From the May 01, 2010 issue of Futures Magazine • Subscribe!

Capturing forex trends in 7 steps

The forex market makes up one of the most liquid and profitable trading arenas in the world. Trillions of dollars worth of currencies are traded almost daily, and traders can take advantage of huge leverage (as much as 100-1), subject to new regulations. Not only can traders wield massive buying power, but there’s also a low cost of entry. Most forex brokerages allow clients to open an account with as little as $1,000.

In addition, forex is a true 24-hour market where currency pairs are traded around the clock. This accounts for the incredible liquidity, allowing your orders to be executed almost instantaneously. In these ways, for many aspiring traders, forex represents the hopeful realization of their desires to one day make the transition to full-time professionals, making fortunes in the markets. However, while the forex markets have incredible potential, they are not without disadvantages that, unfortunately, have broken apart more dreams than they have made.

Forex can be a source of continued income that grows ever larger with each year, or it can be a Grim Reaper to your trading account, killing your trade equity while condemning you to a job that you hate. The key to long-term success is to confront the reality of trading forex without compromise, look deep into the disadvantages as well as the advantages.

First, understand that forex is incredibly volatile. If you don’t have a plan for risk control, these volatile moves can bleed your trade equity dry. If you try to come into forex with tight stops, then you are going to suffer a so-called “death of a thousand cuts,” where quick price jumps stop you out repeatedly just before the currency pair takes off and leaves you behind. To make it in forex, you have to plan for volatility and know how to exploit it for profit.

To make matters worse, forex brokers don’t charge commissions like they do in the equity markets. Instead, you pay a bid/ask spread that could run anywhere from two to five pips, on average. So, just starting out of the gate, you are already in the red, and if you don’t adjust for the risk it can get much worse quickly.

Next, leverage can make your fortune, or it can cost you one. While you can buy and hold stocks indefinitely, and your risk is only confined to the amount you paid for them, in forex the losses are open-ended and can get out of control if you don’t know what you are doing.

Game plan
In forex trading, there is almost always a clear trend in place. This makes it important to define what type of trend you’re going to trade, while taking into account your trading rules. Forex markets move between contraction and expansion (see “Surfing the Momentum Wave,” September 2009), where price consolidates between two price points before moving into an expansive move where the currency pair resumes its trend. This ebb and flow is as constant as waves coming in and out with the tide.

To take advantage of this pattern, you can use a setup called the Forex Slingshot.

On a price chart, place a 13-day and 34-day simple moving average (SMA) and the moving average convergence divergence (MACD) indicator. Apply the Forex Slingshot setup as follows:

1) Find an eight-week contraction in a currency pair.
2) The 13- and 34-day SMAs should be in proper order: 13 over the 34 and sloping upward for longs; 34 over 13 and sloping downward for shorts.
3) As price breaks out from this contracted price pattern, wait for price to pull back to the 21 SMA or between the 13 and 34 SMAs.
4) Scan the price action for the price bar that sets the pivot high (for shorts) or pivot low (for longs).
5) When price resumes in the direction of the dominant trend, enter the trade as price trades beneath the intraday low set by the pivot high for shorts or the intraday high of the pivot low for longs.
6) If price trades into the 34-day SMA, then no setup exists.
7) Use the MACD as a secondary confirmation of your entry.

Applying the plan
Near the middle of May 2009, the U.S. dollar/Canadian dollar currency pair (USD/CAD) finally broke out of a contracted price pattern and moved to the downside. On May 17, a Forex Slingshot setup forms as price pulls back after the initial breakout, and a position is taken on May 18 as price trades under the May 17 low of 1.17550 (see “Downside break,”). Your stop is placed above its intraday high.

A few days later, the MACD confirms our entry when its fast moving average crosses downward through its slow moving average. (The MACD is a lagging indicator that is used for secondary confirmation of an entry.) The USD/CAD continues its downward spiral where the MACD begins to show an oversold condition, and a trader could have exited at the bottom at 1.1113 for a potential profit of 64 pips.

The Forex Slingshot also works well within congested trend patterns like price channels. Price channels are often contracted between two trendlines that act as either support or resistance, depending on where price is trading. If you scan the market and train yourself to spot these types of channels in the price action of the currency pairs you are tracking, then you can drop down to a smaller time frame and use the Forex Slingshot to signal setups (see “Channel opportunity”).

Last year, the dollar and Japanese yen currency pair (USD/JPY) peaked in April 2009 before beginning its decline. By taking a look at the larger time frame to get a big picture perspective of the USD/JPY, you could tell it was trading within a price channel and eventually trading below its March 19 low.

By sticking to the Forex Slingshot rules, you could have scaled down in the time frame to observe the price action trade between its channel lines, while patiently waiting for a setup to appear.

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