverses.This risk is not as high as people think because when the news breaks, there is maximumenergy and the market will respond. The risk of no surprise does occur and that resultsin a small move, causing the risk of smaller losses than a whipsaw because essentiallythe price doesn’t move beyond a previous range and there is little room for profits. But
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if you’re on the bull or bear trade and it is a big move, you have the same challenge ofwhen to get out. The advantage is that you are not immediately wrong.Playing Both Sides at the Same Time (the Hedger) In this strategy, thetrader wants to participate in the news breakout but doesn’t want the risk of prediction and the costs of waiting to decide direction. This strategy means you are buyingand selling the currency pair at the same time. As soon as the news breaks out, a decision has to be made as to which side to get out of. Should it be the winning or thelosing side?The first tactic is to get immediately out of the losing side. This may cost you 20 pipsor more on a strong move, but it also means you’re in on the winning side. So the pricefor the ride depends on how quickly you can get out. Getting out of the loser first followsthe logic that at the break of the trade there is maximum momentum, and being in at thispoint is, in fact, the best time to be in. This strategy works well when there is a big move.Figure 14.12 shows a classic breakout in response to positive dollar nonfarm payrollnews release. The hedge strategy would have worked out, with the loss of about 20 pipson buying the EURUSD, offset by a gain of up to 60 pips with buying the USDCHF. Fewtraders could get the maximum gain out of this kind of move and would more probablyachieve a 15- to 25-pip move in about a 15-minute period.Getting out of the winner first is a variation of this strategy. In other words, keepthe loser and get out of the winner because the first minute is when there is maximum energy. Then manage the losing side. The idea is to wait for a retracement onthe loser. This strategy can backfire; if there is a small move on the news, both sidescan lose.News trades can occur on any currency pair because all countries have key economic data releases. There are many hedge combinations for trading news that affectcurrency pairs. The same principle of going long and short at the same time applies (seeTable 14.2). Some forex firms now allow hedging in the same account. Other firms allowthe creation of a subaccount. For example, one can buy EURUSD in one account andsell the EURUSD in the other account. But when this is not permitted, there are otherways to employ a hedge strategy. If one is doing the EURUSD news and buying also theUSDCHF, there is a pip differential. The EURUSD moves $10 per pip (per $100,000), andthe USDCHF will vary. To obtain an actual hedge, one needs to rebalance the trade. Forexample, if a trade were put on when the USDCHF was at 1.22, it would move $8.20 perpip. So a trader doing a hedge would trade 10,000 for the EURUSD and 12,500 for theUSDCHF to balance out the move.The trader will find that the implementation of these news trading strategies mayvary, based on the forex firm involved. One should test them out to determine if a greatdeal of slippage occurs at the firm you are considering.
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FIGURE 14.12 Currency Moves in Response to Nonfarm Payroll Report.Source: www.tradesignal.com.
POST-NEWS RETRACEMENT TRADERThis strategy is by far the most consistently productive and should be part of the initialset of strategies used by beginning traders. The idea is that after the break of the news,there will be retracement—the price will move from a high to a low, or from a low to ahigh and then retrace. The trader waits for the retracement failure and looks to enter atrade on the direction of the original break. The retracement failure point is most likely
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TABLE 14.2
U.S. newsBritish newsJapanese news
Hedge Combinations for Diﬀerent NewsBuy EURUSD and buyUSDCHFBuy GBPUSD and buyEURGBPBuy USDJPY and sell GBPJPY
to be a Fibonacci-based pattern. After a news release, there is the initial move, but therecan be many retracement attempts and therefore many opportunities to trade.An aggressive version of this is to wait for the move after the release of the news, andthen when it stops and reverses, put on a reversal trade. This strategy of fading the moveadds a scalping tactic and provides more opportunity. But the far greater percentagepayoff is on trading post-news retracement. If the price does retrace to a Fib point, thenthe trade can employ the setups that work in other times.
SUMMARYWhich economic data release should you trade? Every currency pair has economic newsthat affects that pair. It’s hard to know in advance which ones will be important. The keyfactor is whether the market is surprised. Check your economic calendar and highlightkey news releases. Focus on those releases that will report on inflation, job growth, andhousing data. Initially, be sure to use low leverage or test your skills in simulation.
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Alternative Setupsand TradingStrategies
his book is designed to provide traders new to forex knowledge that helps shapetrades. This knowledge includes fundamentals, charting analysis, technical indicators, and market psychology—to name just a few. The act of trading becomesthe application of these areas of knowledge with the forex trading mixing-and-matchingtechniques and tactics. The setups used will vary along with the trader.Charting companies such as eSignal, VisualCharts, TradeSignal, and Prorealtime areexamples of current excellent forex chart providers. These providers often offer manyindicators, including some that may not be relevant to forex trading. For example, indicators that show volume cannot be used for spot forex. Some companies include experimental indicators that are developed by traders but have not been proven. This chapterexamines alternative setups and compares them with traditional setups that use morecommon indicators. Which is better? That will depend on the skills of the trader. Forextrading success is not a process of instant creation but a process of evolution. You shouldtry different setups and determine which mix is best for you.
T
STRATEGIES FOR STOP LOSSES AND PROFITLIMITS—ESSENTIAL COMPONENTS OF RISK CONTROLEven if you mastered all of the elements of fundamental and technical analysis, trading success would still require risk control. The most frequent question asked is: Whereshould I put my stops? There is no definitive method for stops, but the most importantfirst step is to determine the risk per day that a person wants to tolerate. For example, if161
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you have a $10,000 account, and the risk per day is 2 percent, this means that the traderwill tolerate a loss up to a limit of $200.Any level of risk has the consequence of providing a boundary for the trading. Unlessyou have an unlimited ATM machine to replenish your account, risk discipline is a criticalfactor. The consequence of having $200 risk per day is that the trader needs to decidehow much risk a particular trade is worth. Is the next trade worth the entire risk of theday? A $200 risk must also be translated into pips. Trading at standard size amountsof $100,000, the value of each pip move is $10. This means that putting on a trade thatresults in a 20-pip loss would result in using all of the risk for that day. The trader in thissituation would be foolish to risk a whole day’s trading capital on one trade unless it wasa fantastic setup. The trader should make room for several trades by choosing smalleramounts to trade. Mini lots that involve putting on $10,000 would mean that the value ofa loss of 20 pips would be only $20. There is room for 10 more losing trades that day!The concept of a risk per day can be better understood as having two accounts. Thefirst account is your real account with the capital in it. But the second account is the riskcapital account. Ask yourself how many pips you are willing to lose per day. By puttingon trades of $10,000 on a currency pair, many more trades can be taken. Yes, it does limitthe gains, but during the critical formative period where beginning traders are learningtrading, staying alive is more important than the magnitude of profits.After selecting the level of risk per day, locating a stop loss becomes a choice of thegeometry of the price action. The first approximation for a stop loss location should bethe answer to where you would get out if the market moved against you. In other words,if you were to buy a currency pair, then the stop loss would be where one would sellit—and vice versa. The trader will look to the trend line and support and resistance linesto find the location. But it’s not that simple in forex. Remember, there is noise in theforex market. There is no precise location for the price, since it is a bid-ask market. Oneof the most frequent sources of losses for beginning traders is being stopped out veryquickly. They place the stop close to the entry. In forex, the noise may take up three tofive pips easily.The response to this situation is to allow the prices to vibrate through its range.Here is where looking at larger time frames is important. You may trade off a 5-minutechart, but remember the price pattern of the 5 minutes provides a close look. Zoom outto the 15-minute and 30-minute charts to find more secure levels of resistance or support. This translates into putting one’s stop loss above or below the 15-minute supportor resistance, or above or below the 30-minute support or resistance. If you’re tradingoff a 4-hour chart, then day support or resistance is an appropriate level for locatinga stop.Another method for finding an optimal location for a stop is the level of volatility.Putting a stop above the extreme Bollinger band is one solution because that wouldrecognize that the price would have to go to new extremes to get stopped out.
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Another tool for locating the stop is the average true range (ATR) indicator. The ATRprovides a measure of the “reaching” ability of the price in terms of its lows and highs.Remember that the range is defined as the difference between support and resistance.The ATR compares the range’s behavior to previous closes, highs, and lows. The ATR isthe greatest of the following three values:1. The difference between the current maximum and minimum (high and low)2. The difference between the previous closing price and the current maximum3. The difference between the previous closing price and the current minimum
The ATR becomes a smoothing indicator of the true range over the periods selected.How do we apply it to stops?When the trader chooses to trade off a specific time interval, such as the 5-minutechart, the range of that time interval is expected to be less than the range of the 15-minutechart. Generally, the larger the time frame, the larger the distance between support andresistance. By watching the ATR, the trader can get a sense of whether the candles themselves are increasing in volatility.Table 15.1 gives an example of two currency pairs and their associated ATRs fordifferent time periods. If the ATR with a period 14 indicates a level of 9 pips, let’s sayon a 15-minute chart, this means that the lows and highs could have been 9 pips higheror lower on the average for the previous 15 candles. A good way to understand this is tovisualize any candle to stretch beyond its highs and lows 9 pips either way. So if the traderplaces the stop near or at the ATR level, it is inviting being stopped out by the naturaltendency of the market to swing in the plus or minus 9 pip range around a candle. Hereis how to use this: A good rule of thumb is to use two times the ATR for your stop. Ifone is trading on the 15-minute chart, then two times the ATR of the 15-minute candlesprovides room to breath.Alternatively, one can use the 30-minute ATR as the stop distance, even if one istrading off the 5-minute or 15-minute chart. By doing so, the trader is acknowledging thenatural vibrations of the price. Try to test this application out by putting on two trades inyour simulation account. Place a stop on one of the trades based on your own selectionTABLE 15.1
Comparative ATRsAverage True Ranges for 14 Periods
Currency Pair
5-Minute
15-Minute
30-Minute
4-Hour
Day
Week
GBPUSDEURUSD
35
95
159
3628
10162
295179
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criteria, but for the second lot, put the stop on two times the ATR of the 15-minute chart.See how your frequency of being stopped out is reduced. In Table 15.1, we see that theATR of the British pound–U.S. dollar (GBPUSD) pair was 9 and that the ATR of theeuro–U.S. dollar (EURUSD) was 5. Using the rule of two times ATR, traders looking toput on a trade in the GBPUSD would be sure to have a stop above 18 pips. Those lookingto trade the EURUSD could place the stop above 10 pips, since the ATR was lower invalue.Very often, the question arises: Should the stop loss be a ratio of the profit? In otherwords, if the trader were going for a 20-pip move, should the stop be 60 pips? The ideaof a positive ratio of reward to risk is at the surface a good one. Having bigger winnersthan losers is critical to profitability. But having an arbitrary ratio between a profit targetand a stop loss is just that—arbitrary. It does not reflect the reality of the dynamics of theprice movements and actual conditions facing the trader. It does not take into accountwhether there have been increases in volatility in the range. Additionally, if a trader isachieving a very good win-loss ratio, then it is possible to be profitable even if there aremore losers than winners.Consider the situation where a trader has a ratio of 60 percent wins. If the trader hada risk of 20 pips per trade and a profit of 20 pips per trade, the result would be (6 wins× 20) – (4 losers × 20), or +40 pips. In contrast, a trader with a ratio of 40 percent winsand an average profit of 40 pips with an average loss of 20 pips would result in a net of(4 wins × 40) – (6 losers × 20), or the same 40 pips. In other words, the reward-to-riskratio depends on the performance results. A very good trader can, in fact, have a highnegative ratio and still be profitable.
TRAILING STOPSThe question of trailing stops is always a topic of controversy. Should one have trailingstops? Where should a trailing stop be placed? There are a variety of approaches thatprovide different answers. First, the trader is new to trading and has not accumulatedmany trades, and putting on a trailing stop could be detrimental to improvement in performance. This may not seem obvious. However, a trailing stop is a predetermined pipincrement that is distant from the price. If the price moves further by 10 pips, a trailingstop set for a 10-pip trail would adjust further. The problem with this approach is that itis delegating to the market the decision to get out of the position. The trader should bewatching the position, and putting on a trailing stop may be an incentive not to watch. Additionally, an arbitrary trailing stop such as 10 pips may be an invitation to being stoppedout because the natural noise and vibration of the market could easily exceed that
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trailing stop (remember the ATR discussion). Finally, when traders are trading for relatively small targets such as 15 to 20 pips, it’s important to get good at achieving thosetargets and not focus on pushing the profits further. Keeping in a position after it reachesone’s goals may not be as productive as simply adding another lot to the original position.It is easier to get a 40-pip total profit from two lots than to use a trailing stop to try to getanother 40 pips.Rather than trailing stops, a valid approach is to move a position to break even whenpossible. If the target has been reached and the trader wants to stay in, moving the stopto a breakeven point results in a free ride on the trade. A good rule of thumb would beif you sold a currency pair, the breakeven stop loss would be 5 pips above your entry.If you bought the currency pair, the position of the breakeven stop loss would be 5 pipsbelow the purchase. In multilot trading, where a trader can capture profits on some ofthe lots, it makes sense to move the stops down to a breakeven location.Finally, mental stops are very popular and very dangerous. A mental stop is one thatcan easily be changed with the onset of an emotional whim. Mental stops violate thecardinal principle that all trades should have three components: the entry order, a stoploss order, and a profit order.For those traders interested in avoiding stops, using options instead of stops is anarea worth pursuing once they have experience in trading.
PROFIT LIMITSProfit limits are orders that are designed to close a position with a profit. Technically, ifthe ongoing trade was to buy, for example, the EURUSD at 1.3200, then the profit-limittrade would be a sell limit at 1.3220 if a 20-pip profit was desired. The price would haveto go through it to execute the trade. The limit order guarantees that price or better, butnot worse. But the price has to go through the position. Many new traders see the pricehit the limit and think it should have been executed. The question arises of how to formprofit targets. This is the other side of the stop loss issue.The major difference between being able to formulate a stop loss risk-control strategy and being able to formulate a profit-limit strategy is that one has total control overstop losses. Where to set them is up to the trader. But achieving profit targets is not under the control of the trader. Market conditions vary and setups vary, with the potentialfor small profits, from 5 pips to bigger moves of 50 pips and more. The best approach isto become proficient in getting small moves. A good medium ground for setting a profittarget is 15 pips on the trade. This target falls within the ranges offered by the marketunder even small time frames. It is achievable, and coming close to it is acceptable. The
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goal of the trader should be to become competent in achieving an average 15 pips pertrade. Once this is achieved, gaining more pips can be accomplished by adding more lotsand by becoming skilled in managing the trade. This brings us to the issue of multiple-lottrading.
MULTILOT TRADINGPutting on more than one lot is a milestone in the evolution of the trader. Multiple-lottrading provides enormous efficiency for the same effort. But it comes at a price.The risk of quick and large drawdowns is proportionally greater. Multilot trading becomes a double-edged sword. The new trader needs to learn how and when to put onmultiple lots.The first rule of multiple-lot trading is the rule of three. Each trading decision can bebroken down into three components:1. Financial2. Technical3. Psychological
All three converge to trigger a trade. The trader makes a financial decision on howmuch to risk. At the same time, there is a technical decision on quality of the setup. Finally, there is an unquantifiable factor on whether the trade feels good. It is very difficultto quantify how each component contributes to the final trigger of the trade. Because itis impossible to separate these three factors, the best approach by a trader is to think ofthree lots as the best way to trade multiple trades. Each lot, in a sense, serves a differentmaster. The first lot calibrates with the financial objective of the trade and would get alimit of the average goal per trade of 15 pips. The second lot would be aligned with thetechnical aspects of the trade and get a limit that is related to the range. It would be morethan the first and would be designed to capture more profits. In other words, if the rangeis 50 pips, the first lot is always set at 15 pips, and a second lot is set at 40 pips (just shortof the other side). The last lot becomes the wild card—it serves the psychological needsof the trader. You can decide to have a very large limit, such as 70 pips or more, or evenleave it totally open. The effect of this approach is that when three lots are put on, thetrader will be able to manage the trade without over