In order to succeed in the long-term in any activity you need to have a plan. In trading, this is called a trading plan. It includes many different aspects of trading, such as your money management, risk management, analysis, and trading system.
Notice that your trading system is just one part of your trading plan, and many traders have a few trading systems for each market condition (i.e. trending, sideways, risk-off environment etc).
Traders who don’t have a trading plan often let their emotions interfere with their strategy, which in turn leads to bad market decisions and losses. With a trading plan, you’ll know exactly how to act in any situation, which will limit costly trading mistakes.
A trading plan also provides you with a complete framework to measure your trading results, so will know what are your weak points and where you need to improve. Without a trading plan, this would be nearly impossible, and you would repeat the same trading mistakes over and over again, and in the end possibly blow your trading account.
Developing Your Personalized Trading Plan
How to be Disciplined in Trading
Having a trading plan is the first step to become a profitable trader, but sticking to your plan is the key to success. This is where discipline comes into play. A disciplined trader who sticks to his trading plan will always have a larger survival chance than a newbie who opens positions based on emotions and guesses. This is not called trading, but gambling, and you don’t want to gamble on the forex market. Instead, your goal is to make rational moves and learn from your mistakes, so you can improve your trading performance on a daily basis.
A good trader is very similar to a good sportsman. Can you imagine an undisciplined athlete, who doesn’t have a training plan to improve his performance and limit mistakes, to make it to the Olympics? It’s the same with trading. Having a well-rounded trading plan and following it disciplined makes the main difference between a successful and an average or losing trader.
How to Find the Right Trading Strategy and Set Trading Goals
Trading strategies are not universal tools that suit all traders. Different people have their unique characteristics that will ultimately affect which trading strategy is best for them. You need to answer some questions to yourself first in order to develop the best trading strategy for you. Do you have plenty of time during the day to watch the markets, or do you want to place a trade and forget about it for weeks? What is your risk tolerance and initial capital you plan to invest? What are your expectations from the market?
All these questions, and more, need serious consideration from your side. You need also to think about why you want to be a forex trader in the first place, and what your trading goals are. The best way is to think about measurable goals that you can track easily. For example, you might want to make a 5% monthly return, be profitable more than 60% of time, or double your account in six months. Whatever it is, pay attention that it needs to be countable and measurable.
Once you know all the answers, you can decide on which trading strategy suits you best. We will discuss more about different trading types in the next chapter.
Discovering How Much You Can Afford to Lose
Forex trading involves a high risk of loss, and you should precisely know how much you’re prepared to risk. To do so, you need to figure out what your risk capital is.
Risk capital is the amount of money that you’re able to lose.
You should only trade with your risk capital, and be prepared that there is a possibility that you lose it all. Never trade with all your savings, you still need to be able to pay your bills at the end of the month!
Again, a trading plan will help you to avoid losing your entire trading account. If you risk, let’s say, 1% of your account per trade, you will need a pretty high number of losses to blow your account. Nevertheless, you should always trade first on a demo account until you become profitable, and only then switch to a real account.
Determining What Tools to Use – Hardware, Software, etc.
The main tools you need in forex trading are a stable internet access, a broker account and a trading platform. However, there are also a lot of other tools that can help a lot in trading. For example, online platforms where you can trade together with other traders can help you to see the market from a different perspective, and avoid missing on trading opportunities. One of the best out there that we’ve found is SmartTrader.com, which also features an advanced charting tool.
In addition, having a back-up plan in case your laptop or Wi-Fi breaks is also something you should think about. In the end, you don’t want to lose a profitable trade only because you didn’t have an internet access to close your position.
Discovering Your Trading Style
Each trader has his own preferences when it comes to trading. While some traders like to watch the markets all day long, and take many trades on a very short time-frames, other traders prefer to open a position and forget about it for months. Both of these trading styles have their names, the first is called scalping, and the second position trading. And there are a few more styles in between. So, let’s see what the main trading styles are in forex trading.
Scalping is a very exciting and fast-paced trading style, with the main objective to make small gains from many trades. Scalpers hold their positions open from a few seconds to a few minutes, and need to be able to change their bias quickly. They also trade only during the busiest market hours, when two sessions overlap (for example the 8:00 am-12:00 noon EST for the NY-London overlap), and need to be intensely focused on the market for a few hours.
Scalpers need to pay attention to spreads, as they take many trades during the day. That’s why they mostly focus on the most liquid currency pairs, such as EUR/USD, GBP/USD and USD/JPY which offer the lower spreads. In addition, they need to avoid trading during major news releases, as the wider spreads and slippage can work against them.
Day trading is also a short-term trading style, but with less trades than scalping. Day trading involves taking one trade per day, and closing it by the end of day with either a loss or profit. Day traders need their time to analyze possible setups at the beginning of the day, and deciding on which direction they will take. They need also to be aware of currency fundamentals, as they can have a significant impact on intraday trading.
Day trading practically includes several trading styles:
- Trend trading – taking trades in the direction of the overall trend. This also includes multiple time-frame analysis, as you need to see the bigger picture from the longer time-frame, and then move to the short ones to determine your entry point.
- Countertrend trading – trying to catch the end of a trend and opening a position in the opposite direction. This is a riskier style, but can return huge profits if you catch the beginning of a new trend.
- Breakout trading – trading the breakouts of major support and resistance levels. With breakout trading, you want to catch the break of major levels which can lead to a sharp move in price in the direction of the breakout.
This is a trading style where traders hold their trades for several days. They want to catch the “swings” in price, which can require several days or more to form. The following chart shows what swings are.
With this trading style, you want to catch these swing highs and lows, selling when a swing high forms, and buying when a swing low forms. Swing trading also allows for having larger stop losses, to account for the increased price fluctuation during the period of holding the position. This is a great style for traders who don’t have time to watch the market during the day, and are patient.
Position trading is a very long-term trading style, with trades that are open from several months to several years. Needless to say, this trading style requires a very patient and well-capitalized trader. Trades that are open for so long, have a high chance to go against you some time in the future, and require a large trading account that can withstand large price movements in the opposite direction.
Position traders need to fully understand currency fundamentals, as they are what move the market in the very long term. It’s important to understand concepts such as balance of payments, interest rate differentials, economic outlook and purchasing power parity. Unless you are really prepared to invest time in learning everything about currency fundamentals, you would be better off with shorter-term trading strategies.
Keeping a Trading Journal
Keeping a trading journal is one of the most important things to do when it comes to long-term success in trading. It’s a way to measure and track your trading performance, and to help you spot what needs to be improved. Keeping a trading journal can also help you in becoming more disciplined, which is one of the key attributes of a successful forex trader.
A trading journal includes much more than just the entry and exit points of your trade. It’s a comprehensive overview of your trading psychology and also includes reasons of why you took a particular trade. This will help you to determine whether a similar trade in the future will have chances to become profitable. Now that you know the importance of keeping a trading journal, let’s see what needs to be incorporated into your journal entries.
- Market views and philosophy – the way you see and understand the markets need to be included in your trading journal. Why do you feel bearish or bullish today? Is it because of a particular news event or article you read in the morning? Did the market move in the direction that you expected?
- Market observations – You need to observe the market for a long time until you become familiar with its movement. The market tends to repeat some patterns from the past (technical analysis), and every pair can act different in different situations. Your trading journal should include your market observations for each trading day.
- Trading mistakes and missed opportunities – By noting your trading mistakes you have a much better chance to improve in the future. Closing trades too early, trading based on emotions, overtrading, wrong position sizes, and missed opportunities can have a big impact on your success as a trader. Try to find situations where you made those mistakes and improve them in the future.
- Performance statistics – any performance-related data that can be measured and expressed in number should be included in your trading journal. Information on entry and exit points, risk/reward ratio, risk per trade, stop-loss and take-profit level, profits and losses and others need to become a part of your journal entries.
Now, that might seem a lot. So here are the specific elements that you need to have in your trading journal:
Potential trading area
The potential trading area is the area where you aim to open your position. This area is determined by rules that you’ve written in your trading plan. For example, your plan may be that you trade breakouts of support and resistance levels, pivot points, or trendlines.
Whatever it is, it needs to be strictly described in your trading plan. The time when you see a potential trade setup, your potential trading area tells you where you want to open the trade, so that it has a high probability of success with a limited risk. The potential trading area is a price zone between the current price and your entry zone.
Now that you’ve found your potential trading zone, it’s time to look for an entry trigger. Remember, a potential trading zone doesn’t guarantee that your trade will be a winner. You need to watch out for confirmation signals to enter the market.
Those confirmation signals can be overbought/oversold indicator levels, or reversal and continuation candlestick patterns. For example, if your potential trading zone is an area where the price approaches a major resistance level, the entry trigger could be a doji or shooting star near the resistance for a short entry, or a long bullish candlestick that closes above the resistance level for a long entry.
The next element your trading journal needs to have is the size of your position. This is in big part influenced by the size of your trading account and the risk you’re taking, and needs to be strictly described in the risk management part of your trading plan. For example, if you decide to risk 2% of your trading account per trade, this will ultimately determine what your position size will be. If you multiply your stop-loss in pips with the dollar-value of a pip, you can easily find out what position size you should take so that you don’t risk more than 2% of your account.
Let’s say your trade setup shows a high-probability buy trade, and you want to take that trade with a 50-pip stop loss just below the recent support line. If your trading account is $10,000, and you don’t want to risk more than 2% on a single trade, this means that the maximum loss of that trade should not exceed $200. With a 50-pips stop loss, your position size should be around $4 per pip ($4*50= $200), or 0.4 lots.
Trade management rules
Trade management rules are also a very important element of your trading journal. They describe how you manage an open trade. It’s crucial that you know the rules before you open a trade! What are your stop-loss and take-profit levels, and what will you do if the trade goes against you? Will you use a trailing stop on a particular trade or not, and why? You need to know the answers to these questions before opening a trade. Opening a trade is easy, but the exit point and trade management when the trade is already open will determine if it will become a winner or loser. Always know how you’ll manage your trade ahead of time, and the entries in your trading journal will help you a lot to avoid mistakes you’ve made in the past.
Now that your trade is closed either with a profit or loss, you need to make a trade retrospective on what worked and what didn’t. This part of your trading journal is called “trade retrospective”. Think about all the points we mentioned above, and how your decisions impacted the outcome of the trade. Is your potential trading area not well defined? Maybe your entry trigger was perfect but the take-profit level was unrealistic, so the trade went against you and hit the stop-loss? Or was your position size too large, so you risked too much of your trading account? Don’t rush through these crucial questions. Trade retrospective is a process where you learn about both your mistakes and good decisions, which will help a lot in your trading.
What is Risk Management?
Without risk management, even the best trading strategy in the world will fail in the long run. Most traders rush into trading without thinking about risk management, and that is the number one reason why many of them fail. The fact is, risk management is the most important part when it comes to be a successful trader. It defines your risk per trade, lot size, when to cut losses or take partial profits, etc. It’s what makes the difference to the bottom line between a profitable and losing trader.
How Much Capital do I Need for Trading?
The amount of initial capital that you need for trading depends on various factors. Beside the initial trading capital, some traders also decide to invest in other trading tools with the hope to get an advantage in trading. For example, you could join a trading course which can cost anything between a few hundred to a few thousand dollars, or you could simply learn on your own with websites that teach you how to trade.
Additional charting software, special indicators or a live news feed for fundamental data can also cost a lot of money. You really need to ask yourself if this will help you in trading and if it will pay off in the long run.
And then we come to the trading capital. To trade on the forex market, you’ll need to deposit your initial trading capital with a broker. The amount will vary from trader to trader, and some brokers even accept initial deposits as low as $20. Of course, trading with an account this small is not a good idea, as you’ll need enough capital to withstand price fluctuations and to set reasonable stop-losses.
The size of your initial capital depends on how much you can afford to invest, and you should only trade with a sum that you’re able to lose. Don’t trade with all your savings! That being said, anything of $1,000 and above will be enough for the start. However, don’t expect to earn for a living with a trading account of $1,000. Once you feel confident with your trading strategy, you can invest more as it will allow you to increase your position size while respecting your risk management. In fact, some traders deposit $100,000 in their trading account, or even more!
Drawdown and Maximum Drawdown
If you don’t follow a strict risk management, you could quickly experience a drawdown in your account, or even blow your entire trading account. A drawdown is simply the reduction of your trading account after a series of losses, presented in percentage terms. For example, if your trading account went down from $10,000 to $5,000 after some losing trades, your drawdown would be equal to 50%. Your maximum drawdown is calculated in a similar way, and represents the maximum loss of your account from its peak to its lowest trough, before a new peak is attained.
How Much Should You Risk per Trade? The Golden 2% Rule
How much of your trading account should you risk on a single trade? The golden rule is to never risk more than 2%. If you’re new to trading, the risk per trade should be even lower, at around 1% of your trading account.
If the size of your trading account is $10,000, you should never risk more than $200 ($10,000 x 0.02) on a single trade! This way, you’ll still have enough capital if you experience a series of losing trades.
The reward-to-risk ratio measures how much you risk on a trade to how large your potential profit will be. Ideally, you would like to take trades with a reward-to-risk ratio of at least 3:1 or larger. This means, you have the potential to gain 3 times more than you’re risking. For example, if your stop-loss is 30 pips, you should aim to a profit of 90 pips to maintain a reward-to-risk ratio of 3:1.
This also depends on your trading style. If you’re a scalper, you could go for a lower reward-to-risk ratio, while position traders can aim for a profit that is 10 times the amount they’re risking (a 10:1 reward-to-risk ratio.)
Risk management is the key concept to survive in the forex market. It makes the difference between profitable traders and losing ones. Your risk management plan should strictly state what your stop-loss levels and risk per trade are, what trades you will take based on your reward-to-risk ratio, and what position sizes you will trade. Even the best trading strategy in the world will eventually fail if you don’t pay attention to risk management and know how to cut your losses.
What is Leverage in Forex?
The high leverage available in the forex market is one of the reasons why so many traders are attracted to this exciting market. However, many new traders still don’t know what leverage is, how it is calculated and what a margin closeout is.
Leverage is a loan provided by your broker, which is used to take advantage of price movements on a significantly larger transaction than your initial trading account would allow to open. The average daily price movement on the forex market, with daily price changes of around 1%, is relatively small compared to the equities market. This is the reason why forex allows trading on high leverage, as these small price changes translate to significant amounts of money on large positions.
Forex brokers typically offer leverage in the amount of 20:1, 50:1, 100:1 or even 400:1. For example, a 100:1 leverage means you can open a position worth $100,000 with just $1,000 of capital.
Margin and Leverage
To trade on leverage, you need to deposit a collateral for the loan provided by the broker. This is called the margin. You don’t need to worry about this, as the broker will automatically allocate a portion of your trading account as the margin for a position.
The amount of the margin depends on the size of the leverage that you’re trading with. Taking the example above, a 100:1 leverage requires a margin of 1% of the position size, i.e. $1,000 ($100,000 x 0.01). The following table summarizes the amount of margin required for different leverage sizes.
As you can see, trading with a 400:1 leverage requires only 0.25% of margin. While this might seem attractive, it’s important to know that a higher leverage also comes with a higher risk. If a leveraged position goes against you, this will significantly increase your loss as well. Leverage amplifies your potential profits, but also amplifies your potential losses!
Margin calls, or margin closeouts, occur when your leveraged position against you, and your total trading account is in danger to fall below the margin required for the position. Your broker will automatically calculate this for you, based on your Net Asset Value (NAV) and unrealized gains/losses of the open position.
If a margin call happens, your broker will automatically close all open positions at the current rate, and all that is left in your trading account will be the margin. For example, let’s say you open one lot, which equals to $100,000, on a 100:1 leverage with a trading account of $3,000. Your broker will automatically allocate $1,000 of your trading account as the margin, and you will have $2,000 left as a “free margin” to take other trades and to withstand price fluctuations. If the position goes against you, and the unrealized loss exceeds your free margin, you’ll receive a margin call.
The Risk of a Highly-Leveraged Trade
The move of the GBP/USD pair after the Brexit vote, for example, could easily wipe out your account if you had an open buy position during that time without a stop-loss. With a fall of 1,000 pips, let’s see what would have happened to your $10k trading account. Assuming you had a long position worth $100,000 on a 100:1 leverage, the margin allocated for opening this trade would amount to $1,000. You still have $9,000 of free margin. But, this position size carries a pip value of around $10 per pip, and the 1,000 pips fall translates into a $10,000 loss. You would have received a margin call even before the fall in price came to an end. This example shows you not only the danger of trading on high leverage, but also the necessity of stop-losses in trading.
Higher Leverage Increases Transaction Costs
Trading on high leverage also carries higher transaction costs. A larger position size has a higher dollar-value per pip, which increases the cost of spreads in trading. For example, a spread of 2 pips equals to $20 of transaction cost on a position size of $100,000. You need to take this into account when defining your trading plan and the position size you’re planning to take.
What is Position Sizing?
Position sizing refers to the size of the position you’re trading, in lots. While one standard lot equals to a position worth $100,000, some brokers also offer mini lots ($10,000) and micro lots ($1,000) to trade. Note that this doesn’t refer to the size of your trading account, but to the position size in trading. Trading $100,000 on leverage still represents a standard lot size.
Your risk management rules will determine what position size to use. But, your account denomination will also affect your position size. To make this clearer, let’s go through some examples with different account denominations.
Your Account Denomination is the Same as the Counter Currency
Let’s say you opened a trading account in US dollars with a broker, and deposited $2,000. If you don’t want to risk more than 2% of your account per trade, how would you determine which position size to use?
First, you need to determine how many pips you’re going to risk on a particular trade, i.e. your stop-loss level. Let’s say you want to enter a high-probability trade with a stop-loss of 40 pips.
To calculate your position size, do the following:
- Specify how much you want to risk per trade according to your risk management. In our example, 2% of $2,000 is $40.
- Next you need to find out is what pip value equals to the amount you want to risk, based on your stop-loss level. To do so, divide the amount risked with the stop-loss ($40 / 40 pips = $1 per pip)
- In the end, multiply the value per pip by a known unit/pip value ratio of EUR/USD. For example, a standard lot position size ($100,000) has a pip value of $10.
$1 per pip x ($100,000 / $10 per pip) = 10,000 units of EUR/USD
This gives us the correct position size you should use: 10,000 units of EUR/USD, or 0.1 lots.
Your Account Denomination is in the Same Currency as the Base Currency
This calculation is a little bit different than our previous example. Let’s say, you open an account with a European broker and deposit 2,000 EUR in your account. Assuming your risk per trade is still 2% of account size, and your trade setup on EUR/USD shows that a 40 pips stop-loss is appropriate, you would calculate your position size as follows.
- Your risk per trade equals now 40 EUR (2% of 2,000 EUR)
- Now, we introduce a new step – we need to calculate what your risk per trade is expressed in US dollars (because the value of a currency pair is based on the counter currency). If the current exchange rate of EUR/USD is 1.2500, your risk per trade expressed in USD is $50 (40 EUR x 1.2500).
- The remaining steps are the same. Your appropriate pip value based on your stop-loss of 40 pips is $1.25 ($50 / 40 pips).
- In the end, multiply your pip value with a known unit-to-pip ratio. $1.25 x ($100,000 / $10 per pip) = 12,500 units of EUR/USD.
Now, your adequate position size is 12,500 units of EUR/USD, or 0.125 lots.
Your Account Denomination is Different from the Base and Counter Currency
The third example we will cover is how to calculate your position size if your account denomination is different from both the base and counter currency. Let’s say, your account is denominated in US dollar, and you want to trade EUR/GBP. Here are the steps to calculate your position size, assuming all numbers regarding your risk stay the same as in the previous examples.
First, you need to express your risk in the counter currency, i.e. GBP. If your risk per trade is $40, and the current GBP/USD exchange rate is 1.30, your risk in pounds would be 30.77 GBP.
Next, divide the risked amount by your 40 pips stop-loss, to get the pip value. This is 0.77 GBP (30.77 GBP / 40 pips)
And finally, multiply your pip value by a known unit-to-pip ratio. 0.77 GBP x (100,000 of EUR/GBP / 10 GBP per pip) = 7,700 units of EUR/GBP.
Your position size for this trade should be 7,700 units of EUR/GBP, or 0.077 lots, to maintain your preferred risk per trade.
Types of Stop-Losses in Forex Trading
By now, you already know what stop-loss orders are and why they are so important. You should never place a trade without a stop-loss, or you will blow your account sooner when the price goes against you. The forex market can sometimes be extremely volatile, especially during important news releases. Always place a stop-loss!
Now, let’s move on to cover the four main types of stop-losses. In general, you can place stop-loss orders based on four factors: percentage, price-action, volatility or time.
Stop-Loss Based on a Percentage of Your Account
This is the most basic type of stop-loss orders, which is based on a predetermined percentage of your account size. For example, if you decide to risk 2% of your account per trade, you would place a stop-loss which equals the 2% of your account size.
However, this is not a smart move. You should never place stops which are based only on the size of your account. Remember the previous chapter about how to determine your position size? Always place your stop according to the current market conditions, and then calculate the position size in order to risk a maximum of 2% of your account.
Stop-Loss Based on Support and Resistance Levels
A stop based on support and resistance levels is placed just below a support level, or above a resistance level. Support and resistance levels are price levels where the price has difficulties to break through, making these types of stops a much better decision than stop based on percentage of your account. Take a look at the following example. The EUR/GBP pair touched the red support line and sky-rocketed afterwards. A smart stop-loss would be the one marked below, just below the support line but with still enough room to account for a fake break of the support line.
Stop-Loss Based on Price Volatility
The next type of stop-loss orders are stops based on the average price volatility of a currency pair. This can be helpful as your stop can be triggered too early if you don’t take into account the average price volatility over a certain period of time. For example, the if the daily volatility of the GBP/JPY pair is 140 pips, you would be stopped out very soon if you take an intraday trade with a 15 pips stop-loss. There are a few methods to determine the volatility of a pair, such as using Bollinger Bands or the Average True Range indicator.
Bollinger Bands are a popular tool to measure price volatility. If you forgot, the bands widen when the price is volatile, and squeeze when the price is ranging. Based on this, you can simply put your stop-loss beyond the bands. The following chart shows how Bollinger Bands widen and squeeze depending on price volatility.
The Average True Range indicator measures the average volatility over a certain period of time. If you set the ATR to a setting of 10, the reading will show the average volatility in the last 10 periods. If you set it to 25 on a daily chart, it will show you the volatility over the last month. Placing a stop based on volatility becomes a lot easier with the help of Bollinger Bands and the ATR indicator.
Stop-Loss Based on Time
These stops, as the name suggests, are based on a predetermined period of time. You can decide to close your position when the NY-London session overlap is over, or by the end of the trading day. If you don’t want to hold your positions over the weekend, you can simply close them with the end of the trading day on Friday.
Common Mistakes with Stop-Losses
Now, let’s explain the most common mistakes that traders make when using stop-losses. Although stop-losses should be used on every trade as a part of your risk management, try to avoid the following mistakes:
Placing Stops Too Tight
This is one of the most common mistakes traders make. The forex market can fluctuate unpredictable in short periods of time, and if you place your stop too tight, there is a high chance that you’ll be stopped out before the price continues to go in your direction. It’s important to give the price enough room to “breathe” when considering where to place your stop-loss.
For example, placing a 10-pips stop loss while entering a long position on the daily EUR/USD chart, will most likely close your position in a matter of minutes (although you intended to hold the position for a few days). Always consider the price volatility of the pair.
Using a Pip or Dollar Amount as a Basis for Stops
You should always place your stops based on actual market behavior. Using a stop-loss based on an arbitrary pip or dollar amount has nothing to do with the market. Remember what you learned in the previous chapters about how to determine your position size based on risk per trade. Always use a sound analysis to place your stops.
Placing Stops Too Wide
Another common mistake is placing stops too wide from the entry price. In this case, stop-losses lose their actual purpose. You should always care about your reward to risk ratio. For example, placing a 500 pips stop-loss on an intraday trade, requires a 1,500 pips profit target to maintain a 3:1 reward-to-risk ratio. Most currency pairs don’t move 1,500 pips in a month.
Placing Stops Exactly on Support or Resistance
Support and resistance levels are useful targets for placing your stops, but you should always place them a few pips above or below these levels. Even if the support and resistance levels hold, the price tends to at least touch them before changing direction. You would be closed out even if your trade had a high-probability of success.
Don’t Let Emotions be the Reason You Move Your Stop
Once the price goes against you and hovers very close to your stop, it might be tempting to move your stop. If you do this, you let emotions override your analysis. You should never do this, unless you want to lose more money in the long run.
Do Trail You Stop
A trailing stop moves in the direction of a profitable trade by a predetermined amount of pips. This is a good idea, as it locks in profits and still gives the price enough room to breathe. However, you should aim to set a reasonable pip-amount for your trailing stop. A 5-pip trailing stop would not be of much help and you could get closed out too soon.
Don’t Widen Your Stop
This is a very similar mistake as moving your stop based on emotions. Once the price hits your stop, you should move on a look for other trading opportunities. Nothing positive comes out of widening your stop. You’ll only accumulate losses in the long run.
Scaling In and Out of Positions
You can actively manage your overall risk by scaling in and out of positions. Simply said, scaling means adding or removing units from the position size of your trade. This means, you add to your positions when the trade is profitable, and close some of your positions when the trade goes against you.
Scaling can help you to lock in your profits and reduce your overall risk on a particular trade. It also helps to catch the best entry point for a trade, as you can add to your position around an important price level without having to exactly know where the right entry point is.
However, scaling also comes with its drawbacks. While it can be used to reduce overall risk, scaling into a position can also increase your risk if you improperly add more and more units to an existing position. Scaling out of positions always reduces your risk as you reduce the market exposure, but also limits the potential profits you can make.
For example, let’s say you opened a long position on GBP/USD with a 10k position size (0.1 lots). As the price moves higher and your trade becomes profitable, you find out that the Fed might hike interest rates which is bullish for the US dollar. However, you don’t want to close your position completely as the news are not confirmed. Instead, you can simply scale out of the position by closing 5k units (50%) of the trade, locking in profits, and leave the remaining position open. A smart move would also be to put a trailing stop on the remaining position, in case the price goes against you.
Scaling into a position which is going against you can be risky, and should not be done if you’re new to the markets. However, if the total risk of the positions is inside your risk per trade, you can do so, but always remember to use stop-loss orders.
Let’s say the EUR/USD pair is approaching a major support zone, and you think about opening a long position. As this is a support zone, and not line, there is no precise price level where you could jump into the trade. Instead, you can scale into the trade by opening 5k units at one price, and once the trade shows to payoff, another 5k at a higher price. In this case, you reduced your risk of opening a 10k position if the support zone didn’t hold and the trade went against you.
When Scaling in and out of positions, you always need to follow these rules:
- The levels for adding or removing additional units should always be predetermined
- Your total risk should never exceed your total acceptable risk-per-trade, as stated by your trading plan and risk management
- Use trailing stops to limit the risks of scaling
What are Currency Correlations?
A correlation is a statistical term that measures to which extent two variables move in the same direction, opposite direction, or completely random in relation to each other.
A correlation of 1.00 means the two variables move in perfect correlation relative to each other, while a correlation of -1.00 means that the two variables move in completely different directions (i.e. if one going up $1, the other will move down $1). A correlation of 0.00 shows that there is no correlation between the two variables, i.e. they move in completely random fashion relative to each other.
When applied to the forex market, this means that two currencies can move in the same direction, opposite direction, or completely random relative to each other.
Knowing the currency correlations is very important to reduce risks, as your risk will be doubled when trading currencies with a high correlation coefficient.
The next table shows the correlation coefficients of EUR/USD to other major currency pairs, over a period of 1 week, 1 month, 3 months, 6 months and 1 year.
Make Sure not to Double Your Risk!
When trading two or more currency pairs at the same time, you need to know their correlation in order to avoid adding to your risk. Take a look at the table above, EUR/USD and AUD/USD have a very high correlation of 0.90 over one month, which basically means that when EUR/USD is moving up, so does
AUD/USD. And when EUR/USD is moving down, so does AUD/USD.
Simply said, you double your risk by opening trades on EUR/USD and AUD/USD in the same direction.
On the other hand, you also don’t want to open trades at the same time on two pairs that are highly negative correlated, such as EUR/USD and USD/CHF, as they will basically cancel each other out, i.e. one trade may be a winner, but the other has a high change to be a loser.
Currency correlations change over time!
It’s also important to note that currency correlations will change over time. Do you see how the correlations change in the table above, over the different time frames? In fact, currency correlations change quite a lot and are never the same over the time. There are many factors that influence this, such as investor sentiment on a particular country, or interest rate changes by central banks.
You need to stay up-to-date on the most recent currency correlation coefficients, and many online sites will offer the newest correlation tables. Just do a quick Google search and you will find them.
Currency correlations are important as they can double your risk if your trades are positively correlated (and opened in the same direction), or leave you break-even if the trades are negatively correlated. That’s why it’s important to know the current correlation coefficients, and how to trade them to go in your favor. They can also double your profits if your analysis goes right, but you need to always make sure you trade in the boundaries of your risk management rules!
Spotting and Avoiding Forex Scams
In this article, we discuss the most common forex scams, and the main regulatory bodies of the major countries worldwide. The forex market is relatively new for retail traders, and many dishonest people try to sell their “tools” to traders who want to make money. Ads like “Buy my trading system to pocket 1,000 pips per day without risk” are one of the most common scams in forex. Those also includes trading robots, managed accounts, broker scams and other. We will cover them in the following lines and show how you can protect yourself.
Always remember the best way to protect yourself from scams is to rely on your own trading and analysis but please you use this article as a guide. There is no holy grail in forex trading that will make you profitable with the click of a button.
However, not all offers are scams, as there are also legit managed account providers, forex signals providers and trading robots in the market. If you really want to try a forex signal provider, or forex robot, make sure to make your research before you pay any amount to the provider.
Now let’s look at some potential account types that are popular scams.
Forex Managed Accounts
Forex managed accounts are operated by a professional trader, who trades the capital of investors for a percentage of the profits. Although there are also legit forex managed accounts, a lot of them are shady where the only intention of the “professional trader” is to take your money.
Once you invest your hard-earned money with the scammer, you will most likely not see your money again. Always make your due-diligence of these offers, and check on the internet or with relevant authorities if the offer is legit or a scam.
Forex robots are programs that are loaded into your trading platform, which then automatically open and close positions based on some algorithms and current prices. However, most of them are not programmed to operate in different market conditions, which can then lead to huge losses.
Forex robots often rely on simple technical rules such as moving average crossovers, to open and manage your trades. The problem is, many of the sellers claim that their robots are “always profitable”, and that you never have to trade again by yourself. Most of those offers are scams and you should practice your own trading instead of relying on shady forex robots.
Forex signals are very similar to trading robots, with the difference that they only give you the entry and exit points to act upon, and don’t execute the trades. Forex signal providers will send you the targets via email or SMS, after you have subscribed to their service for a fee.
The problem is that most of these services rely on the same algorithms as forex robots, and aren’t profitable in all market conditions, if at all. However, just like with managed accounts, there are legit forex signal providers where professionals analyze the market. Check which providers are legit by researching on online forums and discussing with other traders.
You should always deposit your money only with a well-known and regulated broker. There are many brokers out there who try to cheat on their clients. Some of the popular methods is to charge substantially higher spreads than normal, or to try to “hunt” your stops by artificial price movements (called “stop hunting”).
Protect yourself from these scams by choosing regulated brokers with good user reviews on the internet. Regulated brokers are registered as Futures Commission Merchants (FCM) with the CFTC in the United States, or the Financial Conduct Authority (FCA) in the United Kingdom.
US Regulatory Agencies
In the United States, there are two major regulatory agencies: the CFTC and the NFA.
The CFTC (Commodity Futures Trade Commission) was formed in 1974 to protect futures and commodities traders. The CFTC also publishes the popular Commitment of Traders (COT) report which we covered earlier. The CFTC’s mission is to protect market participants from fraud and manipulation in the financial markets, and you can find their website here: www.cftc.gov
The NFA (National Futures Association) was formed in 1982 to regulate the futures market in the United States. As currencies are also traded on the futures market, it regulates the forex market as well. The NFA is overseen by the CFTC, and its mission is to ensure the integrity of the futures industry, protect market participants and enforce NFA members to meet their regulatory responsibilities. The NFA website can be found here: www.nfa.futures.org
Foreign Regulatory Agencies
United Kingdom: Financial Conduct Authority (FCA) – a non-governmental agency, with the objective to protect consumers and promote healthy competition in the financial services industry. – www.fca.org.uk
Prudential Regulation Authority (PRA) – the PRA is part of Bank of England, with the goal to promote a healthy financial system in the UK – www.bankofengland.co.uk/pra
Switzerland: Swiss Financial Market Supervisory Authority (FINMA) – the financial regulator of banks, securities dealers and stock exchanges in Switzerland – www.finma.ch
Australia: Australian Securities and Investments Commission (ASIC) – financial regulator of companies, financial markets, insurance industry and financial services in Australia – www.asic.gov.au
European Union: European Securities and Markets Authority (ESMA) – the European Union financial regulatory institution and European supervisory authority – www.esma.europa.eu
Japan: Financial Services Agency (FSA) – an agency of the Japanese government that oversees banking, securities and exchange, and insurance sectors in Japan – www.fsa.go.jp/en/
Using Different Forex Analysis in Trading
You may find that you like a little part of different types of analysis that you come across during your trading. You may feel that one of them is not better than the other, and you might find that one has more to offer than the other; it just depends on how you view each of them. You should trade all of your trades based on the type of analysis that you feel the most comfortable and profitable using.
A little review:
Technical Analysis is a study of the price movement on the charts.
Fundamental Analysis is the look into how the economy is doing, or how it is going to be looking in the near future.
Market Sentiment Analysis is what determines whether the market is either a bull or a bear, depending on the current and future fundamental outlook.
Fundamental factors shape the sentiment analysis, while the technical analysis basically helps the visual side of the market with the sentiment which applies the framework for each and every trade that is made.
All three can work together to provide the best trade ideas for the trader. All the figures and base are there, and all that is needed is for you to put them to the test when you make your trades. If you have only one or two, then the trade is shaky, but when you put in all three and you will be good to go with the best trade decision.
In order to become your best at Forex trading, you need to know how to use each of these to become the most effective trader. You shouldn’t just focus on one type of analysis to make a trade, if you see a trade you really enjoy, and think you can make a decent chunk off of it.
If you proceed to purchase this trade, and the trade then goes to a 100 pip move in the other direction because one of the banks went into bankruptcy, this is because everyone else is trading in the other direction, and you’re stuck with the bankrupt. You just lost a lot of money with just that one trade. This is because you did not think about fundamental or sentimental analysis in the process.
Don’t just rely on one analysis to get you through trades. You should learn how to balance all three of them for the best trade. This is the way that you will get the most out of the trades that you make. Of course, trading goes into more depth than what is taught here. You will need to learn more about pivot points, divergences, and Gartley patterns.
Here are some reasons why you should remember to use fundamental and market sentiment analysis together:
Once you become more involved in trading, mixing the two analyses together will result in better learning and trading skills through the market.
By using both analyses together, you get a better understanding of all three and how to make the best market trading decisions as you continue to learn more about the Forex market.
With traders, the markets never reflect all the information out there in the market because it is assured that traders will never all act the same way in regards to the information. This is simply not how traders operate. It is a bit tougher to get your hands on this information, and each trader is going to have their own opinion or even explanation of how and why the market does what it does.
The market is, in all actuality, a network that is complex and made up of a number of individuals who want to spam any and all news feeds out into the open for others to see.
It can be difficult to wrap your head around this information, and because opinions vary so much, each individual trader will have his own ideas about why the market does what it does. The market is also a complex network that includes a number of individuals who want to spam any and all news feeds out into the open for others to see.
The market is a place that represents all of the traders and what they feel for the market — at the same time. The traders’ feelings and positions in the market form the sentiment of the market and what makes it go.
If you have a strong feeling for the market, and you have something to say when you’re a trader, there can be problems. Despite how strongly you feel, you cannot make the market move to your favor. If you think that the dollar is going to rise in the end, but more people do not think so, you will be proven wrong (and there’s nothing you can do about it).
You have to take into consideration everything the market stands for — but pretty much, majority rules when it comes to trading. You have to keep in mind how the market is feeling at any given time.
You have the choice on how you would like to incorporate the market’s feelings and sentiment into any trades that you make or the trading strategies that you use. You can ignore market sentiment, but it might not be for the best in the end, depending on what type of trades you make.
If you learn the ways to gauge market sentiment, this skill can become a seriously important aspect of all the trades that you decide to make. Understanding sentiment can be a key to your trading, and your skills will only improve with continued effort and experimentation in the market.
Technical Analysis is a framework — the skeleton of the market used by traders when they study price movement. It is a very important scale. There is a theory that goes along with this analysis which includes that one person can look at any historical price movement and then determine what the current trading conditions are and what the potential price movement will be.
There is main evidence that is pretty much theoretical, and it is that all current market information can be reflected by the current price. If the determined price reflects the information in the market, then the price action is all that you really need to make the best trade decision.
Technical analysis is literally all about history repeating itself, and you having to pick up on the trends and pattern. The price level that is held as a key support or even a type of resistance in the past market history, encourages traders to keep their eyes open for the pattern. The historical price level is what they base their traders around.
If there have been similar patterns that form in the past in the market, then this is what traders will have to look for when making trades. This is because trade ideas are formed which allow them to believe that the price will act the same way that it once did before.
When you’re a forex trader, and someone mentions technical analysis, the first thing that will pop into your mind is a chart. This is because that is what technical analysis uses, and it is the easiest way to visualize the historical data that you need to remember. When you look at the past data that is presented on the chart, then you can base your future trades off of the history of the old trades. These charts are actually patterns and indicators that tend to turn into wonderful trades that are self -fulfilling.
When more traders start looking for trends on the charts in the history of Forex, this is when the trends and patterns are more likely to repeat themselves in the markets, which mean better payouts for the traders. Technical analysis is a very subjective way to go about trading. Even though you might be looking at the same chart as another trader, doesn’t mean you both will make the same trade since every trader gets something different from each chart.
You have to understand the concepts behind technical analysis to keep up with forex trading, and there can be a lot to learn, such as Fibonacci values, pivot points, and Bollinger bands.
Fundamental Analysis is one of the most revered and respected ways of analyzing the forex market, and whenever somebody mentions “fundamentals”, they are referring to the economic information about the country associated with a currency. You’ll see that fundamentals can cover a wide range of forces on a currency’s price, deriving from economics, politics, or even the environment.
The process of fundamental analysis involves studying all that information and using an analysis of known fundamental forces to predict what will happen in the future price of a company’s currency.
Fundamentals require a study of the entire world around us, including factors such as employment figures, inflation, interest rates, the political climate and economic growth. Anything with a large enough impact to affect a currency price is considered a fundamental force.
Fundamental analysis can give investors ideas about how a currency price could change based on certain economic events. The fundamental data that supports trading decisions can take many forms.
This data could, for example, be a report about a country’s home sales, or it could be a policy change made by a large country’s bank. Many times, the economy shifts simply from the release of information like this — and when investors react, the economy can change whether the information released is true or not. In fact, often changes take place before a report is even released when traders expect a report to say something specific.
Fundamentals Can be First
When it comes to interest rate changes, many fundamental investors can estimate interest rate hikes days before an actual statement is ever released. Currencies have even been known to jump more than 100 pips moments before a major event takes place – which makes for a profitable time to trade for fundamental traders with the correct training and software.
That’s why many traders keep up with current events and get ready for fast moves just before certain economic information is released!
Most of the information used for fundamental analysis comes from economic indicators. Just like a smoke alarm that goes off at the first sign of a fire, a company’s economic indicators provide clues to how well its economy is doing.
While it pays to understand the value of an indicator, it is just as important to understand the market’s anticipation and its guess at that value.
Before you even think about trading, you have to take in account how the actual figure is going to affect the predicted one.
Try not to worry about it, the whole process is much easier than it sounds, and you don’t have to be a brain surgeon to understand it.
While fundamental analysis is a great tool to guess at what the future economic conditions of a country are, it isn’t very good for predicting a change in price direction. The fundamental information isn’t specific enough, and you will get a much better idea just by looking at technical indicators.
Fundamentals Analysis is About Feelings
The forex market will react more to how people feel than it will to anything else. If people feel strongly about a particular report, the market is likely to be very volatile that day.
Because different traders have different interpretations of the market, it can become difficult to predict how the market is going to move. That’s why there is a huge amount of uncertainty in fundamental analysis, and why you need technical analysis to fill in the missing pieces.
Many traders have a hard time figuring out how to use the huge amount of information that is out there. It can be difficult to factor all of that information into economic terms and figure out how it is going to affect the price of the currency. Don’t forget that there are two currencies in every pair and that to get the best results, you have to look at the information for both countries involved.
Long term and medium traders benefit more from fundamental analysis than they do from technical analysis. That’s because they can follow long term changes in a country that would not affect the prices of a currency pair in any one given day.
Short term traders prefer to focus on technical analysis because short term strategies can predict short term changes much better than fundamental analysis.
Surprisingly, the best solution may be to use both Technical and Fundamental analysis!
If you focus purely on technical analysis, your strategy will be crippled when a large economic event occurs — especially an unforeseen one. At the same time, fundamental analysts miss out on many short term opportunities that technical analysts profit from routinely.
You may find that a mix of technical and fundamental analysis covers all angles. You’re aware of the scheduled economic releases and events, but you can also identify and use the various technical tools and patterns that market players focus on.
By practicing both types of analysis, you will cover all of your bases. You will miss out on far fewer opportunities and possibly make much more money.
Spotting and Trading Moving Averages
Moving averages are often used to identify and confirm a trend in the currency market. As described in earlier articles, a trend is simply a price that continues to move in one of three possible directions: up, down or sideways. Now, let’s see how moving averages can be used to find a trend.
The following is a daily chart of EUR/USD with a 100-day moving average (MA) plotted on it.
A moving average confirms a trend if the price crosses below or above the MA, and the MA changes its slope. The first part of the chart shows a downtrend on the EUR/USD pair. At point (1), price crossed the MA from above and changed its slope downwards, signalling that bears took contol over bulls.
The downtrend remained intact until the price crossed the MA from below at point (2). However, an uptrend is still not confirmed as the MA hasn’t changed its slope yet. What we see at the middle part of the chart is a sideways market where the MA remains more or less horizontal.
Finally, at point (3) the price crossed the MA again from below, with the MA changing its slope upwards. The price remains clearly above the 100-day MA, signalling that a possible uptrend has begun.
It’s important to remember that moving averages are lagging indicators, which means that it takes some time until MAs finally confirm that a trend reversal has happened.
How to Use Moving Average Crossovers to Enter Trades
One of the most simple forex strategies, and one of the most popular uses of moving averages, are moving average crossovers. Traders often use a short-term and long-term MA crossover to open trades on the market. There are many MA crossover strategies available on the internet, but we will explain one of the most effective.
For this strategy, plot a 5-period EMA and a 50-period EMA on a 15-minute chart. To enter a long position, wait for the 5-period EMA to cross the 50-period EMA from below, and for the following candlestick to close above the 5-period EMA. To enter a short position, wait for the 5-period EMA to cross the 50-period EMA from above, and for the following candlestick to close below the 5-period EMA.
The following example shows long and short setups based on MA crossovers, on a 15-minute EUR/USD chart.
At point (1), the 5-period EMA crossed above the 50-period EMA and the following candlestick closed above the 5-period EMA. This signals a possible entry into a long position. The same happened again at point (3).
On the other hand, points (2) and (4) show examples of the 5-period EMA crossing below the 50-period EMA, with the succeeding candlesticks closing below the 5-period EMA. These MA crossovers signal an opportunity to enter short positions. Stop-loss levels should be placed very close to the entry point, and moved to break-even as the trade turns profitable. You can also use trailing stops with this strategy.
How to Use Moving Averages as Dynamic Support and Resistance Levels
Moving averages can also be used as dynamic support and resistance lines. They are called dynamic, because these support and resistance lines constantly change in relation to recent price action. They are not like traditional horizontal support and resistance lines which we introduced in earlier articles.
The most popular MA periods that are considered as dynamic support and resistance lines are the 50-period EMA, 100-period EMA and the 200-period EMA. Let’s take a look how a moving average can act as dynamic support and resistance on the following chart.
The green circles show how the 50-day EMA acts as a dynamic support and resistance on the GBP/USD daily chart. As many trader follow the mentioned periods (50, 100 and 200) MAs, their ability to act as support and resistance becomes a self-fulfilled expectation.
Using Moving Averages
In this article, you’ve learned how to use moving averages in a variety of situations. Moving averages are a very popular technical tool used by traders worldwide. You can use moving averages to find the trend, enter trades on MA crossovers, or simply use them as dynamic support and resistance lines.
The slope of the MA can give a reliable indication of the state of the current trade. Are we in an uptrend, downtrend or ranging market? Looking at the MAs can give us the answer.
MA crossovers, another popular utilization of MAs, can create many trading signals in a short period of time. However, being a lagging indicator, traders should be aware that MAs can also create many fake signals.
Last but not least, many traders watch for the dynamic support and resistance levels created by the 100-day and 200-day EMA, which often act as major turning points for the price.
Divergences are a great way to determine tops and bottoms of trends, and thus making the right decision on when to enter and exit a position. In this regard, divergences are actually a leading indicator of future price action!
Normally, both the price and the technical indicator should move in the same direction. A divergence in forex occurs when the price and the indicator fail to simultaneously make higher highs or lower lows, i.e. they are “diverging” one from another. You can use any indicator for spotting divergences, like the RSI, MACD, stochastic and so on.
There are two main types of divergences, a regular divergence, and a hidden divergence. Let’s explain both types in the following lines.
Regular divergences are used to spot a possible trend reversal, and can be further divided into bullish and bearish regular divergences.
A bullish divergence occurs during a downtrend, when the price makes lower lows but the indicator makes higher lows. As price and momentum should move in the same direction, if the indicator fails to make a lower low this is a sign that the trend may reverse.
The following graphic shows a regular bullish divergence.
A bearish divergence is the opposite of a bullish divergence. It forms during an uptrend, when the price makes higher highs (HH), but the indicator fails to follow the price and instead makes lower highs (LH). This is a sign that the current uptrend may reverse.
The following graphic shows a bearish divergence.
Unlike regular divergences, a hidden divergence indicates that the underlying trend may continue. Hidden divergences can also be grouped into hidden bullish divergences, and hidden bearish divergences. A hidden bullish divergence forms during an uptrend, when the price makes a higher low (HL), but the indicator makes a lower low (LL). This situation signals that the current uptrend is about to continue.
The following graphic shows a hidden bullish divergence:
A hidden bearish divergence forms during a downtrend, when the price makes a lower high (LH), but the indicator makes a higher high (HH). If you spot a hidden bearish divergence, chances are the current downtrend will continue in the future.
Here is a graphic showing a hidden bearish divergence:
How to Trade Divergences?
Now that you know what regular and hidden divergences are, let’s take a look at real life examples of using divergences in trading.
The following chart shows the GBP/JPY pair with a regular bullish divergence.
The price made lower lows, while the RSI oscillator didn’t follow the price and made higher lows instead. This is a regular bullish divergence which indicates that the downtrend is about to end. And really, the pair started a new uptrend afterwards!
The next chart shows a hidden bearish divergence, formed on the same pair.
The price made lower highs (LH), but the RSI failed to follow the price and made higher highs (HH) instead. The result is that the downtrend continued its direction.
How to avoid entering too early when trading divergences
Just like with other trading tools, you should wait for additional confirmation when trading divergences to avoid cumulating losses. Although divergences are a great tool, you can make them even more profitable if combined with the following confirmation signals:
· Wait for a crossover of MAs – when a regular bearish or bullish divergence occurs, you can wait for the moving averages to cross which gives additional security that the current trend has ended.
· Wait for the indicators to break the trendline – when plotting a trendline on the indicator itself, you can wait for the indicator to actually break the trendline before entering a long or short position based on the divergence.
Determining Market Environment
Not every trading strategy is suitable for every market environment. Traders need to know the current state the market is in, to determine which strategy will achieve the best trading results. For example, Fib retracements and trendlines are very useful in trending markets, but in a ranging market you would be better suited with pivot points or support and resistance levels. That’s the reason why it’s so important to know which state the market is in:
- Trending up or down
A market is trending if the price makes consecutive higher highs and higher lows for uptrends, or lower highs and lower lows for downtrends. You can simply draw a trendline to determine whether the market is trending up or down. The following chart show a market trending up, making higher lows all the way up.
The ADX indicator can be used to determine if a market is trending or ranging. This indicator has a value of above 25 if the market is trending, and below 25 if the market is ranging. The following chart shows the ADX indicator with values above 25 (green) and values below 25 (blue). You can use this indicator as a confirmation that a trend has started.
A range-bound market, as the name suggests, is a market environment where price trades horizontal or sideways. The price stays inside a range of a higher price and lower price, where the higher price acts as resistance, and the lower price as support. The following chart shows a range-bound market.
Just like with trending markets, we can use the Average Directional Movement Index (ADX) indicator to identify ranging market conditions. Remember, an ADX value above 25 indicates a trending market, while a value below 25 indicates a ranging market. The following chart shows how to use the ADX indicator to spot a range-bound market.
An ADX-value below 25 is marked with blue rectangles, and shows that the market is not trending enough to push the value of the indicator above 25. This defines a ranging market condition. On the other hand, the green rectangles where the ADX is above 25 show a market which is trending (making higher highs or lower lows).
Retracements vs. Reversals – What is the Difference and How to Identify Them?
Retracements and reversals can often look the same for traders new to forex, that’s why it’s important to exactly know the difference between them.
A retracement is simply a short-lived price movement which goes against an established trend. Retracements often form higher lows during uptrends (and lower highs during downtrends), confirming that the overall trend is still intact. They can also form after huge price movements, but the underlying fundamentals of the currency pair do not change, pushing the price back in the direction of the trend. Retracements are usually measured with the Fibonacci retracement tool, which we have covered in earlier lessons.
Reversals, on the other hand, can occur at any time with the underlying fundamentals of the currency pair changing. After a reversal, a new trend establishes which makes higher highs in an uptrend, or lower lows in a downtrend.
Let’s look at the next picture to see how retracements and reversals look in the market.
The left part of the chart shows a downtrend, with retracements marked with green rectangles. They go against the trend for a short time, and make lower highs before finally going back in the direction of the overall downtrend. The lower highs and lower lows show that the downtrend is still intact.
Eventually, the price forms a higher high (red arrow in the middle of the chart), signaling that a reversal into an uptrend may be ahead. After that, the price was forming higher highs and occasionally retraced to form higher lows, confirming that the new uptrend is intact.
How to Protect from Reversals?
As you already know, reversals can happen at any time when the underlying macroeconomics of a currency pair change. So, if you have an open position, you need to be prepared any time for a reversal and lock your hard-earned pips. Stop-losses are mandatory in any trading strategy, and you can even use trailing stops to prevent exiting too early, but still be secured in the case a reversal happens.
Trailing stops simply follow the current price, and automatically adjust the stop-loss to be a certain number of pips away from the current price. So if you are in a winning position, trailing stops will automatically adjust to lock your profits in case of a reversal.
A breakout happens when the price breaks a support and resistance level, Fibonacci level, trendline, etc. This is usually accompanied with a rise in volatility, which means the price start to move really fast just after the breakout happened.
As a trader, you want to catch these breakouts and enter the market just on the breakout, in order to capitalize on the rise in volatility.
Unlike in stock markets, where traders have information about trading volume, forex traders don’t have access to such information. This means that we have to rely on good risk management in order to enter a good breakout trade.
Trading on high volatility can also be risky as the large price movements can trigger your stop-loss in a short period of time.
How to Measure Volatility
As said before, volatility measure the price fluctuation over a certain period of time. Knowing the volatility of a currency pair can be of big help when looking for breakout opportunities.
You can use a few excellent tools to measure the current price volatility, like Bollinger bands and the Average True Range indicator.
Bollinger bands is actually designed to do exactly that. It consists of three lines, one of them is a moving average and the other two are plotted at 2 standard deviations above and below the moving average. When the two lines widen, the volatility is high – and the when the two lines contract, volatility is low. The following chart shows how to use Bollinger bands when measuring volatility.
The Average True Range (ATR) indicator is another useful tool to measure price volatility. An increasing value of the indicator indicates a rising volatility, while a decreasing value indicates a falling volatility. The following chart shows how to use the ATR indicator to measure volatility.
Types of Breakouts
There are two main types of breakouts in the forex market:
· Continuation breakouts
· Reversal breakouts
A continuation breakout is a breakout which continues in the same direction as the main trend. They occur after the price consolidates (range-bound market) after a significant move in price.
A reversal breakout, as the name suggests, reverses the previous trend in the opposite direction. In the beginning, it forms just like a continuation breakout, after the price consolidates after a big push in price.
There are also a third type of breakouts, called “false” breakouts. A false breakout occurs when the price moves outside the consolidation range and closes outside, but doesn’t continue in the direction of the breakout. Instead, the price moves back inside the consolidation range.
How to Trade Breakouts Using Trendlines and Channels
Beside trading breakouts out of consolidation phases, you can also use trendlines and channels to trade breakouts. By now, you already know what trendlines and channels are. When the price makes higher lows or lower highs, you can connect those price swings with a trendline and wait for the price to break out above or below the trendline. The following chart shows how to use trendlines when trading breakouts.
Similar to trendlines, you can also use channels to trade breakouts. When the price bounces off the upper and lower channel trendline, it’s only a matter of time when a breakout will occur. After the price breaks the channel, wait for the candlestick to close and enter a position in the direction of the breakout. The following chart shows how to trade a short position after the price breaks out of a channel.
Measuring the Strength of a Breakout
There are a number of ways to measure the strength of a breakout in order to confirm it. One of the most popular is to use technical indicators like the MACD or RSI.
As you already know, the MACD plots a histogram which is telling a lot about the underlying momentum of the price movement. As the histogram gets bigger, the momentum is getting stronger. And as the histogram gets smaller, the momentum gets weaker. The MACD can be used to spot divergences between the price and the indicator, which tell us about the underlying momentum of the recent price movement.
The RSI plots the changes between the recent gains and losses during a specific period of time, and can also be used to spot divergences just like the MACD indicator.
One of the ways to use MACD and RSI to confirm breakouts is to look for divergences in the price and the indicator, which we discussed earlier. If a bullish divergence forms during a downtrend, it shows the bearish momentum is getting weaker and indicates that a reversal breakout is more likely. Similarly, if a bearish divergence forms during an uptrend, it shows that the bullish momentum is losing steam and that a reversal breakout could be ahead.
Fading breakouts, i.e. trading against the direction of the breakout is a great short-term strategy. Many breakouts will initially fail and create false signals, which means the price will move back to its prior price level in the end. This is how the big players with large trading accounts trade. They know that smaller retail traders will jump on a trade as soon as a breakout happens. The big players will place opposite orders than retail traders, as any sell position needs buyers on the opposite site, and any buy position needs sellers.
This is how false signals form which in the end move back to their prior price level. And as many breakouts initially fail, you can benefit from it on opening trades against the breakout i.e. fading the breakout. But remember to use stop-loss orders all the time, in case the breakout shows to be a real one.
How to Detect Fakeouts?
When the price breaks a support or resistance level, trendline or channel, traders expect that enough momentum has built up and the price will continue in the direction of the breakout. However, this is not always the case.
If the support or resistance level has a high importance, it is more likely that the price will try to break it but ultimately fail, creating a fakeout, i.e. false breakout.
You should wait for the second candlestick to close also in the direction of the breakout, or wait for the broken resistance to act as support (and vice-versa) to confirm that a breakout isn’t a fakeout. As discussed earlier, using divergences and measuring the strength of the momentum can also help in confirming real breakouts.
Is it Possible to Trade Fakeouts?
Yes! Fading breakouts is possible and can be a great short-term strategy. However, you need to be careful that the fakeout is not a real breakout, otherwise your stop-loss will be hit pretty quick. In order to spot fakeouts and trade them, you need to look how the price performs after the break. Let’s look at the next chart.
Look at all these false breakouts. They all have one thing in common, the long wicks show that the momentum wasn’t strong enough to push the price in the direction of the breakout. Furthermore, the price-action before the fakeout looks bearish, without enough buyers to catapult the price highers. You could trade all these fakeouts, with tight stop-losses just above the wicks. The real breakout shows a big green candlestick breaking the trendline, which is a sign of a real breakout.