By James Chen, CTA, CMT
When trading in the forex market, traders who wish to maximize their probability of success should pay close heed to several key principles and practices. This article discusses some of these principles and then provides a specific, step-by-step strategic method for putting them into effective practice.
First and foremost, traders should always apply prudent risk management. Good risk management fosters longevity in trading, and traders should ALWAYS strive to target longevity. Only through surviving to trade another day can a trader truly have any chance of achieving consistent profitability. The proper practice of risk management primarily involves the active limiting of market risk, most often through the wise placement of stop losses.
The second key principle is to follow the prevailing trend. Though this principle is often over-eagerly touted by market gurus and educators, its importance cannot be emphasized enough. While there are successful counter-trend traders in all financial markets, trading with a strong, prevailing trend is one of the best ways to take advantage of existing market momentum. One of the most important primary factors of successful trading is simply making sure that one’s directional bias is correct, and that one stays on the correct side of the market. By trading ONLY WITH the trend, this feat is more readily accomplished.
The third key principle is to exploit pullbacks within a trend (dips in an uptrend or rallies in a downtrend), wherever possible. Pullback trading epitomizes the sensible act of seeking optimal trade entries within trends. In an uptrend, entering a long trade on a downside pullback is ideal because the trader buys into the trade at a lower price, in anticipation of selling higher for a profit on a potential uptrend continuation. By the same token, in a downtrend, entering a short trade on an upside pullback is ideal because the trader sells short into the trade at a higher price, in anticipation of buying back (or covering) lower for a profit on a potential downtrend continuation. Pullback trading is common, but the intelligent trader should not just look for any pullback that occurs, as they can often quickly turn into reversals of the trend. Rather, the key event to look for is the pullback RECOVERY, where price begins to recover from the temporary pullback and starts to move back in the direction of the prevailing trend, thereby providing some indication of a potential trend continuation.
The fourth key principle to be discussed here involves ensuring a prudent reward-to-risk ratio. Generally speaking, this means that traders, and especially trend-following traders, should seek trades having potential reward (profit) significantly exceed potential risk (loss). Particularly when dealing with trend trades,
Trading with the trend is essentially taking the path of least resistance. having a relatively high reward-to-risk ratio allows for less frequent (but substantially larger) winning trades to overshadow more frequent (but substantially smaller) losing trades, thereby targeting net profitability. There are many different ratios that different traders use for different purposes and strategies. Common ratios, depending on the trader and the circumstances, include 2:1, 3:1, and 4:1. A 3:1 reward:risk ratio, for example, simply means that one strives to make one’s winning trades at least three times the size of one’s losing trades.
With these prudent principles of high-probability Forex trading kept firmly in mind, the trader can then look to formulate a specific trading strategy that effectively puts these principles into practice. One solid strategy that fits these principles well is one that I have coined, the Deep Pullback.
The rationale for this trading strategy is straightforward – a costeffective location to enter into a trend trade is where price begins to recover from a significant (hence, “deep”) pullback within a strong trend. In an uptrend where a trader is looking to buy, or go long, the most cost-effective location for entry is after substantial price dips, optimally getting the trader into the uptrend at a relatively low price. In a downtrend where a trader is looking to sell short, the most cost-effective location for entry is after substantial price rallies, optimally getting the trader into the downtrend at a relatively high price. If the correction does not turn into a trend reversal, a deep pullback is better than a shallow one simply because the entry on a deep pullback occurs at a more advantageous price than on a shallow pullback.
When a deep pullback occurs, trade entry should be considered only if price indicates a potential RECOVERY from the pullback by turning back in the direction of the prevailing trend. Once this occurs, a trade with the trend can be entered and risk control measures can then be set in place, along with a potential profit target according to the trader’s desired reward-to-risk ratio.
The setup is simple. Hourly or other short-term charts of major currency pairs are scanned for the following criteria.
1) The first criterion is trend. A trend is in place only if there is separation and a Correct Order of Moving Averages (COMA) – in this case, three simple moving averages (SMA): 50, 100, and 200 periods. For an uptrend, the correct order of moving averages consists of the 200-period SMA on the bottom, followed above it by the 100, with the 50 on top. For a downtrend, the correct order of moving averages consists of the 200-period SMA on top, followed below it by the 100, with the 50 on the bottom. If this first criterion is fulfilled with a COMA, the second criterion should then be considered.
2) The second criterion is the deep pullback. Within a trend as defined by the first criterion, a trade is considered only if price moves deep enough – to the 100-period SMA or more. Therefore, in an uptrend, a pullback dip is considered deep enough only if price moves to the 100-period SMA or lower. In a downtrend, a pullback rally is considered deep enough only if price moves to the 100-period SMA or higher. If this second criterion is fulfilled with a deep pullback that goes to the 100 SMA or more, the third criterion should then be considered.
3) The third criterion is a pullback recovery. This is indicated in an uptrend by the Slow Stochastics main line crossing and closing above the oversold (20) line after having been previously oversold, or on a downtrend by the Slow Stochastics main line crossing and closing below the overbought (80) line after having been previously overbought.
The Deep Pullback on a GBP/USD hourly chart uptrend (chart courtesy of FXDD-MetaTrader)
Once all three criteria are met, a trend trade may be entered immediately on the fulfillment of the third criterion. After entry, for a long entry in an uptrend the stop-loss can then be placed just a few pips below the low of the pullback dip. For a short entry in a downtrend the stop-loss can then be placed just a few pips above the high of the pullback rally.
With strictly-controlled, defined risk in place, attention can then be placed on targeting profits through the use of a predetermined reward-to-risk ratio. For example, if operating on a 3:1 reward-to-risk ratio (where reward is set at three times risk) in an uptrend, the trader would take the size of the defined risk (entry price minus stop-loss price), triple this risk amount, and then add that value to the entry price to derive the profit target price.
The Deep Pullback strategy can be employed as a robust trading method that fulfills some key principles of high probability trading. The strategy’s strict, built-in trading criteria filter out lower probability trades and present potentially higher probability trades which, when coupled with strong risk management, can contribute significantly to an effective overall trading approach.
James Chen, CTA, CMT, is a highly-experienced trader, analyst, and author, and is currently Director of Trading and Investing at Investopedia. He is also a Chartered Market Technician and a registered Commodity Trading Advisor. Chen is the author of Essentials of Foreign Exchange Trading (Wiley, 2009), Essentials of Technical Analysis for Financial Markets (Wiley, 2010), and the DVD-set, High-Probability Trend-Following in the Forex Market (FX Street, 2010). He is also a frequent speaker and contributor to key financial media, including Reuters, Dow Jones, Bloomberg, and Forbes.