be made up of countlessshort- to medium-term swings both up and down. This will occurwhether the market is in trending mode (overall price movementin one general direction) or ranging mode (sideways price action).Swing traders attempt to capitalize on all of these swings.Another way in which swing trading differs considerably fromposition trading lies in the general duration of trades. Whereas position traders will attempt to ride a trend as long as it remains intact,swing traders will have slipped in and out of a long-term trendmany times over before the trend is finally exhausted.
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However, many traders like to define swing trading strictlyin terms of the duration of each trade. Some would say that theideal swing trade should be held for two to five days, while others may say it should be one to four days. This viewpoint is verycommon, but perhaps somewhat misinformed. Much more important than the duration of the trade are the goals and principlesbehind this method of foreign exchange trading. The primarygoal of swing trading is to exploit the natural advances and declinesthat are inevitable in any market, regardless of the timeframe. Thetime span of the trade is infinitely less of a factor in defining successful swing trading than the timing of the trade. Timing is oneof the primary keys to executing good swing trades. After executinga well-timed entry, the trader should then determine the durationof the trade by how much the market is willing to offer on thatparticular swing, and not by some arbitrarily predetermined periodof time.As a classic technical approach to the markets, swing trading utilizes the most salient aspects of technical analysis as its main tools.This includes the pillars of support and resistance, trend, momentum,and volatility. With these tools, swing traders tackle the markets byidentifying short-term, tradable turns (or swings) within the contextof a larger trend or trading range. In a trend, this could mean tradingpullbacks in the direction of the trend. In a trading range, this couldmean trading the up-and-down price oscillations between supportand resistance. Specific technical tools used in swing trading includetrendlines, horizontal support and resistance lines, moving averages,and oscillators. As for charting timeframes, perhaps the most popularones for swing traders are generally anywhere from the one-hour
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chart (where each bar/candlestick is worth an hour of price movement) to the four-hour and daily charts.Swing trading allows traders to pinpoint precise, high-probabilityentries and exits for each and every trade, based soundly upon thetechnicals. A typical swing trade begins with a perception by thetrader that a market turn might be in the midst of occurring. Thisperception could be fueled by a host of different triggers, whetherit is an oscillator reaching severely overbought or oversold, a priceoscillator divergence occurring (described later in this chapter),a reversal chart pattern forming (also described later in this chapter), a break of a trendline occurring, or price reaching a significantsupport/resistance level. Any or a combination of these events, orother technical indications, could trigger the trader’s perception thatan impending turn could potentially occur.Once the initial perception is triggered, the prudent swingtrader immediately searches for confirmation. For example, if theinitial perception is triggered by a divergence indication, the traderwill check to see if any other patterns, support/resistance levels and/or oscillators are confirming an impending swing. If there is indeedconfirmation, the experienced swing trader would then considerpossible entries and exits (stop losses and profit targets) to determineif the trade is viable from a risk/reward perspective (as discussed inChapter 6).Given the prevailing trade conditions, if the reward-to-risk ratioappears to be sound, the swing trader would then decide upon thesize and leverage of the trade if these factors have not already beenpredetermined. The final step in the swing trading decision processwould then be to prepare to enter the trade with either a market
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order or a stop/limit entry order. Simultaneously, the trader wouldalso set stop loss and/or trailing stop parameters, as well as an appropriate profit target according to the trading plan.For short- to medium-term timeframes, swing trading can potentially be a very-high-probability approach to forex. Price swings areextremely prevalent in every financial trading market and on everycharting timeframe. The up and down swings occur naturally during all market conditions, whether in a trending market or a tradingrange. Moreover, setting risk management controls in the form ofstop losses, as well as determining optimal risk/reward parameters,can be extremely precise and straightforward for the typical swingtrade.
D ay Trading — In and Out, Day In and Day OutThe majority of beginning forex traders try their hand first at daytrading. This is perhaps due to the fact that this style of trading isgenerally the most exciting and fast-paced of the different styles.There are certainly traders who have made a consistently profitableliving through day trading currencies, but it is definitely not as easyas it may initially appear to be.Day trading is usually defined as the entering and exiting ofpositions within a single trading day. This means that few, if any,trades are held over to the next trading day. It also means that daytraders must necessarily attempt to extract small profits from quickmovements on the shortest of charting timeframes, usually anywherefrom the 1-minute chart (where each bar/candlestick is worth oneminute of price movement) to the 5-minute, 10-minute, 15-minute,
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30-minute, and everything in between. Occasionally, timeframes aslong as the 1-hour chart are used for day trading.Trading on the shortest timeframes in this manner works wellonly if the trader possesses the requisite discipline, technique, andmoney management skills to overcome the formidable odds surrounding this style of trading. One rather considerable difficultywith short-term day trading is the fact that a necessarily smallnumber of pips is targeted for each trade’s profit objective, makingthe cost of the bid/ask spread a very significant prohibiting factor.For example, if a typical profit objective is around 20 pips for a daytrade, a 3-pip spread alone accounts for an immediate handicap of15% of the projected profit. This occurs even before there is actually any price movement on the trade. The day trader therefore has adistinct statistical disadvantage from the outset. In contrast, the 3-pipspread on a targeted 60-pip swing trade or a 300-pip position tradewould represent an immediate handicap of only 5% or 1% of projected profit, respectively.That being said, day trading can still be a viable method ofapproaching forex for experienced and determined traders. The techniques employed by day traders vary widely. Often, these techniquesinvolve breakouts of short-term support and resistance levels. Thiscould mean a breakout of a low volatility trading range, or a sharpmove at the opening of an active currency market like London orNew York. Breakouts are discussed in more depth later in the chapter.Other times, day traders will trade purely based upon indicator confirmations. For example, a day trader may have a ruleto open a long trade if the 5-period exponential moving average(EMA) crosses above the 20-period EMA, but only if the 14-period
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Relative Strength Index (RSI) has also crossed above 30 and theslope of the MACD histogram is up. (Note: These trading rules weremeant to serve as an arbitrary example, and were not actually testedas part of a trading strategy.)Because day trading currencies can be extremely fast and intense,there is usually insufficient time or opportunity to perform discretionary market analysis in a leisurely manner. Therefore, more thanwith any other trading style, day trading often requires concretetrading rules that can be followed without much thinking on thepart of the trader. Clear and simple rules that are meant to be followed to the letter generally work best for ultra short-term day traders. For these traders, quick thinking and quick reactions are amongthe most important traits to possess.As mentioned, day trading currencies is often indicator-based.Traders may overlay several indicators on their price charts such asmoving averages, Bollinger Bands, or a host of others. In addition,they will also frequently add an oscillator or two running verticallyabove or below price such as the MACD, RSI, or Stochastics. Usingthis type of methodology, trading foreign exchange becomes as roteand straightforward as waiting for the various indicators to point inthe same direction at the same time. Although the rules here may besimple, however, this style of trading is anything but easy. It requiresa great deal of discipline to follow strict, indicator-based day tradingrules without allowing emotions to interfere in the process.Besides indicator-based trading, many day traders will tradepurely based upon breakouts of support and resistance. To denotethese support and resistance levels, these traders may manually drawhorizontal lines on their charts depicting levels where price turned
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or consolidated in the recent past. This method of visual determination is perhaps one of the most accurate ways of representingpotential support and resistance. As mentioned in Chapter 3, a tenetof technical analysis is that over time, price will visit and turn at certain levels repeatedly (otherwise known as support/resistance).Other popular short-term day trading methods for determiningsupport and resistance include pivot points, Fibonacci retracements,and trendlines. Day traders will use the levels derived from thesestudies to identify either breakouts of the lines or bounces off thelines. All of these techniques will be discussed in more detail furtheron in this chapter.Day trading appeals to the common human interest in immediate gratification. Many traders who gravitate toward day trading arelured by the illusory promise of instant profits for little effort. Thisparticular promise is an empty one. Nevertheless, if approached inthe correct manner with good technique and excellent risk/moneymanagement, day trading can potentially become a profitable pursuit.
T rend Trading — Going with the FlowDay trading, swing trading, and position trading, as just described,are general approaches to trading foreign exchange. This trend trading section begins a more in-depth look at the methods and strategies commonly used by foreign exchange traders.Trend trading, or trend following, is very similar to the generalposition trading approach used by longer-term traders/investors.The main distinction, as mentioned earlier, lies in the types of analysis that are generally emphasized. Position traders will usually utilize
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both technical and fundamental analysis in their decision-makingprocesses. In contrast, trend followers will commonly employ technical analysis almost exclusively.The goal of trend trading is to jump on a trend when the direction is technically clear, and ride it as long as it is intact. Technicaltrend following purists may identify uptrends when clear higherlows and higher highs begin appearing on a chart. By the sametoken, downtrends are identified by lower highs and lower lows.Trendlines and parallel trend channels will often be used to outlinethese trends on a chart.Another method of measuring the existence and strength of atrend is the use of moving averages, where the slope of a movingaverage may indicate whether there is a current uptrend, downtrend, or neither. Within a trend-trading context, moving averagescan also be used to give crossover signals (as described in Chapter 3).Using this technique, if price crossed above a certain moving average it would be a buy signal, while a cross below would be a sell signal. Alternatively, a cross of a shorter moving average above a longermoving average would be a buy signal, while a cross below wouldbe a sell signal. Moving averages are often used in this way, but thedifficulty lies in the frequent false signals, where several unprofitablecrosses occur in succession, otherwise known as whipsaw.Yet another trend measurement tool that is widely used, but arguably weaker than the prior two methods, is the Average DirectionalIndex (ADX), which oscillates to display the strength and existenceof a trend on a currency chart. Many other indicators and studies arealso used to identify trending conditions, but the three methods justmentioned are probably the most common. Additionally, breakouts
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in the direction of the general trend are another way of confirmingtrend continuation, but this will be discussed further in the sectionon breakout trading.Once a trend is identified and measured using technical studies,the stage of the trend needs to be identified. Clearly, getting in at thebeginning or middle of a trend run is vastly preferable to getting inlate. Although there are no clear-cut delineations among the threestages, each stage can be discerned by its general characteristics.If higher lows and higher highs begin occurring right after awell-defined downtrend or prolonged price consolidation, it couldbe a sign that an uptrend is in its early stage. Prudent trend traders may prefer to avoid entry at these first signs of trend change. Inhindsight, this stage represents the best possible entry point, but atthe time of decision it is full of uncertainty.When the trend moves onto its middle stage, it is consideredto be well-established with consistent prior evidence that price ismaking progress in one direction. It is at this point that many trendtraders will jump on the trend, fueling it even further in the samedirection. From a day trading or swing trading perspective, this typeof entry in the middle of a trend is simply too late. From a positiontrading and trend trading perspective, however, it can be considereda sensible entry targeting long-term profits.When it comes to the late stage of a trend, most of the majormarket players are already in position and looking to take profits.This late stage is perhaps the worst possible time to enter into atrend. But how would a trader know if this stage has been reached,or if the trend still has enough momentum to move much further?The answer to this question is difficult. There really is no way of
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knowing definitively until one can look back in hindsight and pinpoint the very end of the trend on a chart. At the same time, however, many clues will appear on the chart in real-time that hint atthe near-end of a trend, including failures to reach higher highs inan uptrend (or lower lows in a downtrend), prolonged consolidations, and significantly diminished volatility. In any event, it is muchbetter to play it safe by avoiding potential late stage entries altogether rather than risk buying at the highs or selling at the lows.Once a trend and its stage have been identified, the next step fora trend trader is to decide on the timing and location of entry.For trend traders, this decision is not nearly as crucial as it is forshorter-term swing traders and day traders. Riding long-term trendsis all about letting profits run as far as possible. With this mentality, trend traders are not as concerned about pinpointing a perfectlytimed entry as a shorter-term trader might be. That being said,however, the better the entry the better the potential profit picture.Therefore, trend traders generally prefer to enter into a trend at highprobability locations within the trend.As shown in Exhibit 5.1, this would entail buying on the dipsin an uptrend, or the temporary downward retracements withinthe overall uptrend. During a downtrend, it would entail shortselling on the rallies, or the temporary upward retracements withinthe overall downtrend. These areas constitute high probabilityentries for a very clear reason. In the case of an uptrend, buying“cheap” when price is steadily appreciating could perhaps be considered the most intelligent way to conduct trades in any type ofbusiness. The same general principle holds true, but in the oppositedirection, for downtrends.
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EXHIBIT 5.1
Buying on the Dips
Source: FX Solutions – FX AccuCharts
Once a trend has been entered, the trend trader must managethe position, albeit not as actively as a shorter-term trader mightneed to. It should be kept in mind here that the primary principleof trend trading is to let profits run while cutting losses short. Thisis the cornerstone of long-term trend following. With short-termswing trading and day trading, letting profits run is much less of afocus because these types of traders specialize in exploiting relativelyminor price fluctuations. In contrast, trend traders are generally notso quick to take profits. These longer-term traders need to establishan excellent reward-to-risk ratio (as will be discussed in Chapter 6)in order for their few large profits to surpass the many small losses
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that are incurred during up-and-down whipsaws and false trendmoves. So when a good, strong trend is found, the trend trader mustride it for all it is worth.This means that perhaps the best way to manage establishedtrend positions is through the use of trailing stop losses, whethermanual or automated. These dynamic stop losses follow price suchthat profits are locked in as the position accumulates gains. Withan automated trailing stop loss, the market is followed by a certainnumber of pips predetermined by the trader. A manual trailing stoploss is often a more preferred method of managing a trend trade. Inan uptrend situation, for example, the trader would actually movethe stop loss manually. A logical location for each move of the stoploss would be right below the last swing low (or dip). If price continues up, more gains are locked in, and the trailing stop loss getsmoved to progressively higher dips. If price breaks below the lastdip, however, it is a solid indication that the uptrend might possibly be ending. The manual trailing stop loss then promptly takes thetrader out of the position, realizing all of the accumulated profits.Other ways to manage trend trades besides using trailing stoplosses include scaling in and scaling out of position. Scaling intoposition entails entering initially with a small, fractional trade size,and then adding onto the position as the trend develops further. Thiscan be a great way to test the waters without being fully committedfrom the outset. If the trend fails initially, the loss is not excessive. If,however, the trend develops significantly, a full-sized position can bequickly scaled in.Scaling out is just the opposite. Once a full position has matured,and there are indications of a possible waning of trend momentum,
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parts of the position may be closed in succession. The logic of thisstrategy is to lock in and realize profits on part of the position whileallowing another part to take advantage of any further remainingmomentum.Finally, if the trend trade is not exited due to price hitting a stoploss (whether static or trailing) or to the trader scaling out of position, a trade exit may also be made when a profit target is hit. Ininitially setting the profit target, the trend trader should take intoconsideration a minimum reward-to-risk ratio for this type of trade,as well as the prevailing market conditions evident on the chart.On longer-term trend trades, the reward-to-risk ratio, as will bediscussed in Chapter 6, should preferably be set as high as possible.Therefore, the profit target should ideally be set to several timesthe magnitude of the initial stop loss. This, by definition, is the manifestation of the popular trading proverb, “Let your profits run andcut your losses short.” At the same time, however, the market willgive only what it has to give. In other words, a high reward-to-riskratio cannot be forced, as profit potential depends solely upon market conditions. For this reason, the trailing stop loss is generally thepreferred method for exiting trend trades over the more arbitraryprofit target method.Trend trading is one of the most effective strategies for approaching foreign exchange trading. Many of the most successful and wellknown traders, whether they trade stocks, futures, or currencies,consider themselves long-term trend traders. It is perhaps the bestsingle method for capturing major currency price movements, especially since foreign exchange is generally considered to be a marketthat trends frequently.
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R ange Trading — Between a Rock anda Hard PlaceIf the foreign exchange market trends often, what is it doing when itis not trending? Most likely, it is trading in a range. Ranges are periods when price moves up and down without a clear directional trend.Some would characterize the price action during a range as “sideways,”or horizontal. Generally speaking, this kind of directionless price movement is bounded on a top extreme by a resistance line and on a bottomextreme by a support line. Exhibit 5.2 illustrates a typical trading range.It is between these support and resistance boundaries that therange trading opportunities lie. Range trading simply involvesEXHIBIT 5.2
Trading Range
Source: FX Solutions -– FX AccuCharts
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identifying and capitalizing upon the turns within a horizontal trading range. These turns are also considered swings, so the techniquesof range trading are often an important component of a swing trader’s repertoire.While range trading may be a popular strategy, some traders,especially those that concentrate on following trends, consider it tobe a much lower probability method. This is primarily because ofthe fact that the upside in range trading is necessarily capped at theother side of the range. By definition, range traders do not let theirprofits run the way trend traders do. As this is true, range traders canincrease their potential upside by setting a minimum threshold interms of the height of the ranges that they are willing to trade.For example, a 20-pip range that forms on the GBP/USD pairduring Asian session is not really worth range trading. This type ofrange is best reserved for breakout trading, which will be discussedin the next section. The height of the range is just too diminutive tomake it worthwhile as a range trading opportunity. In other words,the potential profit is not sufficient to justify the risk. A 300-piprange, however, can certainly offer range traders an abundance ofgood potential trading opportunities that can be very worthwhile.If stop losses are always placed just beyond the support or resistancelevel from which a range trade is initiated, a profit target (on theother side of the range) that is further away would clearly offer ahigher probability trade from a risk/reward perspective. Therefore,a prudent range trading approach should include some minimumcriteria for the height of the range.Once the height of a potential range is established by at least twoapproximate touches of both support and resistance, preparation for
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range trading can begin. Most range traders will use the commonhorizontal lines on their charts to denote the support and resistancelevels in a range. Some, however, will use dynamic bands, most notably the Bollinger Bands, to outline these levels. Tools like the BollingerBands can certainly be useful in trading ranges that do not possess verystrictly defined upper and lower bounds. With the use of BollingerBands, however, a range trader should also monitor the slope of thesimple moving average running through the middle of the Bands toensure that it is indeed flat or near-flat. Only in this way can the traderbe adequately confident that a horizontal range is indeed in place.On the establishment of the range using one of the methodsmentioned, the range trader might then simply use a common oscillator like Stochastics or RSI to help indicate potential turns at ornear resistance and support. The most common method of readingthese oscillators is to identify the point at which they cross the lineexiting overbought or oversold, which denotes a possible impendingturn. This is illustrated in Exhibit 5.3.Besides the oscillator indications, another turn confirmationcan be found at the break of an intra-range trendline, as shown inExhibit 5.4.Although requiring a trendline break confirmation in this fashionwill almost always lead to a relatively late trade entry, it can presentvaluable evidence that a turn within the range has indeed occurred.A tighter stop loss can then be placed on the other side of the trendline break as opposed to the other side of the range support/resistance.Range trading can be an effective method for trading foreignexchange during periods when there is no discernible trend inthe market. During these periods when price tends to bounce
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EXHIBIT 5.3
Stochastics Turns fromOverbought/Oversold
Source: FX Solutions - FX AccuCharts
repeatedly between horizontal resistance and support, traders musteither utilize methods similar to those described above, or stay outof the market altogether. If an established range has sufficient height,trading the bounces can be a potentially effective approach to sustained nontrending market conditions.
B reakout Trading (and Fading) — Shooting forthe StarsWhere range trading attempts to capitalize on turns that respectestablished support and resistance levels, breakout trading is just
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EXHIBIT 5.4
Intra-Range Trendline Breakouts
Source: FX Solutions – FX AccuCharts
the opposite. Foreign exchange traders who specialize in breakoutsspend their time looking for violations of support and resistance.Exhibit 5.5 illustrates a typical forex breakout opportunity.To many, breakout trading makes more sense than any othermethod of trading, as a breakout with strong momentum can potentially yield a great deal of pips for the relatively small amount of riskinvolved. For this reason, a lot of traders gravitate immediately totrading breakouts. But these traders soon realize that it is not as easyas it may initially appear to be. This is because many of the majorbreakouts that occur in today’s foreign exchange markets tend to befalse breakouts. This is when a breakout occurs without any follow
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EXHIBIT 5.5
Major Horizontal Support Break
Source: FX Solutions – FX AccuCharts
through and then reverses, trapping all of the breakout traders whohastily jumped on the opportunity.False breakouts of this nature tend to be of two types. The firstcan be called a “fakeout,” where a support/resistance line is breachedslightly, but then price just turns back and goes in the opposite direction as soon as most of the breakout traders get trapped.This type of false break is akin to price respecting support/resistance after breaching it only slightly. The second type of false breakis called a premature breakout, where a slight breakout occurs,then turns around to go back in the opposite direction, and thenfinally turns once again to perform a true breakout on a subsequent
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attempt. Both of these types of false breaks can be extremely frustrating for breakout traders.As a reaction to the proliferation of false breaks on currencycharts, some former breakout traders have transformed into whatare called breakout “faders,” where they fade, or trade against, majorbreakouts. Trading against a dominant movement in this way can alsobe a risky strategy, but with the proper risk controls and money management in place, it can be an effective approach in many instances.Whether a trader fades or trades a breakout, the techniques usedto denote relevant support and resistance levels is identical. The simplest, and perhaps most reliable, method involves manually drawinghorizontal lines on a chart that correspond to previous market turns.As explained in Chapter 3, horizontal support and resistance are partlyderived from traders’ collective memory of a given price level, andwhether the general consensus considers that level relatively high orrelatively low. If a price level is considered relatively low (support),buying activity at that level should occur. Conversely, if a price levelis considered relatively high (resistance), selling activity should occur.When these activities occur on a major basis by many market participants, the end result should generally be a turn at support or resistance.Therefore, drawing a horizontal line extending from a previous turnmakes a lot of sense. Traders’ memories of relative price levels are clearest at the levels of previous market turns. That is one of the reasons thatwe frequently see price turn repeatedly at a certain level over a prolonged period of time. Exhibit 5.6 illustrates the