Trade Forex Fundamentally

It’s one thing if you’re strategy gets the direction wrong on occasions, but if your strategy cannot adapt to changing environments, you’ll soon be among the traders who end up in the “forex graveyard.” What do I mean by changing environments? Simply, it’s the level of volatility in the market. This forex trading tutorial will guide you through how to select the right type of trading strategy for the right market. Just think- does it make sense to to find the “holy grail” of forex trading strategies only to realize it only works under certain market conditions? The market is an ever changing being that is super competitive for traders to win at (but potentially very profitable). If you want to make money trading forex you need to differentiate yourself from everyone else. Most people are trading the same strategy without paying attention to how the underlying market behavior is changing. If some strategy was tested during a period of calm, nice, trending markets, do you think it’s going to fare well when a credit crisis develops and the market goes up and down 1,000 pips in  a month due to widespread panic and indecision?

Don’t be like the rest of the losers who just move from one forex trading strategy to another in an endless search for the holy grail, only to realize that had they came prepared with a set of strategies for dealing with different market environments they would’ve been able to make money trading forex during any period.You see, the reason why most people get stopped out is only PARTLY because they misjudge direction. It’s mostly because they don’t even have a clue that they have to judge the level of volatility. You got me? It’s not just deciding whether to go long or short, it’s knowing whether price is making large sustained moves, is confined to a range, or is making erratic swings, because different strategies are required in each case to capture profits and limit the probability of losing.

We’re going to go through how to analyze the forex market and determine which type of strategy to use in your system right now. So let’s go through the strategies required to make money with forex, regardless of the market environment (we’ll go into the mechanics of how to actually make and enter the trades step by step, but for now I want you to see how to know which strategy to use):

1. Ask yourself, “is the market ranging or trending right now? ” You do this by looking at a daily price chart over the last 1-3 months. If price is ranging, you’ll often see price move up and down within a confined range. If price is trending, you’ll see price making a series of higher highs and higher lows in an uptrend and the opposite for a downtrend (a screenshot of these conditions is below). If it has been trending, ask, “which way has price been moving?”
2. Find out what the market is focused on at the moment. Understanding past price action alone doesn’t give you as great of an edge in my opinion. When the market makes a strong, sustained move, there is usually a fundamental economic reason for that happening. Look for keywords in the media that analysts use to explain why a currency has been moving (good sources are Bloomberg and daily investment bank reports). You will hear themes and keywords like, “The Pound has been climbing on higher interest rate expectations in the UK,” or “The US Dollar has been benefiting from fear and risk aversion in the markets.” Don’t get too wrapped up in this step–it’s just important to know that price has been moving due to a good fundamental reason, and not just banks taking currency orders, which is essentially random to traders.
3. If the market is confined to a horizontal range or slowly drifiting up or down, select a low volatility, or range trading strategy. How many times have you heard the phrase, “cut your losses short and run your profits”?- Trading gurus throw out that aphorism like some gold piece of wisdom that will solve your problems, but guess what? It’s NOT always true! In a low volatility, ranging environment, price isn’t making any big sustainable moves. Rather, price is very erratic and likely to hit your stop loss. What you want to do instead is take quick, small profits to take advantage of the small moves in the market, and set your stops large enough to not get stopped out easily. What’s the point of limiting your losses so much by putting stop losses so close to your entry, only to find that you lose most of the time because it’s so likely to get hit? I call this low volatility style of trading, “short gamma” trading, which refers to a style of trading in the options world meaning to trade lower volatility trades, earn steady small profits and have larger infrequent (and controlled) losses. Typical profits are around 40-90 pips per trade and come quite frequently, while the occasional losses may be around 120-270 pips.
4. If the market is moving in one direction fast and decisevely, select a high volatility strategy. If price has been ranging for a while or drifting lightly in one direction and starts to really move (and the move is supported by fundamentals and other indicators), you should be taking very small risks but looking for HUGE gains. When you’re trying to catch the beginning of a new trend, you want to get in early, which is a risk because you might get stopped out a few times until the market finally decides to make a decisive move, but when it finally moves you make a killing in profits. I call these style of trades “long gamma” trades. Again, in the options world, this refers to a trading style that has a lower win/loss ratio, but the wins are enormous compared to losses. I’ve had wins up to almost 1,000 pips with this method, while typical stop losses are between 100-300 pips. It’s important to verify that there’s some kind of a fundamental imbalance leading up to this move and a sentiment shift to indicate that there’s a big driving force supporting your trades. We’ll go over how to objectively identify these in the next couple of posts.

Different types of market environments and volatility levels in forex

You see, the market moves in cycles from ranging to trending to ranging to trending. If you can get this right, choosing direction will be simple because you won’t get confused by the pullbacks in the range, thinking that they are part of a new trend. If you want to make money with forex you have to understand this or you will get caught up in the confusing up and down swings of the market.