program.
Stick with your trading method long enough to give it a chance to work.Don’t even make your first trade until you have studied it under different market environments. This applies to your money management plan too: Give it anopportunity to work.
Trading PsychologyTrading psychology is what separates the men from the boys, the women fromthe girls. You might have made a small mint through paper-trading, but whenreal money is on the line “things” happen. Know thyself !
Fear and Greed, Greed and Fear!By nature all people are emotionally attached to their money. Since the you will betrading with funds that you have already defined as nonessential to your wellbeing, you must cultivate an attitude of emotional detachment from yourFOREX trading account. This is emotional detachment—not indifference ornonchalance. Otherwise, each sour trade will infest you with stress, worry, andfear. Currency trading is not worth an ulcer.On the other side of the coin is overconfidence. One very profitable tradecan induce the novice trader to go “gung-ho” and trade more currency pairs thanhe or she can track efficiently in one trading session. Overconfidence tendsto breed avarice and avarice can lead to financial shakiness. Moderation, levelheadedness, experience, and intuition all play key roles in the formula to successful currency trading. Knowing when to take a calculated risk definitely helps, too.
118
THE BUSINESS OF TRADING
To paraphrase pioneer technical analyst J. Welles Wilder in his book TheAdam Theory of Markets: The first idea is one of emotion and attitude, namelythat in order to be successful one must “surrender” to the market. If one ceases toworry about what might happen or what should happen, then one is free to concentrate on what the market is doing, which is where the profit will be made.
Characteristics of Successful TradersThere are some very basic characteristics attributed to most successful traderswhether they are in stocks, bonds, futures, or currencies:• Successful traders tend to have absolute control over their emotions—they never get too elated over a win or too depressed over a loss.• Successful traders seldom think of prices as “too high” or “too low.”• Successful traders do not panic—they make evolutionary adjustmentsrather than revolutionary changes to their trading style.• Successful traders do not flinch at making the decision to take a loss,never let losses ride, and never add to losing trades.One old trader told me he thought of his positions as stock in a retailstore. If something sells and is making you money, you add to that line.If something is not selling and costing you money, you discount it andunload it as quickly as possible.• Successful traders treat trading as business and not a hobby.• Successful traders stay physically fit.• Successful traders are prepared for all eventualities on any given tradingday. They come to work with a plan that includes many contingenciesand not just what they hope will happen.In your own trading program you should have predeterminedanswers to the following questions: What happens if . . .• prices open sharply higher or lower?• the market is very quiet?• the market is very volatile?• the market makes new highs?• the market makes new lows?• the market goes up early and reverses later?• the market goes down early and reverses later?
Money Management and Psychology
119
• The successful trader trades only with money he or she can affordto lose.Trading FOREX is speculative and can result in substantial losses. Itis also exciting, exhilarating, and can be addictive. The more you areemotionally involved with your money, the harder it is to make objective, clear-headed decisions about market entry and exit.• Successful traders spend at least as much time focusing on money management as they do on a trading method.You don’t have the profile of a successful trader if at least some of theabove traits don’t sound like you. We will offer a few additional moneymanagement and psychology guidelines in later chapters.• Successful traders keep a low profile.• Successful traders “listen” to the markets. Unsuccessful traders attemptto impose their will on the market.
12Chapter
Trading Tactics
his chapter is a potpourri of topics that collectively will determine yourtrading style. Style is what criteria you use to make selections in variousareas of trading. A trading style does not develop out of the blue but willemerge as you make your first trades. But now is a good time to begin thinkingabout these intangibles. Once you start trading, continue to think about yourtrading style from time to time. Giving yourself feedback on an ongoing basis isthe best way to stay fresh and avoid getting in a rut or just plain going nuts fromwatching the markets.
T
Trading StrategyTrading successfully is by no means a simple matter. It requires time, marketknowledge, market understanding, and a large amount of self-restraint. Anyonewho says you can consistently make money in foreign exchange markets is beinguntruthful. Foreign exchange is by nature a volatile market. The practice oftrading it by way of margin increases that volatility geometrically.We are therefore talking about a very fast market that is naturally inconsistent. Following that precept, it is logical to say that in order to make a successful trade, a trader has to take into account technical and fundamental dataand make an informed decision based on his or her perception of market sentiment and market expectation. Timing a trade correctly is probably the most
121
122
THE BUSINESS OF TRADING
important aspect of trading successfully, but invariably there will be cases wherea trader’s timing is off. A successful trader does not expect to generate returns onevery trade.Let’s examine what a trader needs to do in order to increase his or herchances for profitable trades.Trade with Money You Can Afford to LoseTrading FOREX markets is speculative and can result in losses. It is also exciting, exhilarating, and can be addictive. The more you are involved with yourmoney, the harder it is to make a clear-headed decision. Money you have earnedis precious, but money you need for survival should never be traded.Identify the State of the MarketWhat is the market doing? Is it trending upwards or downwards? Is it in a trading range? Is the trend strong or weak? Did it begin long ago or does it look likea new trend is forming? Getting a clear picture of the market situation is layingthe groundwork for a successful trade. No matter how complex and leadingedge your trading system might be, it never hurts to sit back and eyeball thecharts. Markets often have a remarkable rhythm. Look for the following:• The length of the primary trend versus the secondary trend.• The average time between tops and bottoms.• The average range of a bar, whether you are watching 1-minute,5-minute, hourly, or daily data.You will see different rhythms for the same market when viewing charts atdifferent scales—for example, 1-minute, 1-hour, and daily. Put these rhythmstogether for a true perspective on things.Identify the Market EnvironmentEvery market may be defined on a continuum of price movement, or trendslope, and volatility. Volatility measures how much prices move in the aggregate over some fixed period of time. Figure 12.1 indicates an arbitrary scale of1 to 8 for purposes of example only. This can also be studied on differentchart-time matrices.All markets may be measured as an index of where they reside on boththese lines. For example, a market with a very high trend slope and low volatility could be represented as a “7-2” market.
Trading Tactics
1
2
3
4
5
1236
7
8
6
7
8
Price Movement
1
2
3
4
5
Volatility
FIGURE 12.1
Price movement and volatility.
Price movement is the defined slope of a trend from beginning to endpoint. See Figure 12.2.Volatility is the total amount of price movement over a specified time. SeeFigure 12.3.In technical analysis we discussed the concept of trading environment—that all market activity can be defined by where it sits on two scales of volatilityand price movement. Keep the market environment in mind and watch forboth evolutionary and revolutionary shifts. The elements of the trading environment are the time frame and the three-chart system.Time Frame Many traders get in the market without thinking when theywould like to get out—after all, the goal is to make money. When trading, thetrader must extrapolate the movement that he or she expects to happen. Withinthis extrapolation resides a price evolution during a certain period of time.
FIGURE 12.2
Price movement.
THE BUSINESS OF TRADING
124
FIGURE 12.3
Volatility.
Attached to this is the idea of exit price. The importance of this is to mentally put your trade in perspective. Although it is clearly impossible to knowexactly when you will exit the market, it is important to define from the outsetif you will be “scalping” (trying to get a few points off the market), trading intraday, or trading over a longer term.This will also determine what chart period you are examining. If you trademany times a day, there is no point basing your technical analysis on a dailygraph: You will instead want to analyze 30-minute or hourly graphs. It is alsoimportant to know the different time periods when various financial centersenter and exit the market, as this creates more or less volatility and liquidity andcan influence market movements.The Three-Chart System Determine your desired trading time frame. If, forexample, you use hourly charts to determine entry and exit, then use 5-minutecharts for detail and daily charts for a long view of things. If you use5-minute charts to trade, use 1-minute charts for detail and hourly ones forthe long view. See also Table 12.1 for more on timing matrices.
TABLE 12.1Trader
Timing Matrices for Different TradersTiming
Home
Trend
Scalper
Tick
1 to 5 Minutes
1 Hour
Day Trader
1 Minute
5 to 10 Minutes
1 Day
Position Trader
10 Minutes
1 to 24 Hours
2 Days
Trading Tactics
125
Time Your TradeYou can be right about a potential market movement but be too early or too latewhen you enter the trade. Timing considerations are twofold: An expected market figure like the consumer price index, retail sales, or a federal reserve decisioncan consolidate a movement that is already underway. Timing your move meansknowing what is expected and taking into account all considerations beforetrading. Technical analysis can help you identify when and at what price a movemay occur. We will look at technical analysis in more detail later.If In Doubt, Stay OutThe conservative Belgian dentist strategy is “Sit on your hands, sit on yourhands.” The bulls make money, the bears make money, but the pigs just getslaughtered! (The bulls prefer advancing markets, the bears trade in decliningmarkets, while the pigs expect quick killings in any market.)Trade Logical Transaction SizesMargin trading allows the FOREX trader a very large amount of leverage, buttrading at full margin capacity can make for some very large profits or losseson an account. Scaling your trades so that you may reenter the market or maketransactions on other currencies is generally wiser. In short, do not tradeamounts that can potentially wipe you out and do not put all your eggs inone basket.Gauge Market SentimentMarket sentiment is what most of the market is perceived to be feeling about themarket and therefore what it is doing or will do. This is essentially about trend.You may have heard the phrase “the trend is your friend,” which means that ifyou are in the right direction with a strong trend you will make successfultrades. This of course is very simplistic; a trend is capable of reversal at any time.Technical and fundamental data can indicate, however, if the trend began longago and if it is strong or weak.Exercise Contrary OpinionNever be afraid to go against the crowd—the crowd is almost always wrong.Follow the old Wall Street adage “Buy the rumor, sell the news.”
126
THE BUSINESS OF TRADING
Know the Market ExpectationMarket expectation relates to what most people are expecting as far as upcomingnews is concerned. If people are expecting an interest rate to rise and it does,then there usually will not be much of a movement because the information willalready have been “discounted” by the market; alternatively, if the adverse happens, markets will usually react violently.Watch what other traders are doing but don’t follow them!In a perfect world, every trader would be looking at a 14-day RSI (RelativeStrength Indicator) and making trading decisions based on that. If that were thecase, when RSI would go under the 30 percent level, everyone would buy andby consequence the price would rise. Needless to say, the world is not perfectand not all market participants follow the same technical indicators, draw thesame trend lines, or identify the same support and resistance levels.The great diversity of opinions and techniques used translates directly intoprice diversity. Traders, however, have a tendency to use a limited variety oftechnical tools. The most common are 9- and 14-day RSI, obvious trend linesand support levels, Fibonacci retracement, MACD, and 9-, 20- and 40-dayexponential moving averages. The closer you get to what most traders are looking at, the more precise your estimations will be. The reason for this is simplearithmetic: Larger numbers of buyers than sellers at a certain price will move themarket up from that price and vice versa.Check the various FOREX discussion groups once a week to see how themajority of traders perceive the market. Just don’t be a slave to the news.
Trading TacticsThis section concerns the actual details on trade execution, tracking, and exiting. It also assumes that every trading session is attended (that is, that the traderis monitoring the price action while in motion and does not walk away from hisor her trading platform).Once the trader has selected the currency pair, the position to take (buy orsell), and the number of units to trade, he or she will initiate the trade.The trader has two options for entering into a new trade. The simplest iseither a market order in which the trade is executed at the current market priceor a limit order in which the order is delayed until the market price hits the limitorder price that the trader specified.At the same time that the trader enters the market, he or she must also setboth of the stop-loss and take-profit limit moves. As mentioned earlier, by trad-
Trading Tactics
127
ing without a stop-loss safeguard, you are unnecessarily exposing yourself totremendous risk that can clear out part or all of your margin.Setting a reasonable take-profit limit is also important in the event thereis a power glitch or some other disrupting anomaly. Modern computers are taking longer to reboot, after which you must log into your broker’s trading platform. In the four to eight minutes that the restarting process requires, an opentrade may have hit a respectable level of profit return, but the realization did notoccur because you did not place a take-profit limit order or you set it too farfrom the entry price.The placement of the stop-loss and take-profit limits is highly subjectiveand is based on the trader’s sensitivity to risk. Several trading platforms automatically calculate these values (stop-loss and take-profit) when you click on acheck box. Their calculation algorithm may be a simple linear distance from theentry price (say, 15, 20, or 25 pips in both directions) or it may involve somepercentage of the current range of trading. Either way, you are at liberty toadjust the stop-loss and take-profit limit orders in an open position.In a position that moves against you, it is recommended that the trader letthe price action trigger the liquidation of the order and simply absorb the loss.Or, if you believe that the price direction will not reverse itself in your favor, youmay liquidate the position manually before the stop-loss is triggered. It is notrecommended that you lower the stop-loss in a long position with the hopesthat the price will reverse shortly and move in the opposite direction. The oddsare against it. Take the loss, stand up, walk around, clear your head, and startover, preferably by examining a different currency pair.This is the disappointing part to trading. However, when prices move inyour favor, you have more options based on price volatility. If the price movessignificantly in your favor (say, 15 to 20 pips in a buy position), then move thestop-loss above the entry price (say, three to five pips) and raise the take-profitlimit order by 20 pips or so. As the trade continues to advance favorably, continue raising both the stop-loss and the take-profit orders.In this manner, you can successfully “lock in” guaranteed profits while letting the market run its course. Large profits can be realized using this mechanism. The exit mechanism should not be triggered by hitting the take-profitlimit but by a reversal, triggering the favorably adjusted stop-loss limit order.The exception is when you “feel” it is time and exit manually.However, the subjective part is how closely the two limit orders should beset in relation to the current price. When setting the initial values for both thestop-loss and take-profit orders, look for support and resistance lines in the pricesimmediately preceding the current price. This will give you some idea of therange of trading in the immediate past.Lastly, we should discuss pyramiding. This trading tactic involves addingto a favorable open position. This is done very simply by initiating new orders in
THE BUSINESS OF TRADING
128
the same currency pair and in the same position (buy or sell). This tactic may behandled profitably by veteran traders but is not recommended for the novicetrader. The trader must be ever-conscious of margin requirements and the amountremaining in his or her account. Using unrealized profits as the margin for newtrades has landed many a trader in deep trouble. Sharp market reversals in pyramidtrading have a devastating effect on the trader’s margin account. Be forewarned!
Eclectic ApproachShould you use fundamental analysis or technical analysis to determine thedetails of my trades? The veteran technician will adamantly respond “technicalanalysis” while the fundamentalist will confidently reply “fundamental analysis.”The correct answer is both. Any current market data deemed valid,whether fundamental or technical, should never be ignored. It is, however, avery subjective decision on the part of the trader; how much “weight” to put oneither discipline is learned from experience. Do not be afraid to change yourtrading methodology from time to time. But keep changes evolutionary, notrevolutionary. Do not make changes just because a single trade went sour.
Selecting Markets to TradeWe recommend that the novice trader begin by trading the major USD currency pairs only. These pairs usually require a lower bid/ask pip spread, whichincreases your profit potential while reducing your transaction costs.In addition to the transaction costs, you must also examine the currentvolatility of each candidate currency pair. Statistically, volatility is usually defined as the standard deviation of a data sample. However, this is a somewhatlaborious process since it entails summing all the elements in the data sample. InTable 12.2 we use the lazy man’s method for calculating two relatives of volatility, called the absolute range and the relative range of the data sample.Absolute range is converted from a decimal value to number of pips bymultiplying by 1,000 (or 10 in some cases) and expressed as pips in the quote(second) currency.
TABLE 12.2
Calculating Absolute and Relative Range
midrange
= (high + low) /2
absolute range = high − lowrelative range = 100 × range / midrange
Trading Tactics
129
The time period used in Table 12.3 is July 1, 2003, through December 31,2003. The table is divided into three groups: USD major currency pairs, USDminors, and non-USD cross pairs.Currency pairs with a relative range value less than 1.50 should probablybe avoided due to lack of volatility, unless the trader knows how to profit fromhorizontal markets (this involves scalping small profits from numerous tradesand accrues a very large transaction cost in the account summary). Even thoughTable 12.3 required several thousand ticks to compile, it is in no way conclusive.Absolute range is a statistic that characterizes an important property of asingle currency pair. Relative range is used to compare multiple currency pairswith each other.
TABLE 12.3
Selecting Currency Pair Criteria
CurrencyPair
6-MonthHigh
6-MonthLow
AdjustedRange
RelativeRange
Bid/AskSpread
EUR/USD
1.2542
1.0796
1746
3.74
3
USD/JPY
120.36
106.92
1344
3.05
3
GBP/USD
1.8106
1.5663
2443
3.62
3
USD/CHF
1.4217
1.2434
1783
3.35
3
USD/CAD
1.4079
1.2834
1245
2.31
4
AUD/USD
0.7662
0.6355
1307
4.66
4
NZD/USD
0.6839
0.5643
1196
4.79
5
USD/SGD
1.7645
1.7008
637
0.92
8
USD/HKD
7.8104
7.7089
1015
0.33
10
USD/DKK
6.8898
5.9401
9497
3.70
35
USD/MXN
11.4319
10.7456
6863
1.55
50
USD/ZAR
3.7942
3.7513
429
0.28
90
EUR/JPY
137.31
124.84
1247
2.38
3
EUR/GBP
0.7113
0.6812
301
1.08
3
EUR/CHF
1.5749
1.5322
427
0.69
3
CHF/JPY
89.24
79.29
995
2.95
6
GBP/JPY
194.76
180.15
1461
1.95
9
EUR/AUD
1.7567
1.6048
1519
2.26
12
EUR/CZK
32.9606
31.4485
15121
1.17
60
130
THE BUSINESS OF TRADING
Selecting Trading ParametersOnce you have selected the trading currency pair and determined a market entryprice, you must decide the remaining parameters:Trade Unit SizeThis only applies if the broker allows the trader to deal in odd-lot sizes. One recommendation for small-capital traders is that no single trade should ever exceed10 percent of the trader’s margin account.Stop-Loss Order DifferentialThis differential defines the number of pips below the entry price that the stoploss limit order is placed in a buy (long) trade and vice versa in a sell (short) trade.Take-Profit Order DifferentialThis differential defines the number of pips above the entry price that thetake-profit limit order is placed in a buy (long) trade and vice versa in a sell(short) trade.You need to be realistic about these numbers and willing to make adjustments along the way. It is not reasonable to have a 10-pip stop-loss order and a500-pip take-profit order. Scale your differentials to the type of trading you aredoing and the ratio you reasonably expect between winning trades and losingtrades. For example, when trading the EUR/USD pair, you might initialize themarket entry trade with a 15-pip stop-loss and a 30-pip take-profit order.DurationDuration, or expiry, is used on limit orders only and denotes the length of timethat you want the broker to keep an untriggered limit order active. We recommend keeping all limit orders to less than a day (or even a few hours). The logichere is that while trading in a different currency pair, the limit order on the firstcurrency pair may trigger, thereby reducing the amount of available margin.
Trading MatricesMarket action is constantly occurring at different levels, or price matrices, concurrently. A price matrix consists of three consecutive “legs” in a price action: aninitial trend either up or down, a retracement movement in the opposite direction, and a final leg in the same direction as the first leg (see Figure 12.4).
Trading Tactics
131
ContinuationWave
PrimaryImpulseWave50% RetracementWave
FIGURE 12.4
Basic upward price matrix.
We typically measure these based on the time interval involved: streamingtick data, 1-minute data, 5-minute data, hourly data, daily data, and weeklydata. Specifically, parameters must be set to determine when to draw the retracement leg. Typically, either a minimum percentage of the preceding leg mustoccur or a minimum number of pips in the opposite direction will “trigger” anew leg as shown in Figure 12.5.An important decision to make early on is: At what level am I trading,primarily? Types of traders are related to the matrix level they call “home.”Scalpers are most associated with tick data, day traders with 1-minute and 5minute data, and position traders with hourly data. Because of the volatility andleverage in the FOREX markets, few traders call daily data home.While you want to call one or two neighboring levels home, it is a mistaketo avoid giving attention to the levels below and above your home. Typically you
FIGURE 12.5
Trading matrices with different minimum triggeringmechanisms.
THE BUSINESS OF TRADING
132
want to follow the market with your home levels; get ideas about the overalltrend from the matrix just above, and use the matrix below for timing yourentry, exit, and stop-loss orders.
Dagger Entry RuleThe Dagger Entry Rule was first published by Mike Archer in Denver Magazinein June 1978. It is used to determine the price level for an efficient market entrypoint and consists of three steps:Step 1: We wait for a major trend to form. Call it (A). Step 2: Wewatch for a price correction in the opposite direction; call it (B). Thethird step is to complete the dagger: Wait for a sign of an end tothe down trend (B) and buy as soon as prices start up again. Thedagger, of which I have given only the basics, guarantees that youbuy at bargain levels and also that you do not attempt to pick thebottom of the market.See Figure 12.6.
Market TimingHere are some tips for getting the most of market timing. When developingyour own personalized FOREX trading strategy, there are many factors you can
Entry Point
(C)
(A)(B)
FIGURE 12.6
The dagger entry rule.
Trading Tactics
133
research that can turn to your advantage. Four of these involve timing: marketopening, market closing, time of day, and day of week.Market OpeningOfficially the FOREX market opens at 5:30 PM ET, though different brokersreact differently in different time zones. Keep in mind that over the weekendall currency pairs carry an extra premium in transaction costs. A normal 3-pipbid/ask spread during normal trading hours may increase to a 10-pip spread onweekends.Once the weekend transaction costs return to normal, many pairs exhibithigh volatility due to economic influences that occurred over the weekend.Analyzing a set number of currency pairs enhances your profit opportunities.Frequently a trend emerges in one direction or the other and continues until theweekend influences have been satisfied. This may entail tracking several pairsuntil the early hours of Monday morning. When opportunity knocks . . .Market ClosingMany corporations like to clear out last-minute orders Friday afternoon to avoidpossible rollover charges and to reduce the risk of any adverse anomalies thatmay occur over the weekend. This equates to increased volatility right before themarket closes at 4:30 PM Friday afternoon.If you trade during this peak period of volatility, always be certain toliquidate your trades before the bid/ask spread jumps to its increased weekend range.Time of DayFor the most past, the highest volatility periods revolve around banking hours inNew York City. This overlaps only slightly with banking hours in London andFrankfurt. Another factor is the time zone in which your broker is located.Taking these three factors into consideration plus your own time zone, youshould be able to determine periods of high volatility that increase profit potential. See Appendix C for details on time zones and world banking hours.Day of WeekThe days on which the market opens and closes have already been discussed.Other days of the week may also have special significance. For instance, newinterest rates are normally published on Thursdays, which causes immediatechanges in USD currency pairs.
134
THE BUSINESS OF TRADING
Summary
• The decisions you make about specific trading options—both strategyand tactics—determine your trading style. Be aware of your style,monitor it, and make changes wisely.• Stop-loss and take-profit levels should be realistic and complementaryto the type of trading you do.• The market operates at many different levels or matrices concurrently.Identify your home levels early on in your career.• Use matrices above and below your home for clues to the long-termtrend and entry/exit points.• When in doubt, stay out!• The markets will always be around. Missing a potential opportunity isinfinitely better than taking an actual loss.
13Chapter
What to DoIf Things Go Wrong
Evaluating Your PerformanceWe recommend that the novice trader start the trading experience with a simplehandwritten log of his or her trades. This does not mean logging every singletrade, which would be too cumbersome. Instead, record a simple synopsis ofeach day’s performance similar to the format shown in Figure 13.1.
TradingDate
BeginningBalance
No. ofTrades
PairsTraded
7/1/20047/2/20047/3/20047/4/20047/5/2004
FIGURE 13.1
Daily performance log.
135
StrategiesUsed
EndingBalance
Comment
136
THE BUSINESS OF TRADING
Common Trading MistakesThroughout this book, we have mentioned several trading caveats and wish toresummarize them here (with others):• Trading without a stop-loss limit order. Neglecting to set a stop lossis asking for financial disaster. In the event of a power outage, you mayreceive a margin call in the time it takes to reboot your computer.• Trading without a take-profit limit order. Always set a reasonabletake-profit limit order. Again, in the event of a power outage, the marketmay hit your expectations and reverse to the market entry price (or further) in the time it takes to reboot the computer. Always remember:When a trade is beginning to move favorably, you can adjust your takeprofit farther from the market entry price.• Using too much of your margin. Your margin requirement is recalculated with each price change. This is especially noticeable when youhave sold a position and the price is advancing. For small-capitaltraders, we recommend never using more than one-third of the totalaccount balance on any single trade.• Trading too many pairs at one time. First, this could cause a margincall. Many dealers will liquidate all open trades if any single trade generates a margin call, which could potentially eradicate any profit.Second, it clutters up the screen (and the trader’s attention) when fiveor more bar charts are displayed simultaneously on the screen.• Trading at the broker’s closing time. At closing time, most dealersincrease the bid/ask spread to cover low volatility and liquidity. A 3-pipspread may jump to a