It offers severalmethods for placing buy and sell orders—this is the thirdscreen, which we may implement using either intermediate- or short-term charts.”“Begin by choosing your favorite timeframe, the onewith whose charts you like to work, and call it intermediate. Multiply its length by five to find your long-term timeframe. Apply trend-following indicators to long-term chartsto reach a strategic decision to go long, short, or standaside. Standing aside is a legitimate position. If the longterm chart is bullish or bearish, return to the intermediate charts and use oscillators to look for entry and exitpoints in the direction of the long-term trend. Set stopsand profit targets before switching to short-term charts, ifavailable, to fine-tune entries and exits.”Elder’s Triple Screen is a simple but ingenious multipletimeframe approach to forex trading. To trade this technique,the trader would begin with a favorite timeframe, like a 4-hourchart, and call it intermediate. To get the long-term chart, theintermediate chart would be multiplied by five (a factor of 4–6times may actually be more flexible and practical). Therefore, the
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TIPS AND TECHNIQUES (CONTINUED)long-term chart might be the daily chart (4-hour chart  6 = 24–hour chart). To get the short-term chart, the intermediate chartwould be divided by 4-6. Therefore, the short-term chart in thiscase might be a 1-hour chart (4-hour chart ÷ 4 = 1-hour chart).On the long-term chart, the first screen, one would focus ontrend-following indicators like moving averages, MACD, or trendlinesto decide whether to go long, sell short, or stay out of trading altogether due to a lack of trend. On the intermediate chart, the second screen, one would use oscillators like Stochastics or RSI toidentify a likely pullback entry zone. Finally, on the short-term chart,the third screen, one would look for a support/resistance breakoutin the direction of the long-term trend to pinpoint the trade entry.
P oint & Figure Trading — Pointing OutBreakoutsThough visually distinct from all the other chart-trading strategiesdiscussed thus far, point & figure (p&f ) trading is, in many ways,very similar to traditional support and resistance breakout trading onbar or candlestick charts. The primary difference lies in the look andfunctionality of the price charts themselves. Many forex chartingplatforms include an option to view charts using the p&f structure.As described in Chapter 3, p&f charts actually represent price in aradically different manner from the more familiar bar and candlestick charts. Exhibit 5.15, which displays a typical forex p&f chart,shows just how differently they can look.Point & figure trading is trading that is based exclusively uponprice action, which makes it ideally suited to the foreign exchangemarket. Originating in the 19th century, this type of financial175
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EXHIBIT 5.15
Point & Figure Chart
Source: FX Solutions – FX AccuCharts
charting is older than some of the more popular charting methods in common use today. P&f charts are a pure price action playbecause these charts generally exclude all other elements (like time,volume, and opens/closes) other than price. Therefore, a p&f practitioner can focus all attention on the behavior of price action, whichis the most important factor from a technical analysis perspective.Without extraneous elements to clutter the landscape, p&f chartsexcel at representing clear evidence of such important technicalcharacteristics as trend, support/resistance, and breakouts.As shown in Exhibit 5.15, p&f charts are constructed with columnsof boxes alternately labeled with Xs and Os. An X column means that
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price has risen in that column. Conversely, an O column meansthat price has declined in that column. When a reversal occurs on anycolumn, a new column is created going in the opposite direction. Asmentioned earlier, there is no time, volume, opens, or closes on p&fcharts. Only when price moves a sufficient amount, regardless of time,will an existing column grow or a new column be started.Two extremely important variables can alter the way p&fcharts look and act. The first variable is box size. This is the minimum amount that price needs to move before a new box within anexisting column is created. For example, if a column of Xs (whichdenotes a rising trend) has 10 boxes in the column, price wouldneed to move an additional amount equal to the preset box sizebefore another X would be added onto the top of the column. Forexample, if a trader sets the box size on the p&f charting softwareto 10 pips per box, which is a common setting, price would need tomove 10 pips above each X box in order to add another X box ontop. In the same way, price would need to move 10 pips lower thaneach box in an O column in order to add another O box on thebottom of the column.The second important variable is reversal amount. This is theamount of pips that price needs to reverse before a new column iscreated. A new column is only started when a reversal in an existingcolumn exceeds the reversal threshold. The most common setting forthe reversal amount is three boxes, or three “points.” If the box sizeis set at 10 pips and the reversal amount is set at three boxes, thereversal amount in pips is 30 pips. So in a rising column of X boxes,for example, price would need to turn back down against theuptrend by at least 30 pips before a new O column would be started.
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The significance of these two variables should be fully recognized and appreciated, as they are what make p&f charts so effective at representing only the most important major market moves,disregarding all of the minor fluctuations known as “noise.” Forthis reason, p&f charts are excellent indicators of both trend andsupport/resistance.Because p&f charts outline support and resistance so well, one ofthe primary trading strategies in most common use with these chartsis breakout trading. One notable distinction between bar chartingand p&f charting, within the realm of support/resistance, lies in theinterpretation of double and triple tops and bottoms. In the worldof bar and candlestick charting, a double top is a potentially bearishreversal signal. In p&f terminology, however, a double top is a resistance point where traders should be looking for a bullish break tothe upside. The same distinction holds true for double bottoms, aswell as triple tops and bottoms.P&f charts also have their own version of diagonal trendlines,which are drawn at strict 45 degree angles. Chart patterns like triangles are very prevalent as well. Like the horizontal support andresistance levels on these charts, the main method for trading trendlines and patterns on p&f charts is through breakouts.Because point & figure trading focuses exclusively on priceaction, the most important aspect of technical trading, p&f practitioners are able to view and interpret market movement withexceptional clarity. Perhaps for this reason, p&f charts have withstood the test of hundreds of years to fulfill one of its current rolestoday as an increasingly relevant analytical tool for foreign exchangetraders.
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C arry Trading — In the Interest of InterestAs discussed in Chapter 4 on fundamental analysis, carry tradinginvolves the simultaneous purchase of a high-interest currency andsale of a low-interest currency. This creates an interest rate differential yield that the trader can earn on a daily basis.The carry trade is primarily a longer-term fundamental investment strategy that seeks to earn this interest rate differential whileassuming the substantial risks of exchange rate volatility. A strategythat combines the carry trade with technical analysis to help mitigate this risk will be described in this section’s Tips & Techniques.The fundamental concept behind the carry trade is that wheninvestors’ risk aversion is not exceedingly high, international capitaltends to flow towards higher-yielding currencies, thereby contributing to a general exchange rate appreciation in these currencies at theexpense of the lower-yielding currencies. Of course, this is far froma rule, but only a tendency that occurs when the overall market sentiment is towards a greater risk appetite (as opposed to greater riskaversion).It should be stressed here that interest rate differentials goboth ways, and that if a trade carries a negative interest rate differential, the daily charges to the trader’s account on open positions can become prohibitively expensive in many instances. Thisis because the interest rate differential, whether the trader is paidor charged the amount, is based on the full leveraged size of thetrade as opposed to just the fractional amount that the trader putsup in margin for the trade. So, for example, if $1,000 is requiredto open a full $100,000 position at 100:1 leverage, any interest rate
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differential on the trade would be paid or charged as a percentageof the full $100,000 amount instead of just the $1,000 amount. Thiscan add up to a substantial sum if a trade is kept open over a prolonged period of time.At the time of this writing, a commonly carry-traded currencypair is the NZD/JPY, which presently carries a large interest ratedifferential. The New Zealand dollar currently has a high interestrate while the Japanese yen has a low interest rate. Carry traderswho are long NZD/JPY, which means they have borrowed JPY tobuy NZD, would be paid based on the high interest rate differential. Conversely, non-carry traders who are short NZD/JPY, whichmeans they have borrowed NZD to buy JPY, would be chargedbased upon the high interest rate differential.With most retail foreign exchange brokers, this payment orcharge is settled at “rollover,” which generally occurs at the end ofeach business day. This time can vary among brokers. During rollover, open positions that carry a positive interest rate differential arecredited directly into the traders’ trading accounts. Conversely, thosepositions that carry a negative interest rate differential are debiteddirectly from the traders’ trading accounts.Carry trading allows foreign exchange traders to receive substantial interest payments on a daily basis for holding high-interestpositions open. Of course, the risk of adverse price moves canpotentially erase all of those daily interest gains, and then some.But with the help of a high probability carry trading strategy (asdescribed next) and solid risk controls, trading exclusively in thedirection of positive interest yield is one of the most prudent andsensible ways to trade long-term positions in forex.
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TIPS AND TECHNIQUES
The Technical Carry TradeA variation on traditional buy-and-hold carry trading incorporatesthe intelligent use of technical analysis. This method is aptlynamed, Technical Carry Trading. What sets this approach apartfrom traditional carry trading is its strict trade entry criteria thatscreens out low-probability carry trades where price has alreadyover-extended itself. Technical carry trading is a simple strategyfor optimizing trade entries/exits that decreases exchange raterisk and maximizes potential exchange rate profit, while also taking advantage of daily interest payments based upon the traditional carry trade model.The principle behind technical carry trading is that the highest probability strategic entries into long-term carry trade positions are near long-term support/resistance levels. Therefore, ifa substantial positive interest rate differential can be achievedby buying (going long) a currency pair (as in the example of NZD/JPY), the highest probability entry would be near long-term support. When price on the pair is near long-term support, the historical probability is that price should eventually rise. On the flip side,if the positive interest differential can be attained by selling shorta currency pair, the highest probability entry would be near longterm resistance.The first step in technical carry trading is to identify thosecurrency pairs that have a high enough interest rate differentialto warrant holding a long-term carry position. The threshold mightbe set at around 300 basis points (or 3 percentage points) ormore. Perhaps more importantly, however, the likely future direction of the rate differential should be examined, as this willaffect the exchange rate outlook of the currency pair enormously.The future direction of interest rates can be analyzed through central bank statements, economic conditions, the inflation outlook,
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TIPS AND TECHNIQUES (CONTINUED)and other fundamental analyses of the countries/regions inquestion.After screening currency pairs according to the current andpotential future interest rate differentials, the second step in thetechnical carry trade process is technical selection. Of the currency pairs chosen in the first step, the trader might choose totrade only those pairs whose current price is in the bottom onethird of their long-term vertical range (near support). Or, if a pair isentrenched in a long-term uptrend channel, the trader may chooseonly to enter long when price is near the bottom of the channel(again, near support). The primary principle here is to trade onlywhen price is in a high-probability location, like near support whengoing long or near resistance when selling short.The last step in the technical carry trade process is tradeexecution. In order to spread risk and avoid the need to pinpoint entries, technical carry trading may employ a scaled-entryapproach. This involves entering into a long-term carry trade usingmultiple fractional entries. These smaller positions would bespaced evenly within a support/resistance trading zone (as in thebottom one-third of a long-term range) in order to distribute riskacross a wide price region. Exits in the form of profit limits andstop losses would be technically based. If a long carry trade isentered near support, the profit target could be placed near resistance (e.g., the top one-third of the long-term range). Stop losseson a long carry trade could be placed somewhere right below longterm support, much like with other types of technical trades.Technical carry trading is all about increasing the chances ofa profitable trade while simultaneously earning substantial leveraged interest. Since good trading, in general, involves maximizing probabilities under precarious circumstances, the technicalcarry trade strategy performs its function well. At the very least,it improves the outlook of the traditional carry trade dramatically.
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N ews Trading — All the News That ’s Fit toProfit FromLike carry trading, news trading also falls under the general category of fundamental analysis. News trading is simply the attempt toexploit immediate market reactions to major news and economicdata announcements.Many forex news traders will wait patiently before each majornews announcement (as described in Chapter 4), ready to pounceon a trade if the opportunity presents itself. These traders often willhave already memorized the consensus (expected) numbers, andwould then just wait to see if the actual numbers announced on theirup-to-the-second news feed differ considerably from the consensus. If so, the direction of the trade according to the deviation fromconsensus is determined, and the trade is taken. If all works well ona trade like this, the trader will have jumped on a strong price runeither early on or somewhere in the middle of the movement.Some news traders employ a variation of this method by justwatching and waiting during the initial price reaction to the news,which they deem to be unreliable, and then entering the trade on thesecondary reaction.This secondary reaction could either be a completereversal of the initial reaction, or it could be a continuation of the initial move after a pullback or consolidation. This approach is perhapseasier and less frenzied than the first type of news trading, as success inthis case does not necessarily depend entirely upon the speed of entry.Yet other news traders will wait for the news to come out, andthen trade technically in the attempts to capture quick profits.Technicaltrading in this manner necessitates the analysis of very-short-term
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price charts, pinpointing precise support/resistance levels and momentum signals. This type of ultra-short-term technical analysis presents itsown set of issues and difficulties. But when done correctly, it can certainly lend considerably to the news trading process.Generally, news trading is one of the most challenging and difficult approaches to forex. But if a trader has all of the necessarytools and sensibilities to tackle this type of trading, there are certainly potential profits to be made from the news.
C ontrarian Trading — The MajorityDoesn ’t RuleUnlike most of the other methods and strategies discussed in thischapter, contrarian trading is more of a philosophy than a specificmethod or strategy. The root of this philosophy lies in the assumptionthat the general consensus is wrong, and that the astute trader canprofitably exploit this by taking the opposite side of the consensus.Putting this into practice can take several forms. One way to be acontrarian is to pay close attention to what mass media headlines aresaying—and then planning trades in the opposite direction. For example, after a prolonged drop in the U.S. dollar’s exchange rate, oncethe mass media begin to foretell a doomsday scenario for the dollar,contrarians may begin looking into either buying the dollar or covering their shorts. Conversely, when mass media portray a rosy pictureof the U.S. dollar after a prolonged exchange rate appreciation, a contrarian may soon wish either to go short or close out existing longs.The simple logic behind this philosophy is the belief that thenews media, in reflecting and influencing general public sentiment,
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are usually either wrong, extremely late, or both. The contrarianassumption is that by the time the mass media have begun to highlight market extremes, there is usually not a great deal more uncommitted capital available to move price much further in the samedirection. In other words, if almost everyone has already bought intothe euro, and then the media begin saying that the euro should keepgoing up, who else is left to continue pushing price action muchfurther from there? The amount of new capital that is available to beinjected into the currency diminishes dramatically once the majortraders have already staked out their positions in the market.This form of contrarian thinking also comprises the primary ideabehind one method of applying the Commodity Futures TradingCommission’s (CFTC) Commitments of Traders (COT) Report.Among other valuable pieces of information, this weekly documentissued by the CFTC displays slightly delayed reporting on the netpositioning of major market players in the currency futures markets.By revealing the net futures positioning of these major players, thisCOT document can be used by contrarians to trade against extremerelative positioning in the spot forex market.For example, if the COT report shows that major speculators havebeen drastically and increasingly net long in the British pound againstthe U.S. dollar in the past several months, and the current data has justhit the recent peak high in the magnitude of these net long positions,traders may begin looking for the next opportunity to short the poundin a classic contrarian maneuver. Again, the logic here is that if all thelarge players have already bought the British pound throughout a longand swift price run-up, who else is left to keep pushing price up evenfurther? Therefore, the contrarian indication in this hypothetical COT
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EXHIBIT 5.16
COT Report
Source: U.S. Commodity Futures Trading Commission (CFTC) at www.cftc.gov.
example is of a potentially bearish impending price move for thepound. Exhibit 5.16 displays a COT report sample from the CFTC.The current report can be found at the following direct link: www.cftc.gov/dea/futures/deacmesf.htm.Specific methods for using the COT report to trade forex arebeyond the scope of this book, but all forex traders should at leastbe aware that such a report exists and can be of great use in formingcontrarian trade opinions.Another form of contrarianism occurs in technical trading, especially in the context of breakouts. Because many false breakoutsoccur on foreign exchange charts, astute contrarian traders have
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learned to “fade the break,” or trade in the opposite direction of thebreakout. This strategy was discussed earlier in this chapter in the section on breakout trading. It can be an extremely risky way to trade,as it goes directly against the trend and momentum of the market.But if proper risk controls are put into place, it can also be a veryeffective way to capitalize on the many false and premature breaks ofsupport and resistance.Generally, contrarian traders will trade against anything that represents popular opinion. When all of the analysts and media are sayingone thing, it is almost certain that the contrarians are doing the opposite. The primary goal of any contrarian trader is to buy the market ata bottom or short the market at a top. These traders relish the thoughtof competing with less experienced traders who are prone to partakein frenzied buying near peaks and frantic selling near troughs.Although many traders will agree that contrarian trading oftenmakes a lot of sense, to actually become a practicing contrarian takesan iron will, nerves of steel, and great risk management skills. Whilecontrarian traders are frequently correct in their assumptions, tradingagainst the trend and against the masses can often be an endeavorfraught with potentially disastrous pitfalls. It is certainly not a recommended approach for beginners. But even for experienced contrarian traders, much caution must be taken to ensure that one doesnot inadvertently step into the path of a speeding train.
B acktesting — Histor y Repeats ItselfFor any technical trading strategy that has concrete and specifictrade entry/exit rules, backtesting that strategy allows the trader to
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simulate its expected performance using historical price data. Withbacktesting, traders can actually test how well their strategies wouldhave done if executed in the past.Many technical trading strategies possess the qualities to be backtested effectively. Most importantly, they must not have any ambiguityin their rules. One example of a simple strategy that may easily bebacktested is as follows: Go long when the 5-period moving averagehas crossed above the 20-period moving average AND the MACDHistogram has crossed above the zero line AND DMI+ is aboveDMI. Sell short when the 5-period moving average has crossedbelow the 20-period moving average AND the MACD Histogram hascrossed below the zero line AND DMI is above DMI. Althoughthis simple example has not been tested by this author, it illustrates thecharacteristics of a strategy that is conducive to backtesting.Although a backtest may appear to be the perfect method foridentifying the most profitable trading strategies, one major caveatshould be mentioned here. Using past price data to simulate futureresults often misleads traders into believing that their backtestedperformance will always translate into similar results in actual, realtime trading. Many potential factors can and will make hypothetical performance and actual performance differ significantly. Amongthese factors is the fact that markets change considerably over time.A strategy that may have worked one way for the past five yearsmay work in an entirely different way for the next five years as themarket changes and evolves. Often, for example, technical indicators that gave profitable signals in the past are subsequently unableto replicate their performance going forward. This phenomenon canbe extremely frustrating, but it is an integral aspect of what makes
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trading such a challenging endeavor. Additionally, in terms of tradeexecution, trading a strategy in real-time may be much different fromthe way the strategy is backtested. These differences can potentiallyskew the results in a significant manner.Given that past and hypothetical performance may not alwaysbe indicative of future results, however, backtesting is still the bestavailable method for evaluating a strategy without actually tradingit in a real-time environment. Backtesting a strategy provides enormous benefits to the trader, most important of which is a reasonableexpectation of that strategy’s potential worth and usefulness.There are two primary methods of backtesting a trading strategy. The first, and most popular, method is automated backtesting.This requires software that has this capability. A simple Internetsearch will produce many links to this type of software. Automatedbacktesting entails using a specialized program into which a traderinputs the specific rules and criteria of the strategy. The softwarethen automatically applies those rules to past price data and talliesthe hypothetical profits, losses, and other pertinent information. Anentire picture of past performance is created in this way.A less-practiced method of backtesting is performed manuallyand visually by the trader. Armed with concrete strategy rules, thetrader would scroll back in time on a chart and manually applythe strategy as if it was in a real-time environment. Performance datawould then be recorded manually by the trader. Ideally in this typeof backtesting, the trader would advance the chart bar-by-bar inorder to refrain from seeing price action subsequent to the trade athand. This eliminates trading in hindsight, which can be detrimentalto an objective backtest.
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One of the major disadvantages of manual backtesting, whencompared with automated backtesting, is the significant potentialfor human error in executing simulated trades and recording performance results. Furthermore, it takes a great deal of work anddiscipline to simulate trades manually over a large data set withoutstraying from the strict rules of the strategy. Finally, the normal rangeof human emotions and biases that often interfere with actual trading can also be a detrimental factor in achieving objective backtestresults. That being said, however, manual backtesting can provide thetrader with a real “feel” for actually trading a given strategy. Thisprovides valuable trading experience, albeit simulated, that no automated backtest could possibly provide.Whether performed manually or automatically, backtesting canbe one of the most important elements of finding and/or buildinga solid trading strategy. This vital practice can save traders a greatdeal of time and money that might otherwise be wasted on tradingunprofitable strategies.
A utotrading — Robots for HireClosely tied to backtesting is the concept of autotrading. As mentioned in the previous section, automated backtesting utilizes asoftware trading platform to place hypothetical trades when predetermined trading signals appear on historical price data. The purposeof this is to test the potential viability and profitability of a tradingstrategy. Autotrading goes a step further by actually executing realtrades on current, real-time market prices. When a predeterminedsignal emerges, the software actually places a trade automatically.
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This is usually initiated only when all proper backtesting has indicated the likely success of the trading system.Autotrading is common in foreign exchange trading. Manyhedge funds and other entities that manage money via forex tradinguse some form of autotrading in their daily activities. In addition,many private, individual traders have also begun to adopt autotrading to execute their thoroughly backtested and highly optimizedforex trading strategies.For these traders, autotrading is accomplished using an ApplicationProgramming Interface (API), which connects the trader’s system tothe dealer’s trade execution structure. APIs require programming skillson the part of either the trader or a programmer hired by the trader.But once all of the trading rules and criteria are determined by thetrader, programming an API can be relatively straightforward for anyone with programming experience.After the specific trading rules and criteria are determined,the strategy is backtested with positive results, and the API is programmed, autotrading is almost as simple as flipping a switch tobegin the trading process. When this occurs, not only are tradesentered when predetermined technical criteria are met, but tradeexits in the form of stop losses and profit limits can also be programmed into the API. This creates an entire self-contained systemfor trading foreign exchange.As with backtesting, any nondiscretionary technical trading strategy that has clear-cut, unambiguous rules is a good candidate forautotrading. In fact, if a trader has optimized and perfected this typeof a black-and-white trading strategy that runs devoid of humanjudgment, autotrading is perhaps the best way to execute it, as it
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effectively eliminates all human biases, errors, and emotions in thetrading process.
C hapter Summar yThree general approaches to forex, including position trading, swingtrading, and day trading, outline the primary styles that have beenadopted by many forex traders in the market today. Position trading attempts to capitalize on longer-term trends, and can employboth fundamental and technical analysis to determine directionalbias. Swing trading is generally a purely technical style that looks toexploit short- to medium-term swings, or turns, in the market. Daytrading is the shortest-term approach that seeks to get