Mark Thomas — Trade On Track

Continuing on with our price action study, in this article we’ll put together a plan for analyzing a particular currency pair, on a particular time frame, and see if we can work out a way to get some probabilities on price continuation.

In the last article we talked about a study that was published a few years ago that presented some probabilities of price continuing in the same direction. For instance, the study said that if the EUR/USD moved 15 pips on a 1hr chart, then it was 72.4% likely to continue to 40 pips in the same direction, without hitting a 20 pip stop loss. Those figures make it look dead-easy to trade based on probabilities. Just keep trading consistently using a 15pip-break rule, set a stop at 20 pips and a target at 25 pips, and you’ll win 72% of the time!

We’re here to test this little theory out. While I’m a strong believer in consistent, smart trading being able to win the war in the long term, I would like to do some more testing, with more precise entry, stop and exit points. So, in this article, I’ll map out a plan for doing this testing.

There are obviously lots of possible currency pairs to trade when trading the forex. For our new price action study, I thought we should limit the analysis to just one pair, the EUR/USD. Analyzing too many pairs just makes it more complex and confusing than it needs to be. Basically, if we can get some nice probabilities and a workable, profitable strategy on one currency pair, then it’s likely we can apply it to other currency pairs later if we wanted to. Therefore, we will stick to just the EUR/USD figures for now.

To do our analysis, we’ll need quite a bit of price history so that we get a decent sample to do our backtesting. There’s a fine line between “curve-fitting” a strategy and performing a thorough analysis on historical data. What this means is, we want to make sure our probabilities are as accurate as possible, given what has happened to price in the past. But, we don’t want to tweak things in our strategy so far that it ONLY works on the past results. We want decent statistics based on historical information, that is likely to carry through into the future as well.

Also, we need to define how fine-grained our historical data will be for our backtesting. We could take hourly data (high, low, open close figures) – but that leaves a lot of room for error and doesn’t allow us to do any price predictions for anything less than an hour. Or, we could take tick data – which is price information every time we get a new bid/ask data from the broker (could be several per second). This could result in a huge amount of data though, and is probably overkill.

Taking these considerations into account, I think a decent sample of data would be the last 4 years of price information, taken at 1 minute intervals. So, we’ll have open, high, low and close figures for every minute during trading hours, over the last 4 years to work with.

To keep this study as useful and relevant as possible, I’d like to analyze different bar periods. Some traders like to trade 5 minute bars, others are most comfortable with daily bars, and probably the majority of us like to trade the periods in between. So, I will analyze and present statistics on the following bar periods: 5min, 15min, 30min, 1hr, 4hr and daily. I have a feeling that we’ll get the best results on the higher time frames, but we’ll include all of these just to be sure.

With our price study, what we’re hoping to do is just pick a starting point, wait for price to move a certain number of pips in one direction, then measure how far it continues to go in that direction. To keep things simple, we’ll make our starting point the close of a candle (or bar). This could be ANY candle, it doesn’t have to be at the bottom or top of a swing, it doesn’t have to be a long-bodied candle or a doji, it doesn’t have to be reliant on already being in a trade or not. So, for each of our chart periods (5min, 15min, 30min, 30min, 1hr, 4h and daily), we will randomly pick 5000 candle closes over the 4 year history that we have. These candles could be during peak trading times, just before or after news announcements, we don’t care. If we can keep the starting point as random as possible, it means it should be easier for traders to follow any strategy that we can derive from this study.

The idea is that we take our starting point, then wait for price to move to a certain trigger point before we enter. We could go crazy and analyze 20 different trigger points, but that would just provide unnecessary information and overload our brains. I’ll keep things relatively simple and just analyze 3 different trigger points: 10, 15 and 20 pips from our candle close. I don’t really want to go any lower than 10 pips because spread becomes more of a factor and depending on your broker’s spread – traders will obtain different results.

Once we’ve done our ‘virtual’ trade entry at the trigger point, our study will calculate how likely it is that price will continue to various price levels. I will analyze and report probabilities to the following levels PAST the trigger point: 10 pips, 20 pips, 40 pips, 60 pips, 80 pips and 100 pips. So, those pip levels are target levels or the number of pips we would make from the trade if those target levels are hit.

We also need to consider a stop loss level. Once again we could go into a gazillion permutations by analyzing 20 different stop levels with the above targets. That would be madness, so we’ll just consider 2 different stop levels: 20 pips and 40 pips. The stop level would be where the stop is placed from our entry point (which is the trigger price).

In summary, the plan that we’ve mapped out in this article is to:

Take EUR/USD 1 minute data over the last 4 years

Pick 5000 random candle closes for the 5min, 15min, 30min, 1hr, 4hr and daily chart periods

For each of the above samples, test entry levels at 10, 15 and 20 pips past the candle close

Using stop levels of 20 pips and 40 pips

and calculate some probabilities of price continuing on to 10, 20 , 40, 60, 80 and 100 pip levels

That’s quite a bit to get through and we’ll have multiple pages of backtested statistics from this study, which I’ll present in the next article.

Mark Thomas — Trade On Track

This is the first part in a new article series where we study how price moves and how we can profit from the results of what we uncover. This topic of “price action” was inspired by a report that was recently sent to me called “Predicting Price Action”, written by Scott Owens with Omer Lizotte in November 2004 (it can be found here). That report is obviously dated, and its methods and results were questionable. So, this article series will expand on this report, bringing it up to date with more recent backtesting, and explaining in more detail how we can profit from the results found.

The basic question we are trying to answer in our price action study is, “how likely is it that price will continue to move in a particular direction and to certain levels?”. If price starts moving up or down, we are going to analyze what the probability is of price continuing in that up or down direction. We should be able to use this information to build a profitable trading strategy from scratch, or to assist us in making existing strategies more profitable.

Let me give an example: if we find that price breaks past a previous level (perhaps a high or closing price) by 15 pips, we could analyze historical price action to determine how often price kept going to a 30 pip level, or to a 50 pip level or beyond. This would give us a probability (as a percentage), as to how likely price is going to continue past the 15 pip break-out point to higher levels. We’ll need to introduce some rules in our analysis, such as a stop loss point, otherwise we could be waiting forever to see if price ends up going past our break-out point.

By going back through historical price data, we should be able to calculate some decent statistics as to these price continuations. If we can find, for instance, that price continues to a 40 pip level after breaking through a 15 pip trigger level 70% of the time, and that’s with a 20 pip stop loss, then we could formulate a profitable trading strategy from those statistics.

The original “Predicting Price Action” report attempted to do this type of thing by presenting probability figures on a number of different currency pairs, over a number of different time periods. At first glance, the figures looked extremely promising. For example, they stated that on a 1hr EUR/USD chart, if price broke a previous close by 15 pips, it was 72.4% likely to continue to a 40 pip level without hitting a 20 pip stop loss. So, without taking spread into account, it looked like we could make 25 pips (40 – 15) 72% of the time while risking 20 pips. That’s a reward:risk ratio of 5:4 with a 72% win rate. That’s pretty good, considering the only criteria for entering and exiting a trade is price – there is no need for any other indicators.

There were others who read this and did their own testing and got nowhere near those reported results though. The way the results were calculated was not totally clear, a little ambiguous if you like. For instance, was the 20 pip stop loss level calculated from the original ‘break’ point, or from the trigger level (15 pips past the break point)? Another question raised was: is the trigger only determined at the close of a bar (IE. the close is 15 pips beyond the previous close), or is it triggered as soon as price goes 15 pips past the previous close?

I can’t be sure exactly how the probability results were calculated in that original study, but it doesn’t really matter because I’m going to do my own research, calculate my own probabilities, and publish the results in this article series. I’m confident that we will be able to find some favorable results, particularly on the higher time frames, which we’ll be able to use to design a trading strategy that is profitable in the long term.

Price action is often an underestimated component in technical analysis. However, it can and probably should be the foundation for any decent trading strategy, because in the end, price is what we are trading. In the next article I will explain exactly what historical data we’ll be using, what currency pair we’ll be focusing on, what bar periods and also what trigger and target levels we’ll be working with to study our price action continuations.

Read Part 1 Here

Mark Thomas – Trade On Track

In this second article in The Business of Trading, we address other attributes, skills, processes and equipment that you’ll need to utilize in your trading business.  Trading is a serious endeavor to undertake, treat it with the respect and commitment you would give to any other profitable business.

Equipment

Fortunately, the equipment required to get started in online forex trading is minimal and easily accessible.  You can get started with any home computer and an internet connection.  Just download a free trading platform, sign-up for a demo account and away you go!  Do you need more than this to really be successful in trading?  Theoretically, no, but you may find that certain tools make your trading life easier and can be treated as a business expense if you’re making a profit.

There are lots of different software trading platforms out there now, some are free and work well, but it’s worthwhile trying a few different ones to see if they give you more relevant information, are easier to use, or just have a better “feel” about them.  If you require automation in your trading, then make sure you choose a platform that supposes this.  Metatrader is a good “free” choice, but I personally find it a bit cumbersome and “clunky”.    It doesn’t seem to react quickly when I want to make a quick trading decision – but it is full featured and does support automation.  You might also like to try platforms like eSignal and TradeStation which are highly respected by professional traders.

A reliable and fast internet connection is a must for serious trading.  It’s good to have some sort of backup connection too, in case you’re left stranded with an open trade and you need to close it out of monitor it closely.  If your cable or ADSL internet connection fails, make sure you have a dial-up option too.  Even dial-up will be fast enough to get logged in and close your trade in an emergency.

A large screen (monitor) is just about essential, and you may even consider multiple monitors.  A professional trader rarely watches just one chart, and the more screen real estate you have, the more information you’ll be able to show, and the quicker you’ll be able to absorb the information that is presented.   And, it’s not just charts that you’ll be working with as a professional trader, there’s a good chance you’ll also be viewing and using:

• Fundamental (news) information

• Spreadsheets or trading log software

• Forums or social networking websites to interact with other traders

• Other supporting documents such as strategy instructions and checklists

• Calculators or other tools for assessing risk and managing your trades

Make sure your trading workstation is set up in a place where you can shut the door and focus on the task at hand without distractions.  A home office is ideal but trust me, trading at the dining room table on a laptop with 5 kids around is NOT optimal.

The Right Knowledge

To become a successful trader in the long term, there’s a lot to be learned. You’ll need to understand:

• Basic trading terminology, such as: bid, ask, spread, margin, long, short.

• Other trading basics:  Stops / targets, Candles/bars,  session times and chart periods.

• How moves the market and how it works.

• Technical analysis concepts such as: support & resistance, indicators like moving averages, MACD & stochastics.  Also have basic knowledge of the use of pivot points, fib levels and candle patterns.

• Fundamental analysis concepts: Learn about how news affects the markets and why a certain news announcement can move the market in a certain direction.

• Probabilities.  You’ll need to assess your trading success over the course of LOTS of trades.  Learn about probabilities, risk/reward ratios & win/loss ratios.

• Risk management and money management.  To stay in the game for any length of time, you’ll learn that it’s a matter of building your account slowly, with minimal risk.

• Trading psychology.  Learn about fear & greed in trading, how our emotions can affect our decisions on when to enter and when to exit.

• Last but not least, you’ll need to learn a number of different trading strategies that you can prove to yourself are profitable.  This takes time and trial & error – to find the right strategies to suit your trading style and that you are comfortable and confident with.

You can learn many of the basics of trading for free.  Sites like WinnersEdgeTrading.com provide a great resource for traders both new and experienced, and the majority of the information is free.   You can also practice and hone your skills for free, building experience by trading a demo account.

There are times when it’s worth investing some money to learn from those who are more experienced than you though.  Profitable, workable strategies can take quite a bit of time and expertise to develop, so it’s logical that a good strategy will cost money.  Proper mentoring can be a great way to accelerate your learning curve too – seeing exactly how an experienced trader handles different market conditions and being able to get questions answered on the fly can be extremely valuable.

Financing

If you’re making a consistent profit month after month, even if it’s a small profit, you may consider borrowing capital for your trading account.  The amount of income you can earn through trading is going to be heavily dependent on how much capital you have available, so borrowing some of your trading capital can dramatically increase the amount you can earn.  This is called an investment loan and you can generally borrow up to 50% of your investment.

Beware though, if you’re not consistently profitable you could get yourself into big trouble if you’re trading money you don’t even own.  You should have at least 24-36 months of trading history where you can show consistent profits before you even consider getting an investment loan.  Interest rates are generally higher than say a home loan too, you’ll need to make sure you’re earning quite a bit more through your trading than you’re paying in interest.

Trading as a business means you’ll be declaring your trading income on your tax return, but if you’ve borrowed some of the trading capital you should be able to claim the interest on the loan as a tax deduction too.  In other words, the interest that you pay on the loan can offset your trading income, which can reduce the amount of income tax you pay.

Dedication / Commitment

When first discovering trading, the dollar signs may start flashing in your eyes.  It seems like a fast and relatively simple way to make unlimited profits.  Yes, the potential is huge but don’t underestimate the amount of dedication and commitment that you’re going to need to put into the trading business too.  Don’t expect to be rich in 3 months or even 12 months.  Your first goal in trading is to NOT lose money.  Once you can trade and not lose money over a period of time, you can start to concentrate on making profits – small at first, but increasing over time.

Professional forex trading requires a long-term commitment.  It’s going to be hard work, but the journey can be very enjoyable and rewarding.  If trading is something that you love and you believe you can apply yourself to over a long period of time, then the chances are good that you can win the war and beat the average Joe.  In trading, when someone makes a profit it means someone else has made a loss. You are going to need to be smarter, more disciplined and more committed than the majority of other traders in order to make a business out of your trading.

Ongoing Education

Once you’ve learned how to trade and you’re building your trading skills, the learning does not stop there.  It’s an ongoing process, there’s always more to be learned and the more you know, the better trader you will become.

You’ll be able to refine your existing strategies, incorporating newly found knowledge.  You’ll learn more advanced technical analysis skills such as Elliot waves and time-based analysis.  You’ll learn new strategies that suit your trading personality and can improve the performance of your trading, and require less time in front of the computer to make the same or greater profits.

There’s always more to be learned in the areas of discipline and trading psychology too – all these things help you become a better trader.

Accounting and Accountability

Any successful business monitors its spending, its income, and its overall performance on a regular basis.  Businesses generally use accounting software or at least a spreadsheet, to record and analyse the finances.  To run a business without any sort of records would be reckless and in most cases, illegal.

Forex trading as a business should not be any different.  Trading without suitable records is like spending money blindly.  You’ll ask yourself one day “where did all my money go?” and you won’t have any concrete answers.  By recording the details of your trades you become accountable for what you’re doing.  You can go back and analyze what methods are profitable for you and which aren’t.  To increase your trading performance and profitability, you’ll first need to know exactly what it is, how you got there and how to change things to improve it.  You’ll need to know what your maximum drawdown was over the last 3 months or last 12 months.  It’s quite likely that you could have the same drawdown, perhaps multiplied by 2 or 3 times in the future. Can your account handle that?  With this knowledge, you can bump your risk levels either up or down to ensure you stay in the game and increase your profits.

Knowledge is power, so in the business of trading, be sure you arm yourself with as much knowledge as possible.  We’re not just talking about educational knowledge, but also emotional knowledge and the knowledge about what trades you’re taking and why you’re taking them.  I wish you well in this business, make sure you apply yourself with dedication, a thirst for knowledge, and also make sure you enjoy the process!

Mark Thomas — Trade On Track

Looking to make money from forex trading? That’s the aim for most of us and at first, it looks like such an easy thing to do! It turns out to be not so simple though, and I believe many things need to be addressed in a business-like manner in order to be a truly successful trader. To make money in any business requires skills, experience, knowledge, dedication and hard work – the business of trading is no different.

What it means to run trading as a business
There are a few different ways to make a business out of trading. If you’re good enough, you can trade other people’s money and take a commission on profits. This is called being a professional account or money manager. You can do the same type of thing by being employed by a money managing firm, where you’re managing the firm’s money, not the client’s money directly. This is called a proprietary (or prop) trader. Another way to make a business out of forex trading is to teach it or provide other resources or tools that can help traders. This can work if your forte is actually something other than trading, but your trading knowledge and skills complement the business you are in.

However, in this article, we’ll just be discussing personal trading as a business. That is, trading and managing your own money for the purpose of making a profit.

As with any business, there are advantages and disadvantages that need to be identified and weighed up before jumping in head first. Advantages include:

• Being your own boss. The only person you really have to answer to is yourself. You’re calling the shots and it’s up to you how you run your business.
• Unlimited earnings potential. If you’re good enough and disciplined enough, there is really no limit to the amount of income you can earn from trading. If you re-invest all or part of your profits, the cumulative effect comes into play and your account has the ability to keep on growing.
• It’s challenging and rewarding. I find these to be advantages because I’m always learning more and challenging myself. From this, I am also growing – as a trader and personally. Trading can teach you a lot about yourself, exposing strengths and weaknesses. Many of the attributes required in being successful at trading are the same attributes required in being successful at anything.

Disadvantages in running a trading business include:

• It can be a solitary occupation. Most of your trading hours will probably be done on your own. You may be in contact with other traders through forums, email or sites like currensee.com – but in the end, you’re probably in your home office on your own with little social interaction. Some of us actually consider this to be an advantage, but it’s definitely something that needs to be contemplated, even for the most introverted among us.
• Success may fluctuate. Being an entrepreneur and running any type of business means you can have wild swings in risks and rewards. If you’re working for someone else, you usually have job security – you know what your wage is going to be each month and you have a good idea of what it will be next year and the year after that. In trading, it can take a lot of planning and correct execution to attain that feeling of security. You may have some very good months followed by a losing month or two. You must plan to balance this out over time so that your overall trading is profitable and you have the confidence to continue.
• Your financial rewards are dependent on how much you have to invest. With a regular job you can hit the ground running and earn a decent income almost immediately. With trading, you’re normally going to need to build up to a good-sized trading account in order to make a business out of it.

Business Plan
A plan for your trading business is essential, but often overlooked or discarded as not necessary. I’ve often heard the phrase: “if you fail to plan, you plan to fail” and it is true in trading, as with any business.

I just received an email last night written by Brian Tracy, detailing the importance of goal setting. After consulting to more than 1,000 companies and teaching over 4 million people how to set and achieve goals, he says that the one easily-identifiable trait among the supremely successful people he has met, is that they know how to set goals and work hard to achieve them.

Some things you might consider including in your trading goals and your trading business plan are:

• How much you want to make from your trading. Consider how much each month you would like to draw as an income and also how much you’d like to make next year and in 5 years time. Try to be as realistic as possible, but also be conscious about setting your goals high. Get as much information as you can first. Buy books about traders who are making a living from trading, read about them and learn from them.
• How to do it, how to meet your financial trading goals. It’s fine to say “I want to make 10% income per month”, but how exactly are you going to do it? What strategies are you going to use, how much time are you going to spend each day trading, what times of the day will you trade? You may not know all those details yet, so if you don’t – plan instead to learn and practice the skills required so that you get to the point where you know how you’ll get there.
• Goal setting and planning is an evolving process. Don’t worry if you don’t have all the answers yet. The important thing is to set your goals, write down what you can about the achievement of the goal, then make sure you start taking some sort of action immediately. Once you start taking action, regularly review your goals and make sure you’re moving in the right direction. As you learn more and get in the habit of taking action and moving toward your goals, you’ll be able to fill in more of the detail and it will all tend to fall into place.

I could go on and on about planning and goal setting – they are huge topics in themselves, but we’ll leave that for another day. In the next follow-up article, we’ll talk about other topics related to your trading business including: equipment, borrowing & investments, dedication and accountability.

Go to Part 2

Mark Thomas — Trade on Track

I believe one of the biggest mistakes you can make in forex trading is trying things half-heartedly, moving from mentor to mentor, strategy to strategy – always believing there’s a better way to do things out there. I believe one of the keys to success is to master a technique or set of techniques, master the markets, master your craft.

This article is partly inspired by a recently recorded interview of Tony Robbins that I listened to last night.  He emphasizes the need to “master, not dabble” in anything that you want to succeed at.  He was referring mainly to Internet Marketing in the context of the interview, but I strongly believe it is true in many areas of life – especially trading.

If trading were easy, then everyone would be doing it.  The fact is, it is not.  I guess it comes down to what you want out of it – it’s actually fairly easy to lose money, but that’s of course not what any of us want.  The road to becoming even a little bit profitable in the long term, can be a long and hard one.  This road does not finish there though, you can continually refine and master your techniques, your knowledge and your mindset to become more and more profitable over time – hopefully to the point where you can make enough or more than enough to live on.

Tony Striedieck, our resident forex tree guy writing contributor is in the process of telling us how he mastered the craft of trading.  The story he is telling of hard knocks (and large losses of money) along the way is not foreign to many of us.  It’s often those hard lessons that make us knuckle down and treat the process of trading with the respect and the focus it deserves.  We may think we’re learning all the right things to become good traders, but it’s subtleties like having the right mindset, setting goals and a plan, and really focusing and mastering everything we do in our trading that leads to eventual success.  Make sure you follow Tony’s stories and really take in what he is telling us.  I don’t know what’s coming up next from Tony, but anyone who has been through the hard times and has battled through to victory, is worth listening to.

This process of mastering something and not giving up is actually built into us at a very young age.  Never believe that you don’t have what it takes, because I believe that if you want something bad enough – you can figure out a way to make it happen.  I’m looking at my 18 month old daughter running around the house now, occasionally falling over and bumping into walls, but at least she’s up and trying!  Just a few short months ago she was crawling on the floor and looking at the rest of us walking, jumping, dancing, running.  She saw what we were doing and obviously thought it was pretty cool, so she tried it.  But, did she just try for a day or two then give up after a few falls, bumps and bruises?  No way!  She kept going, the same as all of us did when we learned to walk.  Persistence, creativity, the ability to continually learn and improve, building strength, are key ingredients to mastering something, whether it’s walking or forex trading.

My 3 year old son is in another room watching the Disney animation “Hercules” (for the 683rd time).  This entertaining story of the mythical greek character tells of his struggles in controlling his super-human powers.  Hercules knows he has the strength and character to be a super hero, saving the world from all manner of disasters, but he has no discipline, no control over his power – so he goes about creating chaos and turmoil wherever he goes and in whatever he does.   Hercules eventually masters his strength and power, through persistence and mentoring – so he becomes the hero he always knew he could be, and of course: got the girl.  Once again, these struggles are not that different to the process of learning to become a great trader.  We may have it in us, but without the proper discipline, skills and mentoring – we can wreak havoc, destroying trading accounts and more along the way.

In regards to trading, there are many things to master.  Don’t be a Jack of all trades and a master of none. You’ll need to master things like:

• a winning mindset

• a rock-solid discipline

• a mature understanding of how the markets move and what drives them

• how to use technical analysis to find potential trades and manage them properly

• specific quirks in the forex markets, such as currency correlations, around the clock trading, big-player fake-outs, and relevant news events

• analyzing and refining your trading

If you’ve chosen to begin this path to forex trading success, then I believe the rewards can be enormous.  They may not come easily, but if you are committed and willing to master all the necessary skills to get there, then it can be an enjoyable,  profitable and ongoing career path.  Good luck, and trade seriously.

Here’s another NYTime trading system update, now that we’re at the end of October.

I wasn’t able to grab the figures for the last day (31st) because the day hadn’t been closed off yet.  Apart from that though, the month has seen moderate profits of around 8.3% return.

Here’s a list of the trades that were triggered, along with their returns:

There were a couple of losses at the end of September which brought our trade risk level down to zero, based on our money management rules.  So, we’re starting the month of October with a zero risk figure – which is a good thing because there was a string of losses early on.  A few profitable days in the middle of the month sees the strategy pull in front to over $1200 on our initial $1000 investment, but that backed off to $1083 by the end of the month.

Our maximum drawdown for the month was 11.6% ($1225.90 dropping down to $1083.13), so we were fortunate to finish reasonably well for the month. Not up to our calculated average return of 12% return per month, but perhaps things will come good in November.

Mark Thomas– Trade On Track

When reading articles from experienced forex traders trying to teach you something, you normally only hear about how this one was a winner and that one made you 500 pips.  Well, here’s a spanner in the works – here’s how things can go wrong too, because it happens to all of us and it’s part of trading.  If you want to be a good trader, you’re going to need to be able to deal with losses, sometimes big or very frustrating losses.  So, here’s my story from Friday trading …

These days I don’t have a great deal of time to trade at all, but I still like to keep the charts open and if I spot something that looks promising and I have a few minutes to assess it, I’ll check it out.  Earlier in the week I’d had some success with the GBP/USD – I went long and was able to catch 200+ pips, then on Thursday I went short and caught nearly 100 pips.  There were a couple of stopped-out trades in there too, but they were only 20 or 30 pips each.  So, on Friday I was looking at the GBP/USD hourly chart and it seemed that there could be another short setup.  Price had almost touched a resistance line for the 3rd or 4th time and it had just broken through a bullish trend line … see below.

Hourly GBP/USD on Friday, just before my first entry.

If I went short, I knew my stop level would be just above the current resistance level (around 17-18 pips above), but I wanted to know what the potential reward could be, so I went back to a daily chart to have a look. On the daily we were getting lower highs and lower lows, a definite downtrend, and we were just closing a daily bar which was inside the previous daily bar. In addition to that, the body of the inside candle was quite small, almost a doji. The bulls and the bears were obviously fighting it out hard and were undecided which way things could go. I drew a fib retracement from the bottom of the last move up to the current resistance level (see the yellow lines in the chart below) and also a support line which ended up just above the 50% retracement. This seemed an ideal target if I went short, so with the risk/reward ratio being so good, I sold the Pound.

Daily chart

Having decided to take a trade, I zoomed into a 15 minute chart to fine-tune the entry. The chart below shows a 15 minute candle breaking through the bullish trend line and closing. The MACD was also rolling over nicely – it looked like a good time to enter.

Just before first entry

A couple of hours later, I was stopped out. Ok, not a big deal, there wasn’t a great deal riding on it because the risk/reward ratio was so good. The chart below shows the point at which I went short (the vertical blue line) and the horizontal red line was the stop level. The candle that took out my stop was quite strong, but that makes sense because it was a fairly strong resistance level. The strong move up in price wasn’t reflected in the MACD indicator though – we had some divergence. This is a good sign that the push up in price was unwarranted, overbought, so another short entry was on the cards. I kept my eye on things for a few more hours and price was just starting to punch through the current minor support level. It also made a feeble attempt to push up again, only to result in a shooting star candle (see the 2nd last candle below). I went short again, with a stop loss about 18 pips above the last high and a target at 1.6319, just above that 50% retracement on the daily that I pointed out above. So once again, the risk (about 50 pips) to reward (over 300 pips) was still very good.

15min GBP/USD – just before my 2nd entry

At that point I had babies to feed, bath and put to bed, and my own dinner to have, so I left the charts alone for awhile. When I checked back, I saw that my stop had been taken out by about 2 pips, and price had dropped like a rock. In fact, it kept dropping – right to where my target was originally set!

15min GBP/USD – How it ended up

I had this fish on the line twice and both times it ate my bait and got away. If I had put the line into the water a third time, I would have caught that big fish! Not to worry, these things do happen and I hope that at least some of you caught this drop down. Technicals aside, it was the -0.4% GDP figures that came out confirming that the British economy is in a deep slump that sent price down the way it did.

So, how does an experienced trader think about and deal with a situation such as this? He or she should record it, analyze it, and figure out if something could or should have been done differently. Then, the trader should put it aside and move on with the next trading day with an extra experience under his/her belt. That’s exactly what I’m doing and by sharing my experience with you, I’ve been able to analyze it quite thoroughly. What should I have done differently? I probably shouldn’t have taken that first trade so impulsively and I should widen my stops, particularly on the pound, just a little bit more. Alternatively, instead of having a hard stop – I would be better off waiting for a candle close above my ‘virtual’ stop level before closing the trade.

Mark Thomas — Trade On Track

There’s a buzz around the forex world at the moment in regard to correlations between currency pairs and how you can use them to your advantage in your trading. While I haven’t personally downloaded or read any of the “secret” reports on this subject, I thought it might be useful to discuss this topic and to give some examples of how I use currency correlations in my own trading.

A “correlation” is a statistical measure of the relationship between currency pairs. It measures how much or how little a currency pair follows the direction of another currency pair. Currency pairs often move in tandem or in opposite directions to each other, which is quite understandable given the fact that the base currency may often be the same. For instance, the AUD/USD pair has a very high correlation with the EUR/USD pair. Over the past week, the two moved in the same direction 95% of the time. The correlation coefficient is expressed as a number from -1.0 to +1.0. A negative number means that the currency pairs moved in the opposite direction to each other more of the time, while a positive number means they moved in the same direction more of the time. Taking this to the extremes, a correlation coefficient of -1.0 means the two currency pairs moved in opposite directions to each other 100% of the time, while a correlation coefficient of 1.0 means the two currency pairs moved in the same direction to each other 100% of the time.

You can research and monitor the daily closing prices of currency pairs yourself, then calculate the correlations, or you can find a resource that does it for you! One such resource is : http://fxtradeinfocenter.oanda.com/charts_data/fxcorrelations.shtml . Oanda provide a visual tool which lets you quickly see the correlation between currency pairs over the last week, month, all the way up to 2 years. Taking a look at it today reveals that the AUD/USD and NZD/USD closely correlate with the EUR/USD pair (over the last week). This varies over time, but with experience these correlations will become ingrained in you and you’ll be able to make good use of them in your trading.

How do you make use of correlations? There are several ways in which I use the correlations between currency pairs. In general, correlation coefficients are calculated on end-of-day prices, so you would think they may not be very useful for intra-day traders. However, I have found that if currency pairs are closely related over the period of a week or a month, then they will often move in tandem throughout the day too. Here are some ideas for how to use correlations:

• To confirm an entry signal. For example: If I have a trading system that gives me a buy signal on the AUD/USD pair but I am not completely confident, I’ll go to the EUR/USD, NZD/USD or even the GBP/USD to see if a similar setup is possible on those pairs and whether there is little resistance to price moving up. Quite often, there may be an obvious resistance level on the AUD/USD that makes me nervous about buying, but if there is little or no obvious resistance on the correlated pairs – that gives me the confidence to take the signal and enter. If the EUR/USD is able to push upwards quite nicely, then I can be confident the AUD/USD will push up too.
• To avoid false break-outs. I especially like to use this during the European session when there’s often false break-outs on the GBP/USD. If it looks like the GBP/USD is making a move and I’m ready to enter a trade, I’ll flick over to the AUD/USD to see if it is moving strongly in the same direction. The AUD/USD is a lot less volatile than the GBP/USD, even though they are often closely correlated. So, quite often the AUD/USD will NOT break-out when the GBP/USD breaks a support or resistance level, which gives me a clue that it is probably a false break-out and to hold off entering that particular trade.
• To diversify your market exposure. If you take a long position in both the AUD/USD and the EUR/USD, then you’re effectively taking the same trade but with double the stake. Keep this in mind when you’re calculating your risk … sticking to a 2% risk level per trade is not a good enough rule, you need to ensure that you don’t risk too much over correlated pairs too. If you have multiple trade setup options, it’s best to diversify your exposure by taking say a EUR/JPY trade with a USD/CAD trade (two pairs that are NOT closely correlated).
• To hedge your trades. This is, in a way, opposite to the above advice, but I have often used it to my advantage. If you have trade entry signals that seem to defy the general correlation rules, then you might actually like to take both those signals. For instance, the EUR/USD pair nearly always moves in the opposite direction to the USD/CHF pair. If my trading system gave me a buy signal on the EUR/USD pair as well as the USD/CHF pair, then I would probably take both entries with confidence. The reason I would be confident is because it’s likely that at worst, the correlation factor would be in play and one trade would win and the other would lose – with a net effect of a small or nil gain. At best, both trades would win.

Even if you only like to trade one currency pair at a time, always consider looking at the correlated currency pairs to see which way they are going and whether or not there’s upcoming support/resistance. Looking at correlated pairs can give you the extra confidence to enter a trade or even to exit a trade at the right time. Knowing the currency correlations can also help you manage your overall risk in the forex markets.

In this article we will complete the pseudo-code logic behind our fractal-based trailing stop. Previously (see this article: http://www.winnersedgetrading.com/trade-of-the-day/defining-our-fractal-based-trailing-stop-ea), we explored how a fractal point itself could be defined in pseudo-code and we also defined some variables that would remember where our last fractal points were.  In addition, we created some pseudo-code logic to tell us where the trailing stop would go.

Here’s where we’re up to so far:

if longPositionEntered then:
stopLoss = lastFractalDown – priceGap
else if shortPositionEntered then:
stopLoss = lastFractalUp + priceGap

This image shows an example of a short position entered (at the green line). The last known fractal up is about 6 candles back from the entry point, so our stop loss goes just above there (where the red line is).

An automated trading program generally works by looking at the situation (price, indicators etc.) for every new tick that comes along. So, our program has a loop which wakes up whenever there’s new data available (a new tick), then it goes and checks for changes in the situation and acts accordingly. Our main program loop might look something like this in pseudo-code:

for each new tick:
checkFractals
checkPriceBreak
checkFractalPullback
calcNewStopLevel
if hasBeenPriceBreak then:
if canMoveStopLoss then:
moveStopLoss

else if hasBeenFractalPullback then:
if canMoveStopLoss then:
moveStopLoss

Let me explain what we’re doing here.
“for each new tick” is self explanatory. We’re going to execute the processes “checkFractals”, “checkPriceBreak” and so on whenever there is a new piece of data available (IE. a new tick).

“checkFractals” will be a separate process or function where we look at the candles or bars that we’ve just drawn. If we find that a new fractal has been formed (either bearish or bullish), then we’ll update our variables to remember where our last fractal point(s) were. Here is how our “checkFractals” function might look:

checkFractals:
#
# check for a new high fractal
#
if (priceBar[-3].high > priceBar[-2].high) and (priceBar[-3].high > priceBar[-1].high)
and (priceBar[-3].high > priceBar[-4].high) and (priceBar[-3].high > priceBar[-5].high) then
fractalHigh = priceBar[-3].high
if factalHigh is different to lastFractalUp then:
previousFractalUp = lastFractalUp
lastFractalUp = fractalHigh
#
# if not a new high fractal, then check for a new low fractal
#
else if (priceBar[-3].low < priceBar[-2].low) and (priceBar[-3].low < priceBar[-1].low)
and (priceBar[-3].low < priceBar[-4].low) and (priceBar[-3].low < priceBar[-5].low) then
fractalLow = priceBar[-3].low
if fractalLow is different to lastFractalDown then:
previousFractalDown = lastFractalDown
lastFractalDown = fractalLow

So, if a new bearish fractal has been found, we’re updating our ‘lastFractalUp’ and ‘previousFractalUp’ variables with the high prices of the last 2 up fractals that we know about. Similarly, if we’ve just identified a new bullish fractal, we’re updating our ‘lastFractalDown’ and ‘previousFractalDown’ variables with the low prices of the last 2 down fractals.

The next function that we come across in our main loop is “checkPriceBreak”. What this function will do is check to see if price has broken through the last down (bullish) fractal if we’re in a short trade. Or, if we’re in a long trade, the function will check to see if price has broken through the last up (bearish) fractal. Here’s how the function might look:

checkPriceBreak:
hasBeenPriceBreak = No
if longPositionEntered then:
if currentPrice > (lastFractalUp + priceGap) then:
hasBeenPriceBreak = Yes
else if shortPositionEntered then:
if currentPrice < (lastFractalDown - priceGap) then:
hasBeenPriceBreak = Yes

The sole purpose of this routine is to set a variable called ‘hasBeenPriceBreak’. It will be set to “Yes” if price has broken through the last fractal, or “No” if it hasn’t.

Continuing on in our main program loop, the next function to be defined is called “checkFractalPullback”. If you remember in our original design of this trailing stop system, we said that if we’re in a short trade and we have a bearish fractal followed by a higher bearish fractal, then we’d move the stop loss to just above the last bearish fractal, even if price hadn’t broken down through the last bullish fractal. That is what “checkFractalPullback’ checks for. Here’s how it will look:

checkFractalPullback:
hasBeenFractalPullback = No
if longPositionEntered then:
if lastFractalDown is lower than previousFractalDown then:
hasBeenFractalPullback = Yes
else if shortPositionEntered then:
if lastFractalUp is higher than previousFractalUp then:
hasBeenFractalPullback = Yes

In a nutshell, this function will set the variable called “hasBeenFractalPullback” to “Yes” if there has been a fractal pullback, or “No” if not.

The next function in our main loop is “calcNewStopLevel”. This function will just calculate where our new stop loss level could be (not necessarily “will” be, but “could” be).

calcNewStopLevel:
canMoveStopLoss = “No”
if longPositionEntered then:
newStopLevel = lastFractalDown – priceGap
if newStopLevel > stopLoss then:
canMoveStopLoss = “Yes”
else if shortPositionEntered then:
newStopLevel = lastFractalUp + priceGap
if newStopLevel < stopLoss then:
canMoveStopLoss = “Yes”

You’ll notice that some of this function is the same as the logic we used to set the stop loss when first entering the trade. The rest of the function checks to see if the new stop loss would be higher than the previous stop loss (in a long position) or if the new stop loss is lower than the previous stop loss (in a short position). We only want to move the stop if it moves in the direction of our trade. That is why it’s called a trailing stop, we never want to move a stop loss backwards, away from our trade direction.

The final function in the main loop is “moveStopLoss”. All this function would do is move the actual stop loss on our chart to the value stored in the “newStopLevel” variable.

That’s basically all there is to the logic for a trailing stop system based on fractals. The code itself may seem quite complex, but you can see that there’s not a great deal of code there to make it all happen. When we build the EA for Metatrader (coming up in a future article), the code may expand a little bit, but really, the above code encapsulates what we’re trying to achieve. If you’ve been trying to nut out the rules for a trailing stop system yourself, you might like to try pseudo-code as I have above, to break it all down and define exactly what conditions must be met before you move the stop, then define “how” you will move the stop.

Mark Thomas — Trade On Track

While on the topic of fractals, here’s another great use for them: drawing trend lines! Trend lines are a very important part of technical analysis, in fact, they’re probably the one thing you need to get right before you move onto more advanced forms of technical analysis. Trend lines can be drawn in lots of different ways, but I’ll explain in this article and video how to draw basic uptrend and downtrend lines using fractal points. Trend lines are great for identifying breakouts and therefore, possible trade entry points.

Trend lines basically identify areas of support and resistance. A downtrend line (a line that is moving down from left to right) can be interpreted as a resistance line (price finds it difficult to move up and through it), and an uptrend line can be interpreted as a support line (price finds it difficult to move down and through it). Trend lines can be drawn on any time frame, but they tend to be “stronger” on the higher time frames.

Just to recap: we define an upper (or bearish) fractal as a high with two lower highs on either side of it. Similarly, we define a lower (or bullish) fractal as a low with two higher lows on either side of it. Fractals are often called pivot points or swing points.

When drawing trend lines, I start on the right-hand side of the chart and draw back to the left. It’s nice to have the lines automatically extended off to the right of your chart, so it depends what charting program or trading platform you use. With Oanda’s charts, it’s easy to draw from right to left, and the lines are extended automatically to the right. With Metatrader, you have to draw from left to right in order to have the lines extend to the right.

To draw a down trend (or upper trend) line, find the last high (or bearish) fractal on the right-hand side of the chart. Then, look to the left and identify the next fractal point that is higher than the one on the right. Draw a line between the two highs.

To draw an up trend (or lower trend) line, find the last low (or bullish) fractal on the right-hand side of the chart. Look left and identify the next fractal point that is lower than the one on the right. Draw a line between those lows.

As more candles or bars are formed on your chart, new high and low fractal points will be established. As each new fractal point is formed, re-draw your trend lines.

Breakouts can often be identified when price breaks through the upper or lower trend line. On a 15 minute chart, I generally like to see a candle CLOSE at least 5 or 6 pips above or below a trend line before I consider it to be a breakout. Quite often you see a candle punch through a trend line, but retraces and still closes within the boundaries of the line – so it can’t really be considered a breakout.

If you are considering entering a trade based on a breakout of a trend line, it’s much safer to wait for price to break through, move in the direction of your intended trade, then pull back to within a few pips of the original trend line (which might be several candles after the break). If you wait for the pull back, it’s usually a safer way to get into the trade, avoiding false breakouts.

Finally, you can use a trend line to trail a stop too. If you’ve bought on a break out of the upper trend line, you can place your stop just below the lower trend line and follow it up as price moves up. It’s a good idea to leave 7 or 8 pips between the trend line and your stop loss on a 15 minute chart. This buffer can be extended up to 15 or 16 pips if you’re trading higher time frames, like daily charts.

The short video below shows how to draw trend lines and how you could have profited by selling the EUR/USD after a double-top on the hourly, earlier today: