Articles

Forex Trading Strategies

Posted By: TradersLog

Successfully trading the forex market on an intraday basis requires precision and a very careful selection of trades.
The enormous scope of the trillion dollar, 24 hour, globe spanning fx market presents a miriad of opportunities for the short term trader – however a day trader in this market must be aware of certain inherent factors to overcome.

Firstly, the bid ask spread in the fx market, normally at least 3 pips, makes trading on the shortest timeframe – in and out within seconds – very difficult.

The daily ranges can be very wide among certain currency pairs, presenting many opportunities for the day trader – however I feel that the intraday forex trader should look for specific technical and fundamental conditions before entering trades.

Secondly, due to the fact that there is currently no centralized exchange in the forex market, traders lack data on volume and open interest (the number of active contracts for a given security over a given time period)- important sources for traders in other markets – which causes a necessary shift in focus to other technical and fundamental factors.

While interbank dealers are able to see the order book and use this to their advantage, the retail fx trader can exploit their ability to react faster, and also with the knowledge that their trades will not move the market, as the trades of the larger institutions will.

The CME and Reuters are planning to launch a trading platform for fx in Q1 2007 – using CME trade matching and clearing technology – this will address the issues mentioned above (ie the spread will be tighter, you will be able to see volume etc.) and it will be interesting to see whether they can attract the liquidity and create a successful marketplace.

While both technical and fundamental analysis are important to the forex trader, we will begin with a focus on technicals.

The Big Picture

A very important factor in having an edge in the market is to be aware of the big picture – identifying the type of market that exists, whether it is trending or range bound.

To grasp this it is essential to use multiple time frame analysis – even if you are a day trader, you should be looking at daily, hourly and 10 or 15 minute charts. The longer term charts will give you an idea of the overall temperament of the market.

One of the foremost strategies used by banks and hedge funds is to determine the overall trend of the market and enter trades at key retracement levels of that trend.

One of the advantages of trading the forex market is that it normally trends more than the equities market, due to the fact that macroeconomic events can continue to influence the market over a timeframe of months and years.

The fx trader should expoit this understanding of the overall trend of the market by positioning themselves in the direction of the trend.

In an uptrending market, look to buy pullbacks at key levels and the inverse for a downtrending market. One of the strengths of the fx market is that you can expoit market moves whether they are to the upside or downside.

Identifying good entry points to join the trend

A variety of technical tools are used to help gauge good entry points. Basic support and resistance levels (characterised on a bar chart by a sequence of lows or highs that fluctuate only slightly along a horizontal line and represent a level where buy orders outnumber sell orders or the inverse) on a daily chart and fibonacci levels are two examples. I recommend taking a look at Martin Prings article on how to identify support and resistance levels.

Lets take a quick look at Fibonaccci Levels:

Fibonacci Retracements

Chart courtesy of Prophet Financial Systems (www.prophet.net)

Above is an example of fibonacci retracements in use. Fibonacci levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

I have found the 38 and 50% levels to be the most significant. The fib levels were a popular form of analysis among the interbank traders I worked with, and I found the 38% level to work with an eerie accuracy on the 30 minute chart while trading bund futures. Again the longer the timeframe used, the more significant the level.

Measuring the strength of the trend

Attempting to buy the low and sell the high is very often the undoing of the inexperienced trader – and while this strategy works in a range bound market, it is best avoided unless you have identified a market as such.

An important tool for determining the strength of a trend and whether a market is range bound is the Average Directional Index or ADX.

Average Directional Index (ADX)

Chart courtesy of Prophet Financial Systems (www.prophet.net)

Measured on a scale between 0 and 100, readings below 20 are used to indicate a weak trend, while readings over 40 indicate a strong trend. ADX is not used to show the direction of a particular trend, rather to measure its strength.

Stay away from trend following trades if the ADX is below 20 and trending downward.

US Dollar Index

The US Dollar Index (USDX) is a futures contract offered by the New York Board of Trade. It is a trade-weighted average of six foreign currencies against the dollar. Currently, the index includes euros (EUR), Japanese yen (JPY), British pounds (GBP), Canadian dollars (CAD), Swedish kronas (SEK) and Swiss francs (CHF).

USDX broadly reflects the dollar’s standing compared to the other major currencies of the world. It is widely used to hedge risk in the currency markets or to take a position in the US Dollar without having the risk exposure of a single currency pair.

The US Dollar Index allows the fx trader a feel for what is going on in the FX market globally at a glance. If the Dollar Index is trending lower, then it is likely that a major currency that is a component of it is trading higher.

Important Psychological Levels

FX day traders should be able to identify price areas where large order flows will be triggered through the interbank market, and take advantage of the moves that are created by them.

Such levels include major areas of support and resistance on the daily chart and also round numbers such as double zeros – for example EUR/USD 1.2700.

Careful placement of stop loss and profit target orders enables the trader to execute trades with a strongly positive risk/reward factor.

For example, one might place a stop loss of 15 pips from the level and a profit target of 50 pips on the other side if you are attempting to profit from a bounce at such a level.

One should note that stop loss orders are normally placed somewhat beyond the key round figure numbers and profit taking orders are normally right at the key levels.

Attempting to catch a rebound off a major level is best executed when there are other technical factors supporting the rebound. For example if the market had been trading below its 20 period Simple Moving Average (SMA) prior to reaching the key level, this would support the decision to attempt to catch a rebound at that level.

Simple Moving Average

Chart courtesy of Prophet Financial Systems (www.prophet.net)

Identifying these key levels can provide good entries to trades where you are joining the trend, as we discussed earlier, or if you are attempting to profit from a rebound off such a major level.

Bollinger Band® Strategies

Bollinger Bands are a popular study used across all markets – including fx.

Bollinger Bands

Chart courtesy of Prophet Financial Systems (www.prophet.net)

They can be useful in both generating entry and exit signals and gauging trends. The basic interpretation of Bollinger Bands is that market prices will tend to stay within the upper and lower bands.

Bollinger observed the following characteristics of his indicator:

– Sharper price movements tend to occur when the bands tighten and volatility decreases.

– When prices move outside the bands suggests a continuation in the direction of the overall trend.

– Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands indicates a trend reversal.

Bollinger Bands are best used along with other indicators, such as an oscillator like the MACD.

Pivot Point Strategies

An old but reliable tool, originally used by floor traders are pivot points. They are another valuable tool for determining key support and resistance levels.

Formula for Pivot Point Calculator

Pivot = (High + Low + Close) / 3

Resistance 1 = (2 x Pivot) – Low

Resistance 2 = Pivot + (High – Low)

Resistance 3 = High + 2 x (Pivot – Low)

Support 1 = (2 x Pivot) – High

Support 2 = Pivot – (High – Low)

Support 3 = Low – 2 x (High – Pivot)

The prices used to calculate the pivot point are the previous period’s high, low and closing prices. These prices are usually taken from the currency pair’s daily charts, but the pivot point can also be calculated using information from hourly charts. Normally the pivot points are taken from a daily chart and applied to intraday trading.

When the market opens above the pivot, the bias for the day is on the long side. An open below it suggests a bearish bias.

Typically the trading range is confined between the first support and resistance levels and these along with the pivot itself are the most important areas for you to consider.

While looking at pivot points you should be looking for a reversal or break through of the support and resitance levels. If the level fails to hold, this suggests follow through, and the second level of support and resistance can be used as a target.

Interestingly, an area that was a strong support level can often become a resistance level once it has been violated and retraces back to that same level (and the inverse for a previously strong resistance level).

Again, these levels are best used when confirmed with other technical indicators.

Inside Day Breakouts

An inside day is one where trading is contained within the trading range of the previous day.

The volatility breakout strategy entails entering a trade on a stop order above or below the range that has been previously trading – with the expectation that since a breakout has occured price will continue to move in that direction.

Volatility breakout systems are based on idea that if the market moves a certain percentage from a previous price level, the market is likely to see follow through in that direction. In this scenario you are looking for a continuation of the move based on momentum.

One should look for a series of inside days to implement this strategy, and the greater the number of inside days that transpire, the higher the probability of a breakout.

Also, the longer the timeframe used, the stronger the breakout opportunity – hourly and daily timeframes are the best to use.

This strategy is also best used with pairs that see tighter ranges – these are typically the crosses – currency pairs that do not have the USD as part of the pairing such as the EUR/GBP and the EUR/CHF.

Inevitably there will be false breakouts, as the interbank dealers try to trigger the stop orders just outside the breakout levels.

In order to avoid being caught in a false breakout situation, enter your trade with a stop order at least 10-15 pips above the breakout level – meaning the levels above or below the trading range depending on whether the market is breaking out to the upside or downside.

(In case you are not clear on this – a stop order is one that is placed above or below where the market is currently trading and becomes a market order when the market touches the price where the stop was entered. A buy stop is placed above the market and a sell stop is placed below.)

Again one can look to the ADX as an indicator to whether the market is still range bound or beginning to trend one way or another.

Stay away from inside day breakout trade if the ADX is below 20 and trending downward.

The breakout strategy is valuable in that it teaches the trader to do something that is normally counter intuitive – that is to buy the high or sell the low. Novice traders are more likely to try to pick tops and bottoms.

Often the breakout will occur in a fast moving market, making decisiveness even harder. However, if your strategy is in place and you have identified the opportunity, you will be ahead of the game.

Economic Releases

One should probably not use technical strategies to enter trades right around important economic releases such as the employment report.

Key levels of support and resistance will still come into play, after the fundamental data has played itself out in the market – but the short term technicals will hold little relevance.

Among the advantages to the retail fx trader in trading off fundamental data is that the information is readily accessible through sources such as Bloomberg and Reuters, and that the retail trader can actually act faster than the banks and hedge funds.

The impact of major economic news can take some time before it has finished impacting the market, and the day trader can use this to their advantage – benefiting from the momentum generated by the order flow of the bigger players.

The best opportunities are created when the news comes out way off expectation and the market scrambles to correct itself. This can happen quite frequently with releases such as the nonfarm payrolls part of the employment report.

For a good exit to a trade entered based on fundamentals, the trader should look to a significant technical level.

Lets look at the market reaction to some of the major economic releases:

The most timely and broad indicator of economic activity and overall economic health is the Employment Report.

Market Reaction:

Event Fixed Income Equities Dollar
Payroll Employment Up Bond Market Down Stock Market Up Dollar Up
Unemployment Rate Up Bond Market Up Stock Market Down Dollar Down
Payroll Employment Down Bond Market Up Stock Market Down Dollar Down
Unemployment Rate Down Bond Market Down Stock Market Up Dollar Up

The most important quarterly release is Gross Domestic Product (GDP) – the best overall barometer of economic activity.

Market Reaction:

Event Fixed Income Equities Dollar
GDP Up Bond Market Down Stock Market Up Dollar Up
GDP Down Bond Market Up Stock Market Down Dollar Down

Best times to be trading the FX market and the most volatile pairs to watch

The global forex markets trade from 5:00 PM EST Sunday through 4:00 PM EST Friday. Short term trading is usually best when there is good volatility.

Having said that lets take a look at the different global sessions and their characteristics:

European Trading Session (London)

The most important fx dealing center in the world.

London opens at 8.00 GMT and closes at 17.00 GMT. You can expect to see the highest volatility during the European session. GBP/USD, USD/CHF, GBP/JPY and GBP/CHF see the most volatility with average daily ranges of up to 140 pips.

U.S. Session (New York)

Opens at 8.00 A.M EST and closes at 5PM EST.

The second largest forex market place.The busiest time is 8am to noon EST.

Trading activity normally slows down after the U.S. afternoon trading period. GBP/USD, USD/CHF, GBP/JPY and GBP/CHF see average daily ranges of 120 pips during the US trading session – presenting many opportunities for the day trader.

European/U.S. Overlap

8am – noon EST. The market is very active during this period, making it an especially good environment for intraday trades.

Asian/European Overlap

2 a.m to 4a.m. EST. Trading is less active during this period.

Asian Session (Tokyo)

The Asian session opens at 7.00 p.m. EST and closes at 4:00 a.m. EST.

Volatility can be mixed during this period. USD/JPY, GBP/CHF and GBP/JPY have the widest ranges and present the short term trader with the greatest opportunity in terms of volatility.

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