Chapter 10

Training and Preparing for Battle

In This Chapter

arrow Determining what trading style fits you best

arrow Understanding the different trading styles

arrow Developing and maintaining market discipline

arrow Planning your trades and trading the plan

Before you get involved in actively trading the forex market, it’s important to take a step back and think about how you want to approach the market. There is more to this than meets the eye, and we think it’s one of the most important determinants of overall trading success.

Looking at the title of this chapter, you may think we’re exaggerating a bit with the reference to training and preparing for battle, but we’re really not. The Chinese military philosopher Sun Tzu famously observed that every battle is won or lost before it is ever fought. We can think of no better analogy when it comes to trading in financial markets in general or forex markets in particular.

In this chapter, we take you through the main points to consider as you seek to define your own approach to trading currencies. We review the characteristics of some of the most commonly applied trading styles and discuss what they mean in concrete terms. We also look at what constitutes trading discipline and some of the psychological and emotional hazards you’re likely to experience. Last, and probably most important, we run you through the essential elements of developing and sticking to a trading plan.

Finding the Right Trading Style for You

We’re frequently asked, “What’s the best way to trade the forex market?” For starters, that’s a loaded question that suggests there’s a right way and a wrong way to trade currencies. It also implies that there’s some magic formula out there, and if you can just find out what it is, you’ll be guaranteed trading success. Unfortunately, there is no easy answer. Better put, there is no standard answer — one that applies to everyone.

The forex market’s trading characteristics have something to offer every trading style (long-term, medium-term, or short-term) and approach (technical, fundamental, or a blend). So in terms of deciding what style or approach is best suited to currencies, the starting point is not the forex market itself, but your own individual circumstances and way of thinking.

Real-world and lifestyle considerations

Before you can begin to identify a trading style and approach that works best for you, you need to give some serious thought to what resources you have available to support your trading. As with many of life’s endeavors, when it comes to financial-market trading, there are two main resources that people never seem to have enough of: time and money. Deciding how much of each you can devote to currency trading will help to establish how you pursue your trading goals.

remember.eps If you’re a full-time trader, you have lots of time to devote to market analysis and actually trading the market. But because currencies trade around the clock, you still have to be mindful of which session you’re trading, and of the daily peaks and troughs of activity and liquidity. (See Chapter 2 for trading-session specifics.) Just because the market is always open doesn’t mean it’s necessarily always a good time to trade.

If you have a full-time job, your boss may not appreciate you taking time to catch up on the charts or economic data reports while you’re at work. That means you’ll have to use your free time to do your market research. Be realistic when you think about how much time you’ll be able to devote on a regular basis, keeping in mind family obligations and other personal circumstances.

warning.eps When it comes to money, we can’t stress enough that trading capital has to be risk capital and that you should never risk any money that you can’t afford to lose. The standard definition of risk capital is money that, if lost, will not materially affect your standard of living. It goes without saying that borrowed money is not risk capital — you should never use borrowed money for speculative trading.

When you determine how much risk capital you have available for trading, you’ll have a better idea of what size account you can trade and what position size you can handle. Most online trading platforms typically offer generous leverage ratios that allow you to control a larger position with less required margin. But just because they offer high leverage doesn’t mean you have to fully utilize it. (We look at the risk and reward components of leverage in greater detail in Chapter 13.)

Making time for market analysis

In other chapters, we talk about the amount of data and news that flows through the forex market on a daily basis — and it can be truly overwhelming. That’s one reason the major banks that are active in the forex market employ teams of economists, strategists, technical analysts, and traders. So how can an individual trader possibly keep up with all the data and news?

tip.eps The key is to develop an efficient daily routine of market analysis. Thanks to the Internet and online currency brokerages, independent traders can access a variety of daily and intraday market reports, covering both technical and fundamental perspectives. Your daily regimen of market analysis should focus on

  • Overnight forex market developments: Who said what, which data came out, and how the currency pairs reacted.
  • Daily updates of other major market movements over the prior 24 hours and the stories behind them: If oil prices or U.S. Treasury yields rose or fell substantially, find out why.
  • Data releases and market events (for example, the retail sales report, Fed speeches, central bank rate announcements) expected for that day: Ideally, you’ll monitor data and event calendars one week in advance, so you can anticipate the outcomes along with the rest of the market.
  • Multiple-time-frame technical analysis of major currency pairs: There is nothing like the visual image of price action to fill in the blanks of how data and news affected individual currency pairs.
  • Current events and geopolitical themes: Stay abreast on issues of major elections, political scandals, military conflicts, and policy initiatives in the major currency nations.

Establishing a research routine will take some time at first. You’ll have to read many different news stories and analysts’ reports before you get a handle on which sources provide the best overnight summaries, which fundamental analysts are most focused on the forex market, which technical analysts are focused on actionable trading strategies, and whom to follow on Twitter. We tend to focus on the mainstream financial news media, such as Bloomberg.com, Reuters.com, and MarketWatch.com.

Technical versus fundamental analysis

We look at fundamental analysis and technical analysis in greater depth in Chapters 7 and 11. We include them here as elements to consider as you develop your overall approach to the market. Ask yourself on what basis you’ll make your trading decisions — fundamental analysis or technical analysis?

tip.eps Followers of each discipline have always debated which approach works better. Rather than take sides, we suggest following an approach that blends the two disciplines. In our experience, macroeconomic factors, such as interest rates, relative growth rates, and market sentiment, determine the big-picture direction of currency rates. But currencies rarely move in a straight line, which means there are plenty of short-term price fluctuations to take advantage of — and some of them can be substantial.

remember.eps Technical analysis can provide the guideposts along the route of the bigger price move, allowing traders to more accurately predict the direction and scope of future price changes. Most important, technical analysis is the key to constructing a well-defined trading strategy. For example, your fundamental analysis, data expectations, or plain old gut instinct may lead you to conclude that EUR/USD is going lower. But where exactly do you get short? Where do you take profit, and where do you cut your losses? We like to use technical analysis to refine trade entry and exit points, and to decide whether and where to add to positions or reduce them.

Sometimes forex markets seem to be more driven by fundamental factors, such as current economic data or comments from a central bank official. In those times, fundamentals provide the catalysts for technical breakouts and reversals. At other times, technical developments seem to be leading the charge — a break of trend-line support or recent daily lows may trigger stop-loss selling by market longs and bring in model systems that are selling based on the break of support. Subsequent economic reports may run counter to the directional breakout, but data be damned — the technical support is gone, and the market is selling.

tip.eps Fundamental data and events are only one piece of the puzzle. Be aware that forex markets frequently ignore individual reports and do their own thing based on some larger theme or adjustment. That’s why we always stress that the market reaction to data is more important than the data itself.

Approaching the market with a blend of fundamental and technical analysis will improve your chances of both spotting trade opportunities and managing your trades more effectively. You’ll also be better prepared to handle markets that are alternately reacting to fundamental and technical developments or some combination of the two.

Different Strokes for Different Folks

After you’ve given some thought to the time and resources you’re able to devote to currency trading and which approach you favor (technical, fundamental, or a blend), the next step is to settle on a trading style that best fits those choices.

There are as many different trading styles and market approaches in FX as there are individuals in the market. But most of them can be grouped into three main categories that boil down to varying degrees of exposure to market risk. The two main elements of market risk are time and relative price movements. The longer you hold a position, the more risk you’re exposed to. The more of a price change you’re anticipating, the more risk you’re exposed to.

In the next few sections, we detail the main trading styles and what they really mean for individual traders. Our aim here is not to advocate for any particular trading style. (Styles frequently overlap, and you can adopt different styles for different trade opportunities or different market conditions.) Instead, our goal is to give you an idea of the various approaches used by forex market professionals so you can understand the basis of each style. We think this information will help you settle on a style that best fits your personality and individual circumstances. Equally important, you’ll be able to recognize whether your style is drifting and generally maintain a more disciplined approach to the market.

Short-term, high-frequency day trading

Short-term trading in currencies is unlike short-term trading in most other markets. A short-term trade in stocks or commodities usually means holding a position for a day to several days at least. But because of the liquidity and narrow bid/offer spreads in currencies, prices are constantly fluctuating in small increments. The steady and fluid price action in currencies allows for extremely short-term trading by speculators intent on capturing just a few pips on each trade.

Short-term trading in forex typically involves holding a position for only a few seconds or minutes and rarely longer than an hour. But the time element is not the defining feature of short-term currency trading. Instead, the pip fluctuations are what’s important. Traders who follow a short-term trading style are seeking to profit by repeatedly opening and closing positions after gaining just a few pips, typically 5 to 10 pips but also as little as 1 or 2 pips. For more information on high-frequency trading, check out Chapter 3.

Jobbing the market pip by pip

In the interbank market, extremely short-term, in-and-out trading is referred to as jobbing the market; online currency traders call it scalping. (We use the terms interchangeably.) Traders who follow this style have to be among the fastest and most disciplined of traders because they’re out to capture only a few pips on each trade. In terms of speed, rapid reaction and instantaneous decision-making are essential to successfully jobbing the market.

remember.eps When it comes to discipline, scalpers must be absolutely ruthless in both taking profits and losses. If you’re in it to make only a few pips on each trade, you can’t afford to lose much more than a few pips on each trade. The overall strategy is obviously based on being right more often than being wrong, but the key is not risking more than a few pips on each trade. The essential motto is “Take the money and run” — repeated a few dozen times a day.

Jobbing the market requires an intuitive feel for the market. (Some practitioners refer to it as rhythm trading.) Scalpers don’t worry about the fundamentals too much. If you were to ask a scalper for her opinion of a particular currency pair, she would likely respond along the lines of “It feels bid” or “It feels offered” (meaning, she senses an underlying buying or selling bias in the market — but only at that moment). If you ask her again a few minutes later, she may respond in the opposite direction.

Successful scalpers have absolutely no allegiance to any single position. They couldn’t care less if the currency pair goes up or down. They’re strictly focused on the next few pips. Their position is either working for them, or they’re out of it faster than you can blink an eye. All they need is volatility and liquidity. You can find out if you’re a scalper and get some actionable trade ideas for this trading style in the appendix.

Adapting jobbing to online currency trading

tip.eps Retail spreads have narrowed sharply in recent years. Some pairs have spreads that are lower than 1 pip, while other pairs have wider spreads. If you trade pairs or crosses with wider spread, this can make jobbing slightly more difficult; it doesn’t mean you can’t still engage in short-term trading — it just means you’ll need to adjust the risk parameters of the style. Instead of looking to make 1 to 2 pips on each trade, you need to aim for a pip gain at least as large as the spread you’re dealing with in each currency pair. The other basic rules of taking only minimal losses and not hanging on to a position for too long still apply.

tip.eps Here are some other important guidelines to keep in mind when following a short-term trading strategy:

  • Trade only the most liquid currency pairs, such as EUR/USD, USD/JPY, EUR/GBP, EUR/JPY, and AUD/USD. The most liquid pairs will have the tightest trading spreads and will be subject to fewer sudden price jumps.
  • Trade only during times of peak liquidity and market interest. Consistent liquidity and fluid market interest are essential to short-term trading strategies. Market liquidity is deepest during the European session when Asian and North American trading centers overlap with European time zones — about 2 a.m. to noon Eastern time (ET). Trading in other sessions can leave you with far fewer and less predictable short-term price movements to take advantage of.
  • Focus your trading on only one pair at a time. If you’re aiming to capture second-by-second or minute-by-minute price movements, you’ll need to fully concentrate on one pair at a time. It’ll also improve your feel for the pair if that pair is all you’re watching.
  • Preset your default trade size so you don’t have to keep specifying it on each deal.
  • Look for a brokerage firm that offers click-and-deal trading so you’re not subject to execution delays or re-quotes. (See Chapter 13 for more on broker executions.)
  • Adjust your risk and reward expectations to reflect the dealing spread of the currency pair you’re trading. With 1- to 4-pip spreads on most major pairs, you probably need to capture 3 to 10 pips per trade to offset losses if the market moves against you.
  • Avoid trading around data releases. Carrying a short-term position into a data release can be risky because prices may gap sharply after the release, blowing a short-term strategy out of the water. Markets are also prone to quick price adjustments in the 15 to 30 minutes ahead of major data releases as nearby orders are triggered. This can lead to a quick shift against your position that may not be resolved before the data comes out.

Keeping sight of the forest while you’re in the trees

Trading a short-term strategy online also requires individual traders to invest more time and effort in analyzing the overall market, especially from the technical perspective.

tip.eps If you pursue a short-term trading strategy online, where dealing spreads can equal profit targets, you need to be right by a larger margin. To give yourself a better chance of capturing slightly larger short-term moves, always know where you stand in longer charting time frames. By all means, use tick, one-minute, and five-minute charts to refine your trade timing, entry, and exit. But be aware of the larger picture suggested by hourly, multihour, and daily charts because they’re going to hold the keys to the larger directional movements.

Medium-term directional trading

If you thought short-term time frames were exceptionally brief, medium-term time frames aren’t much longer. Medium-term positions are typically held for periods ranging anywhere from a few hours to a day or two, but usually not much longer. Just as with short-term trading, the key distinction for medium-term trading is not the length of time the position is open, but the amount of pips you’re seeking/risking.

Where short-term trading looks to profit from the routine noise of minor price fluctuations, almost without regard for the overall direction of the market, medium-term trading seeks to get the overall direction right and profit from more significant currency rate moves. By the same token, medium-term traders recognize that markets rarely move in one direction for too long, so they approach the market with well-defined trade entry and exit strategies.

Almost as many currency speculators fall into the medium-term category (sometimes referred to as momentum trading and swing trading) as fall into the short-term trading category. Medium-term trading requires many of the same skills as short-term trading, especially when it comes to entering/exiting positions, but it also demands a broader perspective, greater analytical effort, and a lot more patience. Find out if you’re a medium-term trader in the appendix.

Capturing intraday price moves for maximum effect

The essence of medium-term trading is determining where a currency pair is likely to go over the next several hours or days and constructing a trading strategy to exploit that view. Medium-term traders typically pursue one of the following overall approaches, but there’s also plenty of room to combine strategies:

  • Trading a view: Having a fundamental-based opinion on which way a currency pair is likely to move. View trades are typically based on prevailing market themes, like interest rate expectations or economic growth trends. View traders still need to be aware of technical levels as part of an overall trading plan.
  • Trading the technicals: Basing your market outlook on chart patterns, trend lines, support and resistance levels, and momentum studies. Technical traders typically spot a trade opportunity on their charts, but they still need to be aware of fundamental events, because they’re the catalysts for many breaks of technical levels.
  • Trading events and data: Basing positions on expected outcomes of events, like a central bank rate decision or individual data reports. Event/data traders typically open positions well in advance of events and close them when the outcome is known (also known as buy the rumor/sell the fact, or vice versa).
  • Trading with the flow: Trading based on overall market direction (trend) or information of major buying and selling (flows). To trade on flow information, look for a broker that offers market flow commentary, like that found in FOREX.com’s Forex Insider (www.forex.com/forex_research.html).

When is a trend not a trend?

When it’s a range. A trading range or a range-bound market is a market that remains confined within a relatively narrow range of prices. In currency pairs, a short-term (over the next few hours) trading range may be 20 to 50 pips wide, whereas a longer-term (over the next few days to weeks) range can be 200 to 400 pips wide.

For all the hype that trends get in various market literature, the reality is that most markets trend no more than a third of the time. The bulk of the time they’re bouncing around in ranges, consolidating, and trading sideways.

remember.eps If markets reflect all the currently known information that’s available, they’re going to experience major trends or shifts only when truly new and unexpected information hits the market. On a day-to-day basis, incoming economic data and events usually result in an adjustment of prices only within a prevailing range, rather than a breakout, but that’s enough for medium-term traders to take advantage of the opportunity.

Taking what you get from the market

Medium-term traders recognize that sizeable price movements and trends are more the exception than the rule. So rather than selling and holding in the case of a downtrend, for example, they’re looking to capitalize on the 50- to 150-point price declines that make up the overall downtrend. The key here is that medium-term traders will take profit frequently and step back to reassess market conditions before getting back in.

tip.eps Although medium-term traders are normally looking to capture larger relative price movements — say, 50 to 100 pips or more — they’re also quick to take smaller profits on the basis of short-term price behavior. For instance, if a break of a technical resistance level suggests a targeted price move of 80 pips higher to the next resistance level, the medium-term trader is going to be more than happy capturing 70 to 80 percent of the expected price move. They’re not going to hold on to the position looking for the exact price target to be hit. It goes without saying that it’s better to catch 75 percent of something than 100 percent of nothing.

Long-term macroeconomic trading

Long-term trading in currencies is generally reserved for hedge funds and other institutional types with deep pockets. Long-term trading in currencies can involve holding positions for weeks, months, and potentially years at a time. Holding positions for that long necessarily involves being exposed to significant short-term volatility that can quickly overwhelm margin trading accounts.

tip.eps With proper risk management, individual margin traders can seek to capture longer-term trends. The key is to hold a small enough position relative to your margin that you can withstand volatility of as much as 5 percent or more. Mini accounts, which trade in lot sizes of 10,000 currency units, are a good vehicle to take advantage of longer-term price trends.

For example, let’s say you’re of the view that the euro is going to weaken due to the high debt levels of some of the member countries and the potential for a sovereign bond default. EUR/USD is trading around 1.3500, for this example, and you think it’s heading to 1.1000 or even lower. But if EUR/USD strengthens above 1.4500, you think the debt crisis will have been resolved and you’d want to exit the trade. In this case, you’re risking 1,000 pips to gain 2,500 pips. For a 10,000 EUR trade size, that works out to a risk of losing $1,000 (10,000 × 0.1000 [1,000 EUR pips] = USD 1,000) or gaining $2,500 (10,000 × 0.2500 [2,500 EUR pips] = USD 2,500).

Identifying the macro elements that lead to long-term trends

Long-term trading seeks to capitalize on major price trends, which are in turn the result of long-term macroeconomic factors. Before you embark on long-term speculation, you want to see how some of the following macroeconomic chips stack up:

  • Interest rate cycles: Where are the two currencies’ relative interest rates, and where are they likely to go in the coming months? Narrower interest-rate differentials will tend to help the lower-yielding currency and hurt the higher-yielding currency; wider interest-rate differentials will help the higher-yielding currency and hurt the lower-yielding one.
  • Economic growth cycles: What’s the outlook for relative growth over the next several months? An economy that is in an expansionary phase of growth is likely to see higher interest rates in the future, which would support that currency. An economy that is showing signs of slowing may see interest rate expectations lowered, hurting the currency in the process.
  • Currency policies: Are the currencies considered to be excessively overvalued or undervalued by the major global trading powers? Is the G20 or national government/central bank agitating for changes in a currency’s value?
  • Structural deficits or surpluses: Do the currencies have any major structural issues that tend to see currencies weaken or strengthen, such as fiscal deficits/surpluses or trade deficits/surpluses?

Trading around a core position

Just because you’re trading with a long-term view doesn’t mean you can’t take advantage of significant price changes when they’re in your favor in the medium term. Trading around a core position refers to taking profit on a portion of your overall position after favorable price changes. You continue to hold a portion of your original position — the core position — and look to reestablish the full position on subsequent market corrections. Remember: It never hurts to take some money off the table when you’re winning.

tip.eps Taking partial profit on a long-term position works best when the currency pair you’re trading is reaching significant technical levels, such as multiday or multiweek highs. If the trend of the currency pair you’re holding is displaying a channel on the charts, taking partial profit near the top of the channel in an uptrend or near the channel bottom in a downtrend is one way of judging when to take partial profit.

The risk with trading around a core position is that the trend may not correct after you’ve taken partial profit, never giving you the chance to reestablish your desired full position. But you’re still holding the core of your position, and because the market hasn’t corrected, it means your core position is doing just fine.

Carry trade strategies

A carry trade happens when you buy a high-yielding currency and sell a relatively lower-yielding currency. The strategy profits in two ways:

  • By being long the higher-yielding currency and short the lower-yielding currency, you can earn the interest-rate differential between the two currencies, known as the carry. If you have the opposite position — long the low-yielder and short the high-yielder — the interest-rate differential is against you, and it is known as the cost of carry.
  • Spot prices appreciate in the direction of the interest-rate differential. Currency pairs with significant interest-rate differentials tend to move in favor of the higher-yielding currency as traders who are long the high yielder are rewarded, increasing buying interest, and traders who are short the high yielder are penalized, reducing selling interest.

So let me get this straight, you may be thinking: All I have to do is buy the higher-yielding currency/sell the lower-yielding currency, sit back, earn the carry, and watch the spot price move higher? What’s the catch?

warning.eps Right you are. There is a catch, and the catch is that downside spot price volatility can quickly swamp any gains from the carry trade’s interest-rate differential. The risk can be compounded by excessive market positioning in favor of the carry trade, meaning a carry trade has become so popular that everyone gets in on it. When everyone who wants to buy has bought, why should the price continue to move higher? Even more daunting, if the price begins to reverse against the carry trade, it may trigger a panic exodus out of the trade, accelerating the price plunge. Take a look at Figure 10-1 to get an idea of the trends that can develop around carry trades as well as the sharp setbacks that can happen along the way.

Carry trades usually work best in low-volatility environments, meaning when financial markets are relatively stable and investors are forced to chase yield. Keep in mind that carry trades need to have a significant interest-rate differential between the two currencies (typically more than 2 percent) to make them attractive. And carry trades are definitely a long-term strategy, because depending on when you get in, you may get caught in a downdraft that could take several days or weeks to unwind before the trade becomes profitable again.

In the wake of the Great Financial Crisis of 2008–2009, major central banks slashed their benchmark interest rates to zero or nearly zero, and many of them are still around that level, or lower in some cases, as of this writing. Near-zero interest rates have eliminated much of the appeal of the carry trade in recent years, and it looks to be several years until interest rates are normalized and attractive differentials put carry trades back in vogue.

9781118989807-fg1001.tif

Source: eSignal (www.esignal.com)

Figure 10-1: AUD/JPY trends higher in line with carry trade fundamentals (Australia’s interest rates are much higher than Japan’s), but it meets sharp setbacks along the way.

Trading on Auto-Pilot

In Chapter 3, we refer to algorithmic trading systems and indicate these were mainly the tools of hedge funds and other institutional players. The rapid growth of the online forex market has spawned a diverse array of automated trading systems for individual traders, known as Expert Advisors, or EAs for short. EAs represent yet another trading approach and one that can blend many of those we outlined earlier.

EAs come in all shapes and sizes with varying complexity or number of rules. (EAs are also known as rules-based trading systems, meaning whenever the systems’ rules are satisfied, a trade signal is generated.) Some are fully automated (nondiscretionary), firing off trades whenever the rules of the program are met by market movements. Others generate trade alerts and require a manual confirmation by the user before executing a trade (discretionary). Some EAs can be bought off the shelf in a ready-to-go, black-box format, meaning you’re using a trading model designed by someone else that usually doesn’t allow for modifications. Other EAs come in a build-it-yourself format, allowing you to select the rules you’d like to apply to your trading.

Potential inputs to drive an EA system

There are literally unlimited inputs that can be combined to form the set of rules that go into an EA, but most of them are usually based on technical indicators or price developments. Here are some of the more popular inputs:

  • Crossovers: These could be crossovers of anything from moving averages (like a 5 minute and 15 minute for a short-term EA, or 9 day and 21 day for a medium-term EA) to momentum oscillators (like stochastics or MACD, again of any time frame).
  • New price highs or lows: Some trend-following models generate trade signals when new highs or lows are made, usually based on the close of a defined time period, like a new high on an hourly closing basis.
  • Time periods: Some EAs will function only during specified time periods, say during peak liquidity hours in the London afternoon/NY morning. Still others will function only around specified data releases, when a directional move may be more likely.
  • Daily or weekly closes: Longer-term systems may look for a daily close above/below a daily moving average, Ichimoku lines, or some other technical approach.

Because many EAs are based on a combination of rules, there’s virtually a limitless number of possibilities. Here’s an example of one possibility for the long side of a short-term EA: Buy EUR/USD (specify amount) on a new high 5 minute close, if 5 minute MACD is positive, and GBP/USD is also making new high 5 minute close, and 5 minute RSI is <80, and time is between 0600ET-1200ET, and day is between Tuesday and Thursday. The EA would also include something similar for the sell side and also a set of rules for exiting the trade. Note these rules are untested; we just wanted to give you an idea of how an EA might look.

Caveat emptor on models

warning.eps EAs carry their own set of risks and limitations. Just as you wouldn’t put on a blindfold and go for a Sunday drive, you shouldn’t expect an EA to deliver a smooth ride all the time. EAs are all based on historical relationships between the various parameters, or rules. And as the ultimate risk disclaimer goes, “past performance is no guarantee of future results.”

remember.eps EAs rely on back-testing to evaluate their potential future trading results. Back-testing is a process where a set of rules is applied to historical price data to see how the system would have performed. The results are by definition hypothetical, and don’t reflect real-world trading conditions (for example, execution slippage, re-quoting, or price gaps, to mention just a few). To be sure, there is much to commend historical relationships, and we certainly employ them in our own mental models for forex trading. You need to be aware that they can break down, and factor that into your trading plan.

One important result of using an EA is that if you go with a nondiscretionary system, you’re taking emotion out of the picture, and that may improve your trading discipline, which we look at next.

Using social media for trading: The power of the crowd

The arrival of social media has taken online currency trading by storm. Not only are sites like Twitter a great source of news for forex traders, but they can also be used to make trading decisions. In this section, we take a look at three of the most popular ways to use social media to help you with your trading decisions.

Crowd surfing

Some brokers have developed algorithms that trawl through Twitter, blogs, and other sites in an attempt to grasp bullish and bearish sentiment in the market. For example, these systems would be able to let you know if the majority of the social media it trawled is bearish about the EUR, which could then be a sell signal. Although limited, some academic studies have shown that these systems can have a predictive element that may be useful to your trading.

However, there are drawbacks — for example, not all sentiment is the same. A random person mouthing off about the EUR on Twitter may not be as accurate as a major currency analyst or fund manager who uses social media to explain why she thinks the EUR will fall over the next week. It’s also worth remembering that you shouldn’t use a sentiment indicator in isolation. It’s far more effective when combined with other things, like fundamental or technical analysis.

If you’re interested in using a sentiment indicator, ask your broker if it provides one. Keep in mind that extra charges may be involved if you want to access this type of system.

Net positions long/short

This is another form of sentiment indicator where brokers look at their own universe of users or clients and post whether their clients are long or short a selection of currencies, commodities, or equities. You can choose to either follow or ignore the crowd.

A popular way of using sentiment data is to use it as a contrarian indicator. Statistically, you may find that your fellow traders are wrong more often then they’re right, so if the data shows that the “market” is long on the USD, you may choose to go short on the USD.

warning.eps One of the drawbacks is the universe of users who have been polled to find out what positions they’re taking. A low number of users, or a user with a very large position, can skew this data, so use it at your own risk.

Copy the leader

Some currency brokers offer a service whereby they publish the trades of their most successful clients, and you can then follow their every move. For example, these trade leaders may put on a long EUR/USD trade; if you wanted to follow them, you would get an alert to place the same trade, or in some cases you could request that trades be executed automatically for you.

This is every lazy trader’s dream. You literally do nothing — you just follow someone whom you believe to be better at this than you, and reap the profits with him or her. But there’s no such thing as a free lunch. When you’re copying trade leaders, keep in mind the following:

  • The charges for this service can be huge for followers, so make sure it’s worth it before you dive in.
  • Make sure that you understand how the trade leaders’ performances are calculated. For example, trade leaders can run losses and still be top of the pile based on historical performance.

remember.eps Do your research and don’t think that following a trade leader is the answer to all your trading woes. Trade leaders have bad positions, too.

Developing Trading Discipline

remember.eps No matter which trading style you decide to pursue, you need an organized trading plan, or you won’t get very far. The difference between making money and losing money in the forex market can be as simple as trading with a plan or trading without one. A trading plan is an organized approach to executing a trade strategy that you’ve developed based on your market analysis and outlook.

Here are the key components of any trading plan:

  • Determining position size: How large a position will you take for each trade strategy? Position size is half the equation for determining how much money is at stake in each trade.
  • Deciding where to enter the position: Exactly where will you try to open the desired position? What happens if your entry level is not reached?
  • Setting stop-loss and take-profit levels: Exactly where will you exit the position, both if it’s a winning position (take profit) and if it’s a losing position (stop loss)? Stop-loss and take-profit levels are the second half of the equation that determines how much money is at stake in each trade.

That’s it — just three simple components. But it’s amazing how many traders, experienced and beginner alike, open positions without ever having fully thought through exactly what their game plan is. Of course, you need to consider numerous finer points when constructing a trading plan, and we focus on them later in this chapter. But for now, we just want to drive home the point that trading without an organized plan is like flying an airplane blindfolded — you may be able to get off the ground, but how will you land?

Taking the emotion out of trading

If the key to successful trading is a disciplined approach — developing a trading plan and sticking to it — why is it so hard for many traders to practice trading discipline? The answer is complex, but it usually boils down to a simple case of human emotions getting the better of them. When it comes to trading in any market, don’t underestimate the power of emotions to distract and disrupt.

remember.eps So exactly how do you take the emotion out of trading? The simple answer is: You can’t. As long as your heart is pumping and your synapses are firing, emotions are going to be flowing. And truth be told, the emotional highs of trading are one of the reasons people are drawn to it in the first place. There’s no rush quite like putting on a successful trade and taking some money out of the market. So just accept that you’re going to be experiencing some pretty intense emotions when you’re trading.

The longer answer is that because you can’t block out the emotions, the best you can hope to achieve is an understanding of where the emotions are coming from, recognizing them when they hit, and limiting their impact on your trading. It’s a lot easier said than done, but keep in mind some of the following, and you may find you’re better able to keep your emotions in check:

  • Focus on the pips and not the dollars and cents. Don’t be distracted by the exact amount of money won or lost in a trade. Instead, focus on where prices are and how they’re behaving. The market has no idea what your trade size is and how much you’re making or losing, but it does know where the current price is.
  • It’s not about being right or wrong; it’s about making money. At the end of the day, the market doesn’t care if you were right or wrong, and neither should you. The only true measure of trading success is dollars and cents.
  • You’re going to lose in a fair number of trades. No trader is right 100 percent of the time. Taking losses is as much a part of the routine as taking profits. You can still be successful over time with a solid risk-management plan.
  • The market is not out to get you. The market is going to do what it does whether you’re involved in it or not, so don’t take your trading results personally. Interpret them professionally, just as you would the results of any other business venture.

Managing your expectations

Currency trading is a relatively new opportunity for individual traders, and a lot of people have no frame of reference about what to expect when it comes to price movements. A frequent question asked by newcomers is “How much can I expect to make on this trade?” Whoa, Nelly. Talk about a loaded question.

remember.eps Financial markets are not bank ATMs, and the forex market is certainly no exception. There are a lot of people speculating on which way various currency pairs are going to move; some of those people are going to be right, and some are going to be wrong. Some may also be right for a moment but suddenly end up on the wrong side of equation.

Before you get involved with trading currencies, you need to have a healthy sense of what to expect when it comes to trading outcomes. Many people choose to focus only on the upside prospects of currency trading, like the view expressed in that loaded question earlier. But losses are part of trading, too. Even the biggest and best traders have losing trades on a regular basis.

tip.eps One of the keys to establishing trading discipline is to first accept that losses are inevitable. The second step is to dedicate yourself to keeping those losses as small as possible. Most experienced traders will tell you the hardest part of trading is keeping the money you’ve made and not giving it back to the market.

Imagining realistic profit-and-loss scenarios

The trading style that you decide to pursue will dictate the relative size of profits and losses that you can expect to experience. If you’re trading on a short- to medium-term basis, look at average daily trading ranges to get a good idea of what to expect.

The average daily trading range is a mathematical average of each day’s trading range (high to low) over a specified period. Keep in mind that this figure is just a statistical average — there will be days with larger ranges and days with narrower ranges. Also, average daily ranges will vary significantly by currency pair.

But the average daily trading range covers a full 24-hour trading session and tends to overstate what short- and medium-term traders can expect from intraday trading ranges. Generally speaking, you’re better off anticipating more modest price movements of 30 to 80 pips rather than aiming for the home-run ball.

And no matter what any infomercial tells you, you’re not going to retire based on any single trade. The key is to hit singles and stay in the game.

Balancing risk versus reward

Trading is all about taking on risk to generate profits. So one question is frequently posed: “How much should I risk in any given trade?” There is no easy answer to that question. Some trading books advise people to use a risk/reward ratio, like 2:1, meaning that if you risk $100 on a trade, you should aim to make $200 to justify the risk. Others counsel to never risk more than a fixed percentage of your trading account on any single trade. It’s all a bit formulaic, if you ask us, and it also has no relation to the reality of the markets.

tip.eps A better way to think about risk and reward is to look at each trade opportunity on its own and assess the outcomes based on technical analysis. This approach has the virtue of being as dynamic as the market, allowing you to exploit trade opportunities according to prevailing market conditions.

Another factor to consider in balancing risk and reward is the use of leverage (see Chapter 13). In online currency trading, generous leverage ratios of 50:1 or 100:1 are typically available. The higher the leverage ratio, the larger position you can trade based on your margin. But leverage is a double-edged sword because it amplifies profits and losses.

warning.eps The key here is to limit your overall leverage utilization so you’re not putting all your eggs in one basket. If you open the largest position available based on your margin, you’ll have very little cushion left in case of adverse price movements. It may seem sexy to trade as large a position as possible, but whoever said prudent, risk-aware trading was supposed to be sexy? Keep your feet on the ground, and don’t lose your head in the clouds of leverage.

Keeping your ammunition dry

The margin you’re required to post with your forex broker is the basis for all your trading. The amount of margin you put up will determine how large a position you can hold and for how long (in pips) if the market moves against you. Unless you just won the lottery, your margin collateral is a precious, finite resource, so you have to use it sparingly.

If Hamlet were alive today and trading currencies, his famous soliloquy might begin “To trade or not to trade?” One of the biggest mistakes traders make is known as overtrading. Overtrading typically refers to trading too often in the market or trading too many positions at once. Both forms suggest a lack of discipline, and sound more like throwing darts at a board and hoping something sticks.

Keeping your ammunition dry refers to staying out of the market, watching and waiting, and picking your trades more selectively.

Opportunity lost or opportunity cost?

One of the more popular market aphorisms is “You’ve got to be in it to win it.” Though it’s obviously a truism, we would counter that trading discretion is the better part of trading valor. Holding open positions not only exposes you to market risk, but can also cost you market opportunities.

After you enter a position, your available margin is reduced, which in turn lowers the amount of new positions you can establish. If you’re routinely involved in the market because you don’t want to miss out on the next big move, you actually run the risk of missing out on the next big move because you may not have enough available margin to support a new position for the big move.

tip.eps Don’t be afraid about missing out on some trade opportunities. No one ever catches all the moves. Instead, focus on your market analysis and pinpoint the next well-defined trading opportunity. (We look at spotting trade setups in Chapter 12.)

Thinking clearly while you still can

Another virtue of trading less frequently is that your market outlook is not skewed by any of the emotional entanglements that come with open positions. If you ask a trader who’s long EUR/USD what he thinks of EUR/USD, surprise, surprise — he’s going to tell you he thinks it’s going up. That’s called talking your book.

But being out of the market, or being square, allows you to step back and analyze market developments with a clear perspective. That’s when you can spot opportunities more clearly and develop an effective trade strategy to exploit them. All too soon, you’ll be on to your next trade, and the emotional roller coaster will start all over again.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.15.17.1