1) So first volatility. FOREX is volatile. period. It turns out that currencies trade in a quarter cent range most of the time and then jump ranges by quarter cent multiples. Quite often a whole cent. Now if you are using the old “keep your stops tight” adage as an attempt at minimizing risk you are most likely trying a five or ten pip stop loss. Well forget it. You stop loss must be outside the current price range so that it will only be hit if the currency revalues – not on minute to minute volatility. So for me that means the stop loss is not 30 pips. Assuming I am careful with order placement and I am coming in at the lower end of the price range then the stop will only be hit on a move against me by more than a whole price band.

2) Technical Indicators. Well after years of using them I have concluded they don’t work. Why? because if you offset them by a random number they also appear to provide support and resistance.  They also ignore fundamentals. If your technical indicator tells you that support is right in the middle of a trading range you are screwed. Even pivot points and bollinger bands are dodgy.

3) Fundamentals. By this you need to think about what is happening. Banks value currency based on interest rates, GDP, Risk etc and come up with a maximum price they will pay for a currency as well as a view of whether they think it will gain in value or whether they want to reduce their exposure to it. The desire to lessen their exposure to risk is as big or even bigger than their desire for profit. Even if they don’t make money they are under pressure to not lose money. So banks come up with a price and a direction.  Above this they will sell and below this they will buy. Banks don’t use weird numbers like 1.2913 Its either 1.29 or 1.2925. When the price changes it will change by a quarter(0.0025) a half(0.005) or a whole unit (0.01). Not some piddly little offbeat number like 0.0017.  So avoid piddly little numbers – you are just setting yourself up to have some institutional trader sell to you at too high a price or buy from you at too low a price.

In the following chart I have placed in quarter and half cent lines (darker). It is obvious that these provide support and resistance. By entering at the lower side of a range and ensuring the stop loss is more than a whole band away from the current range should ensure that the stop will only be hit if the price changes bands rather than on spurious wobbles.

In fact it is these levels that cause pivot points to appear to work. The highs and lows are defined by quarter cent ranges. Which means that if it turns out that the highs and lows are a half or whole unit apart then the central pivot which is half way between them will end up being on a quarter unit line. So Pivot points appear to work when they happen to correspond to a quarter unit line.

The Plan

Determine the current range and place an order at the lower (or upper) side of it with a stop loss at least a trading band away from volatility. Trade in the direction of the underlying trend.

The problem started with Bollinger bands.  I found that I was keeping charts on several different time scales in order to determine what traders using the different time scales would be seeing. Then I noticed they all seemed to work.  I am a pure maths type of person and that is not possible.

Then I discovered that if you offset the Pivot points by a random amount they also appear to work – for any random offset.

Okay now try moving a horizontal line down over a chart. I bet you will be able to find a support and resistance level somewhere on the chart at every value you place the line at.

So we have a problem here. Its an optical illusion of sorts. Your brain sees the points a reversal occurs at and flags the points that it doesn’t occur at as a “price broke resistance” level.

You may as well choose a random price and say that it will be a support level.

In fact I have pretty well convinced myself that it is impossible to predict support and resistance levels to any higher accuracy than choosing a random number.

Now trend information that is different. At the moment I am of the opinion that with some level of accuracy the broad direction of the market can be predicted within a  small window about any time.  That argument is based around a loose intermediate value theorem argument. If the price is currently going up at 10 pips per hour on average for it to reverse and start moving at -10 pips per hour the average price will have to go through 0 first.

So how do people trade off indicators?  Most likely good money management.

Pretty well screws up all my trading plans that were based on entering at particular support levels.

To date we have.

1. Risk Reward needs to be greater than or equal to 1:3. Anything else makes it hard to pull ahead. Even at 1:2 you are only ahead by your at risk amount assuming a 50% fail rate.
2. Keep your stop loss a bit larger than 1 standard deviation on the time scale you are scalping under.
3. Don’t change your per trade risk. Scalping  is a numbers game. It relies upon a sequence of trades to work.  If for example you have a 5 pip stop on one trade and a 10 pip stop on the next then you have just screwed up your risk reward ratio.  The loss on that single 10 pip trade is the same as two consecutive 5 pip losses.  You can increase your take profit amount for the same reason.
4. Use Stop Orders for trending markets. Limit Orders for range bound markets.
5. Let the price come to you.
6. Less is more.  The more indicators you have the more conflicting signals you will see.   If the information provided by an indicator is already visible on your chart don’t use it.  If it conflicts with other indicators, don’t use it.  The hard part of this game is reading entries. The whole point of using indicators is to filter out unwanted possibilities and to highlight good possibilities. The last thing you want to do is to increase the number of possibilities and hence your own internal confusion.
7. Support becomes resistance and vice-versa in trending markets.

Limit Orders.

These are probably the most common used by newbies.  The Limit order will enter if the price is at or better than the price you have selected.  The big problem with a Limit order is that the price is by definition moving against the direction of the order when it is opened.  Secondly we all use stop losses correct?  Stand back and think about this for a minute.  the limit order together with the stop loss order defines a narrow range within which you are making the assertion that the price will not only enter but will also turn around. Is your analysis that perfect? Have you allowed for volatility?

Keeping in mind the random forces acting on price this is almost impossible to do unless there is some form of brick wall the price will hit and not move past.  It is effectively the same as throwing a wobbly dart at a small target.  Good luck.

For Limit Orders to work they require a reasonably large stop loss together with a major support or resistance level.  But even with something like an outer Bollinger band or a pivot point you will still need to allow for a standard deviation or more for your stop loss.

They require a high level of skill to use but if you get it right they are also the most profitable.

Use with range bound markets with clear support and resistance levels.

Stop Orders

Stop Orders open when the price crosses the line. They act as a trip wire. Unlike limit orders they assume the price is moving in the direction you have chosen.

The problems with Stop Orders are slippage, the amount the price moves between when the line is crossed and when the computers actually manage to get the order into the market. This can be huge on economic announcements or illiquid markets.  They also don’t get the best possible price.

This has to be traded off against not getting any price at all.  It is very easy to place a limit order and simply not be hit at all.

The caution with stop orders is when they are placed just outside a convergence zone. When breakouts occur the price has a habit of kicking back to the support level within a tick or so of the breakout – not talking 5 minute ticks here, am talking sub second tick by tick charts. So care has to be taken to ensure the stop loss is clear of the convergence area.

You will need to check with your provider to see how slippage affects your stop and take profit levels. Will they be placed at offsets from your original order or offset from the actual price obtained?

Use with trending markets. Care to ensure your stop loss is not likely to be hit on the inevitable micro retracements.

Market Orders

Don’t use them.  Slippage is likely to be large from when you click your mouse and the order eventually makes it into the market. The big issue is your stop losses and take profits will be offset from where the price was when your order ht the market not where they were when you clicked your mouse.

This in itself was good. In fact still is. The problem is that we have had a skittish market of late. The broader trend of the last few months has ended and we have had a slew of economic announcements that pretty well sidelined me.  When viewed in hindsight the plan works well. In practice it had been hard to read which level it is settling out at.  It pretty well sets me up for one trade a day which if I miss for whatever reason leaves me with no income.

So what I need is a more flexible method that is less dependent upon economic context that can handle some volatility and that allows more trading opportunities.  I also need to do something about dead hours during the day which just doesn’t really work.

So for that we turn to scalping.  I have done some, in fact a lot of analysis about volatility and risk reward ratios and have pretty well come to the conclusion that risk/reward is independent of time scale.  As mentioned in another post the whole concept of “buy low” “sell high” boils down to buying at the extremes of the Gaussian distribution below average price and selling at the upper end of the distribution above the price.  This has to be combined with an allowance for “wiggle room”.   Both of these things are defined in terms of a single quantity, the standard deviation. The minimum stop loss needs to be about 1 standard deviation and the maximum reward is a trip from one side of the bell shaped curve to the other, which is about 4 standard deviations giving you a maximum risk reward ratio independent of time of 1:4 .

Or more practically I found I needed a stop loss of about 25 pips to pick up the average London open move of 100 pips. But I could have obtained the same risk reward with a trade of 5 pips as a stop and 20 pips as a reward.  The difference is that there are far more 20 pip moves per day than there are 100 pip moves.

You can work through the math, but it works out that if you divide your daily risk into many smaller trades the probability of a loss on the day assuming a risk reward ration of 1:3 is almost negligible. In fact if your per trade probability of a win loss is 50% then the probability of 10 successive losses is

Whereas if you put it all on one trade the probability is 50%.

The Plan

Well that’s enough for background. The new plan is in a sense the same as the old.  It keeps the different behavior during different session and keeps the use of broad Bollinger bands. The difference is that it uses Bollinger bands that have been set to show what a 15 minute trader would see.   In other words 20 x 15 minutes which is 300 ticks on a 1 minute chart. It also overlays the pivot points.

It uses normal bars rather than candles because I am looking for convergence rather than candle formations.

This chart is of the Australian SPI200 cash, but it also applies with the EURUSD etc.

The general idea is to scalp through the day on the SPI200 and then in the evening pick up the first couple of hours of London open trade on the EURUSD.

I am assuming say 10 trades per day, risk reward is small.  The stop is about 5 pips including spread for the SPI200 (1 pip spread) and about 7 for the EURUSD (2 pip spread). Reward is correspondingly tight using a risk reward of 1:3.

The at risk amount for the day is the same as before – (not posted here)  but is spread out over an assumed 10 trades per day.  Risk for the day is a small percentage of total capital with returns compounded back in.

I have modeled it out using a spreadsheet assuming 10 trades a day over a couple of months using a coin toss technique for success or not per trade. It breaks even more or less at a 70% per trade fail rate.  Provides a reasonable income at 50% fail rate and is massively profitable with a 30% failure rate.

The key driver is consistent income rather then the promise of get rich quick.  Its a job not a casino.

So if we assume you buy low and sell high, then the best you can reasonably expect is for the price to move from one side of the bell shaped curve to the other. In other words to make four standard deviations. Your risk will be one standard deviation which gives a risk/reward ratio of 1:4 independent of time scale.

Now of course there are exceptions. You may be lucky enough to pick up the beginning of a longer trend. Remember though that this is luck. You cant know in advance that you have picked up that exact price and of course if it starts trending then it will affect all time frames.

The following pictures of the EURUSD demonstrate. The first is on a one minute time frame, the second a 15 minute time frame. Notice how if I didn’t tell you the time frame they pretty well all look the same. But more importantly notice the relationship between how much “wiggle room” you would need to allow compared to reasonable reward.   The coloration of the background reflects the session dominating.

The same applies to daily and even weekly charts.  Interesting.

1 Minute EURUSD

15 Minute EURUSD

If you think about what is happening with Forex it is obvious. A bank will set a price for say the EURUSD of say 1.2900. They wont be saying 1.2913. They might say 1.2925 or 1.2950. Someone trading for the bank will have a maximum price set for them by management that they can pay for a currency unit. Under this level the bank considers the currency is cheap and above which the bank can sell the currency at a profit.

Popped a grid of quarter cent lines around the price up on the chart and guess what – it fitted. So where now. Well after last nights mistake of trying to fight the chop around an announcement will stay out. Its non farm payrolls again.

But longer term the trick seems to be to identify the half cent or so range that the currency is locked into – staying a long way away from the middle where all the volatility is. And guess what I have been doing – placing my orders right into the middle of the trading ranges thinking I have picked a top or bottom. Hence why I get stopped out so much.

Instead I should place orders at the extremes of the trading range. Pretty obvious huh – damn I hate hindsight. Why cant I have the hindsight before I try something.

2 September 2010: Discovered a major flaw in my strategy. I had been relying upon technical indicators – both bollingers and pivot points to determine support and resistance levels in order to place my orders. Well the bad news is that they don’t work. They look like they do, lots and lots of people use them. They don’t and can be shown not to be able to. Why? well with pivots when you calculate them try offsetting the central pivot by a random amount. You will find the new set also “shows” support and resistance. With Bollingers try using different sampling intervals – which will also show support and resistance. Think about that for a while in the context that you could have chosen any offset or time interval.

Bollingers can help filter out noise and pull out trend information, but can not determine minimum and maximum points.

OK that was a bit of a knock, but the good news is that it means I can stop wasting my time – and money on them. So from here it is back to a basic moving average trend following strategy. In other words move from trying to enter at the very bottom or top over to wait for the trend to be established and then jump on.

Hindsight: Tried trading through US jobless claims anouncements and now know why people don’t. Absolute horror session. Like being on a small boat in a choppy sea. Swings of up to 50 pips over a minute or so which when a normal days is only 100 pips are huge. Wont be doing that gain in a hurry

1 September 2010: Stripped everything off the charts except the pivot levels. Went back over a lot of old data to convince myself they do work. Both The AUDUSD and EURUSD moved heavily through the day am not sure they have a lot left in them for tonight. Will see.
Hindsight: Well I misread that one. Its not often that Australia shakes the world markets but it looks like our GDP figures broke the deadlock between the bulls and bears. Probably good news perhaps we will get some trend back into the markets now

31 August 2010: Having a rethink again. Getting the direction right is reasonably doable. Staying in the trade without being stopped out is well nigh impossible. Also having a rethink about Bollinger Bands. The seem to work – except for one small problem. They appear to work on every time scale and that does not seem possible. Something smells wrong with the maths. A bad case of an “In Hindsight Indicator”. That is to say when you look at the price and see it bounce off the line it appears to work. Problem is your brain doesn’t see the occasions when it doesn’t. As a rather absurd example you could draw a random curve across a price chart and at some points the price will intersect the curve. Because you want to see something you will. So yes Bollinge Bands tells you how far things are from the mean and whether things are oversold or overbought, that is all cool. Am just not convinced it is picking up reversal points. So am going back to the old floor traders pivot points at the moment. They definitely work. The problem is you only get a couple of of opportunities a day which screws up the idea of keeping myself busy scalping through the day.
Hindsight: Opened a couple of positions that didn’t get filled. Pretty Ho Hum

30 August 2010: New week, again. Think I have finished fiddling with charts for the most part. Now to focus on actually getting the orders in in the right direction at the right time. Just had a look at the daily charts for the EURUSD. Something does not look healthy. Despite the recent rally it is still making lower highs and lower lows. The economic cheer squad may be out in force saying the worst is over. Until the data matches the cheers I am going to retain my pessimistic view. In simple terms until the West remembers that it needs to actually make and sell something at a competitive price to make money which will result in profits, employment, economic growth and all that we are all going to be in a world of shit. And we have to do all that while paying off the decades of socialist baby boomers voting themselves free stuff and pay rises as well as the recent “stimulus” spend. Not a hope in hell. Should have known something was wrong when they introduced a GST to ensure that the government could raise taxes from money spent on credit…..
Hindsight: Managed to get stopped out yet again. This is becoming irritating. I figure the stop loss is still too tight. This seems to be the key issue. The volatility about the price is massive and I am not nimble enough to work it.

27 August 2010: Looking to improve on yesterday. Market shows signs of starting an up trend. The heavy falls from a fortnight back haven’t been followed up by even heavier ones and it looks to have found support midrange above the June lows which is good. The fly in the ointment is that tonight we have UK GDP which will probably be unchanged – when was the last time you saw something “Made in the UK”? More often than 3 months ago? Probably not. This will affect London based traders from around 6:30 pm my time (9:30 am their time). Market likely to be wishy washy until this is out of the way. Not worth the risk of holding through this. The big worry is US GDP is out tonight and Bernanke is speaking. The neutral position of the market could easily sour unless he can find some good news or a way to put some positive spin on bad news or at least the lack of good news. Not sure how many times you can this. That is around midnight so won’t hit me.

Hindsight: Market seemed to heave a sigh of relief after Bernanke announced it wasn’t the end of the world for this month at least. And if it is then the Fed is prepared to help out. That’s good to know – can’t figure out what they can do though. If it comes down this time it will be because the money spent last time didn’t do a damned thing and now we have to pay for it. Annoying when the ASX moves 2% during the New York session and then wallows during the Australian session.

26 August 2010: Good day. Have pretty well nailed the new charts for the continuing scalping adventures. Have placed a couple of small orders. A lot easier using Stop orders rather than Limit orders. One wrong and two right. Trouble is the two rights ended up only being very small gains. Need to rethink my strategy of moving the stop loss into a risk free position early. It ensures that no loss will occur – but the resistance becomes support rule pretty well means this price will be tested at some point.
EURUSD being capricious again. Doesn’t quite know if its Arthur or Martha. Wants to fall but a huge support level underneath it.

Hindsight: Need to open up my stop loss amounts a tad during the London session. Need to be more flexible on strategy. The Asian session has different behavior to London. Pretty well given up on a one size fits all set of rules and order types. Just will have to be flexible. Need to not be quite as risk adverse. Also by a tad. Looked back over last nights session – down a whole $14. A couple were dud trades where the market changed its mood. Nothing can be done about them. The others were because I moved my stop loss to protect my position too early and got stopped out on normal volatility. If I had worn the risk a little longer it would have been a profit.

25 August 2010: Changed from using Limit Orders to Stop Orders. So much easier. In hindsight it is a lot easier to say something is too high, is coming down and will keep coming down for a while than it is to say something is currently coming up, but is too high and will turn around within a given narrow range somewhere above where it is. Damn! months wasted figuring out this little bit of logic…. Play trading using stop orders today was so much easier. Almost but not quite trivial. Anyway famous last words will see what happens when I put some skin in the game and all the emotional what ifs kick in.

Hindsight: Not a lot on this one. Thankfully didn’t try trading it. Gapped up 30 pips on the German Business climate index and then the market decided that it wasn’t really good news and promptly spent the rest of the session falling.

24 August 2010: Continuing adventures learning how to scalp. Tick by Tick charts look to be an interesting tool to help read the orders coming in from second to second to see how they track with the average price. A bit like reading a ticker tape. If the ticks are above a long term average sentiment is up if not then down. On going problem of finding a simple rule that works most of the time. Trading Bollingers on a tick chart wont work. Would be hard pressed to cover the spread. But still looks good.

Note: Definition Spread. The price you pay either side of the actual price in lieu of brokerage. For example EURUSD at the moment actually is 1.2621. If I buy I pay 1.2622 and if I sell I get 1.2620. The 2 pip difference is the brokers profit. The broker is buying or selling at the actual price and pockets the difference. More likely the broker is paying a smaller spread to a down stream provider actually. On forex minis at $1:00 a pip it is pretty good. But still if you are only looking at 10 pips a trade the broker is making 20% of profit and gets paid even if you are wrong.

Hindsight: Managed to clear another hurdle. Order types. I had been using Limit orders which enter if the price is better than the target. Big problem. It assumes that the market is going to reverse direction somewhere between the entry price and the stop loss. In order for the Limit order to open it has to be going in the wrong direction in the first place. With MAJOR support and resistance this may work. But with a tight stop it effectively is the same as throwing a wobbling dart at a Bull’s-eye. Might do a separate post on this one. Must use Stop Orders to open.

23 August 2010: New week. Monday day time annoying. My 1 minute data appears to have been reset which means my 300 tick bollingers didn’t come up until 2:00 pm. Will watch the EURUSD with a view to scalp.

Hindsight: Placed a couple of orders that didn’t get hit, then managed to confuse myself. Big question at the moment. Limit orders which gives the best price with the risk of it pushing through and stopping out vs stop orders with the risk of slippage and not the best price.

20 August 2010: More work done on the scalping strategy,  interesting results. To have a quick look and using artificial numbers as an example.

If you make the assumption that you are aiming at 10 individual 10 pip scalps rather than 1 single 100 pip trade and ignoring spread costs you would still at the end of the day make 100 points. But the risk is significantly different. If you assume a 50% probability of an error and use the rule that risk is about 25% profit at best (30% probably more realistic) then on the single trade you have a 50% chance of losing 25 pips (and a 50% chance of making 100 pips, but we are looking at risk not reward).

Now if you spread the risk over 10 separate trades the probability of losing the same amount is equal to losing each trade which is

A lot lower. In fact almost impossible. In fact if you work it through over a sequence of trades using a given at risk amount for the day and assuming that reward is about 3 times risk then the expected return is

which means that no return will occur when

which works that you would have a Probability of Loss of  a walloping 75%.   I figure that if three quarters of your trades went wrong, you would not have the stomach to continue using that strategy and would fix it.

I can see why various web sites make the claim that most successful traders scalp.  They may miss the big wins, but they are almost guaranteed to bring in a regular income every day. When you work through all the figures assuming a high figure of a 50% fail rate it turns out that they would bring some money home every day. If you measure success by survivability than this looks good.

Now all I have to do is get my entry and exit signals right.

Hindsight: Didn’t trade. Watched the SPI200 and the first couple of hours of EURUSD with a view to changing to a scalping strategy. Seems viable. The resistance becomes support rule holds well in a trending market. Need to do some work on entry placement on Bollinger band bounces. It seems to push through quite aggressively at times.

19 August 2010: Spent the day evaluating a scalping strategy. Lower but more consistent returns. To use a horse racing analogy its the same as taking your “play money” and taking lots of small bets across lots of races rather than placing it all on the nose of one horse in one race. The odds of loosing all of them is small, but the gains are lower. Consistency would be good. The difference with a horse race is you can limit how much you pay the bookie if you are wrong and can take your winnings when your horse is in front half way through the race. EURUSD fell hard at the start of the Asian session and then drifted sideways all day. No obvious direction at the moment.

Hindsight: Choppy at the start of the session then rose solidly. Thankfully I was working on the scalping strategy and didn’t take it. The rule of trading from support at open would have failed. Am starting to think that that rule only applies in a trending market – Like the last few months.

18 August 2010: EURUSD Drifted down through the Asian session. Not looking good for tonight. Is currently sitting on a lower support line with 2 brick walls of resistance a few points above it. To go up it needs to push through the daily and weekly mid lines. Are things that bullish? If it is going to go down it has to push through the daily lower bollinger. And arguably I have already missed the boat for the latter. In hindsight it will have moved somewhere and in hindsight it will make sense. Am stuffed if I can see it at the moment. Will see. Perhaps a short from the midline.

Hindsight: Got the direction wrong. It wandered undecided for a while then ended up pushing through the resistance levels only to fall. Having a rethink of the one trade a day at London open. If I get it wrong or conditions are wrong I am out for 24 hours. So am thinking about trying to scalp the Australian SPI200 again. Spread the risk out over more smaller trades and increase the number of entry opportunities. Also need to kill the Australian trading hour boredom. Being alert during Australian trading hours and tired when the action starts at London open is still a big problem. Thinking about the risk reward ratio which is the same for one minute charts as one day charts means that technically there is no real difference. Trouble is the Australian SPI200 does most of its moves New York time and tends to slide during the day.

17 August 2010: Moved a bit early yesterday. Will hold back until a little closer to open today. Once again the Asian session was unusually strong. Something brewing in Japan apparently. The Yen heading to 15 year lows. Am tossing up whether to try and trade it. Last time was a disaster. Watching a sideways sliding price for hours on end is a slow form of torture and I am not nimble enough to scalp effectively. At present on the EURUSD 1.29 is beckoning with the weekly mean line just a little above at 1.291. The question is whether it will return to the daily mean at 1.2827 before heading up. The really big question is whether 1.29 is the upper end of the range or whether last weeks sell off was over done. Order placed : Long @ 1.28285 Stop 20 Limit 100.

Hindsight: Entry was perfect. Thankfully moved to a free carry position because the price ran into the weekly mid level and didn’t have the legs to continue. Out at a small profit. Lesson be more pessimistic on the profit target, particularly if there is a technical brick wall in front of it.

16 August 2010: A new week with all the economic announcements behind us. A bit ambiguous today. We have the daily mid bollinger at 1.28, but we have the weekly bearish 1 standard deviation at 1.2817. Unusual strength during the Asian session continuing with the EURUSD rising. So the question is which one is resistance or will it break both. The weekly is normally a stronger line so I figure short from around 1.2814. A bit risky because it needs the price to pop its head above the daily mean at 1.28 and get beaten back down. But if its strong enough to push through the mean line how likely is it to be beaten down. Order placed : Short @ 1.28139 Stop 20 Limit 100.

Hindsight: Stopped out; EURUSD opened far more bullishly than expected and pushed through both resistance lines, the central pivot, took out my stop by a couple of pips, turned around and proceeded to fall. Eventually rose late in the session. Messy night.

Possible lessons here; Stop placement. It wound up just under daily standard deviation line – was bugging me, but I didn’t move it. Needless to say that is where it reversed. Moving stops is another bad idea by the way so I don’t recommend it. Alternatively wait a little later before placing the order.  I would have thought differently if it had cleared the daily mid bollinger before I placed the order. As another alternative check the momentum in the lead up to open. In this case it was climbing hard and allow for an overshoot.

Note to self; the plan is profitable at even a 68% failure rate, so figure out the lesson then suck it up sweet heart and move on.

13 August 2010: Friday the 13th and the market has been rising slowly for most of the day. The expected retracement from the last few days of blood letting I think. Another abnormal Asian session. Worries about the Yen it seems. Its a Friday so people will want to close out for the week, could push it higher. Am thinking short, the question is where from.

Hindsight: Market fell as expected. Was a lot weaker than expected though. In fact looking back over the week my caution appears to be groundless. If I alter the plan to be not as strict regarding a pull back to resistance/support and instead look for the resistance/support level that the market is stalling at towards the end of the Asian – start of the London session then it would have worked every day this week. I really need to have more confidence in the technicals and have to stop second guessing myself. The model is solid . Period. The problem from here on in is psychological. Hmmmmph Googling psychology of trading brings up a whole world of pain.

12 August 2010: EURUSD licked it’s wounds all day, retracing slightly. Not sure whether to expect profit taking before further falls, a sideways slide until NY open or another slam down from London open. Doomsayers are out in force, which means the bargain hunters will be competing with the people who missed last night. Am not expecting to trade unless something obvious pops up. Perhaps a short from the central pivot. It’s a bad week. Should note for the sake of hindsight that the normal London open pull back did not occur. Whether that implies a sideways slide or indecision I don’t know. For the sake of putting a number in the ring 1.30 is pretty close to where it could retrace to. Will see tomorrow.

Hindsight: Looks like the market has settled down. Went nowhere near the 1.30 level that I thought it may have come up to. In fact didn’t even make the central pivot. Could have, should have, didn’t trade a bounce from the mid Bollinger. Need to adapt the plan to be a little more flexible. Am extremely risk averse, but to the point of not trading is also not good.

11 August 2010: Heavy falls throughout the Asian session have taken most of the wind out of the market. Even heavier falls from an hour before open. The plan says to trade opposite the pull back that occurs before London Open. Today would be more akin to standing in front of a run away freight train and hoping it stops and reverses. Annoying, this will make four days sidelined. What we want dear Mr Market is a normal boring sideways sliding Asian Session so that when the Poms crawl off the tube and into their offices at 7:00 am all they have to do is think is “Buy” or “Sell”.

Hindsight: Well the good news was I stayed out and the bad news is I stayed out. As I suspected last night was a run away freight train. Market fell a further 250 points so going long from open would have been a bad idea. On the bad news front is I don’t have a strategy to jump aboard a moving train. The current plan relies upon changes in market direction that occurs when different groups of traders with different sentiment enter the market at different times. I need to develop one to handle the case that the train has left the station and the market is trying to jump aboard after it has moved. Perhaps a breakout strategy using stop orders instead of a reversal strategy using limit orders. Need to think – annoying. Once again it confirms my opinion that the market is female. As capricious as all hell. Soon as you figure her out, she changes on you. This is gonna be a bad week.

10 August 2010: Sidelined waiting for the FOMC meeting on monetary policy tonight. Will be glad when this round of data is past. Not sure what the Yanks can do with regard to interest rates if they need further stimulus, they are already at 0%.  Market has fallen solidly and broadly throughout the Asian session – 160 pips on the EURUSD pair since this time last night, 75 of them today. Unusual as the Asian session is normally flat. Technicals on the daily chart have all crossed into a sell. EURUSD  has pulled back up a little in the lead up to London open which on a normal day would suggest further falls tonight.  On a normal day I would call it down from about the pivot at 1.3178 -except today ain’t normal.

Hindsight: Fell from 1.3185 – 7 pips over my guess, not too bad. Put in 95 pips before heading up late in the NY session. Should I have traded it? Don’t know – staying out on news days is safe, but is the caution needed?

9 August 2010: Expected a pull back down to the Central Pivot/Central Bollinger before open to set up for a long. Didn’t happen. In fact pulled up the other way.  Just can’t convince myself it is setting up for a short.  Market expected to meander ahead of tomorrow nights (5:15 am Australian time) Fed Reserve Interest Rate Decision. EURUSD and everything else looks toppy.  US economy not indicating a strong recovery. The market has had several good weeks of rises and still feels bullish. Against that the daily technical indicators are showing overbought.  If things are going to pull back, around now would be when it happens.  Caution methinks, am going to sit this one out.

Hindsight: Meandered and then fell as the technicals indicated . Eventually dropped about 75 pips by NY close. Doubt I would have held that long. Still it would have had perhaps 55 accessible pips in it. Got to have more confidence in the technicals.

6 August 2010: Sitting it out. US monthly unemployment figures due out late in the London session. Looks like the EURUSD will meander until then.

Hindsight: Drifted down to the lower Bollinger where it bounced a solid 150 pips late in the London session following the employment report. Looks like the market was just sitting on the sidelines then went back to normal. It would have been worth placing an order at the lower Bollingers. BUT there was always the risk of a huge fall on the employment figures.

Since then I have been through a couple of trading plans, have beaten the psychological hurdle of actually placing a live trade – imagine trying to reach into some complicated machinery with spinning gears and slamming doors to grab a coin, make even the slightest error and its going to hurt…

Have made numerous stupid errors: Traded against the trend. Canceled good orders minutes before the market puts in a solid 150 pip rise. Gone to the bathroom just when the price has decided to move. Have astutely watched the market go nowhere for hours on end to nod off just when it wakes up. You name it, I have done it.

Now that I have finally reached the point where I can with reasonable accuracy make some sense out of the EURUSD pair it is worth going back and having a look at where I started.

The problem of making money boils down to determining the time and direction of the larger moves in the following chart. Ensuring that the price does not move against you by the smallest possible amount after you enter and ensuring that you get out before it changes direction on you.

Easy huh….

The second chart is the same time period, but this time marked up.

Notice how the larger moves tend to occur on session boundaries. Normally Green to Blue (London Open) or Blue to Pink (New York) .  This takes care of the “when” the move will occur.

See how the price moves tend to occur between the bands across the chart.  That takes care of the minimum and maximum price as well as the direction and for that matter the stop loss distance.

I challenge you to go back to the original chart and find the same information.

As a rule set. The EURUSD Forex market is a random process about a daily average price. It trades between support and resistance levels situated 1, 2 and occasionally 3 standard deviations from the daily mean. It trades in the direction of greatest opportunity around this trend line. It always returns to this mean. It puts in its largest moves from session open (unless there is major economic news expected) .

In fact it seems that no matter what you do the market will find a way to stop you out and take your money from you.  Sound familiar?

From a naive view you would think placing an order would have a 50% probability of being right or wrong.  You place an order and the market will go either up or down.  In fact based on this you would expect a coin toss strategy of tossing a coin and going long or short would be successful.  If you are wrong you lose a fixed amount. If you are right you would win more than this. Over time you would pull ahead.

The reason this does not work is conditional probabilities.  A successful trade is a trade that “Goes in The direction you choose” AND “Does NOT cross your stop loss on the way  there”.  To put this in the naive picture – and the math is wrong by the way, but it is only a picture.  This is the

(Probability of NOT stopping ) (Probability of going where you want).

which if you think of your high school maths is

(1-Probability of stopping) (Probability of going where you want).

So naively if there is a 50% probability of it going one way or another from one moment to another you would have something like a

(1-0.5) (0.5)=0.25 =25%

probability of a successful trade. Far worse than a simple up or down question.

Drunkards Walk

Now in truth the probability depends upon the proximity to your price. In fact you could assume a Gaussian from moment to moment if you wanted to delve into the math.  The math is non trivial by the way and depends on tick size and all sorts of other  things.  To do it properly you have to assume a Gaussian at every tick and look at the probabilities after a sequence of ticks which soon brings in the question of how many ticks, how much it will move from tick to tick etc etc and the problem gets bigger and bigger. It ends up being Einstein’s drunkards walk problem or in fact Einstein’s drunkards walk across a sloping hill side where you want the drunkard to get to his destination without bumping into some  arbitrarily placed wall on the way. Needless to say if where you want the drunkard to get is against the slope of the hill you are screwed before you start.

Suffice to say the closer your stop is to your price the higher the probability that the price will hit it and the lower the probability of a successful trade.

In fact the way things work out is that when using stop losses there are far more ways to lose money than there are to make it.  The closer your stop is to your price the higher the probability of it being hit.  The benefit of course is that your loss is limited which is a lot better than the 50% probability of a HUGE loss if you didn’t have a stop at all.  When trading Forex and futures you are using someone else’s money so the option of riding out a loss in the hope it will turn out in your favor simply does not exist.

The Solution

To beat this you need to change your thinking to make your stop placement the key thing that will make the difference between a winning trade and a losing trade.  You like me probably look at the price action from a view of where the price currently is and where it could go.  That is you are looking at how much you could make.

You are only going to make this amount of  money IF the price does not hit your stop loss on the way there.  So what you have to do is look at where the price is NOT going to go and put your stop there.   In simple terms you have to optimise the relation

(Probability of NOT stopping ) (Probability of going where you want).

There are lots of ways of doing this.  Placing your stop below the recent high or low opposite to where you are trading.  Placing it outside the Bollinger bands against the direction you are trading.  Using a fixed amount that is large with respect to the Average True Range over the time period you expect to be in the trade. Placing your stop behind a support or resistance level.

No matter what you do you need to have your stop where it will be hit ONLY if your are wrong about the trend of the market.

What you can’t use is the old adage of “Keep Your Stops Tight” because that equates to almost a 100% probability of being stopped out.

This is counter intuitive. Your natural desire is to minimize your loss which in fact will cause you to place your stop close to the price increasing your probability of a loss.

So next time you look at a chart look for two things.  Where the price could go and where it couldn’t.  Where it could go is your target and where it couldn’t is your stop.

The good part of the old plan was the session boundaries. 

I was also playing with longer term stochastics to give a broader trend direction which was sort of there, but not quite.

The new plan keeps with the concept of statistical moves but uses Bollinger bands rather than stochastics.  It is far more visual as well.

In the chart below the first thing you notice are the coloured bands. What they are are the different sessions. Yellow is Sydney, Green is Hong Kong, Blue is London and Red is New York. The Grey after the Red is when no market is open.  It can be seen that the biggest price moves occur in particular sessions. Normally London but this week New York has been figuring heavily.

On top of this are a big set of three Bollinger Bands.  These are set to collect the last 24 hours trading data which is 288 ticks on a five minute chart at 1, 2 and 3 standard deviation intervals.   You can see they provide good support and resistance lines for the intra day action.  What I was missing was context of where prices were in terms of cheap or expensive. This fills that in.

Also on the chart is a five tick Heikin Ashi inside a normal set of 20 tick Bollinger bands for entry exit timing.

The idea is to trade the larger momentum moves that occur during the London Session (Blue). New York opens at about 11:30 PM my time and as much as I seem to like staring at a computer, following a trade through from midnight to NY close is out.

Also on the chart at the bottom is a 1.5 times the standard deviation with a 200 tick moving average through it to help with stop loss sizing.

In words it boils down to start an hour or so before London open. Wait for the market to pull back to a support level – it always seems to.  Not sure why, could be Asia closing, could be people setting up a stop hunt, could be anything.  Place the order and wait. Exit when it is on or close to the normal (2 Std Devs) Bollinger bands.

The third set in grey are a guide to an overcooked market – likely to reverse.

Pivot points are also there as a guide to other resistance levels.