Trade Forex Fundamentally

Why do traders continue to lose money trading forex despite learning more tools, tips, and tutorials?

 It’s not like one has to be a genius or have some super trading strategy to achieve forex success. In fact most traders I’ve run into think too much and overcomplicate their strategy. What it really all comes down to is recognizing what has a higher possibility than not preceding a price move in a particular direction, and capturing as much of that move as possible.

Frustrated forex trader

But what do most traders do?

Instead of stalking the market and waiting for a trade to come to them, they chase after the market, trying to find patterns that aren’t really there.  Instead of spending time to really analyze what the driving force of the market currently is and which direction it’s pushing, they take trades that go against the trend, lose big, and find their trading spiraling out of control. Now it’s not really hard to understand why only a small fraction of total traders get the largest fraction of trading profits in this market.

So what’s needed to achieve forex success and profits?

Traders need to stop trying to fight the market and outsmart it by combining dozens of indicators, looking for patterns, and trying to guess tops and bottoms. People forget that the market is made up of human beings, not price charts, economic data and indicators. The forex market especially is driven by a very powerful driving force called sentiment. Sentiment is the degree to which the market feels bullish or bearish about price and it doesn’t depend on the past or the future—it represents the state of the market, RIGHT NOW.

Just think about this for a second. Would you rather rely on:

1. Some price pattern that may have repeated itself in the past but has no guarantee of repeating itself in the future and could just be due to short term randomness of the market, OR
2.  Some economic theory that says a currency pair may go down in the future some time because of the current debt situation, OR
3. An indicator that is based on the immediate state of the market and can tell you immediately when to get in and out?

I hope you realize that #3 is sentiment, which is a blend of technical analysis (#1) and fundamental analysis (#2).  So now that you see the value in it, how do we analyze sentiment in an objective way so we can keep out our emotions and increase our win rate and forex profits?

Methods to analyze sentiment like a pro

I basically look at a combination of price action, positioning data, and economic news releases to determine what dominant direction of the market sentiment is suggesting. Here are the methods:

From the chart:

• New highs and lows. As simple as this sounds, if price is making new weekly highs and holding those levels, bulls obviously are being more aggressive than the bears and confidently believe there’s a reason for price to be valued higher (i.e. sentiment is positive on all lower time frames). Although this sounds rudimentary, you’d be surprised to learn how many traders sell a currency pair after it makes a new high because they think it will respect some resistance level on their chart.
• Large volume bullish/bearish candles. When you see large, full bodied, bullish candles (especially after breaking new highs), rest assured that the bulls are in control of the situation and sentiment is very positive. On the other hand, if you see price attempt to move up, but in several cautious steps, or price moves up and immediately gets rejected from some level, beware: that’s not strongly positive sentiment.

Examples of spotting forex sentiment on a price chart (click to enlarge)

From special tools and economic data:

• COT data. Commitments of Traders (COT) data reveals the positioning of major players in the forex futures market such as large hedge funds and exporters. If they are moving the market and thus determine sentiment, would you want to be on the opposite side of their trades? Check out my post on using the COT to “spy” on the market for more detailed strategies.
• Currency strength meter. Using a forex currency strength meter to find out which currencies are strong and weak on an individual basis can allow you to buy currencies with strongly positive sentiment and sell ones with very weak sentiment. Why? Because money flows from the weak ones to the strong ones—wouldn’t you like to ride that trend? Read about how to use a currency strength meter here.
• Price reaction to news events. Large funds and banks put on trades well before economic data releases (which are scheduled every week) based on their economists’ predictions of how data will turn out. If, for example, the number for employment in the U.S. comes out much worse than expected, we would expect USD/JPY to go down fast. If it doesn’t, or it goes up instead, that is a reflection of positive sentiment in the market. See previous post on using news to gauge sentiment.

I hope that you can pick a couple of techniques from here that resonate with you to really identify and align yourself with the powerful driving force of the forex market: sentiment. Keep in mind that like anything this doesn’t work 100% of the time but it does give you an edge because you’re doing what most traders don’t do: move with the market instead of fighting against it or trying to outsmart it.

In my post on forex mechanical system trading I showed how $10k could’ve turned into nearly $51,000 using my long gamma forex trading strategy with a currency strength meter. Using a currency strength meter was just one edge that contributed to profits.  But just think if we added more edges to our strategy—it would increase the probability of success for each trade, decrease the magnitude of negative drawdowns, and  increase the bottom-line profits of your account! So what can we add to form an “arsenal” of edges?

Using the Commitment of Traders (COT) indicator to confirm direction

COT data gives you information on the positioning of other major players in the market (see previous post on COT forex trading strategy), so why not combine it with the currency strength meter so that you have two pieces of confirming evidence for making a trade in a certain direction?

Your forex trading edge can be as simple as looking at the net futures positioning for your currency pair of interest (it’s the red line on the COT indicator at Timingcharts.com charts) and ascribing a positive direction if the positioning is net long (number of positions is positive) and ascribe a negative direction for the currency if the positioning is net short (number of positions is negative). Why? The net positioning (a.k.a. “small speculators”) is the difference in the number of currency contracts between the commercial traders and the large speculators, both representing a huge share of market volume. It takes a lot of time for these types of traders to turn their positions around, so their net positioning represents the sentiment of the currency for the medium time frame.

I simply took the technique described in the above paragraph to determine the direction of the pair and compared it to the direction suggested by the currency strength meter, which was used in isolation for my previous strategy. If the two were in agreement of direction I had a confirmation and would look for an entry, depending on my other filter criteria.

Before and after using the secret weapon

Let’s take a look at how the long gamma strategy performed for the EUR/USD pair from 2007 to 2010 (the strategy was backtested using the MetaTrader4 program). I selected a pair that didn’t have exceptional performance with this strategy over this time period (meaning it may have suffered longer and larger drawdowns than desirable) to emphasize how negative aspects of trading such as drawdowns can be alleviated by having multiple edges for confirmation. The first chart shows the equity growth of a $10,000 account throughout the testing period–$24,000 is not bad in that time period, but notice how it suffered a dip (42% of account lost) and just barely made up for it after a lot of time passed.

FX trading performance with just currency meter (click to make larger)

Now let’s look at the same currency pair, strategy, and conditions, except we use COT to help us confirm direction.  Now the drawdown is only 31% (vs. 42 from previous) and the account increases well beyond the initial high in account equity at nearly $25,000. Here we make $265 per trade vs. $196 per trade with just the currency meter. Are you starting to see how important getting the direction right with different indicators is?

FX trading performance with both currency meter AND COT (click to enlarge)

There’s your secret weapon for forex profits. If you can keep adding edges like this to your trading, you will find that your win rate goes up, your expected profit per trade goes up, your drawdowns go down, and most importantly, your confidence soars! 

All right, last time I showed you how to make the so called “Short Gamma” trades, which take quick, small profits in ranging environments so that you can make money even if the market’s not moving much. In this forex trading tutorial I want to show you how to capitalize on HUGE movements in the market using a few forex trading secrets.

Similar to the previous case, we’re looking for a massive imbalance to develop in the market. Think of the market as a rubber band. If things are stretched too much and something happens such that one end gets loose, the rubber band corrects itself and moves back to equilibrium. The market is the same way.

How do we capitalize on this imbalance and get in before everyone else does?

Once you’ve done your analysis and determined that an imbalance is present and decided which way it will correct to start the next massive 2,000 pip+ trend, you are ready to consider an entry. But how? Using a technique I call, “Long gamma” trading.

Long gamma trading means you are only taking small losses but are gaining relatively large winners. The disadvantage compared with short gamma trading is that your win/loss ratio will be somewhat lower (just based on statistics), but the good news is that when you win, you win big. So how do we actually trade this? Let’s continue…

Attention signal (Is there an opportunity?)

With long gamma trades we want to first identify an opportunity. The indication of an opportunity is that we are either breaking out of a ranging environment or that a previous trend has become exhausted and is turning around sharply. Remember when we talked about market cycles? We want to make sure conditions are right for entry. Market cycles tell us that price action tends to move from ranging to trending and back to ranging ad nauseum. That means when you see a sideways-ranging period, the longer it exists, the likelier price is to break out in a strong move. Similarly, markets don’t trend forever in one direction, so if we see a large reversal combined with an imbalance we should be prepared for a large move to occur in the opposite direction. When either of these two types of attention signals show themselves, we start looking for triggers to enter.

The trigger for entry

 When an opportunity comes along with these types of strategies, it doesn’t matter precisely what price level you enter at because things are so random. Rather, it’s more important to be aligned with the immediate driving force of the market—sentiment.  Think of it this way—sentiment is like the wind in a boat’s sails: if you have some difficulty starting out it doesn’t matter so long as the wind is blowing. Your trigger is to enter after price has proved that sentiment is in the direction of the unwinding of the imbalance and is starting to form a new trend for you to ride. Here’s how:

1. If price has been ranging on a weekly chart, your trigger for entry is when price breaks out of the range in your direction and closes outside the range. If price has been trending but the trend has reached exhaustion and has turned around on a weekly chart, your entry trigger is when price has moved in your direction for at least two consecutive weeks with larger than average volatility. If you see big candles in the direction opposite of the latest trend, you’re on the right track.
2. Enter the first position at market price.
3. Set your stop loss at 2 * the 14 day average true range (ATR) value to allow plenty of room for randomness- (i.e. for price to “breathe”) so you don’t get stopped out easily by the randomness of the market. If the ATR is 100 pips for today, then your stop should be set at 200 pips.
4. Risk no more than 5% of your account equity. If you have a $20,000 account and your stop loss is 200 pips, you would buy with a max position size of 50,000 or 5 mini lots.
5. Enter a second position after at least 2 days have passed and price has moved a bit away from your first entry (this is to allow the market time and space to move around so that you don’t overleverage yourself)
6. Hold no more than 2 positions at a time
7. Take profits at 3 times the size of your stop loss (e.g. if your stop loss is 200 pips, then you take profits after 3*200 = 600 pips have been reached). This is to maximize the share of the total trend that you capture. Alternatively you could set a trailing stop so that you can follow the trend for as far as it goes.
8. Do not enter if price moves against your direction violently. This means that something is surprising the market and volatility is increasing (which doesn’t suit this strategy). Objectively this means, for example, if you see a big downward candle on the chart when you’re going long that is at least 1.5-2*ATR. When this happens, wait for price to stabilize and start moving back toward the middle of the range while going in your direction. Patience pays off here.

There you have it- how to make money trading forex in high volatility environments. It’s important to combine this strategy with other strategies in your arsenal so that you capture big trends in fast moving markets, and you capture quick forex profits in slow, sideways markets.

I know that you’ve been waiting for a strategy that combines the best of both worlds- it takes advantage of the true driving forces that control forex price action: sentiment and fundamentals, but at the same time it’s as objective as the technical systems that you’re used to.  Well here it is. I’ve taken my famous long gamma trading system based on sentiment in the forex market and systematized it to the point where everything is mechanical and objective.

The result? Testing the rules of the forex trading strategy from 2007 until 2010 yielded over a 400% return on the AUD/USD pair. Starting with an account size of $10,000 back then using these rules would’ve yielded a balance of $50,931.04 this year. What’s the secret? It’s not that complicated- it uses some of our common forex trading tools that we discussed earlier to gauge the overall sentiment of the forex market.

Here’s how you can do it in a few easy steps:

1. Use a currency meter (such as the CCFp indicator available for Metatrader) on a weekly time frame and wait for AUD to become strongly positive as an individual currency, and for the dollar to become very weak as an individual currency, and get ready to go long (get ready to go short if the reverse happens).
2. Make sure that price is trending and not ranging. In other words, price has been making new highs on a daily chart or the Momentum indicator is showing a value of 102 or greater.
3. Make sure that price has not pulled back more than 2.5 times the daily average true range for the last 2 weeks. This ensures that money is flowing into the base currency of interest with some momentum.
4. Enter at market price, setting a stop loss at 2 times the daily average true range, and a take-profit of 3 times that for a good risk/reward ratio.
5. Enter up to 2 positions at a time, but make sure each entry is separated by 100 pips to give price plenty of room to “breathe” and so that we can account for short term randomness in the market.
6. Get out if the sentiment turns around as indicated by the currency meter before the stop loss is hit.

The results are not based on “curve-fitting,” an evil practice of forex backtesters who keep tweaking their system on past data until they turn a bad system into a good one only to find that it doesn’t work in the future. There were periods where it didn’t work as well, but hey, let’s be honest- there’s no such things as the holy grail. There will be periods where you will have losing trades no matter what strategy you trade- are you prepared to deal with that?

Furthermore, This is only based on one sentiment indicator. Just imagine what things could be like  if you added on other fundamental sentiment indicators such as COT data to strengthen your edge? I’ll comment on the addition of more tools to enhance your forex trading system in a subsequent post so stay tuned.

So there you have it. An objective forex mechanical trading system that is based on how the market works (money flows from weak to strong currencies) rather than some cheap nonsense pattern/moving average-based system. It certainly takes the guesswork out of forex profits!

I’ve showed you a lot about the power of currency options in your trading. They offer a type of flexibility and comfort that’s hard to get in regular trading.

This video I’m sharing with you is a recording of a live forex options trade done on the GBP/JPY so you can see how we actually analyze and enter trades to make money trading forex.