within thebands.
SCENARIO PLANNING
Once you have a general overview of the market, you can begin planning yourtrading responses to a number of different scenarios that may take place duringthe day. Not only does this exercise your mind, but asking yourself “what willhappen if the Euro breaches 1.3560?” or “what will be the market reaction to aweak retail sales number?” also helps make your trading reaction to these eventsautomatic.
Make sure that you know ahead of time what news is scheduled to be released,the market expectations, since all too often traders forget that there is more newsout there than just the 08.30 NY releases, so keep an eye out for market movingevents from Asia and Europe that may have a big impact on prices.154 Beat the Forex Dealer
 
 
 
 
 
 
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Chart A.4 A moving average envelope contains most of the daily moves for even notoriouslyvolatile pairs such as the sterling/yen.
If after all of this preparation the price action does not correspond to your scenarioand game plan (you were bearish on cable but it blasted through several of yourresistance levels) then you should take this as a red flag and probably sit on yourhands until you can re-evaluate the day’s events.
STAY FOCUSED
Understanding the big picture does not mean understanding the whole picture.Since you cannot trade everything, focus on your favorite pairs and get to knowthem well. It takes a lifetime to understand a currency’s behavior, how it reactsto things like oil prices, interest rates, etc., so concentrate on learning a few pairsvery well instead of following everything half-hearted.
ALWAYS TAKE NOTES
Although it may seem like a thankless task, keeping a trading journal is the bestway to reap the benefits of the analysis you have just done above. After all, if youdon’t keep a written record how are you going to know if your thoughts were onHow to Set Up Your Trading 155
 
the money, or if your tactics proved to be wrong? Keeping a record will keep youfrom repeating costly mistakes (“I’ve been in this situation before, what did I do inthat case?”) since it may be hard to remember your motivations for entering a tradepost-fact. At the end of the day you are your best teacher, and before going homefor the day you should make sure to write down your feelings on the majors andset some targets for the overnight market. This will create a continuity of thoughtand help you jump back into the market the following morning. You can also usethis to fine-tune your forecasting and technical abilities.How to Trade Price Action
 
The sharp moves often seen in the FX markets can be difficult to trade and properlyadjust to, even for advanced traders, but learning to read and interpret the priceaction in situations like these gives us a big leg-up. In a steep decline, for example,one must be careful to measure the reaction of the longs to know if the move hasa chance to turn into a rout. By looking at the reaction of the longs as soon as therate begins to extend south, you may be able to determine if the market is sittingon a large number of long positions or not.
Usually, if a spike lower is followed by a sharp V-shaped recovery, then youshould be wary of shorting the pair. Masses of buyers entering the market atlower levels tells you that the market is not particularly long, and the lower pricesrepresent “bargain” levels for those wishing to accumulate long positions.
On the other hand, if after the initial move lower any uptick is sold into, youcan be fairly sure that the market is caught long and wrong. The longs realize thatthey hold bad trades, and are eagerly awaiting any uptick to offload some of theirpositions. This is when smart traders and dealers smell blood and go in for the kill.
Take a look at chart A.5 to see how the market reacts during sharp moves.
1. Sellers come into the market for whatever reason (news, etc.) and over-whelm any bids, driving the pair lower. When the pair slows down andconsolidates the move, the reaction of the market here is critical.
2. No sharp recovery is seen, indicating that the nobody considers this correc-tion to be a “cheap” buying level, and more likely than not some trappedlongs are feeling the heat. The pair moves in a steady fashion as shortstake profit, reload, and short again. The pair will continue to move loweras long as there are more sellers than buyers, and it falls until some sortof equilibrium point is reached.
3. Normally the rate would rebound a bit from this area as shorts buy backtheir positions, but seeing the attractive round number nearby, stop huntersand retail “chasers” join the short selling party. The pair briefly breachesthe round number, takes out any remaining stops and rebounds as dealersbuy back their shorts. The longs have now either been stopped out or cuttheir losses.Beat the Forex Dealer
 
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After the last flurry of selling, the market is left leaning on the short side,with no fresh supply hitting the market. This imbalance in turn createsthe perfect “short squeeze” set up. Since the market tends to follow the‘maximum pain’ theory, it will now probably head north to try and causesome pain to the other side of the market. As soon as the dealers understandthat the selling pressure has ended and the original longs have long beenshaken out (remember, they have access to order flow), they slowly startto bid up the pair.
4. Expecting a continuation of the move, new shorts (chasers) are taken ona final move lower. The market at this point is oversaturated with shortsand a sharp V-shaped recovery takes place. Like dominos toppling over,the shorts are easily squeezed by the dealers. Squeezes tend to be sharpand vicious, reflecting the panic the shorts are in. Never underestimate theresults of disorderly forced buying/selling, and never fade a squeeze; lestyou end up getting “squeezed”.
In this case, the original orderly down-move took approximately 2 hours to unfoldwhile the short squeeze retraced the entire move in a mere 30 minutes. Simplycomparing the two halves of the chart reveals the difference between orderly marketmoves and forced buying/selling (stops). A testament to the power of fear.
Moves like these are typical of a purely speculative market where “hot money”is out chasing prices and no real money or long-term fundamentally inspired betsare being placed. Basically the day to day chop of the FX markets.
So how does one trade these choppy markets?
TECHNICAL HELP
Moving averages are one of the oldest tried-and-true indicators, but since they arelagging indicators to the short term trader they seem to be of little use. As with allprice-driven indicators there are trade-offs, and one has to look at the MA itself tofind good uses for such a tool.
The most widely looked at MAs are the 50, 100, and 200 day MA which are asimple, yet efficient ways to gauge trends, their strengths (measured as a% awayfor the MA), and reasonable support levels. All day-traders should know wherethese levels sit on the daily charts, because as widely followed indicators theyattract stop hunters and should therefore be avoided.
Since moving averages essentially relate the past price action, they can also beused effectively intra-day for entering and exiting positions in one-way markets.During sharp moves, it can be difficult for a trader to properly enter a positionsince retracements are far and few, and the “it can’t go higher/lower” mentalitymay set in.160 Beat the Forex Dealer
For example, even though you were bearish on cable, at the end of the day youfind yourself on the sidelines looking at a 200 point drop, or worse, caught tryingto pick a bottom.
In this scenario, the MAs can be used as dynamic resistance levels to trade off of,with much better results than the stop-happy static support/resistance levels knownto the whole market. Using the 10 and 20 you can effectively choose when to openand close your position based on price action, not just an arbitrary number. Referto chart A.6.
 
 
 
   
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Chart A.6 Using moving averages during sharp moves.
1. The market breaks lower and you miss the initial short, but after a bearishcross you have the opportunity to enter a position once the price tests the10d ma. This is the first dynamic resistance and should be sold into (asecond can be sold at the 20). In this instance you have numerous chancesto enter shorts. Notice how this beats simply selling the next break lower.
2. Once in a trade, choose to exit 1/2; of the position when the 10 is breached(closed bar), and the other half when the 20 gives way (3). After the 20gives way the price action is telling you that there are more buyers thansellers out there, and the dynamics of the move have changed.How to Trade Price Action 161
 
The advantages of using MAs in this manner is that it gives you dynamic levelsto trade off and gauge price action, rather than agreeing on arbitrary levels or your‘gut’ to tell you when you should take profit. By taking these decisions off of yourshoulders and turning them into a systematic ones, you are less prone to take profitstoo early and it has the added benefit of placing less strain on your psyche. Takea look back at chart A.5 to see how effective the MAs were in protecting profits.How to Build a Position
 
Formulating good trading strategies and views on the market is all well and good,but if you don’t have a proper way of entering your positions in an orderly mannerthen you may find your trade in the red the minute you enter the market.
SCALING
It is common knowledge that the ideal way to trade is to gradually enter a position,and then gradually exit as your targets are met. In theory this approach is beautiful;in reality most traders will find it very hard to accomplish. It is hard to add anincreasing amount to your position when it looks worst, and hard not to take profitsonce it moves into the black. The psychological aspect is often times too great andlucky are the few that can sit still while the market gyrations make your P/L swinglike a kite in the wind.
One way to get around these considerations is to take small chunks out ofthe market instead of going for the entire move. Taking profit in a trade is veryimportant not only for the balance sheet, but also for your psyche. Profit takingbreeds a positive mentality that all traders need, and in case the position turnsaround and you end up with a loss, at least you put some pips away to soften theblow.
BUILDING A POSITION
Trying to time the perfect entry/exit is a fruitless exercise engaged by traders thatserves only to hinder your trading. Professional traders know that they are notlikely to enter at the “exact” top or bottom, so instead they focus on figuring outthe price range for their entry.Let’s take a look at a real-world example using the loonie (USDCAD):Because of our technical analysis and interpretation of the price action, we thinkthe loonie is poised to fall and enter a short position (chart A.7).164 Beat the Forex Dealer
 
According to our money-management guidelines, our risk should be no morethan $200 on a $10K account (2%). We have two options:
e One 100K lot with a 20 pip stop.
e Multiple mini lots with varied stops.
 
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You can immediately see the flexibility you give yourself by trading smaller lots,which is exactly the reason most retail traders should trade mini accounts. Yourtotal risk should be what’s important to you, not nailing the exact entry point. MostFX platforms these days calculate your average cost automatically, so figuring outthe risk on multiple positions is fairly easy to accomplish.
Let’s say we decide to trade 5 mini lots (leveraging 5 times). If we where totrade them all at once, then we would need to set a 40 pip stop. We are risking thesame amount ($200) but at a lower risk profile. The more experienced you get withyour trading, the more comfortable you will be in varying your entries and stops.
Of course, before we are even close to entering the trade we will already havecharted out the day’s trading levels which we can use to enter and exit the trade.With five lots to trade, we begin to enter incrementally higher amounts once ourentry price is reached.How to Build a Position 165
 
       
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1. First sell order executed @ 1.1330Just getting our feet wet, making sure we have an “interest” in the market.
Now, one of two things can happen. The more common one is to see the priceshoot up as soon as we enter our short. This is when most traders scream “thisalways happens to me!”, but in our case we are just happy to see better sellinglevels. On the other hand, if the pair proceeds to immediately plummet, then ourposition would already be in the black. Not a bad place to be. Starting small meansputting yourself in a win-win situation.
2. The loonie moves higher and we sell 2 more @ 1.1345We are now short 3, and we have two more bullets remaining.
After a few minutes, the pair continues to move higher and is sitting at 1.1355,25 pips above our original entry. If the rate continues to climb higher, we stillhave 2 more lots to better our cost, or if we feel uncomfortable with the trade wecan choose to exit with a meager loss. Using the one-lot strategy, we would havealready been stopped out.166 Beat the Forex Dealer
 
3. The pair finally begins to come off and gains downside momentum.We enter our final two shorts @ 1.1333We are now short 5 avg. cost 37.
Note that this is not “averaging down,” which is a desperation move. This isbuilding a position. We were able to get a better cost for our short (37 compared tothe initial 30) and managed to ride the blip higher that stopped out many of yourfellow traders.
Once the topside stops are taken out, the trade now has room to move on thedownside. We exit according to our support levels, taking out 2/3 and leaving therest with a stop at entry looking for lower levels.
Big traders rarely trade with fixed orders in the market (for fear of revealingtheir intentions), and enter and exit positions according to price action. This typeof trading is probably best suited for experienced traders with established tradingstyles, while new traders are better-off trading with multiple fixed orders in themarket which lets them focus on tweaking their analysis instead.
Building a position means establishing ranges for you to trade off of, rather thantrying to define absolute values for the perfect entry. In the FX market there is somuch intra-day noise that trying to find the perfect entry and exit of any trade ispractically impossible; so why bother? Instead of thinking “at what price should Ienter,” you should be thinking “what is a good 10-15 pip range to enter/exit mypositions?” As long as your analysis is correct most of the time, you should beable to make money most of the time as well.
TRADE YOUR TIMEFRAME
Once in the trade, a crucial mistake some traders make is to trade out of theirtime frame. Once in a trade, it can be tempting to scour different charts in order tofind some glimmer of hope that may turn that losing trade into a winner. A tradeopened according to the 3 minute chart will turn sour, but a stubborn trader willnot let go and turn to the 15 min or 30 min charts where the trade looks better. Asyou may have guessed, this never works and only opens the door to larger lossesand more pain for the trader.
Learn to cut your losses short. If you opened your trade according to a signalfrom the 3 min chart, get out as soon as the 3 min chart tells you the trade is nogood. It’s no use to flip time frames until you find a chart that suits your needs;remember that you are following the price action, not the other way around.
The only time it’s appropriate to switch time frame is when the trade is deepin-the-money. If the signal came from the 3 minute chart but extended farther thanyou thought, it may be reasonable to think that the move has further to go. Switchingto a longer time frame may show you the market rolling over and confirming theHow to Build a Position 167
signal. In this case it is wise to take some profit and let the rest run, but a goodrule to follow is to get out according to the time frame you used to enter the trade.If your original analysis was incorrect, then you can’t to turn a loser into a winner;no matter what fancy indicators or software you may use. Trash in... .trash out, asthey say.How to Trade Out of a LosingPosition
 
One of the most important lessons any trader needs to learn is how to effectivelytrade out of a losing position. Although this is usually the realm of money man-agement techniques, at some point in their careers traders may find themselveswith a trade that is deep underwater and that has the potential to wipe out theiraccount.
Although it would be easy to note that if proper money management rules arefollowed this situation should never arise, in the real world traders do sometimesfind themselves in these positions because of a slip in judgment, technical problem,or simply stubborn behavior. In any case, most traders do at some point find them-selves with a run-away position, and what they do in such a scenario determinestheir longevity in the market.
When holding onto a big loser, most traders have two choices: cut the positionimmediately for a huge loss, or try to average down and hope for a turn around.Neither approach is particularly attractive, seeing as how you take a big monetaryhit with one, or place all of your chips on the table and hope for the best with theother.
There is a third way: trading yourself out of the market. Great traders simplyrefuse to take an outright loss by way of a stop, and instead once they realize thatthe market has proven them wrong they begin to “lighten up” by slowly tradingtheir way out of a losing position.
Once you realize your position is dead in the water, your mission then becomesto better your average cost without adding to the position. Adding to the position(averaging down) only creates more pain, and can quickly take away your flexibilityas the loss grows and becomes unmanageable. So instead of adding, we need tocut part of it on a dip in order to gain more breathing room and be able to tradeout of the rest.170 Beat the Forex Dealer
 
 
 
USDJPY Daily Chart
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Chart A.9 The key to this strategy is flexibility.
Take a look at the chart at left to better illustrate this technique. Assume that youare short against the trend and you want to get out. You are faced with theseoptions:
. Get out of everything and take a substantial loss.° Hold onto it and hope the pair will collapse before you run out of margin.° Cut part of the position on any reasonable dip.
The benefit of cutting part of your position on a dip is two-fold. First, althoughyou are forced to take an initial loss, you free up liquidity and give yourself moreflexibility to react to future price moves. Any move now is a good move. If theUSDJPY bounces higher, you can re-load at better selling levels to improve youraverage cost. On the other hand, if it immediately collapses then great, it’s movingin your direction.
The other great thing about cutting part of your position is that you instantlytake some of the stress away. Keep in mind that one of the most stressful aspectsof trading is the psychological impact a running loss may have on your trading.Faced with big losses, most traders are keen to stop the pain immediately, and thustake needless hits.
Once you have cut part of your position, you then proceed to make small tradesand slowly better your average cost. Using intra-day volatility, you make smalltrades to effectively trade out of your position.How to Trade Out of a Losing Position 171
 
THE RUN-AWAY TRADE
To better illustrate this technique, let’s look at an example of the same USDJPYmove that surely caused a lot of pain to many traders not following a flexibletrading strategy (refer to chart A.10).
1. Around the beginning of October, we believe that USDJPY is overboughtand in the process of topping out. We think the rate may fail near the113.70 resistance level, so we take an initial short at 113.50. Our plan isto scale into the position and this is our first shot — always stay flexible.
In this swing trade, we are looking for a move back down to the 109 support levelin the coming weeks. We are willing to risk 150 pips total, for a very reasonable1:3 risk/reward ratio (risking 150, looking for around 45Opips,). We realize that themarket may overshoot the previous top (searching for stops), so we remain flexibleand are prepared to add two more shorts higher.
2. After initially failing at the 113.70 resistance, the dollar rallies and takesout stops to print a new high of 114.20. So far it’s no surprise, we knewthis could happen and we take advantage of the higher levels to set oursecond short @ 114.10.
We are now short 2 at an average of 113.80 (113.50+-114.10). Stop is 75 pips away(150 pips divided by 2 lots). Always keep an eye on your fotal exposure, sincethat is what is most important.
3. The dollar begins to sink as planned and the trade is now in the black.We are looking to add a third short if it breaks below the figure (113.00),since that will be an indication that momentum is picking up steam tothe downside. Unfortunately the pair does not break the figure, but insteadrebounds and is soon testing the highs once again.
4. During this rebound we can choose to either cut the trade at cost, or stickwith it. Our gut is telling us that something is not right, but we believe thepair is still ripe for a reversal so we stick with the trade. The move mightbe taking longer than we thought, but techs still point to a decline andthere seems to be some good supply near the previous highs. We decide totake our third (and final) short @ 114.40. We are now short 3 lots average114.00, (113.50+114.10+114.40). Stops are set 50 pips away (150 pipsdivided by 3).
5. The dollar proceeds to tank, taking out stops and quickly jumping anotherbig figure. At this point you decide to disregard your money managementrules and remove your stops — it’s already up almost 600 pips, it can’t gohigher! The pair is so overbought that it has to correct, and I will cut myposition when it does.Beat the Forex Dealer
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Trying to out-think the market is never a bright idea, since the market doesn’thave to do anything. Whenever the market is faced with something it can’t do, itquickly proceeds to do that exact thing. This is because the traders hoping for areversal are all sitting on the same trade, and vulnerable.
We know we are in trouble. We are short average 114.00, and with dollar-yenprinting 115.50 we have an unrealized 450 pip (150 x 3) loss ... well above theinitial 150 that we were willing to risk. This simple trade is now looking like itmay very well take a large chunk out of our account, and the stress level increases.We are tempted to simply stop the pain, get rid of it all and regroup. Stubborntraders may be tempted to double up and bet on a decline.
 
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Shrewd traders do neither. After getting over the initial shock of the situationwe take a deep breath, some aspirin, and decide to take control of the situation;we’re going to fight tooth and nail until we come out of this trade alive.
We re-analyze the situation from an objective point of view and realize thatthe market has effectively proven us wrong. Pride has no place in FX trading;the market proved us wrong and we move forward. The USDJPY is not going toreverse lower to 109, and if anything, it looks like it wants to go higher.
The one thing that saves us during these bad trades is the same thing thatsaves dealers, namely the fact that that currencies do not move straight up (ordown), but rather have a tendency to make a move, consolidate, then continue. Thisstair-case pattern is evident in most financial instruments, and simply indicates theaccumulation/distribution stages of a move. Longs may take some profit and shortsmay get stopped out, and both need time to set new positions. You should considerthese consolidation periods as your window of opportunity (box 6-7).
With our new understanding of the situation we look for a dip to free up part ofour position. This soon happens and the pair dips to test the 115 level.
6. We get rid of one lot at 115.10. We take a realized loss of 160pips (firstin, first out). Now we are short 2 lots avg. 114.25, with an unrealized lossof 170 pips. Taking the loss hurts, but we have now given ourselves moreflexibility (and margin).
The flexibility we have given ourselves means that whatever the yen may do atthis point, we can handle.
7. We wait for a range to develop. This soon takes place as a rough 100point range develops and trades for almost 10 straight days. We recognizethat a range has developed and begin to actively trade the third lot thatwe freed up. Shorting near 116, we buy it back near 115. This techniqueproves effective and we are nimble enough with intra-day trades to quicklypocket a good amount of pips to offset some of the loss. With some quickrange-trading we have put on 7 trades averaging 30 pips each which wipesout our realized loss and brings our unrealized loss to a much more man-ageable 120 pips. Depending on our outlook, we can then choose to eithercut the whole position (in accordance to our original 150 pip stop) or con-tinue to trade this way until a good amount of pips have been pocketed tooffset the loss.
The key here is to never add to your total exposure, but to manage it instead. Bypocketing all of those small amounts, you are effectively bringing up your averagecost and making it easier for you to get out with a reasonable loss. Getting outwith a small loss when originally faced with a position deep in the red often feelsbetter than taking a profit, since you know that you fought in a market that wasHow to Trade Out of a Losing Position 175
against you; and survived. Further satisfaction comes from the fact that you knowretail traders are getting wiped out as the pair moves higher!
Remember these simple steps to trading out of a bad position
° Unload part of your position on a dip
° Wait for a consolidation to take place and a range to form
e Trade the range with multiple quick ins-and-outs
° Minimize your loss and get out. Don’t try to turn a losing trade into awinner!
WHEN TO CUT AND RUN
Although you may be able to trade yourself out of most positions, there are timeswhen you should take a loss and simply get out. If a sharp move happens for someunexpected reason (9/11, political event, etc.) then it’s best to get flat as soon aspossible. No one has time to evaluate the ramifications of such an event, so it isbetter to get out and re-evaluate later.
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Chart A.12 Political decisions can have long-lasting effects on a currency and should notbe faded.176 Beat the Forex Dealer
In general, if a trade feels off at some point, then you should think about gettingout. It will probably save you much heartache in the long-run. The “gut” simplyrepresents your subconscious mind, which is constantly processing and storinginformation that you may not be aware of. The longer you trade, the more reliableyour gut reaction will be, since it will have accumulated a vast knowledge base ofcharts and patterns over all those years. You’ve probably seen similar set-ups beforebut cannot remember them, and your gut feeling is your subconscious flashingwarning signs. This information should not be taken lightly and good traders learnto trust their instincts. 
NOTESSpeaking Like a Dealer
 
To new participants in the FX market, some of the terminology and parlance mayat first be a bit confusing because of the nature of the market. By definition everyspot transaction is made up of two transactions, making all moves relative toone another. One must be especially careful when