Categories
Forex Daily Topic Forex Price-Action Strategies

Remember the Rule ‘Set and Forget’

In today’s lesson, we are going to demonstrate an example of H1 breakout trading. Usually, in this strategy, the price goes towards the direction with good momentum if things go accordingly. In this example, the breakout candle, breakout confirmation candle are immaculate, but it takes a long pause before it hits the target. It has a lesson to give us. Let us dig into this.

The price after being bearish finds its support. It consolidates for a while and produces a bearish pin bar followed by a bearish engulfing candle. Traders are to wait for a breakout at the level of support to get them prepared to go short on the pair.

The last candle breaches the level of support and closes well below the level. The candle is having a tiny lower spike. Ideally, H1 breakout strategy traders wait for such a breakout candle.  They are to wait for the next H1 candle to close below the breakout candle. If that happens, the game is on. Let us proceed to the following chart.

As expected, the next candle closes below the breakout candle. The candle looks very bearish, being an ideal candle to confirm the breakout. The sellers may trigger a short entry right after the last candle closes. Let us have a look at the same chart with some calculations in it.

The sellers may set the level of stop-loss above the level where the trend is initiated. They may set the take-profit level with 1:1 risk-reward. It means

Entry- Stop Loss= Take Profit-Entry.

The price consolidates after the signal candle. It bounces at the level, where it bounced some hours earlier. This is the first sign of a double bottom. It looks the buyers may take over the control, which may make the price hit the stop loss. You may remember, in one of our lessons, it has been recommended that a trader may have to close his entry manually. It was an example of the Friday market. Today’s market is not the Friday market. Thus, we must not close it manually, as it may get us a loss, but we must let it run. Let us wait and see how it ends.

It looks much better now. The price heads towards the South with good bearish momentum. It may not take much time to hit the target.

It does not go according to your calculation. It takes much longer than our expectations. However, it hits the target at last. The lesson that we have learned here is we must let a trade run to do its bit. Once we take entry after measuring the risk-reward, we must be patient. In a word, we must remember the rule ‘set and forget.’

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Forex Course Forex Daily Topic

Introduction To Forex Course 3.0

Hola Readers! We have successfully completed the first two courses and received an amazing response for both of them. We can’t thank you enough for that. Also, we hope these first two courses have helped you in understanding the most fundamentals basics of the Forex market. It is very important to know these basics in order to succeed in the Forex market. We have made a quick navigation guide for both the courses just for you to access the articles easily.

You can find them here the guides for – Course 1.0 | Course 2.0

With all these basics in mind, we will be moving on to our new course, which is a bit different than the other two courses. We are saying this because the first two courses are more inclined towards information and theory. But Course 3.0 is all about Technical Analysis. Hence most part of it deals with the practical applications that are involved rather than just theory. The quizzes and everything remain as is, but a lot more effort from your side is required to ace the knowledge that we are going to provide in the lessons.

Having said that, Technical Analysis has the most logical approach to the prediction of price movement than the Fundamental & Sentimental Analysis. There are a lot of components within the technical analysis, and some of them include Price-Action trading, technical tools such as Indicators & Oscillators, Volume based trading, etc. In this course, we will be going through all of them in detail.

Topics that will be covered in this course 

Everything About Candlesticks

Support & Resistance Levels

Moving Averages

Popular Indicators & Oscillators

Fibonacci Trading

In each of the topics, there will be about 7 – 10 article lessons where complete information is provided related to the topics. Quizzes will be available for each of the articles like before.

We are proud to present this course to you as it is prepared by some of the top technical traders with great expertise in this field. Aren’t you excited? We wish you all the best in studying and learning the concepts with at most interest. Cheers!

Categories
Forex Daily Topic Forex Videos

How To Get An Edge In Forex Using Statistical Thinking – Trade Like A Forex Titan Part 4

Stats for Traders IV – Determine the quality of a trading system

To determine if something is good or just a product of randomness is not easy. The pharma industry spends years and costly double-blind studies to determine if a new chemical compound is better than a placebo (distilled water, or just a pill of sugar). This kind of evidence is needed because, as we have seen, almost nothing is sure in mother nature.

How to determine the goodness of data set


Taking the example of the pharma industry, to assess the properties of the new drug, scientists basically create two data sets. One dataset contains all the data measurements of the specimens taking the placebo and another dataset recording the same data of the specimens being administered the drug. So they end up with two groups, and, basically, they want to know if both groups belong to the same statistical distribution or from a different one. The statistical test to do this analysis is called the T-Test.

The T-Test

A T-test allows us to compare the average values of the two data sets and determine if they came from the same population. In the case of Pharma, the placebo group is the equivalent of a random sample with a zero mean, and scientists apply the T-Test to see if the average parameters of the group treated with the drug are similar or different from the placebo group. In the case of a trading system, we would like to know how far is the trading system away from a random trading system. The T-Test will answer not just the question of whether the system or strategy has the edge over a random pick, but it enables us to qualify and rank systems.

For a T-Test to be valid, we need to ensure several details! Scales of measurement must be standardized in both data sets. That means, the collection of the data should be standardized with one unit of trade, and preferably also using units of a standard Risk as a description of profits and losses.

The data collected is representative of the system. That means the data should be collected under all possible conditions the system will experience. The number of samples must be as large as feasible, and to comply with point 2 from a large historical database to account for every possible market situation: Bull, bear, sideways with low, mid and high volatility.
The standard deviation on both samples – random and strategy – should be similar. Making sure point 1 is guaranteed, point 4 is also insured.

The basic formula for when the size of both groups is equal:

t = (m1 — m2) / (σ / √N )

where m1 and m2 are the averages of the two groups and sigma σ is the standard deviation of the samples (assuming equal sigma on both)
if m2 is zero (random) the formula simplifies to:

Q = m / (σ / √N )
Where we have changed the t letter for Q, meaning quality, therefore knowing the average m and standard deviation sigma (σ) of a trading system, we can compute its quality Q.

We can look at m as the signal of our system

And σ / √N as the nose of the system.

Therefore, to maximize Q, we need to make m large and the denominator σ / √N as small as possible.

Qualifying trading systems.
From the Q equation, we can see that the denominator σ / √N is the ratio of the standard deviation and the square root of N, the number of trades. This makes it hard to compare systems with a different number of trades since it will make substantially better the same trade system as the number of samples grows.

SQN
Dr. Van K Tharp came with the idea of capping N the trade number to 100, even when the test is made with a large sample number. This way, we can compute m, the mean with all available data, but cut N to 100 to calculate the Q metric. That formula modification is called SQN, or System Quality Number.

SQN is
Q = m / (σ / √N ) when the sample size N is below 100 and
Q = m / (σ / 10 ) when the sample size N exceeds 100.

The SQN reveals if the system is worth trading. Systems below 1 are hard to trade because it presents a noise figure higher than the signal. That will create lots of doubts on a trader because, on multiple occasions, the system will underperform. An SQN of 1.5 is a very decent system, that can be traded with discipline. Systems beyond 2 are sound. If by chance, you end up with a system with SQN greater than 3, you’re a lucky fellow. Please call and share it with us.

The next release will explain how to make use of the SQN to assess the health of the markets.

Categories
Forex Daily Topic Forex Price-Action Strategies

Friday Trading May Need More Attention

The Forex market is open from Monday to Friday. Since Friday is the last day of the week, traders may need to look after their trade more. To be precise, they may need to close their intraday trades manually. In today’s lesson, we are going to demonstrate an example of this.

This is an H1 chart. The price after being bearish has been trapped within a rectangle. It could make a breakout either side. However, the last candle suggests that the price is bearish biased. It closes within the level of previous swing low. If the price makes a bearish breakout, the sellers may trigger a short entry upon the breakout confirmation. Let us proceed to the next chart.

The price action produces an inside bar. As we know, an inside bar is a relatively weak reversal candle. It may push the price towards the North; however, if a bearish candle breaches the level of support, the sellers may get ready to go short on the pair.

The last candle breaches the level of support. It is not an explicit breakout. Nevertheless, the candle closes below the level. If the next candle closes well below the breakout candle, the sellers may trigger a short entry by setting the Stop Loss above the trend-initiating candle.

Yes, the next candle closes well below the breakout candle. The sellers may trigger a short entry right after the last candle closes. Usually, the take profit level is to be set with a 1:1 risk-reward ratio on the H1 breakout strategy. Do not forget that it is Friday. It is an essential factor to remember while trading in the H1 breakout trading strategy.

The last candle gets us some green pips. It looks good now. Most probably, it is going to get us the reward, which it usually does. We must wait and hold the position.

We have been waiting for long. The price has been on strong consolidation. It is still to travel more to hit the Take Profit. As mentioned, it is Friday. The market is about to close (within 2 hours). Usually, most of the pairs get sluggish before the market closes on Friday. On Monday, many pairs start trading with a gap. There is no point holding H1 breakout positions during the weekend. Thus, we may close the trade manually and be happy with half the profit of our expectations.

Categories
Forex Daily Topic Forex Videos

How To Get An Edge In Forex Using Statistical Thinking – Trade Like A Forex Titan Part 2

Stats Applied To TradIng Part II

In our last episode, we discussed how to qualify turning points as a filter to validate TA signals based on the intrinsic statistical properties of the Normal Distribution.
In this video, we will continue developing ideas to improve the chances of success in Forex and Crypto trading.

Better Fibonacci Retracements and Extensions


Fibonacci retracement is a prevalent indicator to evaluate retracement entry points, and a Fibonacci extension is also a popular method to assess potential target levels. It is based in the golden ratio, coming from the Fibonacci number sequence. As you should know, the Fibonacci sequence starts by 1,1, and the following members come from the addition of the two previous numbers.


As the numbers grow, a Fibonacci number divided by its previous number in the series gives the golden ratio: 1.6180. The reciprocal, a Fibonacci number divided by the next number, provides the other golden ratio: 0.6180. 0.382 comes from the ratio of a Fibo number and the second next. 0.236 is the result of a Fibo number divide by its 3rd next. 0.1459 results from the division of four distanced Fibo numbers, and we could go on forever. To these ratios, trading software adds the 0.5 and 0.75 levels and the complimentary and extensions.

It is hardly useful to have a forecasting tool that tells you the next retracement could end at 14.6%, 23.8%, 38.2%, 50%, 61.8%, 75%, 85%, or 100% of the last top, but with no likelihood associated with each level.


What if we could classify the retracements and assign them the probability of occurrence? Well, we really can. We could keep a record of all the past retracement, organized for the bull and bear movements, and then bin them in chunks of 10 percent and create a histogram and, from there, assign a probability to each bin. Or, we could just take the average and the standard deviation of all retracements for bulls and bears, separated, and use the well known probabilistic profile of the Normal Distribution to assess probabilities.

That would also apply to extensions. By keeping track of every impulsive movement following a retracement, we can typify the behavior of the asset. We could create the average and standard deviation of the last 30-50-100 occurrences and create a statistical profile similar to the retracement case.

In the case of the retracements, we can see that the average plus 1SD would be very high probability entry points since only 16% of the cases the retracement went further down.
In the case of extensions, the average minus one SD would be a sweet spot for the first take profit level, being the second the average and the third the average plus one SD.

Stop Settings

Until now, we have discussed entry and exit points taken from a statistically minded perspective. What about setting stops in the same way instead of the obvious levels everybody notices, including institutional traders?

Setting stop levels can be rather straightforward if we know the distribution of the prices. If the entry point takes place at the average +1SD retracement level, the average plus 2SD is a good stop level, as the likelihood of the retracement to reach it would be just 5%.
We could, even, keep track of the history of stops, using John Sweeney’s Maximum Adverse Excursion concept. To summarize it, The MAE method is a stop-loss setting system that tries to place the stops at the historical optimal level based on past trades.

The method tracks the price paths during positive trades to see the maximum adverse excursion taken by the trades before moving in our favor. That way, we could detect the level beyond which there is a high probability that the trade will not be profitable. That is the optimal level for the stop-loss.

For more on Stop settings, please read:

Maximum Adverse Excursion

The Case for Average True Range-based Stop-loss Settings

Masteting Stop-Loss setting: How about using Kase Dev-Stops?

Categories
Forex Daily Topic Forex Price-Action Strategies

The Trend on the Daily Chart Means a Lot

Most of the Forex trading platforms have charts from 1M to Month. It is a debatable issue to determine the best chart among them. All these charts have merits as well as demerits. However, the Daily Chart plays an important role as far as determining the trend is concerned in the Forex market. In today’s lesson, we are going to demonstrate an example of how long term trend on the daily chart may help us guess the price’s next direction.

This is a daily chart. The price after being very bearish gets choppy. A bullish breakout may make the price go towards the North. On the other hand, a bearish breakout keeps the price being bearish. It could go either way. However, the long-term trend on this chart is bearish biased. Moreover, the last candle comes out as a bearish engulfing candle. Thus, the pair may get bearish again. Let us flip over to the H4 chart and find out how it looks.

The chart shows that the price has been bearish on the H4 chart. However, the price finds its support at the same level, where it had a bounce earlier. If we consider only the H4 chart, the price may get bullish. Do not forget that the daily chart’s long-term trend is bearish. Let us proceed to the next H4 chart.

The last candle comes out as a bearish engulfing candle closing below the level of support. It may get tough to guess what happens here. Have a look at the same chart with two horizontal lines to make things simpler.

The price produces that bearish engulfing candle after a bullish corrective candle. The Stop Loss level is explicit, so it is entry-level. The sellers may trigger a short entry right after the last candle closes. Since there is no support nearby, the sellers may hold their entry until it produces a bullish reversal candle.

The short entry goes well — the price heads towards the South with good bearish momentum. The last candle comes out as a bullish engulfing candle. It is a strong bullish reversal candle. It is time for the sellers to close the entry.

As mentioned, the price in such a case can make a bullish breakout too. Traders must look for long entries then. However, in such price action on the daily chart, we may concentrate more on the chart when it produces a reversal candle in favor of the long-term trend. This is how we give ourselves more chances of getting an entry.

 

Categories
Forex Daily Topic Forex Videos

The Basics Of Statistical Analysis In Forex Part 3 – Predicting The Future

Why you should Know The Normal Distribution

What is a Distribution

A Distribution comes from our need to measure and qualify objects or items when the potential number of elements is too large to evaluate one by one. It is hardly practical to have a record of all the heights, weights, races, clothes, and shoe sizes of every person. It is impossible to have a record of all possible stock or Forex pairs prices. Of course, we already have a historical record, but we cannot have a record of future prices. But we want and need information about these and other items.

Wouldn’t it be great to have valuable collective information about the properties of the data collection instead of an endless list of prices, heights, or weights?

Histograms

Let’s imagine that we are to record daily price changes from the current open to the previous day open. We could see that some days the price seldom moves while others there are larger and larger movements. Lets only plot ten possible ranges five on the positive side and five on the negative side, from zero to ±0.21, ± 0.2% – ±0.4%, and on toll ±0.8% -±1%. All changes bigger than 1% will be included in the ±0.8% – ±1% range.

We have made a histogram of price changes. It is a very coarse approach to prices, but it shows useful information. We see that it is more common small changes than large changes, for instance.
We could refine it using more bins. This is how it looks using 40 bins.

Using fewer bins, we can perceive the same distribution than using more bins. We lose information, but if we chose the bin distribution appropriately binning is quite convenient.

The Normal Distribution

Karl Friedrick Gauss was thought to discover the Normal Distribution, also called Gaussian Distribution, although 100 years earlier was described by Abraham d Moivre. Still, his discovery remained obscured until after Gauss published it. It is considered the most useful distribution in modeling due to the fact that many phenomena follow the Normal Distribution. Measures of height, weight, intelligence levels closely follow the normal distribution. Also, the Normal Distribution is the limiting form of other distribution types.

The Central Limit Theorem

One of the key statistical applications involving the Gaussian Distribution has to do with how the averages distribute. That is, if we take several random samples of a collection of data, the averages of the samples will approximate to a Normal Distribution, regardless of the distribution of the original data. This is very powerful because it allows us to generalize about future prices from the averages computed using samples of historical data.

Properties of the Normal Distribution

The Mean (M)
The most obvious measure of the Normal Distribution is its Average or Mean.
M = SUM ( All elements ) / N (the number of elements)
The mean tells us the most common value of the distribution. If the distribution were about prices, it would tell us the fair value of the asset.
The Standard Deviation (SD)
The other significative measure of the Normal Distribution is the Standard Deviation. Computing it is a bit more complicated than the average, but it is rather easy as well.
The standard deviation tells us how far from the center, on average, are its elements.

1.- We measure the distance of every individual component (dxi) from the mean
dxi = M – xi

2.- Since the differences may be positive or negative, we square this value to take away the sign, creating a collection of squared differences.
dxi2 = dxi^2

3.- We take the average of the squared differences. The result is called the variance (Var).

Var = SUM( dxi2)/ (N-1)

Wait? Why N-1? Well, that has to do with the fact we are dealing with samples, not the whole population. By dividing by N-1 will make the value less optimistic on short samples. As the sample size grows, the Sample Variance gets closer and closer to the population variance.

4.- We take the square root of the sample variance, and the result is the Standard Deviation

SD = √ Var

Normal Probabilities


 Normal distribution probabilities

Now that we have our data (prices, trade returns, and so forth), we can use the normal distribution to extract useful information.
If the distribution, for instance, were the returns of our strategy, we would arrive at two main values: The average profit and the standard Deviation of the profits. What can that tell us about what to expect from our future returns?
The Normal Distribution is well known, so we have how values are statistically distributed.
We know that 68.2% of the values lie within one SD from the mean, 95.4% of the values lie within 2SD, and 99.7% of them within 3SD.
Let’s say as an exercise that your mean gain is 100 dollars with an SD of 60. What can we expect from our future profits?

We can anticipate that
  • 64% of the time, our returns will lie between 40 and 160 dollars,
  • 13.6% of the time will be between -20 and +40 dollars,
  • 13.6% between 150 and 210 dollars.
  • 2.1% of the time your strategy will lose from 20 to 80 dollars
    but also,
  • 2.1% of the time, you will get from 210 to 270 dollars.

As a caveat, Usually, the distribution of gains and losses is not normally distributed. Therefore we should not expect the percentages shown here. As homework, google about the Chevyshev’s inequality for a more general probability scaling.

Categories
Forex Daily Topic Forex Price-Action Strategies

Don’t Only Rely on Your Initial Assumption, Dig into It

In today’s article, we are going to demonstrate an example of an entry, which is derived from the daily-H4 chart combination. It is a typical entry once we flip over to the H4 chart. Before flipping over to the H4 chart, there is a good lesson, which may help us in the future. Let us get started.

This is a daily chart. It shows that the price, after having a bounce, heads towards the upside. It finds its resistance and produces a bearish marubozu candle. The combination of the last two candles is also known as track rail. It is a strong bearish signal. Usually, the daily-H4 combination traders may want to flip over to the H4 chart to hunt an entry. However, the level of support seems too adjacent to offer a short entry. In naked eyes, the daily chart shows that there is very little space for the price to travel towards the South. Is it? Let us flip over to the H4 chart and reveal the truth.

This is the H4 chart. It shows that the price is on consolidation, searching for its resistance already. The level of support is far enough to offer some handful of pips to the sellers.

The chart produces a bearish engulfing candle closing below the last swing low. The sellers may trigger a short entry right after the candle closes. Let us not just guess it. Let us measure it by drawing two horizontal lines.

These two lines determine the stop loss and entry-level. The drawn support is far enough to offer excellent risk-reward. If you are not sure, measure it with the tool on the trading platform. The risk-reward is 1:1.5 here. Let us now find out the result.

The price heads towards the level of support and produces a bullish reversal candle as well. The sellers have grabbed some green pips. The consolidation, the signal candle, and the risk-reward are perfect here. Do you remember how it begins, though? The daily chart does not look that appealing at the very outset despite producing an excellent daily bearish reversal candle. In naked eyes, it looks bad. However, once we have flipped over to the H4 chart, it is a different story. It looks very appealing, and in the end, it offers an excellent entry. In the beginning, do not just skip a chart by its outlook. Dig into it. The habit of digging may get you more entries.

Categories
Forex Daily Topic Forex Videos

The Basics Of Statistical Analysis In Forex Part 1 – Understand Your Edge

The Basics Of Statistical Analysis In Forex Part 1 – Understand Your Edge

Anyone interested in Forex trading needs a basic knowledge of statistics, and even the basic rules governing probabilistic calculation. Do not quiver yet. We promise you that this will be simple and entertaining, at the same time.

But why do we need all this?
A possible answer can be found in our latest video article “Why Knowing your Strategy parameters makes sense.” But, ultimately, because if you are serious about your profession as a trader, this is one essential ability to hold.

Basic terms we need to know

Probability: this area of math study involves predicting the likelihood of various outcomes. For instance, the possibility of your next trade is a winner. This mathematical area is a modern development of what early on was the mathematics of gambling. Probability theory is also related to the theory of errors, of which Pierre-Simon Laplace was the first to propose back in 1774 analytical formulas about the frequency of errors.


Statistics: We can define statistics as a collection of facts belonging to a collection of events, objects, or, more generally, a set. There are two kinds of statistics: Descriptive statistics try to describe a set in such a useful way. We can, for instance, describe a typical Englishman by its average height, weight, number of hours of sleep, the average income, the average number of males, and so on. Another type of statistics is “Inferential statistics” or statistical inference. Sometimes, it is not practical (or impossible) to measure all items produced by a process, such as on trading. Therefore, we take a sample of the whole data collection, and through it, try to infer general properties or forecast or approximate its future events.

 


Chance: We refer to chance if we know the event is uncertain to occur. Of course, if we see the event will always happen, for instance, the sunrise, the chance is 100 percent sure to occur. In trading, we use it in connection with the probability of a trade to be a winner or a loser. Generally, we refer to the chance of occurrence when we lack the specific knowledge for an event to happen. Still, we might infer its probability based on the previous events statistics.


Stochastic: When the chance is involved, the process is called stochastic or having stochastic relations. Stochastic is the opposite of deterministic. Newton’s Laws are deterministic. There is no element of chance involved. But practical measurements of objects following these laws involve some elements of chance since instruments have intrinsic errors and people measuring it also err.

Random: Random is an event that cannot be predicted. For instance, Nobody can predict the future price of an asset. Not even the price it will have the next mintute. A random sample is when every member of the set or collection has an equal probability of being chosen for the sample set. If some elements are more likely to appear then others, then this particular sample is not random. In trading, a random market is unpredictable. Is the noise of the price. Nobody can profit in a random market long term. But, sometimes, the market is a mix of randomness and bias or trend. In that case, traders who caught the trend can be profitable.

Categories
Forex Daily Topic Forex Videos

How To Succeed In Forex – Why Knowing your Strategy parameters makes sense

 

Why Knowing your Strategy parameters makes sense

Usually, traders’ interest focus on entries. Forecasting seems to them a crucial skill for succeeding in the Forex market, and they think other topics are secondary or even irrelevant. They are deadly wrong. Entries are no more than 10 percent of the success of a trader, while risk management and position sizing are crucial elements that the majority of traders discard as uninteresting. Let us show why risk can be such an exciting topic for people willing to improve in their trading job.

Making sure our strategy is a winner

There are two ways to trade The good one and the bad one. The good one is when the trader fully knows the main parameters of his system or strategy. The bad one is when not.
So, why do we need to know the parameters to be successful? The short answer is that it is
Firstly, to know if the system has an edge (profitable long-term).

Secondly, by knowing the parameters, we will know how much we can risk on each trade.
And thirdly, and no less important, by identifying these parameters, we can more easily define the monetary objectives and overall risk (drawdown).


Good, let’s begin!

The two main parameters of a strategy or system!

To fully identify a strategy, we need just two parameters. The rest of them can be derived from these two with or without the position size. The parameters in question are the percent of winning trades and the Reward-to-risk ratio.
Mathematical Expectancy (ME)
With these two parameters, we can estimate if the system is a winner or a loser using the following simple formula, defining the player’s edge: ME = (1 + A)*P -1

Where P is the probability of winning and A is the amount won. The formula assumes that A is constant since this formula came from gambling. Still, we can very much approximate the results is A is our average winning amount, or even better, the Reward-to Risk Ratio.


As an example let’s assume our system shows 45% winners with a winning amount two times its risk
ME = (1+2)*0.45 -1
ME = 0.35
The mathematical Expectancy (ME) expressed that way, shows the expected return on each trade per dollar risked. In this case, it is 35 cents per dollar risked.

Planning for the monetary objectives
Once we know ME, it is easy to know the daily and weekly returns of the strategy. To do it, another figure we should know, of course, the frequency of trades of the strategy. Let’s assume the strategy is used intraday on four major pairs delivering one trade per pair per day. That means, the system’s daily return (DR) will be 4XME dollars per day per dollar risked, while monthly returns (MR) will be that amount times 20 trading days:

DR = 4 x ME = 4 x 0.35 = 1.4
MR = 20xDR = 20 x 1.4 = 28

Therefore, a trader risking $100 per trade would get $2,800 monthly on average.
That is great! By defining our monthly objectives, once knowing ME and the number of trades the system delivers daily or monthly, we can determine the risk incurred. For example, another bolder trader would like to triple that amount by tripling the risk on each trade. Why not a ten-fold or a hundred-fold risk to aim for 280K monthly income?


Drawdown

That touches the dark side of trading, which is drawdown. Drawdowns are the result of the combination of the probability of losing of the trading system and the amount lost. Drawdowns are unavoidable because a system always shows losing streaks. Therefore, any trader must make sure that streak does not burn his trading account.

The risk of ruin increases as the trade size grows, so there is a rational limit to the size we should trade if we want to keep safe our hard-earned money.
As a basic method to be on the safe side, a trader must first decide how much of his account is willing to accept as drawdown, and from there, use as trade size a percent of the total balance which satisfies that condition of maximum drawdown.

Let’s do an example

Let’s say a trader using the previous strategy will not accept to lose more than 25 percent of his funds. As an approximation to this drawdown, we can think of a losing streak of 10 consecutive trades, an event with 0.35% probability of happening. Which is the trade size suitable to comply with these premises?
Trade Size = MaxDD% / 10
Trade Size = 25% / 10 = 2.5%
That gives us the reasonable trade size for this particular trader. If another trader is not willing to risk more than 10%, then his trade size should be 1%. Once this quantity is known, the trader only has to compute the dollar value by multiplying by the current balance.

Resetting the objectives

Let’s assume the balance is $5,000, then the max risk per trade allowed is $ 125. That means we could expect a monthly return of about $3,500 on the previously discussed strategy for a max drawdown of no more than 25%. If the trader would like to earn $7,000 instead, he should add another $5,000 to the account to guarantee a 25% drawdown or accept a 50% drawdown and risking $250.

Final words

Please, note that this is just an example and that sometimes the trade size is limited by the allowed leverage and other conditions. Also, note that trading the Forex market is risky. Therefore, please start slow. It is better to begin by risking 0.5% and see how your strategy develops and the drawdowns involved.

The first measure you must take is creating a spread-sheet annotating all your trades, including entry, exit, profit/loss, and risk per trade. Then compute your strategy parameters on a weekly basis. This is a serious business, and we should be making our due diligence and keep track of the evolution of our trade system or systems.

Categories
Forex Daily Topic Forex Price-Action Strategies

Significant Levels Must be Counted

Price action traders are to take entry and exit by determining support and resistance on the naked chart. Significant highs and lows are considered to draw support and resistance, which help traders find out stop loss, take profit as well as risk-reward. In today’s article, we are going to demonstrate an example of a level holding the price as support, where the price had a rejection earlier. Let us find out how we are to deal with such levels.

This is the daily chart. The price heads towards the North with good bullish momentum. Look at the last candle. It is a strong bearish candle with a long solid bearish body. The daily-H4 chart combination traders may want to flip over to the H4 chart to find short entries.

This is how the H4 chart looks. The price has been bearish. The last candle comes out as an inside bar. If the price consolidates and produces a bearish candle breaching the lowest low, the sellers may go short on the pair. The question is, where do they set their take profit level? Look at the red line, which is drawn right at the point where the price had a rejection earlier. The level of support is further down, but the red-lined level is a significant level, which the sellers must consider before making any selling decision on this chart.

The price produces a bearish engulfing candle breaching the lowest low. It means that the price has found its resistance. The sellers may draw two lines here to identify their stop loss and entry point.

This is how it looks with two drawn lines. The live above is the stop loss level. The price breaches the line and closes below it. Thus, the sellers may trigger a short entry right after the candle closes. Let us proceed to the next chart to find out how the trade goes.

The price heads towards the South with good bearish momentum. Look at the last candle, which comes out as an inside bar. It produces right at the flipped support. This is where the price had a strong rejection earlier. The sellers shall set the take profit right here. Some traders may take out partial profit and use trailing stop loss by making sure that they do not lose even a single penny. Both have pros and cons. However, the matter of fact is they must count such level before making any trading decision. It helps them determine the take profit level, risk-reward, and trade with more winning chances.

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Forex Daily Topic Forex Price-Action Strategies

An Entry Derived From an Unusual Consolidation

Price action traders love to see the price consolidates and makes a breakout towards the trend direction. Consolidation offers better risk-reward as well as a better chance of winning a trade. In today’s lesson, we are going to demonstrate an example of a consolidation, which is rather unusual. Let us proceed.

This is a daily chart. The chart shows that the price produces a bullish engulfing candle at a flipped level of support. The daily-H4 chart combination traders may flip over to the H4 chart for the price to consolidate and a bullish breakout to go long on the pair. Let us flip over to the H4 chart.

The H4 chart shows that the price heads towards the North by producing bullish candles consecutively. The buyers shall wait for the price to find its support, consolidates, and makes a bullish breakout. Let us proceed to the next chart.

The chart produces another candle, which has a bullish body. In naked eyes, it is a bullish candle, but it is not. It is an Inside bar, which closes within the level of resistance. Let us have a look at the next chart.

The next candle has a little bullish body as well. Many traders may think that the price is still with the bull. Do not get trapped here. The candle closes within the level of resistance again. The price has not found its support yet. However, it has been on a tricky consolidation.

Look at the last candle, which closes above the level of resistance. The price bounces at the level where the first candle (Inside Bar) bounced. Since a bullish engulfing candle breaks the level of resistance, technically traders may trigger a long entry right after the candle closes. Let us proceed to the next chart to find out how the trade goes.

The price keeps heading towards the North for two more candles. As it seems, it may go towards the North further. An unusual consolidation and an explicit breakout seem to work wonderfully well for the buyers here. We usually see that price consolidates by producing bearish candles on a bullish market and vice versa. In this example, we have seen that the price may consolidate by producing inside bars as well. An Inside bar/s may confuse us. It may make us think the price is not on consolidation. Now we know consolidation sometimes may look different. However, it works as well as usual consolidation.

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Forex Daily Topic Forex Price-Action Strategies

Need the patience to Manage Trade by Taking Partial Profit

Partial profit taking is a handy feature that Forex traders often use. Since the Forex market is very volatile, traders take out a portion of profit and let the rest of the trade run to get them more pips. Traders need to have patience, though, if they want to manage the trade by taking a partial profit. In today’s lesson, we are going to demonstrate an example of partial profit-taking and find out the importance of having patience.

This is a daily chart. The price produces a bullish harami right at the level where it bounces earlier. The daily-H4 combination traders are to flip over to the H4 chart to find out long opportunities. Let us flip over to the H4 chart.

The H4 chart looks fantastic for the buyers. The first candle comes out as a bullish engulfing candle followed by another bullish one. The price consolidates and produces a bullish reversal candle as well. The buyers are to wait for an H4 breakout at the resistance to trigger a long entry.

The price comes down to find its support and heads towards the North to make the breakout. Look at the breakout candle, which is a good-looking bullish candle with long lower shadow. The buyers have been waiting for this. It is time to trigger a long entry.

The price keeps heading towards the North after triggering the entry. The last candle comes out as a strong bullish candle, so the buyers let their trade to go along. Let us proceed to the next chart.

The chart produces a bearish reversal candle. The price may go up to the black marked level. It means that the price has enough space to travel and offer a handful of pips. The price may make a bearish move from here as well. What do the buyers do here? They may take out a portion of the profit. They may take out a 50% profit and leave the stop loss where it is. It will allow them grabbing more pips if it keeps going towards the North. If it does not, they will not lose a dime.

The price gets caught within a bullish rectangle. Do not forget that it has been a long time that the buyers were sticking with their trade. They have been very patient. The price still does not make an upside breakout. It might go either way. Let us proceed to the next chart.

At last, it makes a breakout at the first rectangle. It consolidates again with several candles and makes another bullish breakout. Eventually, it hits the level. Traders have grabbed more pips by taking a partial profit. However, we must not miss the part that they are to be extremely patient. Taking a partial profit may help us be more consistent in making a profit, but we now know what we have to put in to do it accordingly.

 

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Forex Daily Topic Forex Price-Action Strategies

Do not Mix up, Stick with the Rules

In today’s lesson, we are going to demonstrate an example of an H4 chart offering an entry. The daily-H4 chart combination traders are to keep an eye on the daily chart first. Once the daily chart produces a daily reversal candle from the support/resistance zone, they are to flip over to the H4 chart to take an entry. Today, we are going to do it in another way for a reason. We are going to start monitoring from the H4 chart. Let us start. Soon you will know why I am doing it so.

This is the H4 chart, and the red-marked level is daily support. It shows that the price is at the level of support. The last candle comes out as a bearish candle with a long lower shadow. It suggests that the level may produce a bullish reversal soon.

As expected, the chart produces a bullish engulfing candle right at the level of support. A bullish engulfing candle at a support zone has a strong message to send to the buyers that it is their territory.

The price goes towards the North for one more candle. It then has a correction and produces another bullish engulfing candle closing above the resistance. This is an ideal sequence for the price action traders to take a long entry. Let us assume that we do not trigger an entry here and have a look at the next chart.

The price keeps heading towards the North. It means that we have missed an opportunity to make some green pips here. Everything seems perfect, but why we skip taking the entry. Is it a mistake? Is not it? No, it is not a mistake. We shall not take the entry as far as the daily-H4 chart combination chart is concerned. We have started monitoring the chart from the H4 chart today. The daily-H4 chart combination traders are to monitor from the daily chart. Let us have a look at the Daily chart how it looks before flipping over to the first H4 chart here.

You see that the last daily candle comes out as a bearish one. It closes within a level, which has the potential to hold the price as a level of support. However, it has not produced a bullish reversal candle yet. Thus, they shall not flip over to the H4 chart. This is the reason that the daily-H4 chart combination traders may not take the above entry. The H4-H1 chart combination traders may not get an entry here as well since the level of support is not H4 support. The price does not react to the level on the H4 chart in recent times.  It moves towards the North by obeying other trading methods but not according to the price action chart combination trading.

We must be disciplined and must not mix up one strategy with others but stick with the rules. Sticking with the rules is one of the most important factors to be consistent in trading.

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Forex Daily Topic Forex Price-Action Strategies

Consolidation and Breakout: The Two Key Movements in Price Action Trading

Price action trading mainly relies on consolidation, trend, and breakout. Reversal candle is another feature that traders keep an eye at. Typically, double top/bottom, morning star/evening star, and engulfing candle are considered the strongest reversal signal. However, even an inside bar may create an excellent bullish/bearish momentum if the price consolidates and makes a perfect breakout. In today’s lesson, we are going to demonstrate an example of this.

We are looking at an H4 chart. It shows that the price heads towards the North with extreme bullish momentum. A bearish inside bar followed by another bearish candle makes a reversal. The price after being bearish may have found its support. The buyers are to wait for the price to make a bullish breakout at the level of resistance. The sellers are to wait for consolidation and a bearish breakout at the level of support.

The price starts having a correction. If it keeps going towards the North further, it may get choppy. If it finds its resistance nearby, the sellers may find an opportunity to go short on the pair.

The chart produces a bearish engulfing candle. It means the price finds its resistance. If it makes an H1 breakout at the level of support, the sellers may want to trigger a short entry. Let us now have a look at the same chart with those two levels.

The equation gets much simpler with those two levels. Since this is an H4 chart, the sellers are to flip over to the H1 chart to get a breakout and trigger a short entry. The reversal candle looks strong enough to make the sellers keep an eye on the pair to take a short entry upon a breakout.

This is how the H1 chart looks. The price seems to have found two levels of support here. However, the H4 chart looks very bearish, which may keep driving the price to make a breakout at the level of red marked support.

Here comes the breakout. The candle closes well below the level of support. It has a long lower shadow, but it has a thick bearish body as well. The sellers may trigger a short entry right after the candle closes by setting stop loss above the resistance. Take profit may be set at the last swing low on the H4 chart. Let us proceed to the next chart to find out how the entry goes.

The price heads towards the South with good bearish momentum. It makes another bearish breakout at the last swing low as well. Concisely, the sellers grab some green pips from the entry.

If we concentrate on the first candle of the trend, we see that the candle is a bearish inside bar. An inside bar is considered the weakest reversal signal. However, it produces an excellent short signal here because of perfect consolidation and the breakout. The above example signifies the importance of consolidation and breakout in price action trading.

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Candlestick patterns Forex Daily Topic

Candlestick Trading Patterns V – The Long Black-bodied Candlestick

In the previous article, We talked about candles with long and white bodies and discovered how such a candle could provide us with very useful information about the hidden properties of the market situation and the psychology of its participants.

Actually, a black body in a currency pair is equivalent to a white body in the reciprocal pair. That is, the black body of the EUR/USD is the white body of the USD/EUR. In any case, in Forex, we can also operate with commodities, energy, or stock CFDs, therefore in this article, we will develop the properties and informative potential offered by the long-black candle bodies.

As we said in the article on long-white candles, the market can be described by two types of movement: impulsive movement and corrective movement. Large black-bodied candles (like the long-white candles) belong to the impulsive movement category, and as such, are indicators of a trend, in this case, a bearish one.

A black body in a topping area

As in the case of the white candle, a long black candle in a topping zone is a clear warning of the trend halt. For the warning to be stronger, the black candle must clearly be longer than the candles that preceded it. A black candle of this kind indicates that the bears have taken control.

Image 1 – The long black-bodied candle appearing after an uptrend.

In the previous image, we can see that the black body erased the gains acquired by the preceding five candlesticks showing a rush of close orders. Then, after the initial selloff, a short recovery but buyers were not able to move the price to new highs.

A long Black-bodied candle confirms resistance

If a top consolidation area appears, and, then, a black body shows up, it is an extra confirmation that the resistance area will hold, and the trend is reversing.

Image 2 – The long black-bodied candle appearing at a resistance level

On the picture above, the price topped and retraced, followed by a recovery touching but not exceeding the previous top close. Then the engulfing black body started up at the same level, but it created an exceedingly large body surpassing the previous retracement low and closing near it. That was the confirmation for bears to push the market down.

The Long Black-bodied candle breaks a support

The break of a support level by a long black candlestick is terrible news for bulls. This situation should be considered more bearish than other less evident breakouts.

Image 3 – The long black-bodied candle breaking support trendline and SMA 50-SMA

In the case of the preceding image, which corresponds to a 2H Euro Stoxx 50 chart, the large-bodied candle not only broke the ascending trend line but, also, the 50-Period SMA. This confirmation is what bears needed to move down the price.

Long Black-bodied Candle as Resistance

The top and open of a long black-bodied candle will act as resistance levels. That situation happens when the price retraces the complete impulse. According to Mr. Nison, it is more typical the retracement to stop near 50% of the candle’s body. In consequence, a typical strategy following the trend is to place a sell-short position at that level with a stop-loss level over the top of the candle.

 

Image 4 – The top of a black-bodied candle as a resistance

Conclusions

A large black body is a clear indication of a bear trend, especially if it appears at previous tops or resistance areas. We should always pay attention to a black body and analyze the implications of it in terms of market sentiment, and also its meaning as a new resistance area. Finally, from the point of view of a price-action trader, large black bodies are an opportunity to open a position with the trend, after waiting for a pullback. Not always the pullback will happen, but when it does, it is a low-risk place to create a short entry.

 

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Forex Daily Topic Point and Figure

Point & Figure: Profit Target and Stop-loss Settings Made Simple

Something new traders struggle with is trying to find appropriate profit targets and stop targets. Point & Figure charts make a process that is a struggle into something that is very, very easy. Two methods can be used to identify profit targets on a Point & Figure chart: Vertical Method and Horizontal Method. I am only going to show you the Vertical Method because the entire series I’ve done here has strictly been on the use of 3-box reversal Point & Figure charts.

The Horizontal Method can be found in Jeremy Du Plessis’s work. The Horizontal Method is more applicable to the most traditional form of Point & Figure – the 1-box reversal chart. There’s a formula for calculating the profit target on Point & Figure. Don’t get freaked about the word formula – the process is very simple.

Long Profit Target
Long Profit Target

Buy/Long Profit Target = (number of Xs in prior column * box size) * (reversal amount) + lowest O of the current O column.

Short Profit Target
Short Profit Target

Short Profit Target = (Number of Os in prior column * box size) * (reversal amount) – highest X of the current X column.

 

Stops

Regarding stops, I always stick with the reversal amount – so my risk is always, no matter the trade, 3-boxes worth. On my standard 20-pip box size Point & Figure charts, 60 pips are my max loss on any trade. Some authors suggest putting the stop one box below (or above) the reversal amount, but I’ve always stuck with the reversal amount being my stop.

The Blind Entry Trading System

I want to tell you something that might be a little mind-boggling. I’ve been teaching Point & Figure to another class this year, and we’ve focused on live testing the ‘blind entry’ trading strategy in Point & Figure – which is nothing more than taking every single multiple-top or multiple-bottom break without any other filter. We focused on the following pairs:

GBPUSD, AUDUSD, USDCAD, USDJPY, GBPJPY, EURGBP, EURUSD, and AUDJPY.

We did not use any profit targets. We exited trades only when the reversal column appeared. So our losses were always limited to just 60 pips on a 20-pip/3-box reversal Point & Figure chart. We traded from March 1st, 2019 through December 7th, 2019. The results below detail the net pips at the end of our trading period:

GBPUSD = +1,060 pips

AUDUSD = -60 pips

USDCAD = +200 pips

UDSJPY = +1060 pips

GBPJPY = + 2,620 pips

EURGBP = +480 pips

EURUSD = -280 pips

AUDJPY = +1,200 pips

Net Total pips = +6,280 (the average for the class was +5443 pips).

To put that into perspective, with a 0.1 (10,000 unit) Lot size, that’s a net $6,280.00. A full Lot would have equaled a net $62,800. I had one woman who traded an odd 3.33 Lots as her standard position size (I guess it is not that odd if you think about it). She led the pack with her real net pip count at +6,880 – with a 3.33 lot size that meant she made a net $229,104. I was and remain very envious of her performance – she should probably be teaching!


Sources:

Dorsey, T. J. (2013). Point and figure charting: the essential application for forecasting and tracking market prices (4th ed.). Hoboken, NJ: John Wiley & Sons.

Kirkpatrick II, C. D., & Dahlquist, J.R. (2016). Technical Analysis: The Complete Resource for Financial Market Technicians (Third). Old Tappan, NJ: Pearson.

Plessis, J.J. (2012). Definitive Guide to Point and Figure – a comprehensive guide to the theory (2nd ed.). Great Britain: Harriman House Publishing.

DeVilliers, V., & Taylor, O. (2008). Point and figure charting. London: Financial Times/Prentice Hall.

Categories
Forex Daily Topic Forex Price-Action Strategies

Daily-H4 Combination – Rather Mechanical than Emotional

 

In today’s article, we are going to demonstrate an example of a daily chart, which after having a bounce at Double Bottom support heads towards the North. However, the question is whether the daily-H4 chart combination traders find an entry or not. Let us find this out.

The chart shows that the price has had several bounces at the level of support. Without any doubt, it is a strong level of support, in which buyers would love to keep an eye on the price action around this level. A bullish reversal candle around this level, like the last one, would make them flip over to the H4 chart to go long upon breakout. We are not flipping over to the H4 chart right now. You find out the reason in a minute.

The price on the H4 chart may have consolidated but never made any breakout on the following day. The candle is called Bearish Harami. Usually, it attracts buyers. However, the daily resistance is not too far, so the buyers may not be interested in buying the pair on the daily chart.

As expected, intraday sellers pushed the price down. Then, a bullish engulfing candle forms right at the level of support. The daily-H4 combination traders are to flip over to the H4 chart. Let us flip over to the H4 chart and find out how it looks.

The chart looks bullish, but the momentum is not there. The level of resistance is far enough, which suggests that there are still some pips for the buyers to grab. The buyers are to wait for consolidation and an upside breakout to go long on the pair.

The next candle comes out as a bullish candle too. The price has covered some distance. This means the price is offering less number of pips. However, if it consolidates from right there, the buyers would still be offered a good risk-reward. Let us proceed to the next chart.

The price keeps heading towards the North. It does not offer an entry. Moreover, it even makes a breakout at the level of resistance. This means the level of support has been working with command. Matter of regret, the daily-H4 chart combination traders have not been able to take an entry in such a strong bullish market.

When things go like this, it annoys us. This is obvious. After all, we are the human being, not a machine. The thing is we often have to deal with things like a machine in the Forex market. It is hard and needs someone to be mentally strong. Whatever it is, we must work towards it.

 

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Forex Daily Topic Point and Figure

Point & Figure Charts: Introduction

Point & Figure Charts

If the only chart style you have ever been familiar with is Japanese candlesticks or American bar charts, then no doubt Point & Figure charts will look very foreign. They have the appearance of random and new while also being very organized and very old looking. Point and Figure charts are the earliest known forms of technical charting that we know of, and many civilizations have generated some Point and Figure charts out necessity. Another concept that may be difficult to grasp if you are new to price action only chart styles is that Point and Figure charts are an intraday charting style, but is void of any time component. Live data is necessary when using Point and Figure charts. The fact that Point and Figure is an intraday chart style will confound most people who are familiar with charts that utilize the component of time, like Japanese candlesticks. Most of you who are learning about Point and Figure charts will assume that Point and Figure is a long term chart form. It is tough to create the mindset that time is not a factor in Point and Figure. But let’s get to the chart.

 

Point & Figure Chart Basics – Box Size and Reversal Amount

Point & Figure charts are represented by a Box Size and a Reversal Amount. Boxes are represented as Xs and Os. The trader or analyst determines the Box Size. Depending on the market you are trading and the Reversal Amount, the Box Size will vary from one market and instrument to the next. I will provide a table with the box sizes I use in my trading at the end of this article. On a Point & Figure chart, Xs and Os represent price direction. Xs, often colored green, represent price moving up. Os, usually colored red, represent price moving down.

The trader or analyst also defines the Reversal Amount. Historically, Point & Figure charts were 1-box Reversal charts. Today, 3-box reversal charts are the most common. There is no limit on the number of boxes required for a reversal. I only use 3-box reversal charts – they perform exceptionally well in Forex markets. The Reversal Amount dictates how many boxes price needs to move to print a new column of Xs or Os. Let’s look at the Box Size and Reversal Amount on the chart below.Box Size & Reversal Amount

Box Size & Reversal Amount

Pair Box Size (in pips) Pair Box Size (in pips)
AUDCAD 20 GBPAUD 40
AUDCHF 20 GBPCAD 40
AUDJPY 20 GBPCHF 20
AUDUSD 10 GBPJPY 20
CADJPY 20 GBPNZD 40
CHFJPY 20 GBPUSD 20
EURAUD 40 NZDCAD 20
EURCAD 20 NZDJPY 20
EURCHF 20 NZDUSD 20
EURGBP 20 USDCAD 20
EURJPY 20 USDJPY 20
EURNZD 40 USDCHF 20
EURUSD 20

 

How much time does it take for a column to change from X to O?

Your transition to a price action only chart from a Japanese candlestick chart is going to continually be hampered by continuing to think that ‘time’ has someplace on a Point & Figure chart. You will look at a chart and say to yourself, ‘Well, that column of Xs has been there for a while, it can’t move anymore, it will probably reverse.’ While the concept of time is not used, some pieces of software will allow you to imprint the month on the chart where the month’s number will appear at the price level it was trading at when the month started. This can give those who are transitioning to Point & Figure as a new chart style some ‘grasp’ of time. See below.

Months on Boxes
Months on Boxes

Some traders may find having the month displayed as a benefit. Is it useful? I think so. It does at least give a sort of perspective of time and how long something has remained in a single column or how many reversals have been printed on the screen. Additionally, cycle analysis teaches that we often see some of the highest probabilities of trend changes or corrective moves occurring at the start of a new month. If we observe a new month starting near an extreme high or low, we could be looking at an imminent reversal with at least a high probability short term trade option.

 

Trend Lines and Patterns

Another concept that people new to a price action only chart style might find difficult to understand is that P&F charts are always in a bear or bull market. And depending on the time frames you trade on a Japanese candlestick chart, Point & Figure charts may change bull and bear trends frequently or infrequently. Two types of trendlines can be drawn on a Point & Figure chart:

  1. Objective (requires only one point to draw).
  2. Subjective (requires two or more to draw).
Trendlines
Trendlines

Objective Trend Lines or Dominant Angles are also called 45-degree angles. Dominant angles only require one point to be drawn, and they are always drawn from O to X or X to O (in 3-box reversal charts) – and always to the column right next to eachother. The software I am using for these articles is called Optuma by Market Analyst. In Optuma’s software, they auto-draw some of the dominant trend lines. Subjective trendlines are drawn the same way you would draw any other trendline on a Japanese candlestick chart. I rarely, if ever, utilize subjective trendlines. In some of the strategies I will go over, the dominant/45-degree trendlines are useful in determining the direction of the trading you should take.

Patterns such as flags and pennants will show up on Point & Figure charts just like you would see on Japanese candlestick charts. The same principles that we would apply in trading continuation patterns like flags and pennants are the same on a Point & Figure chart. There are some stark differences between the breakouts of a pattern on a candlestick chart versus a Point & Figure chart. There is a primary difference between how we treat breakouts of patterns and trendlines on a Point & Figure chart versus a candlestick chart.

 

Most Important Rule To Follow

                There is one primary rule that must be followed when trading on Point & Figure charts.

Only Enter Trades After Multipletops/Multiplebottoms have been broken.

I’ve said that Point & Figure charts are unambiguous. The entry rules in Point & Figure reinforces that statement. When a multiple top appears, the entry is always on the next X above the multiple top. When multiple bottoms appear, the entry is always on the next O below the multiple bottom. See the charts below:

Double Top & Double Bottom
Double Top & Double Bottom
Multiple Tops and Bottoms
Multiple Tops and Bottoms

A question often arises when an X or O breaks a trendline: do you enter a trade when the trendline is broken? It depends. The entry rules of multiple tops and multiple bottoms still apply. Even if the price breaks a trendline, a multiple top or bottom needs to be broken to take an entry. Further discussion into entry rules and entry strategies will be discussed in further articles.

 

Sources:

Dorsey, T. J. (2013). Point and figure charting: the essential application for forecasting and tracking market prices (4th ed.). Hoboken, NJ: John Wiley & Sons.

Kirkpatrick II, C. D., & Dahlquist, J.R. (2016). Technical Analysis: The Complete Resource for Financial Market Technicians (Third). Old Tappan, NJ: Pearson.

Plessis, J.J. (2012). Definitive Guide to Point and Figure – a comprehensive guide to the theory (2nd ed.). Great Britain: Harriman House Publishing.

DeVilliers, V., & Taylor, O. (2008). Point and figure charting. London: Financial Times/Prentice Hall.

Categories
Candlestick patterns Forex Daily Topic

Candlestick Trading Patterns IV – Long White Bodies

There are two kinds of price movements in the markets: Impulsive movements and corrective movements. The ideal impulsive action is characterized by a continuous rise or decline from the opening level to the closing one, this being the highest or lowest point of the period. The ideal corrective movement is described by a lateral movement in a short-range and close opening and closing levels.

Most trading candles can be separated into those two moves. When impulsive movement prevails, the candle shows a large body, and only visible traces of the corrective action are perceived as upper and lower wicks. Corrective-motion candles have a short body and relatively long wicks at one or both ends.

A white and large-bodied candle body is indicative of a bullish impulse, whereas a black and large-bodied one shows a bearish or selling impulse. Therefore, when one of these appears at a critical level showing the opposite direction to the prevailing trend, we have to take notice of it.

Long White Candle at a low price level

A single candlestick Is mostly not enough for a proper forecast. However, a large candlestick at the end of a severe drawdown is a warning sign that the trend might have ended. If the candlestick shows its low, touching resistance levels, that is a second clue for a reversal, and also serves as a confirmation of the support level.  A white candlestick bouncing off a trendline gives credibility to that line.

 

In the above chart, we see the retracement of the price touch the trendline and then bounce with a white candle, that might have served as a good entry point to trade long. Further up, we see that the price still obeys the line in the second retracement, in this case, with a candle with a large lower wick.

Long White body breaking resistance

A Long white-bodied candle breaking resistance levels are usually a good confirmation of that fact. As we see in the chart below, the price crossed the resistance level decisively and never looked back. This is the kind of confirmation for a bullish continuation traders need.

Long White Body as Support

A long white body sometimes is retraced to test the bulls. But, on the occasions, the price retraces all the previous candle’s advance, its body bottom acts as a support level to hold the price and maintain the trend alive. It is more common that a Fibonacci level of the candle’s retracement would stop the pullback. According to Mr. Nison, the middle of the candle body is a usual support zone.

Once the underlying trend is established, a suitable method to enter the trend is to buy at 50% retracement, with a stop-loss below the white body. That way, the risk of entry is halved while profiting from mild retracements.

Takeaway

A single white-bodied candlestick can depict great information value to a savvy trader. This impulsive candle warns about potential trend changes, confirms breakouts when breaking resistance levels, and acts as support during retracement periods, thus, also showing potential levels to jump in and profit from the newly discovered trend.

Categories
Forex Daily Topic Forex Price-Action Strategies

An Old Theory about Support/Resistance

Support and Resistance are the two extremely important components in financial trading. Price action traders rely on them as a critical component of their trading strategies.

Ideally, 90% of the indicators are able to reveal support and resistance levels. An ancient theory of support and resistance says that support becomes resistance and vice versa and interesting point is the theory still works nowadays as well as it did in the past. In today’s lesson, we are going to demonstrate an example of this long-used theory.

In the above figure, the price heads towards the North with good bullish momentum. It pauses at a level of resistance, where the price had a rejection earlier. The equation is simple here. If the price produces a bearish momentum and makes a breakout at the last swing low, the sellers are going to look for short opportunities. In case of an upside breakout, it remains buyers’ territory.

A bullish engulfing candle breaches the resistance. If the price confirms the breakout, the buyers keep dominating here. It seems that the sellers do not have any reasons to be optimistic soon.

The breakout level holds the next candle, as well. This move is a confirmed breakout. However, the buyers are to wait for price consolidation, which gives them a level of support to set stop loss and an upside breakout to trigger an entry.

Oh! No, a bearish Marubozu candle comes back in. All of a sudden, things look a bit different here. The buyers and the sellers both have chances. Let us find out what the price does next.

The price confirms the bearish breakout with an Inside Bar. Look at the last candle on the chart – a bearish engulfing candle forms at the resistance zone. The sellers may flip over to the H1 chart to take a short entry since it is an H4 chart.

The price takes some time to get bearish. It may have been consolidating on the H1 chart for several hours. However, it does get bearish in the end — the price heads towards the South with extreme bearish momentum. The last candle comes out as a Doji candle, which may make some sellers think about taking an exit. However, the way it has been heading towards the downside, most likely it may go towards the last swing low.

The Bottom Line

There are so many strategies, indicators, EAs in the market. It would be tough to suggest if you ask me which one works best. Then again, if I am asked to choose just one strategy, my choice would be “Sell at flipped over resistance; buy at flipped support.”

Categories
Candlestick patterns Forex Daily Topic

Candlestick Trading Patterns III – The Doji, The Most Critical Candle

The Doji

The Doji is a special candle, not only because of its striking appearance but also because it is one of the most vital signals in trading. This figure is so important that we need to understand it very well, as it is one of the safest trading signals when properly applied.

Fig 1 – A Doji on a chart

The Doji is characterized by having the open and close at the same level while standing out for its elongated upper and lower shadows. The figure of the Doji has a precise meaning. Buyers and sellers are in a state of mental indecision. The Doji is a powerful sign of trend change. The probability of a turn increases if in addition to the Doji:

  1. The next candles confirm the Doji’s signal
  2. The market is overextended
  3. The chart does not have many Doji.

The perfect Doji has the same open and close values. Nevertheless, if both levels are separated a few pips, and the candle can still be seen as a single line, it can be considered as Doji.

The Doji is a powerful signal to detect market tops. Steve Nison says that a dog is a sign of indecision by buyers, and an upward trend cannot be sustained by undecided traders. Nison also points out that, from his experience, the Doji loses some reversal potential during downtrends. That observation may apply to the stock market but is useless in pairs trading, as they are symmetric. In this case, a bullish trend of a pair is a bearish pare on the inverse pair and vice-versa. So a Doji will always have a similar meaning: The trend is compromised.  When trading commodities, indices, or stock ETFs the trader should take this into account, though.

In view that a Doji is such a powerful signal, it is better to act upon it. Better to attend a false signal than ignore a real one. Therefore, dojis are signals to close positions, since a Doji alone does not mean a price reversal.

The Northern Doji

The northern Doji is called a Doji that shows up during a rally. According to Mr. Nisson, ” The Japanese say that with a Doji after a tall white candle, or a Doji in an overbought environment, that the market is “tired.” Therefore, as said, a Doji does not mean immediate market reversal. It shows the trend is vulnerable.

 

FIg 2 – Down Jones Industrial Average showing northern Doji.

As we can see in the chart above, a Doji after a large candle, as in the first case, is followed by a gap and a drop to the base of a previous candle that surged after a gap.  The next Doji we see was an inside bar that just acted as a retracement and continuation. In the third case, we can see two Dojis, the second being a kind of hanging man with no head. In this case, we notice that the third bearish candle is the right confirmation of the trend reversal. It is not uncommon to observe tops depicting several small bodies, one of which is a Doji.

The Long-legged Doji

Fig 3 – Long-legged Doji in a SPY Daily chart.

We already know that a small body and long upper and lower shadows is called a high wave candle. If the figure doesn’t have a body is called “long-legged Doji,” and also called “rickshaw man.” As it happens with high-wave candles, it reflects great confusion and indecision.

Gravestone Doji

The gravestone Doji is the Doji that begins and ends at the low of the day. According to Stephen Bigalow, the Japanese name is set to represent “those who died in the battle.” Gravestone Dojis are a rarity.

Fig 4 – Long-legged Doji in the UK-100 Daily chart.

 

Dragonfly Doji

The Dragonfly Doji occurs when the price moves down since the open, and then it comes back and closes at the open. When it happens after an uptrend is a variant of a hanging man.

Fig 5 – Long-legged Doji in the DAX-30 Daily chart.

Conclusions

Dojis are important figures that warn trend reversals, especially if it happens at support or resistance levels.

Dojis need confirmation for trend reversals. When that happens, they create morning star and evening star formations. They also are followed by other small bodies, creating a flat top or bottom.

A safe precaution when encountering these figures while a trade is active is to close or reduce the position or, alternatively, tight the stops.

 


Sources:

Japanese Candlestick Charting Techniques, Second Edition, Steve Nison

Stephen Bigalow, Profitable Candlestick Signals

 

Categories
Forex Chart Basics Forex Daily Topic

Caution! A Big Round Number Ahead

In today’s lesson, we are going to demonstrate an event to find out what the price may do around the big round number. A big round number plays a significant role as far as traders’ psychology is concerned. The price usually gets volatile around a big round number. It may get tough for the traders to find out entries around the big round number. Let us now dig into USDCHF recent activities around the big round number 1.00000.

The price is heading towards the North with good bullish momentum. Look at the last candle. This is one good bullish candle, which states that the buyers are dominating the pair. Do you notice anything unusual here?

Here it is. The candle breaches through the level of 1.00000. As a trader, you must not miss such a big round number. Now that the price makes a breakout, you are to wait for the breakout confirmation and a strong bullish reversal candle to go long on the pair. This might be one of the best trades in your trading life if things go accordingly.

The price comes back in. However, it still looks all right for the buyers since if we consider the spikes at the last swing high. A bullish engulfing candle closing above the last bearish candle would be the buying signal. On the other hand, if it keeps going towards the downside, the sellers may take over the baton.

The price does not produce any bullish momentum. For the last four H4 candles, it could go either way. Traders are to wait patiently since this is the game around a massive round number.

Here it comes. It has now become sellers’ territory. The candle forms right at the level of 1.00000. The level could have been a level of support. It is now a level of resistance. The sellers on the minor charts keep going short; on this chart, they are to wait for consolidation and downside breakout to ride on the next bearish wave.

It consolidates and produces a sell signal after four H4 candles. The last H4 candle suggests it may be time for the price to consolidate again. An explicit bullish breakout at the level of 1.00000, did not work for the buyers. It could happen at any level, but when we deal with a massive round number, we happen to see it more often.

The Bottom Line

The market runs on many aspects, and traders’ psychology is one of them. Many traders set their Stop Loss and Take Profit at round numbers. Thus, the price may get extra volatility around a big round number. We may get breakout even on the H4 chart, which may turn out to be a fake breakout. We must remember this every time we see a big round number.

 

Categories
Candlestick patterns Forex Daily Topic

Test your knowledge about Candlesticks

After our discussion about short-bodied candlestick in our article

Candlestick Trading Patterns II – Everything you need to know about Single Candlestick Signals

Here you can test your newly acquired knowledge about the matter. If you haven’t read it, please do so before the quiz.

 

 

[wp_quiz id=”51631″]

 

 


Reference: The Candlestick Course – Steve Nison

Categories
Forex Daily Topic Forex Elliott Wave

Analysis and Trading with Triangles

In our previous article, we discussed how we could simplify the zigzag and flat pattern by the chartist figure known as a flag. In this educational article, we will see how triangles can be used in wave analysis.

The Background

Within the Elliott wave theory, triangles represent one of the three basic corrective formations. Similarly, in traditional technical analysis, triangles represent consolidation and continuation formations of the trend.

Elliott defined triangles as a formation that have an internal structure subdivided into five waves following a 3-3-3-3-3 sequence. At its time, Elliott identified two triangle variations, which are classified as expansive or contractive.

In general terms, triangles represent the market indecision or the balance between the buying and selling forces.

The following chart shows the model of the triangles in their contractive and expansive variants, under the Elliott Waves theory and Traditional Technical Analysis perspective.

According to the point of view of the traditional technical analysis, we can observe that the triangle pattern is not forced to have five internal segments, as in Elliott’s wave theory. In consequence, a truncated zigzag or truncated flat structure could be simplified by a triangle pattern.

The Trading Setup

The trade configuration of a contracting triangle pattern has the following characteristics:

  • Entry Level: A buying (or selling) position will be activated if the price exceeds and closes above the swing of the previous top.
  • Profit Target: The first profit target level will take place at 78.6% of the Fibonacci expansion, while the second will be at 100%, and finally, the third profit target level will be at 127.2%.
  • Protective Stop: The invalidation level of the trade setup will be located below the lowest swing of the triangle pattern.

The trade configuration of an expansive triangle pattern has the following properties:

  • Entry Level: The trade will be activated if the price exceeds the height of the expanding triangle.
  • Profit Target: The first profit target level will be at 100% of the Fibonacci expansion. The second profit target level will be at 127.2%.
  • Protective Stop: The level of invalidation will be located below the lowest low of the expansive triangle pattern.

Examples

The following chart corresponds to the AUDUSD pair in its 12-hour timeframe. We can observe that the price action developed an expanding triangle formation, which began from mid-May 2019 and culminated in mid-July 2019.

From the chart, we detect that the expanding triangle reached its highest level at 0.70821, which corresponded to a false breakout. Subsequently, the price action resolved the next movement with a drop that took it to plunge until 0.66771.

The sell-side entry was activated once the price closed below the lowest level of the expanding triangle at 0.68317. Once activated the sales position, the price reached the first target at 0.67080.

Another possibility of entry that could be considered would be the closing below the last relevant swing, that is, the closing below 0.69105. This option could provide the trader with a higher profit compared to the risk taken compared to the original entry setup.

The next example corresponds to Silver in its daily chart. From the figure, we observe that the price made a record high early July 2016, reaching $21,225 per ounce, after this, the price action performed a corrective movement, once its found support, Silver built a tight contractive triangle.

After breaking below $18,715, Silver activated a bearish scenario that drove the price to fall to the third bearish target at $15.66 per ounce.

After having fulfilled the third bearish target, the price fell and reached $18.435 on April 17, 2017, where Silver began to build a contractive triangular structure that lasted until the end of June 2018.

Once the downward break of the long-lasting triangle occurred, we see that the price made a limited downward movement, which did not yield below $14 per ounce.

Conclusion

Based on the discussion of this article, we can conclude that regardless of the corrective structures that have three or five internal waves, these can be simplified as triangular patterns. Also, we can observe that a corrective wave or a short-range narrow triangle is likely to have an extended move that, in terms of Elliott’s wave theory, could correspond to an extended wave.

On the other hand, extensive triangular formations, or of a wide range, could lead the price to move in a range not as broad as in the previous case.

Finally, in the last example, we recognize how the alternation principle works in Elliott’s wave theory. Just as the first observed triangle is simple, and has a short duration, and the second corrective formation is extensive and complex.

Categories
Candlestick patterns Forex Daily Topic

Candlestick Trading Patterns II – Everything you need to know about Single Candlestick Signals

This article is to be dedicated to single candlestick key figures. The majority of patterns are created by more than one candle, but some particular candlestick shapes are key figures to gauge the market sentiment and spot reversals.

In every one of them we will deal with the following aspects:

  • Identification of the candlestick
  • Marker psychology interpretation
  • Criteria and use

Key Single Candlestick Figures:

  • Doji
  • Spinning top
  • High Wave Candlestick
  • Hammer
  • Hanging man
  • Shooting star

The Japanese traders call the real body “the essence of the price action.” A scientist might call it the Signal part of the message, while the shadows are the nose of the market. The relation between the body and the shadows delivers unique insights into the sentiment of the traders. Shadows show the fight between buyers and sellers to control the price. A large body and small shadows denote that one of the sides has won the battle during that interval. A short body with large shadows after an extended trend indicates the winning herd is losing steam.

Spinning tops and high wave candles

Fig 1 – Spinning tops and High Wave candles

A spinning top is a visual clue for a candle with a tiny body. The color of the body does not matter.  A spinning top without a body is called Doji, such as the second one in the figure above. The fourth one is very close to it too.

Market sentiment in spinning tops

A the smaller the body, the larger the fight between bulls and bears. It shows that no one had control of the price during this period, as the sellers pressure the price down and buyers up, a small body means no one could outweigh the other party. The demand is counteracted by fresh supply,  and vice-versa, so the market is unable to move.

High Wave Candles

Steve Nison also mentions a close relative to the spinning top, called High Wave Candle. High Wave candles also have very small bodies, but to qualify as High Wave, the formation must also have large shadows on both sides. Shadows need not be of the same size, but they must be large.

Market sentiment in a High Wave Candle

According to Mr. Nison, If indecision is the crucial sentiment on spinning tops, High Wave candles represent “downright confusion.” That is evident because, in the same period, the market goes from the euphory of an extended high to the fear of a large drop, and then to close very near to its opening value. That means total confusion.

Trends and spinning tops

A large white body is like a green light for bulls in an uptrend. A large red body is also a green light to sell. But finding a spinning top in an uptrend means that the buyers do not have the complete control of the price. Therefore, such tops are a warning sign that the trend might be ending. Spinning tops acquire more importance when the price is overextended or close to resistance levels.

Spinning tops during ranging markets do not have any power to warn a trend change, as these stages are too noisy, and filled with lots of small bodies, anyway. Therefore, spinning tops and high waves during horizontal channels have no trading value.

Hammers, Hanging Man, and Shooting stars

Three special cases of spinning tops are the Hammer, the Hanging Man, and the Shooting Star.

Hammer

Fig 2 – Hammer

The hammer has a small real body and a large lower shadow. It is the equivalent of a reversal bar.  The price went from the open to the bottom, then it recovered and closed near or at the high of the session. The color of the body has less importance, although a close above the open has more upside implications. The signal is confirmed with a followthrough candle next to it.

Criteria:
  • The occurrence is after a lengthy downward movement, and the price is overextended.
  • The real body is at the upper top of the trading range
  • The shadow must be two times the length of the body. The longer, the better.
  • No upper or just a tiny shadow
  • Confirmation with a strong bullish candle, next
  • A large volume on the candle confirms a bottom.

 

Hanging Man

Fig 3 – Hanging Man

The hanging man has a similar shape of the hammer, but it shows up after an uptrend. The Japanese named that way because it is similar to the head and body of a man hanging by the neck.

Criteria:
  • The occurrence is after a significant upward move, and/or the price overextended.
  • The body is at the upper end of the trading range.
  • The lower shadow at least two times the height of the body. The color is not essential, but a bearish finish is preferred. the longer the shadow, the better
  • Tiny or no upper shadow.
  • Confirmation with a large bearish candle
  • High volume on the candlestick is indicative of a potential blowoff.
Shooting star

Fig 4 – Shooting Star

The shooting star is a top reversal candlestick and is the specular image to the hanging man.  In the case of a shooting star, it began great for buyers, but after the euphory of new highs, it came to the deception of the selling pressure with no demand to hold the price.  The close happens at the lower side of the trading range. A bear candle next confirms the trend change.

Criteria:
  • The upper shadow should be two times the height of the body. The larger, the better.
  • The real body is at the bottom of the trading range.
  • Color is less important, although a  red candle implies more bearishness.
  • Almost no lower shadow.
  • A large volume would give more credibility to the signal.
  • A  bear candle next is the confirmation of the change in the trend.

 


Reference: Steve Nison: The Candlestick Course

Profitable Candlestick Trading, Stephen Bigalow

 

 

Categories
Forex Basics Forex Daily Topic

A Breakout Brings More Momentum than any Other Trading Factor

A Breakout Brings More Momentum than any Other Trading Factor

A bearish engulfing candle at a Double Top or consolidation resistance is an excellent signal to go short. However, if a bearish engulfing candle closes right within the support level, it sometimes may create an upside momentum on the minor charts. In today’s article, we are going to demonstrate an example of that.

The price heads towards the North with strong bullish momentum. Ideally, traders are to look for opportunities to go long here upon consolidation, followed by upside breakout. The last candle comes out as a bearish candle. It may consolidate and make an upside breakout as things look. Let us go to the next chart to find out what happens next.

The pair produces a bearish engulfing candle. Several rejections and a bearish engulfing candle suggest that traders may want to go short on the pair. If they’re going to go short from here, they are to flip over to the H1 chart since it is an H4 chart. For a reason, I am not showing the H1 chart since the H4 chart itself tells the story that I want to share. Let us look at the H4 chart with another equation.

The candle closes right at a level where the price has bounced earlier. This is an explicit support level, which may play an essential part in the minor charts. Soon we find out how the pair reacts from here.

Look at the last candle. The candle comes out as a bearish engulfing candle. However, look at the upper shadow. It goes up to the consolidation resistance. With some brokers, because of the high spread factor, some traders’ Stop Loss may be swept away. The last candle, after having a strong rejection at around the resistance level, closes below the support. The sellers are to flip over to the H1 chart, wait for consolidation and bearish breakout to go short on the pair.

Again, I am presenting the H4 chart to show the next price movement.

The price does not look back this time. It heads towards the South with strong bearish momentum. The H1 chart may have offered some entries, as well. What lesson do we get from these examples?

  1. In an H4-H1 combination, after an H4 reversal candle, traders are to flip over to the H1 chart to take an entry.
  2. The last swing high or swing low on the H4 chart is to be counted.
  3. If the reversal candle closes right within the last swing high or swing low, it may push the price towards another direction, produce spike and sweep away our Stop Losses.
Categories
Candlestick patterns Forex Daily Topic

Candlestick Trading Patterns I – The Story

The Financial markets are an exciting place for many people, attracted by dreams of infinite wealth. However, these markets are one of the most complicated environments on earth. The fact that millions of people exchange assets in financial markets makes them very difficult to predict, as each of the participants has its own vision, interests, and objectives.
That is why traders are always investigating the best tools to allow them to detect market sentiment in every situation.

Fundamental versus Technical

In the past, fundamental analysis was the only tool that allowed investors to detect whether a value was overvalued or undervalued. That gave them the keys to future trends, and to be able to overtake other investors with less information.
Then, at some point, the theory arises that the analysis of price history shows everything necessary for an informed investment. According to this theory, launched by Charles Dow, the price is already included in the fundamental analysis, since the chart is the trace left by investors about the consensus value of the good.

That said, there is a consensus that fundamental analysis is still necessary to detect the macro trend and to position the buying and selling actions in favor of the primary trend, while technical analysis is essential to generate the timing of trading activities.

Fig 1- Old NY Stock Exchange price table and Average chart. Source (https://pix-media.priceonomics-media.com/blog/1230/image04.png)

Chartism was encouraged in the early 1970s and 1980s by the emergence of personal computers, which allowed graphs to be automatically generated, instead of manually drawn, and also analyzed in time frames shorter than the daily.

The OHLC Chart

The technical analysis popularized the use of OHLC graphs that not only indicated the closing value of each interval but also gave the opening, maximum, and minimum data. This allowed chartists to observe the range of movements of the period and obtain an assessment of the volatility.

Fig 2- OHLC Chart in its classical B&W style.

The use of OHLC charts was a big advancement in the analysis of the price action. Soon analysts began to define profitable patterns such as reversal bar, key reversal bar, Doble and triple tops and bottoms, head and shoulders pattern round bottoms, Cup and handle, and many more.

Candlestick Charts

A centuries-old hidden way to analyze the markets came from Japan helped by Steve Nison’s studies of candlestick charting methods. According to him, centuries back, Japanese merchants were at the bottom of Japan’s social scale, well below soldiers, artisans, and farmers. But a prominent merchant began rising in status by the XVIIth century. His name was Munehisa Homma. At that time rice was a medium of exchange. Feudal Lords would store it in Osaka’s warehouses to, then, exchange the receipts when it was convenient for them, thus, becoming a de-facto futures market. Homa’s trading techniques, which included analysis through a primitive form of candlestick charts to gauge the psychology of the marker would earn him an immense fortune.

Fig 3- Candlestick Chart in its modern colorful style.

The major advantage of a candlestick chart over an OHLC chart is the ability to assess at a glance the overall trend and, also many hints about the current sentiment or psychological mood of the trader collective. Color is key to assess the current trend. Also, large bodies signify genuine momentum, short bodies and large wicks mean indecision and fight between buyers and sellers to control the price action.

Candlestick Patterns

Many of the western analysis methods can be applied also to candlestick charts, but these Japanese charts have brought a brand new batch of new patterns to assess market turns and continuations.  We will try to cover most of them, including obviously all major trading candlestick patterns such as Morning and evening stars, haramis, engulfing, three soldiers, and so on.

To refresh your basic knowledge of candlesticks, we recommend the following articles:

https://www.forex.academy/all-you-need-to-be-introduced-to-trading-charts-part-1-line-bar-and-candlestick-charts/

https://www.forex.academy/facts-about-candlesticks-you-never-knew/

https://www.forex.academy/dissection-of-candlestick/

https://www.forex.academy/candlestick-charts-and-its-advantages-in-financial-trading/

 

 

Categories
Forex Basic Strategies Forex Daily Topic

A Story of an Early Exit

Risk-Reward is a factor, which every successful trader takes care of. Before choosing a chart to take an entry, the first thing that is to be considered is the trend, then the risk-reward factor. Once we have set our Take Profit and Stop Loss level, we shall leave the entry either to hit the Stop Loss or the Profit Target. However, today, we are going to demonstrate an example of an early exit.

This is an H4 chart. The chart shows that the price has found its support as well as a resistance zone. After having a final rejection, it makes a move towards the downside. Then, it heads towards the North now (see the next image). Another rejection and bearish reversal candle at the resistance zone may produce a short entry.

The last H4 candle is bullish. However, the candle closes within the resistance zone. It may go either way. The buyers may get an upside breakout; the sellers may get a bearish reversal. Let us proceed to find out what happens next.

In the above chart, we can see one good-looking bearish Marubozu candle. The candle suggests that the sellers may wait for consolidation and downside breakout to take a short entry. The candle forms at a Double Top resistance as well. The price may consolidate around the neckline level.

As expected, the price starts having correction around the neckline level. It needs to find its resistance and produce an H4 bearish reversal candle along with a breakout at the neckline.

Here it comes. The last candle engulfs all the candles by closing below the neckline. An entry may be triggered right after the candle closes. The price has enough space to travel down to the red-marked line, which allows an excellent risk-reward. However, there is a support level in between, that may hold the price for a while.

The price heads towards that level with good bearish momentum. The way it has been going, it may hit the red-marked level within four/five H4 candles. This means one more trading day may be required to hit the original Take-Profit level.

The in-between level is a vital level, which produces the H4 bullish reversal candle. The price has reacted several times at that level earlier. Usually, we must stick with our original Profit-taking target. However, it is also legit to close our entry right after the last candle closes. A question may be raised “why do we close our entry here?”

Reasons for Early Exit

There are two reasons

  1. The support level is significantly strong
  2. The current bar is the last H4 Friday’s candle, which means the market closes once the candle is finished.

The Bottom Line

When using the Weekly and the Daily charts, traders are to let their opened positions to reach the target during the weekend. However, intraday traders should consider closing their floating trade before the week’s end. Mondays often start with a big gap, which may hurt intraday Stop Losses.

 

Categories
Forex Daily Topic Forex Stop-loss & argets

Masteting Stop-Loss setting: How about using Kase Dev-Stops?

The stop-loss setting is a crucial component to the long-term success of a forex and crypto trader. The market forces cannot be adapted to the wishes of traders. Successful traders must accept that fact instead of fighting it for the sake of being right. “What cannot be cannot be, and, furthermore, it is impossible,” said some time ago, a well-known politician in a phrase that did not pretend to be comical. But it states a clear fact: Fight against the markets is like Don Quixote fighting Windmills.

In previous articles, we explained John Sweeney’s MAE method, and also average true range-based stop-loss settings. In this article, we are going to talk about Cynthia Kase’s Dev-Stops.

Cynthia Kase is a well-known and successful futures trader, speaker, and author of several books on trading and technical analysis. She conceded high importance to stop settings. Cynthia says something undeniable to most of us, Technical literature has mostly focused on entries, and almost nothing on entries besides some words on stop-loss or trailing stops. She says that this is like teaching how to drive a car but without explaining where the brake pedal and how to press it.

In her book “Trading with the Odds,” she explains that this situation is mostly due to greed and fear. Traders don’t like to lose, and most of them don’t know when to get out of a trade. Also, she explains that fear of losing causes people to hang on their losses in the hope the market will turn and recover them. Another explanation for this situation is that the beginning of technical analysis was on the stock market, and no company wants its stock downgraded from buy to hold or, worse, to sell. As opposed to Forex, only a handful of people make money shorting stocks, so exits are much less critical on the stock market.

Stops based on fear and greed

Most traders want to squeeze out the most of a trade. Therefore, they decided to use the highest possible leverage. To reduce the dollar risk, they desire to put it as close as possible to the entry-level. But, as said earlier, using obvious levels of support/resistance and set the stop order just two or three pips below is absurd. Better send your money directly to the charity, since they will make much better use of it than the institution that is going to collect your hard-earned money for free.

Risk is imposed by the market

The critical point is not to impose our conditions on the market, but read what the market is telling us in terms of Risk. In trading, Risk is proportional to volatility. Your dollar risk is the amount the price can move against you in a given interval, times your position size.

Volatility is measured using the Range and also by the standard deviation of prices on an annualized basis. One standard deviation of the price holds 68$ of all the potential price movement if we assume prices are dispersed in a gaussian distribution. That means that a price that goes against a trade by one standard deviation it will encompass 34% of the observations (the other 34% would go in the direction of your trade). The problem with using volatility is that a yearly measurement of the price variations does not help with sudden short-term volatility changes. That’s the reason for using ATR instead.

The concept of the threshold of Uncertainty

A trade is a bet on a market trend. We think a particular trend is in place. Ideally, the direction is a straight line between one initial level and a final level. If we think of the short-term price wiggles as random noise, we adapt our trade by placing our stops far enough away from the trend mean to include noise. The magnitude of the noise means we don’t want to exit at the minimum turn against the trade. The trader needs to devise a way to follow the trend while getting out when it ends. 

 The Kase Dev Stops

Using a fixed multiplier for the True Range is an initial approximation. In our article of true range, we used a fixed 2X multiplier to set our stop order away from the market noise. Kase’s Dev Stop uses what she calls the skew of the volatility, the measure at which a range can spike in the opposite direction as a multiplier of the range measure. That makes the Dev-stop an adaptative trailing stop. Dev Stops is a well-known indicator in TradingView. Also, it is available for downloading at the MQL5.com site for your Metatrader workstation. 

Chart 1 – Kase Dev-Stops in a GBPUSD 4H chart.

We can see in Chart 1 that four lines follow the price action. The first one is the mean line and the 1, 2, and 3 standard deviation (SD) lines of a two-bar reversal. As we can see, the 3rd standard deviation is seldom touched, being the 2-SD the conservative method, and the 1-SD the preferred aggressive method. In the case of using 1SD, it is advisable for a reentry plan, or create mental stops that would trigger if the close happens below the 1SD Dev-stop line.

As it should be the norm when learning a new method, it is strongly advisable to backtest it first to assess which SD line works better with your particular asset and objectives. Also, after backtesting your optimal solution, it is prudent to trade it using a demo account. There we could also assess the costs and benefits of the method by adding the brokerage costs.


Reference: Trading with the Odds, Cynthia A. Kase. 1996, The McGraw-Hill Companies Inc.

 

Categories
Forex Basics Forex Daily Topic

A Winner is Not Always a Good Trade

Price action traders use chart combinations such as Weekly-Daily, Daily-H4, H4-H1, and H1-15M, etc. Intraday minor charts’ traders such as the H1, 15M, 5M do not have an undeviating relation with the daily chart. However, it is often seen that if the daily price action is choppy, it gets tough to find out a good entry for the intraday traders. Notably, on a choppy daily chat, it gets extremely tough for the H4 traders to find an entry with good risk-reward. Thus, even a trade that gets us profit may not always be a good one. Let us demonstrate an example of that.

This is a daily chart, which shows that the price action has been choppy. It gets caught within a bullish rectangle. The daily traders are to wait for a breakout. However, the H4 traders know the range. Thus, they are to wait for a daily bearish reversal at the resistance zone and bullish reversal at the support zone. Let us see where it produces the next reversal.

The chart produces an Inverted Hammer right at the resistance. The H4 traders are to flip over the chart; wait for consolidation and bearish breakout to take a short entry. The risk-reward looks good here.

The H4 chart shows the last candle comes out as a bearish candle. If the price consolidates with the support of the candle’s lowest low, a bearish breakout will be the signal to go short.

The next candle comes out as another bearish candle. The candle has a bounce at H4 support, as well. If the price consolidates and makes a bearish breakout, the sellers may take a short entry. There is still space for the price to travel towards the downside.

The price consolidates and makes a breakout at the support. The breakout candle looks good. By setting Stop Loss at the consolidation resistance, a short entry may be triggered right after the last candle closes. Take Profit shall be placed at the red-marked level. Let us find out whether it hits Take Profit.

It does. It gets us profit. The question is whether it is a good trade or not. As far as risk-reward is concerned, it is not a good entry. It gets us less reward than the risk. Thus, traders shall skip taking that entry in the first place.

The Bottom Line

Price action traders may find many trade setups that match with all the norms for taking an entry. However, they must consider risk-reward on every single trade. If it offers less than 1:1 risk-reward, they shall avoid taking that entry. In most cases, an entry offering less than 1:1 risk-reward has less chance to be a winning trade as well. In this example, it is a winner. However, considering entire facts, it is not a good entry.

Categories
Forex Basic Strategies Forex Daily Topic

The Case for Average True Range-based Stop-loss Settings

Most traders are taught to use stop-losses based on critical levels. The basic idea is to spot invalidation levels based on previous low or high. The assumption is that by putting the stop a few pips below or above a support/resistance level will be enough to ensure the right trade will not be stopped out and just bad trades will be taken away.

The problem with that is that all participants in the market, including institutional traders, can see these levels. Institutional traders have lots of cash to play with, so they can push the price down to take all the buy-stop (or sell-stop) orders they see in their price book.

Key-level-based Stops

In the following example, we see the EUR(USD making a breakout after failing to break the previous high, on high volume. A perfect setup for a short trade. We then see the price moving down and then retracing and heading up to our stop-loss. We have been cautious and set it above the last top made on the 6th of November.

Nevertheless, the price kept moving inexorably up until the stop was taken. This is market manipulation at the highest level by institutions. Institutions have advanced tools to observe the depth of the order book, so they know the place and amount of the stops. Also, they have the liquidity necessary to move up the market, take all the liquidity at excellent prices, then continue south.

Chart 1 – EURUSD Key-level-Based Stop-loss placement

 

ATR-Based stops

If we look at the next chart, we see the same asset with the Average True Range indicator added. For this kind of stop-setting strategy, we need to detect the short term range. Therefore, we use a period of five for the ATR indicator. Next, we look at the peak set by the latest impulsive candlestick, which happened ten bars ago, 0.00168, which is about 17 pips. This figure gives us the expected 4-hour price movement for the current market volatility. The usual is to protect us against two times this figure, at least. In this case, we would need to move the stop-loss level 34 pips away from the entry point.

Chart 1 – EURUSD ATR-Based Stop-loss placement

It is wise to keep statistics of the ideal ATR multiplier, because as the number increases, it cuts our position size for the same dollar-risk amount, and also it reduces our Reward-to-risk ratio.

John Sweeney developed the general method of stop-loss placement. He called it the Maximum Adverse Execution method. The theory of it has been already described in our article Maximum Adverse Excursion, so we are not going to repeat ourselves here. Using  MAE delivers statistical-significant and tamper-proof stops, but it is a bit cumbersome. The use of ATR Stops is a simpler and second-best option instead of the foreseeable key-level-based stops.

 

 

Categories
Forex Basics Forex Daily Topic

Attributes of the Signal Candle Not to be Ignored

After choosing a pair to trade, traders wait for the signal candle at the desired zone/level to take an entry. The attributes of the signal candle are important. Ideally, a signal candle is to be a Marubozu candle, barely having an upper or lower shadow, and longer than other candles around. In today’s lesson, we are going to show an example of how attributes of a signal candle affect the market. Let us proceed.

The price after being bearish finds its support. A long consolidation suggests that a breakout towards either side makes the chart lively again. An upside breakout and the confirmation offer good risk-reward considering the last swing high. A downside breakout seems even more rewarding. Let us find out which way the breakout takes place.

It is an upside breakout. The breakout candle looks fantastic. Buyers are to wait for consolidation and breakout at the highest high to go long on the pair. However, buyers shall calculate that the last swing high is not too far away now.

The price continues its bullish journey towards the last swing high, and it consolidates. Flipped support is to be adjusted here considering the Inside bar. However, an upper shadow at the previous swing high holds the price as well up to the Inside bar. The last candle comes out from the zone, though. Look at its attributes

  • It is a bullish engulfing candle
  • It breaches the resistance zone
  • It is a Bullish Marubozu candle

Many of us may trigger an entry here by setting Stop Loss below the lowest low of the candle. Let us find out what happens next.

The price comes down again. It may have swept away many Stop Losses. Thus, the last entry gets the buyers loss. What do you think about the last candle?

  • It is a bullish engulfing candle
  • It breaches the resistance zone
  • It is a Bullish Marubozu candle and
  • It breaches the last swing high

 

Traders may want to trigger an entry here. Let us go to the next chart to see how it goes.

This time it works excellently well. A question may arise here: what the difference is between these two candles?. The only difference that can be observed is, “It breaches the last swing high.”

The Bottom Line

We have demonstrated an example today and learned a lesson. Traders are to be immaculate in making a decision, and they have to calculate every single aspect that is related to the trading decision.

 

Categories
Forex Basics Forex Daily Topic

Using Trailing Stop: An Art to Be Learned by Traders

Using a trailing stop is a way to lock a profit in trading, at least with some profit. A floating profit trade may not always hit its Take-Profit level. Thus, traders use Trailing Stop to lock-in some profits and let it run to hit the target. Otherwise, some trades may result in a loss instead.

In today’s lesson, we are going to demonstrate an example of that.

The price heads towards the North with good bullish momentum. The buyers are to wait for price correction and bullish reversal candle to go long on the pair. Let us proceed to the next chart to find more about the correction.

The correction looks very bearish. However, a flipped support level holds the price. Thus, it is going to be an interesting battle between the bull and the bear. Let us find out who wins. Does it make a downside breakout or a bullish reversal candle?

The chart produces a bullish reversal candle. We can see that this is an Inside Bar, which is the weakest reversal candle. A flipped support creates a bullish reversal candle but does not make any breakout. The buyers are to flip over to the trigger chart to get consolidation and breakout to go long on this. This is the daily chart. Let us flip over to the H4 chart.

The H4 chart looks suitable for the buyers. The level of support produces a bullish engulfing candle. It has started the price correction. An upside breakout from a good level of support is the signal to trigger a long entry.

The price goes upward and consolidates. Upon finding support, the last candle breaches the level of resistance. Setting Stop Loss below the level of support, an entry may be triggered right after the last candle closes. The Take Profit shall be placed at the highest high of the previous bearish wave.

The price continues to go towards the upside for a while. It has started having consolidation. The price has found its support. An upside breakout is to push the price towards the North further. On the other hand, a downside breakout may push the price towards the South and even change the whole equation. Thus, the buyers are to move their Stop Loss. Have a look at the chart below.

The buyers shall move their Stop Loss below the level of support and hope it makes another upside breakout to hit the Take Profit. Let us find out what happens next.

This is what Forex trading is all about. You never know what exactly happens next. The price comes down. It would hit the Stop-Loss, where it was set at the very outset. By using Trailing Stop, the buyers have made some profit. Otherwise, they would have to encounter some loss.

The Bottom Line

Using Trailing Stop is an art. It needs a lot of practice to be master at it. Without knowing how to use it properly, it may hurt a trader instead. Since it is an important trading feature to save us from encountering a loss with a profit trade, a trader must study/work hard on this.

Categories
Forex Daily Topic Forex Psychology

A Strategic Plan for Trade Management

I’ve already stated my view that most wannabe traders put their focus in technical analysis of the market and on trading signals, mostly provided by others, hopefully, more knowledgeable than themselves.

The issue is that any advice, no matter how good it is, is worthless to most of the beginners because the problem is 10% of the success as a trader is entries, 20% exits, including stops and targets, and 70% is the rest of overlooked themes. 

The overlooked themes, all of them has to do with the trader’s psychology:

  • Lack of a strategy
  • Overtrading
  • Not following the plan 
    • Skipping entries or exits
    • let losses grow to wait for a reversal
    • cut profits short, afraid of a reversal…

Every one of these subjects is critical, but if you make me choose, I’d say that overtrading is the worst evil that happens to a novice trader. Improper position sizing kills the majority of the Forex trading accounts. This trait is also linked to the cut profits short, let losses run character flaw, so let’s do create a basic strategic plan to help traders with a basic trade management plan.  

Emotional Risk

For the following plan to work, the trader needs to accept the risk. It is easy to say but challenging to do. Mark Douglas, in his book Trading in the Zone, explains that “To eliminate the emotional risk of trading, you have to neutralize your expectations about what the market will or will not do at any given moment or in any given situation.”

That is key. You cannot control the market. You can only control yourself. You need to think about probabilities. Create a state of mind that is in harmony with the probabilistic environment. According to Mark Douglas, a probabilistic mindset consists of accepting the following truths:

  1.  Anything can occur.
  2. To make money, there is no need to know what will happen next 
  3. It is impossible to be 100% accurate. Therefore there is a win/loss distribution for any strategy with a trading edge.
  4. An edge is just a higher probability of being right against a coin toss (if not, the coin toss would be a better strategy)
  5. Every moment in the market is unique. Therefore
  6. A chart pattern is just a very short-term approximation to a statistical feature, therefore less reliable than a larger data set pattern. We trade reliability for speed.

The idea is to create a relaxed state of mind, ultimately accepting the fact that the market will always be affected by unknown forces.

The Casino Analogy

Once that is understood and accepted, we can approach our trading job as if the trading business were casino bets. When viewed through the perspective of a probabilistic game, we can think that trading is like roulette or slot machines, where you, the trader, have a positive edge. At a micro level, trade by trade, you will encounter wins and loses but looked at a macro level, the edge puts the odds in your favor. Therefore, you know only need to manage the proper risk to optimize the growth of the trading account.

A plan to manage the trade

Lots of traders enter the Forex market with a rich-quick mentality. They open a trading account with less than 5,000 USD and think that due to leverage, they can double it week after week. This is not possible, of course, and they get burned within a month.

Our plan consists of three ideas

  • Profit the most on the winners, while let die the losers
  • let profit run, or even, pyramid on the gains.
  • Reach as soon as possible a break-even condition, for our mind to attain a zero-state as quickly as possible.

The Strategy and Exercise

Pick a forex pair.

Choose one actively traded pair. All major pairs fit this condition, but then choose the one that provides the best liquidity of your time zone.

Choose your favorite strategy, that you think it works and fits you.

The strategy must include the following components:

An Entry: The entry method should be precise. No subjective evaluations or decisions. If the market shows an entry, you have to take it. Of course, you can condition it with a reward-to-risk ratio filter, since this is an objective fact. Really, having a reward-to-risk ratio filter is quite advisable. A 3:1 ratio would be ideal, but 2:1, which is more realistic, can work as well.

A Stop-loss: Your methodology should define the level at which set your stop loss.

Timeframes: You need to choose a couple of timeframes: A short timeframe to create low-risk trades, and a longer timeframe to be aware of the underlying trend and filter out any signal that does not go with that trend.

Profit Targets: This is the tricky part. We will define at least three take profit points: One-third very-short, one-third defined bt the short-term timeframe, and the rest of the position specified using the longer-term timeframe.

The trade size: Choose a total trade size such that the entire initial risk is no more than 2 percent of your account. So if your account is $3,000, the total risk of the trade will be $60.

Accepting the risk. The smaller dataset needed to get any statistical information is 30. Therefore, you should accept the loss equivalent of 30X the average loss per trade. Think that to analyze and decide about changing any parameter, you must move in chunks of 30 trades.

How it works

 1.- Compute the trading size

      • Measure the pip distance between entry and stop-loss.
      • Compute the value in dollars of that risk
      • Calculate how many mini or micro-lots fit in that amount.

2.- Trade that size and mentally divide it into three parts

3.- take profits of1/3 of the position as soon as you get 5-6 pips profit or 10% of your main profit target. This will help you tame the risk if the trade is a short-term gainer that, next, tanks.

4.- As soon as you get a profit equivalent to the size of your risk (1:1), move your stop-loss to Break-even.

5.- Take profits of the second third of the position when your second target is hit

6.- Let the remaining 1/3 run until your third target (from the longer timeframe) trailed by your stop loss. Use a parabolic approach to the stop loss, as the risk-reward diminishes when approaching the target.

7.- Alternatively, use the profits of the last winning trade and add it to the risk of the following trade. That way, on a combination of two trades, you can gain 4X with a risk of just one trade since the added risk was money taken from the market.

8.- The next trade should start with the basic dollar risk, but computed over the newly acquired funds.


Reference: Trading in the Zone by Mark Douglas.

Categories
Forex Basics Forex Daily Topic

The Simpler the Better

Financial traders follow many charts, patterns, and trading strategies. Each one has its own advantages and disadvantages. Nevertheless, there is a saying, ‘the simpler, the better.’ In the financial markets, especially in the Forex market, a trader cannot deny this truth.

Let us demonstrate an example of this.

The price heads down with strong bearish momentum. The sellers are to wait for an upside correction and a breakout at the support to make it more bearish. Let us proceed with what happens next.

The price has an upside correction, but it did not make a breakout at the support. It instead produces a huge bullish engulfing candle at Double Bottom support. Things are different now. Traders are to look for a long opportunity on the chart.

The price is bullish, but it gets caught within an ascending channel. A breakout at either side attracts traders to trade in this chart. The chart shows that the price makes an explicit breakout towards the upside. Ideally, the buyers shall flip over to their trigger chart to find a long entry. Let us find out whether they find any on the next candle.

The price does not make a breakout at the highest high of the breakout candle. Thus, the traders do not find an entry on the triggered chart. However, see the second candle (bullish candle). It makes a breakout (horizontally) at the highest high of those two candles. The buyers are to flip over the trigger chart again to find an entry. Do they see an entry this time? Let us find out.

 

Yes, they do. The price heads towards the North with good bullish momentum, and it does not come down to the support of the breakout candle. By flipping over to the trigger chart for an upside breakout to trigger an entry, a trader makes some green pips.

In this chart, the price makes a breakout at ascending channel’s resistance just a candle earlier. That breakout does not create bullish momentum. However, when it makes a breakout at the horizontal resistance, it creates the momentum that the buyers look for. I am not saying a breakout at ascending channel’s support/resistance does not offer entry at all. It does. A breakout at horizontal support/resistance offers more entries than the channel’s support/resistance breakout. It is because; it is simple and easy to be noticed by most of the traders.

The Bottom Line

Does that mean we stop looking entries on a channel or other pattern breakout? No, we shall eye on those breakouts; flip over to the trigger chart and trigger an entry if the trigger candle makes a new higher high or lower low. It is just the probability that a breakout at horizontal support/resistance offers more than any other chart pattern. After all, it is simple, and we know “the simpler, the better’.

Categories
Forex Basics Forex Daily Topic

Stop Loss: An Art to be Learned Well by Traders

Setting Take Profit and Stop loss in the right areas are essential factors in trading. A trader does not survive in the market by placing Stop Loss and Take Profit at the wrong places. In today’s lesson, we are going to demonstrate an example of an entry with the level of Stop Loss and Take Profit.

This is a daily chart. The price heads towards the North with good bullish momentum. The buyers are to look for long opportunities at the pullback. Let us wait for the price to make a pullback.

The price starts having a downside correction with an Inside Bar. It produces two more candles that are bearish. After that, it forms a Spinning Top right at a flipped support. This is a bullish reversal candle but not a strong one. A breakout at the top of the Spinning Top attracts the minor charts’ buyers to go long on the pair. However, major charts’ traders may want to wait for a stronger daily bullish reversal candle.

The next candle comes out as an Engulfing candle. This reversal candle attracts more traders to look for long opportunities here. Since it has not made an upside breakout, thus, to take an entry, traders shall flip over to the H4 chart.

This is the H4 chart. The price has a rejection at the red marked level on the daily chart. Thus, this is the level where the price may find its resistance on the H4 chart. This shall be the level to count in setting Take Profit. The H4 chart shows that the price starts having a pullback. Things are getting better for the buyers.

Let us draw the resistance. If the price consolidates and makes a breakout at the black marked level, a long entry may be triggered. However, the buyers must wait to get the level of support.

Here it comes. A bullish reversal candle forms at a flipped support followed by a breakout candle. A long entry shall be triggered right after the last candle closes. Stop Loss may be placed right below the support where the price forms the bullish reversal candle. Many traders set their stop loss right below the breakout candle. In my experience, this offers a better risk-reward, but it often brings more losing trades.

Have you noticed that the price came back and then headed towards the North? If we had set our Stop Loss right below the breakout candle, our Stop Loss would have been hit. Rather than making some profit, we would make a loss here.

The Bottom Line

Setting Take Profit is important, but setting Stop Loss is more important. In my opinion, it is an art. It needs a lot of practice to be well acquainted with the art of setting Stop Loss as immaculate as it can get.

Categories
Forex Basics Forex Daily Topic

The Babe Ruth Syndrome

In his book More than you know, Michael J. Mauboussin tells the story of a portfolio manager working in an investment company of roughly twenty additional managers. After assessing the poor performance of the group, the company’s treasurer decided to evaluate each manager’s decision methods. So he measured how many of the assets under each manager outperformed the market, as he thought that a simple dart-throwing choice would produce 50% outperformers. This portfolio manager was in a shocking position because he was one of the best performers of the group while keeping the worst percent of outperforming stocks.

When asked why was such a discrepancy between his excellent results and his bad average of outperformers, he answered with a beautiful lesson in probability: The frequency of correctness does not matter; it is the magnitude of correctness that matters. 

Transposed to the trading profession, The frequency of the winners does not matter. What matters is the reward-to-risk ratio of the winners.

Expected-Value A bull Versus Bear Case.

Since a combination of both parameters will produce our results, how should we evaluate a trade situation?

Mauboussin recalls an anecdote taken from Nassim Taleb’s Fooled by Randomness, where Nassim was asked about his views of the markets. He said there was a 70% chance the market had a slight upward movement in the coming week. Someone noted that he was short on a significant position in S&P futures. That was the opposite of what he was telling was his view of the market. So, Taleb explained his position in the expected-value form:

Market events Probability Magnitude Expected Value
Market moves up 70% 1% 0.700%
Market moves down 30% -10% -3.000%
Total 100% -2.300%

  As we see, the most probable outcome is the market goes up, but the expected value of a long bet is negative, the reason being, their magnitude is asymmetric. 

Now, consider the change in perception about the market if we start trading using this kind of decision methodology. On the one hand, we would start looking at both sides of the market. The trader will use a more objective methodology, taking out most of the personal biases from the trading decision. On the other hand, trading will be more focused on the size of the reward than on the frequency of small ego satisfactions.

The use of a system based on the expected value of a move will have another useful side-effect. The system will be much less dependent on the frequency of success and more focused on the potential rewards for its risk.

We Assign to much value to the frequency of success

Consider the following equity graph:

 

Fig 1 – Game with 90% winners where the player pays 10 dollars on losers and gains 1 dollar on gainers

This is a simulation of a game with 90% winners but with a reward-to-risk ratio of 0.1. Which means a loss wipes the value of ten previous winners.

Then, consider the next equity graph:

Fig 1 – Game with 10% winners where the player pays 1 dollar on losers and gains 10 dollars on gainers

A couple of interesting conclusions from the above graphs. One is that being right is unimportant, and two, that we don’t need to predict to be profitable. What we need is a proper method to assess the odds, and most importantly, define the reward-to-risk situation of the trade, utilizing the Expected Value concept,

By focusing on rewards instead of frequency of gainers, our strategy is protected against a momentary drop in the percent of winners.

The profitability rule

P  > 1 / (1+ R)  [1]

The equation above that tells the minimum percent winners needed for a strategy to be profitable if its average reward-to-risk ratio is R.

Of course, using [1], we could solve the problem of the minimum reward-to-risk ratio R required for a system with percent winners P.

R > (1-P)/P    [2]

We can apply one of these formulas to a spreadsheet and get the following table, which shows the break-even points for reward-to-risk scenarios against the percent winners.

We can see that a high reward-to-risk factor is a terrific way to protect us against a losing streak. The higher the R, the better. Let’s suppose that R = 5xr where r is the risk. Under this scenario, we can be wrong four times for every winner and still be profitable.

Final words

It is tough to keep profitable a low reward-to-risk strategy because it is unlikely to maintain high rates of success over a long period.

If we can create strategies focused on reward-to-risk ratios beyond 2.5, forecasting is not an issue, as it only needs to be right more than 28.6% of the time.

We can build trading systems with Reward ratios as our main parameter, while the rest of them could just be considered improvements.

It is much more sound to build an analysis methodology that weighs both sides of the trade using the Expected value formula.

The real focus of a trader is to search and find low-risk opportunities, with low cost and high reward (showing positive Expected value).

 


Appendix: The Jupyter Notebook of the Game Simulator

%pylab inline
Populating the interactive namespace from numpy and matplotlib
%load_ext Cython
from scipy import stats
import warnings
warnings.filterwarnings("ignore")
The Cython extension is already loaded. To reload it, use:
  %reload_ext Cython
from scipy import stats, integrate
import matplotlib.pyplot as plt
import seaborn as sns
sns.set(color_codes=True)
import numpy as np
%%cython
import numpy as np
from matplotlib import pyplot as plt

# the computation of the account history. We use cython for faster results
# in the case of thousands of histories it matters.
# win: the amount gained per successful result , 
# Loss: the amount lost on failed results
# a game with reward to risk of 2 would result in win = 2, loss=1.
def pathplay(int nn, double win, double loss,double capital=100, double p=0.5):
    cdef double temp = capital
    a = np.random.binomial(1, p, nn)
    cdef int i=0
    rut=[]
    for n in a:
        if temp > capital/4: # definition of ruin as losing 75% of the initial capital.
            if n:
                temp = temp+win
            else:
                temp = temp-loss        
        rut.append(temp)
    return rut
# The main algorithm. 
arr= []
numpaths=1 # Nr of histories
mynn= 1000 # Number of trades/bets
capital = 1000 # Initial capital

# Creating the game path or paths in the case of several histories
for n in range(0,numpaths):
    pat =  pathplay(mynn, win= 1,loss =11, capital= cap, p = 90/100)
    arr.append(pat)

#Code to print the chart
with plt.style.context('seaborn-whitegrid'):
        fig, ax = plt.subplots(1, 1, figsize=(18, 10))
        plt.grid(b = True, which='major', color='0.6', linestyle='-')
        plt.xticks( color='k', size=30)
        plt.yticks( color='k', size=30)
        plt.ylabel('Account Balance ', fontsize=30)
        plt.xlabel('Trades', fontsize=30)
        line, = ax.plot([], [], lw=2)
        for pat in arr:
            plt.plot(range(0,mynn),pat)
        plt.show()

References:

More than you Know, Michael.J. Mauboussin

Fooled by randomness, Nassim. N. Taleb

 

 

Categories
Forex Daily Topic Forex Money Management

Why Compounding is such a Powerful Tool

Novice traders put their focus on how much leverage brokers are offering as a crucial part of their decision process to choose the right brokerage account. But in fact, as we saw in our previous article, Things you should Know about Leverage, Drawdown and Risk , there is no need for leverages above 30X, and in 99% of the cases, leverage is the rope with which traders hang themselves. 

In this article, we will show that compounding is a terrific tool to boost the growth of a trading account.

In our article To Reinvest or Not Reinvest, That is the Question, we discussed the properties needed for a trading system to be suitable for reinvestment strategies. 

Unhappily, 95% of the traders fail. The main reason for failure is discovered in the final section of the article. The article unveils that the growth factor of any investment strategy is called the Geometric Mean (G).

The Geometrical Mean  G = TWR^(1/N)  has two operators.

N the number of trades registered on the system, so it is just a normalization factor to equate all systems no matter how many trades were recorded.

Thus, TWR is the key. TWR means Total Wealth Return and is 

TWR = SUM(1+%Ri) 

where %Ri is the individual percent gains and losses.  

TWR is a product of (1 + the individual gains). If the gain is negative (a loss), this particular factor will decrease the total value of the account by the percent that was lost. If the gain is positive, it will increment it by the percent gained.

As an example, let’s say that 1,000 USD is the initial amount in a trading account, and two trades were performed. One lost 10%, and the other gained 15%. Which is the final TWR of this account, and which is the final balance?

TWR = (1- 0.1)*(1+0.15) = 0.9 *1.15 = 1.035

Final balance = TWR * Initial Capital

Final Balance = 1.035 * 1,000 = 1,035 USD

In this simple example, we clearly see that a system with large losses greatly hurts the growth of the investment.

For instance, if the first loss were 50% then

TWR = (1-0.5) * (1+0.15) = 0.5*1.15 = 0.575

and Final Balance would be =575 USD

Of course, 100% loss would mean the account wiped out and no second chance to make it grow. Therefore, it seems wise to concentrate on steady and continuous gains and cut losses short.   Let’s explore the long-term performance of low-risk position sizing strategies.

It is evident that a loss limit of 1 percent of the trading capital on each trade looks much better than a ten percent loss in our TWR equation.  The issue here is how it performs as generator of growth.

As a first approximation of what we could achieve, let’s look at an equity curve that might seem boring. It is the equity curve of a 26% yearly continuous growth. That was the rate of return Berkshire Hathaway gave his shareholders. 

Fig 1 – 10-year chart of risk-free 26%/year returns 

In this chart, we show ten years of 26% compounding interest. With an initial balance of $10,000, the final capital is $128,173.33 for a capital appreciation of 1,182%. Not a bad feat!

Well, let’s look at what this strategy does in 40 years:

Fig 2 – 40-year chart of a risk-free 26%/year returns 

We can see that in 40 years, this strategy converts $10,000 into 287,818 million dollars and a total growth of 1.88 million percent.

I know, waiting forty years is too much for the instant-satisfaction generation. Maybe we don’t need to wait so long. But before going further, let’s see the properties of this curve. On the 10-year graph, we can see that it takes 400 months to reach $500,000 and just 100 more months to go from 0.5 to almost 3 million. Compounding needs patience and perseverance because its power comes from the accumulation of past gains. 

A Trade sizing system for the faint-hearted

We are going to use a Forex discretionary system that was used live by a friend. Since we don’t have 40 years of history for it, we will extrapolate it with resampling with replacement to simulate its performance. The system will take three daily trades 20 days per month.

To refresh our memory, the following are the relevant statistical data of the system:

STRATEGY STATISTICAL PARAMETERS : 
 Percent winners         : 58.74%
 Profit Factor           : 1.74
 mean Reward Ratio       : 1.22

 Sample Statistics:      
 Mathematical Expectation : 0.0628
 Standard dev            : 0.4090

 Mathematical Expectation using Bootstraping, Samples=100K, confidence limit 99%: 
 Expectation interval   low : -0.01          high : 0.1776

The main parameters are 58% winners and an average reward to risk ratio of 1.22.

The following chart is one year of simulated performance of this system using a 1 percent risk on every trade:

Fig 3 -1-year chart of 1% risk Model Forex System

The figure also shows all the relevant information needed. We see that the system was able to move the initial balance from $10,000 to $13,729.25 for a total profit of 37.29 percent and a max drawdown of just 3.87%. That system beats Berkshire Hathaway Inc, by a fair margin.

Let’s see what it can do in 20 years:

Fig 4 -20-year chart of 1% risk Model Forex System

We can see that this modest system can produce $91.8 million in 20 years with no more than 6.3% drawdown.

We have shown here that there is no need for high leverages and drawdowns to be successful and rich in the long run.  But to show you the power of compounding, let’s show here the 20-year equity curve using a 2 percent risk to observe that drawdowns above 20% are not needed at all and that high leverages are totally unnecessary.

Fig 5 -20-year chart of 2% risk Model Forex System

This system gets the insane amount of $663 billion in 20 years with just a 12% drawdown, and the first 100 million is reached before year 10, starting with only $10,000.

We could go even to 3 percent. I did the numbers, and still, the drawdown is below 20% for insane theoretical profits. Of course, the system would break down well before such amounts could be traded.

The key idea is to show that insane risks are not the way to richness. The way to wealth is compounding with a controlled risk state of mind.

Categories
Forex Daily Topic Forex Money Management

Things you should Know about Leverage, Drawdown and Risk

Novice traders usually prefer to focus on trade ideas and strategies, believing that the path to success is the knowledge about entries and exits. But in a trading environment with leverage, risk management plays a crucial role. This article tries to show why.

Key points

 In trading, There are two key points a trader must care and make sure:

  1.  That his strategy is good
  2. Risk management trough proper position sizing

Good Strategies and Bad strategies

The first thing to consider is the quality of the trading system or strategy. There are risk management ideas that might convert a losing system into a winner if the problem was that stop-loss settings were wrong, But no position sizing can change a losing strategy into a winning one. Therefore, the first thing a trader should care about is for his system to have a positive edge.

In statistical terms, the strategy should have a positive expectation. If not, the trader should analyze it, find the weak points, and modify it for profitability. Once the system is profitable, it can be traded. Finally, depending on its quality, the system will make grow the trading account fast or slow, and, also, its growth can be optimized through position sizing.

Strategy basic Statistical 

To analyze a trading strategy, we need to normalize its trades to a basic unit and, then extract its four main statistical parameters:

  • Percent winners
  • Mean reward-to-risk Ratio
  • Mathematical expectation
  • Standard Deviation of the expectation.

For example, the system we are going to use as an example in this article shows the following parameters:

STRATEGY STATISTICAL PARAMETERS : 

  •  Nr. of Trades: 143.00
  •  Percent winners: 58.74%
  •  Mean Reward Ratio: 1.22
  •  Mathematical Expectation: 0.0887
  •  Standard dev: 0.4090

It is not a really good system, but it’s tradeable. The Mathematical expectation says that the system, using a basic unit of risk of one dollar, is able to extract a mean of 8.87 cents per dollar risked on every trade. Therefore, the system has an 8.87 cents edge against the market, which is 8.87%.

Drawdown

You can see that here, we did not show the drawdown as a parameter to consider. That is because drawdown is dependent on position sizing. The parameter we can compute, though, is the losing streak, which is the number of continuous losses we could expect based on the percent of losses. As we know, the percent of losers is 1-percent winners. Therefore, in this case, Percent losers = 41.26%

With that information, we can create a probabilistic curve of a losing streak of size N, such as the one here. But the trade size is what is going to define the drawdown parameter.

Fig 1 – Losing Streak Probability Curve

Leverage and Drawdown

Forex is a leveraged trading environment, and many brokers offer its customers the ability to go up to 500:1, meaning traders can use up to 500x the size of its trading account to open positions. But is it wise to get that leveraged? Let’s do an experiment using the above-mentioned system.

As said above, the system has been taken from a real trader and is a good, although not brilliant system. But it is a real no-hype system that can be traded what we want to test. For this test, we will always start with a balance of $10,000 and will increase the trade size using the same trade segment. 

Leverage = 1

Fig 2 – 0.1 Lots per trade

Using a leverage of one, we see that the system shows a max drawdown of 10.4 percent, and the final equity after 143 trades is a bit more than $11.600, which is 16% growth.

Leverage = 5

Fig 3 – 5X Leverage

Using 5X leverage, we notice that the Max Drawdown went to 39.58%, and the final equity ended up at $18,400.00 for an 84% profit.

Leverage = 10

Fig 4 – 10X Leverage

If the trader dares to go to 10X leverage, he must endure close to 61% drawdown for the opportunity to receive 168% profit and a total equity of $26,800 at the end of a 143-trade cycle.

Leverage = 20

Fig 5 – 20X Leverage

Leverage 20X is even wilder. The trader has to withstand up to 83.4% drawdown for a gain of 336.00 % profit.  The question is when to stop? Will a 40X leverage be even better for the profit-hungry trader?

Leverage = 40

Fig 6 – 40X Leverage

We can see that at some point, the risk is too much, and a profitable system, with the wrong risk and size management, can be converted into a very fast losing system and wipe the entire account.

As we see here, a 40X leverage is wild enough to wipe an entire account using a very profitable trading system. We must understand that up to one point, increasing the leverage will increase risk while decrease profitability.

As a summary, let’s see the plot of several account histories with increasing leverage

Fig 7 – 40X Leverage

This time we have plotted the histories on a semi-log scale to be aware of the enormous scale of the drawdowns. On the graph, we can see that the most critical moment of the histories happens at about trade Nr. five or six, which crashes all accounts above 30X leverage. But, if we take this event aside, we can see that to reach its destination traders must endure four more events when they lose close to 80% of their initial funds. We must take into account that at the moment of these events happening, there is no way to know when will they stop and start recovering the funds back.

A Propper Attitude Towards Risk

Position sizing and risk management are the tools traders have to accomplish their trading objectives, but it has to be done correctly.

We first need to set the daily, weekly, or monthly profitability of the trading strategy. Let keep using the previous example.  We know that the system has a mean of 8.87 cents per dollar risked.  Let’s suppose the system has an average of six daily trades. Then, the profitability of this system is $0.53 daily, and $10.64 monthly per dollar risked.

From the losing streak curve, we see that it is wise to be prepared for a max streak of, at least eight losing trades.  Then, we define our comfort zone for drawdowns. Let say we are bold and wanted to risk up to 40% of the capital. To accomplish this, we divide the max 40% drawdown by our defined max losing streak of 8, and the result will be the maximum percent risked on every trade. In this case, Risk per trade = 5%. (That is a huge of risk, we do not recommend more than 1%, by the way).

Now, if your current account balance were $10,000,  the risk per position should be 5% * 10,000, = $500. With that information, we can see that the system would deliver $5,320 monthly, on average.

If we were to double this amount, we would need to double the account balance or wait roughly two months until the profits reached the $10K mark.

The concept of applying a trade size proportional to the account balance helps traders to apply compounding growth to their accounts, while automatically reducing the trade size while in a losing streak on a dollar basis. More on compound growth will be developed in a future article.

 

Categories
Forex Daily Topic

To Reinvest or Not Reinvest, That is the Question

That is one key issue when trading. Should I stick with the same trade size, or is it better to compute trade size based on the account balance?

In his book “The mathematics of money management, Ralf Vince answers that question simply and elegantly, so let’s follow Ralph’s steps to dissect this topic.

No Easy Answer

The question of reinvestment or not can’t be answered directly. Let’s see an example where a wining system becomes a loser by reinvest.

Table 1 – System A

In System A, we have two trades. In the first trade making 50% and -40% in the second one, for a total profit of 10%. If we take the same sequence and reinvest, the system loses 10%.

Table 2 – System B

Using System B, we see there is a gain of 15%, followed by a loss of 5% for a total of 10% gain. This system also nets 10% without reinvestment, but it continues being a winner with reinvestment.

Changing the order of the sequence does not alter the final result, provided none of the trades leads the account to a broke (because then the second trade would not be happening). You can make your own calculations, but multiplication is commutative, isn’t it?: 

 A*(1 +0.15)* (1 -0.05) = A*(1 -0.05)*(1 +0.15)

Geometrical Mean: Key to Qualify Systems under Reinvestment

Let’s add two one-point winners to system A, and two one-point losers to system B.

Table 3 – System A

Table 4 – System B

Now we will take as a reference a typical bank account paying one point per period. 

Table 5 – System C

We already know that system B is the optimal one for reinvesting, but, let’s see which parameter defines the optimal system to fulfill our objective to maximize profits under reinvestment. How could we determine which system is the best for reinvesting, given we had only the information of its non-reinvesting performance?

By percentage of winners, system C will be the winner, by average trade or by total dollars the winner is system A. Risk/reward or lowest drawdown is not the answer. If that was the answer, then we should move our money to a bank account.

 We know system B has the right mix of profitability and consistency, and systems A and C lack one of these properties. So how to measure this mix?

According to Vince, the right formula is the Geometric Mean, which is the Nth root of what he calls “Terminal Wealth Relative” (TWR), where N is the number of trades. TWR is the cumulative amount we would obtain if the initial amount of the trading account were 1 instead of 100. 

TWR = (1+%R1)*(1+%R2)*… (1+%RN)

Where %Ri is the percent returns on each trade.  

A simpler formula to express TWR is:

TWR = Final Capital / Starting Capital 

      And these are the  TWR of our systems :

Table 6 – TWR   

    By taking the square roof of the N trades we obtain

Geometric Mean (G) = TWR^(1/N)

G = (Final Cap/Starting Cap)^(1/Nr of trades)

     Let’s see the G of our sample systems  

  Table 7 – Geometric Mean   

From table 7 we can see that the best performer in terms of geometric Mean is System B.

Final words

The Geometric Mean is the growth factor per trade. A system with the highest G is the system that makes the most profit and grows the fastest on a reinvestment basis. 

G less than one means the system is not profitable and would lose money when using reinvestment.

If we obtain a G = 0, it means we went broke because anything multiplied by zero is still zero, and G is a multiplicative function. Any big losing trade will have a powerful effect in G. That is a mathematical way of saying, “cut your losses short.”

As Ralf Vince put it: “in trading, you are only as smart as your dumbest mistake.


Reference: The Mathematics of Money Management, Chapter 1.

The examples of this article were taken from Ralph Vince’s book, although the formulas were checked and computed using an Excel spreadsheet.

Categories
Forex Daily Topic Forex Psychology

Taking Forex Trading as a Business

Forex trading is a hard business. A trader has to work hard to learn the algorithm of it as well as psychologically strong enough to apply them when it comes to making money out of it. Some individuals may have enormous knowledge as far as trading is concerned, but they do not do well in trading. It is because they are not capable of dealing with the real heat.

Having losses is another inevitable issue with trading, which every trader is to encounter. It does not matter how good a trader is; he or she must face losses. In trading when a trader loses a trade, he loses in two ways

  1. He loses his money
  2. He loses faith in his calculation or belief

Losing the Money

When a trader loses money in trading, I do not think it needs an explanation of how bad it feels. Losing money on any occasion hurts. Traders are bound to err because this is a game of chances, so they sometimes lose money. In the Forex markets, a trader can lose an unlimited amount of money. He can lose an amount of money he even cannot think of. Experienced traders do err as well.

In most cases, it is not about making mistakes. The market can be unpredictable from time to time. Even excellent trade setups don’t always work. This fact may make a trader believe something wrong with the strategy. He starts adding/changing more things with the strategy; runs after Holy Grail. We know what the last consequence is. He quits after losing valuable time and invested money. Statistics show that only around 5% of investors are successful in the Forex market.

How to Overcome It?

A trader must be ready to take losses. He should look at trading as a business, and count his losses as business expenditure. Let us consider. If we run a business, we have to pay utility, rent, wage, miscellaneous spending. A trader may count his losses as an expenditure of his trading business.

Losing on Own Belief

We often ignore this issue at the time of analyzing traders’ psychology. I find this to be a severe issue. When a trader takes an entry, he throws his skill, experience, belief in it. If it goes wrong, he loses a trade on his calculation. Psychologically, it hurts a lot. We can compare the feeling when our favorite team loses a match against an archrival. Losing on own belief is often more painful than losing the money only.

How to Overcome It?

It is a severe psychological trading issue. To overcome this issue, a trader must remember that there is no such strategy in the Forex market, which is 100% successful. Even the best of the best strategy is bound to encounter losses. Typically, if a strategy is successful even in 60% cases, the market analysts consider it as a good strategy.

The Bottom Line

A trader is to take trading as a business. The market is not an ATM. Making money consistently does not mean a trader makes money on every single trading day. A trader is to have some good days and some bad days. There is no point in jumping with joy on good days or being grumpy on bad days. Just take them professionally.

Categories
Forex Daily Topic Forex Risk Management

How to determine if your Trading System shows Dependency

How to determine Dependency in your Trading System

As we have explained in our previous article How to be sure your trading strategy is a winner, traders usually apply position size strategies that conform with the belief that future outcomes somehow are influenced by the previous result or results. This phenomenon, in statistical terms, is called dependency, which means the probability of the next event happening depends on the last or past events. 

The example of a card game such as Blackjack or Pocker, can enlighten this concept. In a deck of cards, the odds of getting a particular card, such an ace is dependent on the cards already on the table. So, the first time, with no card drawn, the probability of drawing an ace is 4/52. But the next time we draw a card, the probability changes to 4/51 or 3/51, depending on if an ace was drawn on the last time.

What does dependency mean to Trade

Having dependency on a trading system or strategy would mean that the odds of the next trade being profitable or unprofitable change with the outcome of the last trade. If we really could prove dependency and its kind, we could adapt our trade size accordingly, making the system more profitable than assuming non-dependency.

 As an example, if we devise a system on which a winning trade precludes another winner and a losing trade another loser, we could increase trade size while on a winning streak and decrease it on losing streaks. That way, we could maximize profits and minimize losses. 

How do we determine if a system shows dependency

Dependency on trading has two dimensions. The first dimension is dependency in terms of wins and losses, which is the sequence of wins and losses showing dependence. The second dimension is if the size of wins and losses also show dependency.

The run Test

On events such as drawing cards without replacement, it is evident that there is a dependency. But when we cannot determine if the sequence of results show dependence, we can perform a Run Test.

The run test is merely obtaining the Z-scores for the win and loss streaks of the results. A Z-score tells us how many deviations our data is away from the mean of a normal distribution. We are not going to discuss run tests here, as there is a simpler and more complete method to find out dependency. If interested in this subject, you can find multiple sources by googling the term.

Serial Correlation

Dependency can easily be measured, using a spreadsheet, since dependency is measurable using a CORREL() function between the trade results, and the same data shifted one place. This technique uses the linear correlation coefficient r called Pearson’s r, to quantify dependency relationships. 

As an example, I passed one trade system of mine I backtested some time ago to a through the correlation function CORREL. The system produced 55% winners with 1.7 reward-to-risk factor on the DAX30 Futures contract.

The following image shows the result on this system, with about 250 trades (only the first 30 shown)

Image 1 – Dependency test on a DAX System

If you click on the image, you can see the result is 0.0352, which means the test failed miserably for dependency. That means we should separate our entry decisions from the trade size. Trade size will be a function of the system’s drawdown and our appetite for risk, not a function of the last trade being a winner or a loser.

Another test in an old trade system I devised back in 2016 for the ES futures gave this result:

In this case, the correlation factor was 0.249. That is a relatively high positive correlation for a system. The figure implies that big willers aren’t usually followed by big losses, and also the vice versa: Big losses are seldom followed by big wins.  Using this system, we could improve the results if we increase our trade size after a win, and decrease the trade size after a loss.

A negative correlation can be as helpful as a positive correlation. For example, on a system with a negative correlation, we can expect large wins after a large loss, so it is wise to increase the trade size if that event occurs. Also, we can expect a large loss after a large win, so it is best to reduce the trade size before a large win.

To better determine dependency, Ralf Vince, on its book The Mathematics of Money Management, recommends splitting the total data of your system into two or more parts. First, determine if dependency exists in the first part of your data. If you detect it in that section, then check for dependency in the second section, and so on.  This will eliminate the cases where it seems to be dependency, but in fact, there is not.

Categories
Forex Daily Topic Forex Psychology

Know The Two Systems Operating inside Your Head

In the introduction of his book, “Thinking fast and slow,”  Daniel Kahneman presents a face with an expression similar to the following image as an example of your mind working in automatic mode. 

By looking at the image, you’ll experience what is called intuitive thinking. In a fraction of seconds, you’ll notice it is a brown-haired young woman (not an old one, not a man or any other animal or object), and you instantly know she is upset. You feel also she is going to start saying harsh words in a loud voice. All that came to your mind automatically and without effort. It merely happened without you intending to do that assessment.

This is an example of what Dr. Kahneman calls System One.

Now look at this: 

28 x 13

Looking at it, you knew it is a multiplication immediately, but the result does not come to your mind instantly. You know you can solve it with paper and pencil or in your head, but you need to make a conscious effort to do it, and the solution comes slowly. If you engage in the process of solving it, you’ll experience the slow thinking process as you follow the steps you’ve learned to solve a multiplication operation. Dr. Kahneman describes this process as “deliberate, effortful and orderly.”

This is what Dr. Daniel Kahneman calls System Two.

System One is in charge of automatic activities such as 

  • Detecting if an object is distant or near
  • Finding the source of a sound
  • Complete the phrase “piece of c..”
  • Change the facial expressions
  • detect a warning or a hostile voice
  • Read 
  • drive a car
  • understanding a language

System One includes innate abilities. We are “programmed” to interpret the reality that surrounds us, recognize objects, focus our attention, and avoid dangers. System One also learns by the association of ideas, and also learn skills such as reading, driving a car, or pattern recognition, such as a chess player or a trader do.

The operations of System Two have one common characteristic: they require deliberate attention, and the process can be disturbed by a loss of concentration.

Here are examples extracted from the book:

  • Focus on the voice of a single person in a noisy room
  • look for a woman with white hair
  • trying to identify a surprising sound
  • telling someone your phone number
  • Count the number of times a word appears in a page

The Interaction between both Systems 

The usual situation when we are awake is that System One and Two both are active. According to Kahneman’s book, System One runs automatically while System Two works in “low-effort” mode, in which almost no effort from its part is needed. System one sends summary information to system two, and System Two has the final word.

Under this scenario, System One continually creates “suggestions” for System Two: impulses, feelings, intuitions, impressions, and intentions. When confirmed by System Two, these impressions become beliefs, and impulses turn into voluntary actions.

It is usual, under normal circumstances, that everything moves placidly. Under these situations, System Two adopts the suggestions sent by System One with small modifications, if any. We usually believe in our impressions and act on our desires.

When System One finds something it cannot solve, it asks for the help of System Two, as in the process of multiplying 28×13. We can feel this whenever we are surprised. That’s the activation of System Two. Surprises activate and orient our attention. That can be lifesaving. A hole in the road, a tiger, appearing 100 meters from you.

 

System two has been taught by our evolution to trust System One, as he is generally quite good at what it does: modeling familiar situations, short-term predictions, and initial reactions to challenges and dangers.

The Conflict

One limitation of System One is it cannot be switched off. Therefore, sometimes, there is a conflict between System One’s automatic reaction and System Two’s intention of control. Under uncertainty situations, System one triggers primary reactions such as fear or greed that System Two is used to believe and act upon. Even when the case does not call for such an automatic response, as usually happens when trading the Forex markets, System Two has a hard time to take control of the situation.

Since System One works in automatic mode, it cannot be turned off at will. Therefore errors due to intuitive thinking are very difficult to prevent. Also, biases cannot be avoided because System two is not aware of them, and when these biases are known, only by a System Two’s deliberate effort can be overcome. In the trading world that translates into people selling at the bottom and buying at the top. These people are making decisions based on the impressions generated by System One. Thus, System Two is inadvertently dominated by System One’s beliefs.

Final Words

If you find yourself reflected by the above scenario, you should establish the steps to break the dominance of your System One. 

  • Define yourself as a Soldier when trading. A soldier only obeys, never thinks. That is the task of your other self: The Planner. Plans are rational and are to be done before the trade opens, not during a live trade. After the trade is open, a soldier executes the plan decided by the Planner.
  • Start trading using risk sizes that do not trigger your primary fears 
  • Make a rational plan and build the discipline to follow it. You’re a soldier.
  • Before the market opens, rehearse trade situations from beginning to end. Establish how you’re going to react based on your trading plan when taking losses or profits. Visualize it in your mind. Look at your mental monitor screen and see the price moving and you making the planned decisions.
  •  Write down your feelings during the open trades. Check for inner conflicts, explain to yourself why you do what you’re doing.
  • Create a log of trade results, also annotating the maximum adverse and also maximum favorable excursions.
  • Grade your trades from 0 to 5 or 10 based on the percentage of the total possible profit you obtained.
  •  After your trading session ended, analyze the performance of your system in regards to the entry point, stop-loss, and profit target placements, and modify these parameters for the next session. But never change them while trading.
  • Compute your system’s performance and analyze if it is still performing as planned or there is a deviation from its past performance.
Categories
Forex Daily Topic Forex Risk Management

How Be Sure your Trading Strategy is a Winner?

To evaluate, the quality of a strategy is an old quest, and its answer has to do with gambling theory, although it can apply to any process in which the probability of profits is less than 100%. Of course, the first measure to know if our system is winning is when the current portfolio balance is higher than in its initial state. But that does not give very much information.

A better way might be to record winners and losers, and have a count of both so that we could apply some stats. It would be interesting to know the percentage of winners we get and how much is won on average. That also applies to losers.

We could try to find out if our results are independent of each other or they are dependent.

Finally, we could devise a way to obtain its Mathematical expectancy, which would show how profitable the strategy is.

Outcomes and probability statements

No trader is able to know in advance the result of the next trade. However, we could estimate the probability of it to be positive.

A probability statement is a figure between zero and one specifying the odds of the event to happen. In simple terms,

Probability = odds+ / ( odds+  +  odds – )

On a fair coin toss game: odds of heads (against, to one) = 1:1

probability Fair coin toss = 1/(1+1)

= 0.5

Probability of getting a Six on a dice:

odds = 5:1 – five against to one

Probability of a Six = 1/( 1+5) = 0.16666

We can also convert the probability into odds (against, to one) of occurring:

Odds = (1/ Probability) -1

As an example, let’s take the coin-toss game:

Odds of a head = 1/0.5 -1 = 2-1 =1:1

That is very handy. Suppose you have a system on which the probability of a winner is 66 percent. What are the odds of a loser?

System winners= 0.66 so -> System losers = 0.34

loser odds = 1/0.34 – 1 = 2 -> about 2:1.

That means, on average, there is one loser for every two winners, which means one loser every three trades.

Independent vs. Dependent processes

There are two categories of random processes: Independent and dependent.

A process is independent when the outcome of the previous events do not condition the odds of the coming one. For example, a coin toss or a dice throwing are independent processes. The result of the next event does not depend on previous outcomes.

A dependent process is one where the next outcome’s probability is affected by prior events. For example, Blackjack is a dependent process, because when cards are played, the rest of the deck his modified, so it modifies the odds of the next card being taken out.

This seems a tedious matter, but it has a lot of implications for trading. Bear with me.

What if we acknowledge our trades are independent from each other?

If we consider that our trades are independent, then we should be aware that the previous results do not affect the next trade, since there is no influence between each trade.

What if we know our system shows dependency?

If we know that our system’s results are dependent, we could make decisions on the position size directed to improve its profitability.

As an example, let’s suppose there is a very high probability that our system gets a winner after a loser, and also a loser after a winner. Then we could increase our trade size every time we get a loser, and, also, reduce or just paper-trade after a win.

Proving there is dependency on a strategy or system is very difficult to achieve. The best course of action is to assume there is none.

Assuming there is no dependency, then it is not right to modify the trade size after a loser such as martingale systems do since there is no way to know when the losing streak will end. Also, there is no use in trading different sizes after a winning or losing trade. We must split the decision-making process from trade-size decisions.

Mathematical expectancy

The mathematical expectancy is also known as the player’s edge. For events that have a unique outcome

ME = (1+A)*P-1

where P is the probability of winning, and A is the amount won.

If there are several amounts and probabilities then

ME = Sum ( Pi * Ai)

The last formula is suitable to be applied to analytical software or spreadsheet, but for an approximation of what a system can deliver, the first basic formula will be ok. Simply set

A = average profit and

P = percent winners.

As an example, let’s compute the mathematical expectancy of a system that produces 40% winners and wins 2x its risk.

ME = (1+2)*0.4 -1

ME = 3*0.4 -1

ME = 0.2

That means the system can produce 20 cents for every dollar risked on average on every trade.

Setting Profit Goals and Risk

Using this information, we can set profit goals. For instance, if we know the strategy delivers a mean of 3 trades every day – 60 monthly trades- The trader can expect, on average, to earn (60 * 0.2)R, or  12* R, being R his average risk.

If the trader set a goal of earning $6,000 monthly he can compute R easily

12*R = $6,000

R= $6000/12 = $500.

That means if the trader wants a monthly average of $6,000, he should risk $500 on every trade.

Final Words

On this article, we have seen the power of simple math statements, used to help us define the basic properties of our trading system, and then use these properties to assess the potential profitability of the strategy and, finally, create a simple plan with monthly dollar goals and its associated trade risk.

 

Categories
Forex Daily Topic Forex Risk Management

Basic Math Skills Traders Needs – Average and Chevyshev’s Inequality Explained!

Most of the people wanting to profit from the Financial Markets think that the secret to success lies in knowing the price turns to start a new trend and also detects when to get out of the trade. They might be right if there were a mathematical formula or crystal ball to show us the right timing. But the truth is the Financial Markets are chaotic and random. Thus, there is no sure way to be right.

The good news is that we don’t need to be right, but be profitable. That can be achieved by taking small losses when the trade goes against us and let profits run when the trade goes as we projected. And the key knowing if we are on the right track is measurements and analysis.

This article deals with how to extract information out of a set of results by computing an average. And also, by measuring the deviation from the norm extract wisdom hidden in the data collection.

Averages

Averages have the purpose of determining the typical value or center of a set. For instance, the mean profit achieved in a month or a year. We assume that the majority of the samples are located near the average, and, also, that the number of cases away from it decreases with the distance to the average.

The computation of an average is simple. We add all elements and divide them by the number of items in the set.

As an exercise, if we have a collection of trading results X, with elements x1 = $1, x2=$-1 and x3=$3 which is our average profit?

Average of X (M) = (x1+x2+x3 )/3 = (1+(-1) +3)/3 = 3/3 = 1 dollar.

The Sample Standard deviation (SD)

It is interesting also to measure how far could we expect the following trades to be away from this mean. There are several ways to measure errors, but the most used is the Standard Deviation. SD for short.

Computing the standard deviation is a bit more complicated than the average, but not much.

1.- We take the difference between the mean and every element, creating a new set of differences.

dxi = M-xi 

2.- Differences may be negative or positive, so we square them to get dxi^2, creating a set of squared differences.

dxi2 = dxi^2

3.- We add all elements of this last set and divide by its n-1, the number of items minus one. This result is called variance

Var = Sum(dxi2)/(n-1)

4.- Take the square root of the variance.

SD = √ Var

let’s do it with our example:

1.- dx1 = 1-1 =0;  dx2 = 1-(-1) =2; dx3 = 1-3 =-2

2.- dx1^2 = 0; dx2^2 =4; dx3^2 =4

3.- Var = (0+4+4)/(3-1) = 8/2 = 4

4.- SD = √4 = 2

After that, we can conclude that our system’s future performance will be one dollar plus or minus 2 dollars.

The Standard Deviation can be thought of as the average of the dispersion of the results.

Chebyshev’s Inequality

Once getting these results, we know a bit about our trading system. Chebyshev’s inequality gives us another handy piece of information. It addresses the question of how many of our samples will lie within a certain distance from its mean.

There are many classes of probability distributions. One of them is the Normal Distribution, with its typical Gauss or bell curve. The Normal distribution is very nice indeed, and many physical phenomena conform with it, such as the length of people or the distance from the target on a dart game. Unhappily, trading results do not conform to it.

The good news is that the Chebyshev’s inequality works with a wide variety of distributions, and guarantees that no more than a certain fraction of values can be farther away than a certain distance from the mean.

Specifically:

No more than 1/k^2 values can be farther away than k* SD

We can say it the other way around:

At least 1-1/k^2 of the values of a distribution are within k*SD from its mean. If we create a spreadsheet using these formulas we get:

Table 1 – Chebyshev’s Inequality

This table provides a lot of information.  We see, for instance, that only 11.11% of the trades are farther than 3 SD from its mean.

  • That means close to 90% of the profit on future trades in the above calculation will be between -5 and 7 dollars.
  • Also, 75% of them will lie within 2 SD – between -3 and 5 dollars.

Since it can be applied to most of the distributions, we could use it with prices. That way, we could determine how far a price is away of its mean and assess overbought and oversold conditions with statistically relevant tools.

Final words

  • Knowing how to compute averages and the standard deviation will help traders quantify and qualify their performance.
  • It is interesting to know how to find the odds for a value to be at a determined distance from the mean value of the distribution.

 

Categories
Forex Daily Topic Forex Range

Hidden Wisdom Behind Range Measures

People coming to the Forex markets usually learned new vocabulary. The first special words they learn maybe are, margin, profit, risk-reward, and candlestick. Perhaps, afterward, they learn new concepts such as Volatility. Also, along with other technical indicators, they get to know one study called Average True Range. However, later, they forget about it since they usually consider it unimportant.

The Average True Range (ATR) is one way to measure Volatility. Volatility is, as we know, a measure of risk. Therefore, ATR can be used as an estimate of our risk. This measurement is essential for us as traders, especially if we are trading on margin. And I’ll explain why.

 

What tells the Range?

A range is a measure of the price variation over a period of time. It is measured between the High and the Low of a bar or candlestick. For instance, the range of figure 1 below (a 4H chart) is 357.9 points. If each point/lot were worth $1, a short position started at the Low of the bar would have lost $357.9 in four hours on every lot traded. Conversely, a long position would get this amount of profit.

True Range

True range is similar to a normal Range, but it takes into consideration possible gaps between bars. That happens a lot in assets that do not trade all day. Not always the close of a session matches the open of the next one. A gap may form. A True range accounts for that by considering gaps as part of the range of the bar if the gap is not engulfed by the range.

Average True Range

As we can see, in the figure above, every bar’s range varies depending on the particular price action on the bar. Some bars are impulsive and move considerably. Other bars are corrective, and their range is short.

Therefore, to measure the average price range an average is taken, usually, the 14-period, although traders can change it. Below we show the 10-bar ATR of the Bitcoin.

On this figure, we see that the ATR gets quite high at some point on the left of the figure, and it slowly decreases in waves. That is normal. Assets move in a series of increasing and decreasing volatility waves, which describes the interests and power of buyers and sellers.

Average True Range and Risk.

Retail traders usually have small pockets. The first measure a retail trader should know is how much his account would endure in the event of an adverse excursion.

As an example, let’s examine the EURUSD daily chart. Observing the 10-ATR indicator in the chart below, we see that the maximum level on the chart is 0.01053 and the minimum value is 0.00664. Since we want to assess risk, we are only interested in the maximum value.

Let’s assume that we wanted to trade long one EURUSD contract at $1.1288 and that, on average, our trade takes one day to complete. How much can we assume the price would move in a single day?

If we take the 0.01053 as its daily range value and multiply it by the value of a lot ($100K) we see that the EURUSD price is expected to move about $1,053 per day. We don’t know if that will be in our favor or not, but from the risk perspective, we can see that to be on the safe side we would need at least $1,053 of available margin for every lot traded.

If the average trade, takes 4 or 8 hours instead, we should set the timframe to 4H or 8H and proceed as we did with the daily range.

For not standard durations, we could use the following rule: For each doubling in time, the average range grows by a factor of the square root of 2.

That is handy also to compute the right trade size. Maybe we do not have the required margin level, but just one fourth. Thus, if we still wanted to trade the asset, we should trim down our bet size to one-quarter of the lot.

How much time our stop-loss will endure?

Based on ATR figures, we could assess the validity of a stop-loss level. If the stop-loss size is too short compared to the ATR, it might be wrongly set.

What profits to expect?

We could assess that as well, on average, of course. If the dollar range of an asset is $1,000 in a 4-hour span, we can expect that amount on average in four hours, and $1.410 (√2 * $1,000) on an 8-hour lapse.

Deciding which asset to trade

We could use the True Range to assess which asset is best for trading. Let’s suppose, for instance, that you are undecided about trading Gold (XAU) and Platinum (XPT). So let’s examine them.

Gold:

Spread: 3.2

$Spread cost: $32

Digits: 2

contract size: 100

MAX Daily ATR: 16, $ATR: $1600

Spread cost as Percent of the daily range: 2%

Platinum:

Spread: 12.9

$Spread cost: $129

Digits:2

Contract Size: 100

Max Daily ATR: 22, $ATR $2,200

Spread cost as Percent of the daily range: 5.86%

After these calculations, we can see that it is much wiser to trade Gold, since the costs slice only 2% of the daily range, while Platinum takes almost 5% of the range as costs before break even.

 

Categories
Forex Candlesticks Forex Daily Topic

Three Facts about Candlesticks you Never Knew About

Candlesticks are great because it makes trends visual at first glance. But most candlestick users stay just with that trait and don’t go more in-depth.

Of course, everybody knows some candlestick patterns such as Morning and Evening Stars, Haramis, Dojis and Shooting stars, but what’ is hiding inside the candlestick?. How to extract market sentiment from its shape or pattern?

So, let’s begin!

1 – Unwrapping a Candlestick

A candlestick is condensed information of the price action within its timeframe. The corollary is that if we go to a shorter timeframe, the candlestick now is a pattern of several candlesticks.

In the chart here we see the unwrapping of a 4H candle into 30-min parts

Three Facts about Candlesticks you Never Knew About

Chart 1 – 4H Hammer Candlestick unwrapped into 30-min candles.

 

We notice that the candle has one segment dominated by sellers and the other part controlled by buyers.

Which sentiment dominates in sellers at the bottom?

  • To the first class belong those traders who could no longer hold the pain of being long and close their position.
  • The second class is made of those who came late to the trend and sold believing the trend will last forever, or quite so.

Which sentiment dominates in the way back up?

  • Late sellers realized that they were in the losing side, so they needed to close their shorts. That meant, they have to buy, adding to the bullish fuel
  • Longs that were taken out of their position see frustrated how the price moves up without them. Hence, some of them retake their longs, while others don’t dare, afraid this is going to be another bull squeeze.

2.- Impulse or correction?

There are only two stages in the market: Impulses and corrections of previous impulses. So how to spot the price is in an impulsive or corrective phase?

Three Facts about Candlesticks you Never Knew About II

Chart 2 – Candlesticks: impulses and corrections.

Impulses break resistances and move with a clear direction. Impulses are what make trends. Corrections move in ranges, lack direction, and usually retraces some or all the advances of the previous impulse.  People usually think in trends as composed by many candlesticks or bars, but we now know that a single candlestick is composed by many shorter-timeframe candlesticks. Therefore, we cannot be surprised if we state that a trend can be made of a single candlestick. That applies also to corrective movements. A corrective movement can be summarised in a single candlestick.

How to know if a candle is impulsive or corrective?

To spot an impulse look for a candlestick with a large body and almost no wicks or shadows. To spot a corrective movement look for small-bodied candles with or without wicks ( usually with wicks).  Sometimes we find both characteristics in a candlestick. That may mean it is a combination of impulse and correction. That is ok since there is no law that forbids the start of a correction or impulse in the middle of the timeframe of a candle. Sorry, the universe is not perfect!

3.- Who is in control?

Once we know facts 1 and 2, we are in the position to spot who controls the price action: buyers or sellers.

One clue is, of course how the candlestick closes, but the other clue is where are and how long are wicks. If we spot several candlesticks with large lower wicks we could reason that the buyers are pushing the price above the bottom of the candlesticks. If wicks happen on top we could deduct the opposite: Sellers selling the rally.

Three Facts about Candlesticks you Never Knew About III

Chart 3 – Candlesticks: Wicks show who controls the price action

A downward trend with a lot of lower wicks is weak. That applies to an upward trend with lots of upper wicks.  Therefore, we can detect the market sentiment by just observing the wick appearance on the candlesticks.

 

Final words

So now we know that there is much more than just fancy colors and trend visualization. We have to inspect and pay attention to body and wicks, also called shadows by Steve Nison. The information provided by a single or a group or candlesticks is worth the time spent.

 

Categories
Forex Daily Topic Forex Psychology

Two Mistakes Novice Traders Should Avoid

On this article we are going to discuss two mistakes novice traders should avoid to succeed in the financial markets. Reading a book about trading or a strategy article on a website makes trading the markets seem easy, But that is far away from the truth.

Judgmental errors

“We typically trade our beliefs about the market, and once we’ve made up our minds about those beliefs, we’re not likely to change them” – Van K. Tharp

 

Joe Novice comes to the markets, after reading a marvelous book explaining to him how to win easy money in the markets. The book has beautiful charts describing how. Joe has learned a lot from this book. Now he knows what bull and bear candlesticks are. He has learned to distinguish patterns. Head and shoulders, double tops and bottoms, the Morning Star and its counterpart the evening star. He also learned some handy indicators such as the Stochastics, the RSI, and the MACD. Finally, he has also get acquainted with the concepts of support, resistance, and breakout. He thought that was key to succeed

Prices Move faster in real-time than on a book illustration.

Joe founded his account with his first $1,000 to experience the exciting world of big wins. Then he downloaded his MT4 station to begin operating. He created the setup recommended in the book and started looking for major pairs and decided that for his scalping purposes, he should use 1-minute charts.

The first thing that surprises Joe is that prices are continually moving. He was switching from pair to pair on his laptop, but nothing happened until he left the chart and moved to another one. The price action seems to occur only when he wasn’t looking! That made him think that he must concentrate on just a couple of charts at a time.

Also, Joe had a hard time making decisions. For some reason, the strategy explained in the book only was evident after the fact. The right moment to trigger the trade seemed never to show. He was late to pull the trigger most of the time, and when not late, the moment to pull it did not appear right.

Representation Bias

How can a trader make money using patterns and levels everybody sees?

The fact is that all technical analysts are able to spot support and resistance levels. So why people make money trading breakouts? Or don’t they?

People believe in charts as if they were truths. They believe that charts represent the activity of the markets. In fact, bars or candlesticks are just approximations to that activity. The issue is that what we see is the representation of past action, but we do not see the reasons why the price arrived at that place.

What if most traders really didn’t have the right information to make decisions. What if only a handful of privileged traders owned that knowledge? Let’s suppose that these smart guys have the privilege to see where is the real supply zone. The zone where they’d do the worst harm to the herd of dumb traders. Wouldn’t it be logical that they tried to stretch the price to that zone to collect the best available prices, then turn back and move the price to the opposite side?

Under that assumption, the next day or week, another technical analyst would see the price extension and figure out where the stop-loss should be. It will reason the optimal place to be just below that zone. However, the fact is that there is an action-reaction phenomenon in the markets. The actions of the market participants change history. The market is an experiment, on which the scientist influences the result with his acts. If he were to trade the previous day, he might have decided the same way as did those who were that day in the market, and, so, would be wiped as the others.

So, how should we proceed?

The strategy should have clear rules of entry, stop-loss, and profit-taking

Traders should back-test the strategy and optimize some parameters. Then they should forward test it in a demo account or using one micro-lot.

After a list of 30 trades, the trader should have a minimum of data samples to approximate percent winners and reward to risk ratio: The two most critical parameters of any strategy. We do not talk about drawdown here, because drawdown is a dependent variable: it can be computed knowing the percent losers and changes with position size.

When deciding about stop-loss placement, Do not use pivot levels. These are already known to the sharks of the market, and will inevitably fail.  The best stop-loss placement is using the Maximum Adverse Excursion technique, a concept by John Sweeney.

Of course, to be able to use MAE, you should record your trades accurately, recording also the MAE information.