SIgma-D: A Simple Approach to Trading Forex

I'm going to outline my approach to trading forex (primarily). The techniques and methods I utilise and the specifics with regard to setups, entry, in-trade management and exit. I will discuss with systematic and discretionary factors.

Caveats
When I use the word 'you' I am talking about myself (to myself?) only and whatever it is I'm saying need not necessarily apply to any other trader. If it strikes a chord with you too, that’s great.

As a guiding principle: Before accepting anything offered by anyone else, test it, challenge it, pick holes in it and think it though. [Including stuff on this thread of course.] If something isn't immediately obvious, intuitive, simple and employable - treat it with great suspicion. Doesn’t mean it’s wrong in any absolute sense, just that if it doesn’t work for you for whatever reason, simply don’t use it.

Only use in live trading what you have been able to demonstrably prove works for you initially on a test basis and then with fractional stakes to test it ‘under fire’. Then and only then will it have a chance of being considered for your trading toolkit.

 

Oservations

Traders: Most retail traders of Forex will be doing so purely on a directional basis and will rarely move into more ‘exotic’ plays involving derivatives or structured trades or even into other markets, asset classes and instruments. This is a big mistake. It’s my belief that those who ONLY trade spot forex do so in the belief it is an easy and quick road to riches. They are not traders. Those who trade or are at least interested in and utilise data from other markets because they are genuinely enthused with trading in the sense of a global marketplace where everything has a price and is related and impacts upon and from every other asset – these are traders. The former have little chance of success, the latter much more so.

The Need for Speed: There are times of low volatility which means there isn't going to be much worth trading. Sitting out is more sensible than getting into a marginal trade just for some ‘action’.

Diversification (in the narrowest sense): Usually, when you have one specific currency showing strength/weakness, it is doing so against a number of others which are showing the opposite. It makes sense to trade the basket rather than attempt to guess which pair will yield the greatest movement.


Greed & Fear: The biggest cause of failure is not inability to recognise an obvious trend, but of setting/moving stops too close to the action.
If you don't get taken out from having your stop too close, you exit too soon, you don't allow the trade to develop.

While a 15 pip stop might be more attractive with regard to position size than a 50 pip stop, if the 50 pip stop lets you make a successful trade with a 10 pip profit with a position size 5 times smaller than the 15 pip trade that cost you all your risk, where’s the sense in minimising your probability of success and making a profit?

Targets and Why You Need One (at least one): Regardless of chosen trading timeframe, having carried out your analysis of directional bias, factors in place to recommend entry and expended the energy to make the entry, if you don't allow the price to move, if you start getting nervous or twitchy and exit, you'll deprive yourself of the reward for your hard work.

The problem with sitting in a trade and where nerves and twitch come from is from uncertainty - not knowing where you should sensibly be expecting to exit i.e. a target.

Many will suggest that you should allow price action to tell you when enough is enough , but they stop short of telling you how you recognise this delightful state of affairs. This is where having a target takes a large chunk of stress out of the game.

 

Delusions

Reward/Risk: There is a delusion that reward/risk has to be a multiple for a trade to make sense; It doesn't. A self-serving industry has grown up around performance metrics. You need a high win rate for both financial and emotional comfort. You may think you and your system can handle 100 small losses and the one big win which dwarfs them - but you can't.

Indicators: There is a delusion that complex and tailored indicators are essential for success. They are not. Another self-serving industry has grown up around this myth. If you can get by without any or just a moving average or whatever - you're probably on the right track.

Intellectual, Social, Personal and Financial Requirements for Success in Trading: There is a delusion that trading is complex, takes years of study and experience and significant capital to become an accomplished and consistently profitable trader. It isn't and it doesn't. Again, another industry (totally self-serving) has grown up around this canard.

The Myth of the Significance of Performance
Positive expectancy as a a basis for determination of trading success is deeply flawed. It does not take into account the impact of the probability of successive losses nor where they might occur in the set of in sample trades.

That's the least of traders' worries when it comes to performance profiles.

Very few technical traders manage to leave their systems alone long enough to produce a statistically significant set of data. The apparent need to tweak nullifies all past data and draws a line under all past results making them meaningless.

 

Don't chase the Price versus It's never too late to get on board. Which is Correct?

This apparent paradox disappears when you have a clear take on where the stop needs to be and where the most viable target level sits. Going back to an above observation on reward/risk, it isn't a matter of the relative distance to each of these levels which decides the viability of the trade, but the probability of price reaching your target.

e.g I've got 40 pips to stop and a 85% probability of making it to target in 15 pips - will I take this trade? Of course I will. Even those hypnotised with the delusion of positive expectancy would (in theory) go for that trade.

But what about a 100 pip stop with an 85% chance of 15 pip target? The +ve expectancy crowd would suggest not - but they aren't looking at what the price has to do to move all the way back through that 100 pips of pain compared with the ease with which it'll slip into profit with the target that much closer.

 

I trade the aud, cad, chf, eur, gbp, jpy, nzd and usd pairs. I use a 15 minute chart. On any given day of the 28 pairs available I will typically be favouring one, possibly two individual currencies against a basket of 'the rest'.

I'll start by outlining how the context within which I'll be looking for setups, how I'll determine the precise best point of entry and the expected target exit levels and times.

After laying a foundation with spot forex, I'll expand my discussion to encompass the other instruments I trade both a standalone trade expressions in their own right and in more complex structures in which I employ them to achieve an optimum return given extant market conditions.

In 10 minutes time at 22:00 BST I'll outline the context within which I will be assessing a single forex pair for tomoroow - eur/usd.

 

eur/usd - Wednesday June 25th 2014.

There is a core sector from 3592 to 3619 with a median level at 3601 around which price will tend to gravitate.

If it breaches the upper boundary of this sector then the probability of a move to 3636 has an 86% probability. A move to 3673 has a 43% probability at the start of the trading day i.e. now. If the first target level is hit by a specific time (11:15 BST) then the probability of the secondary target level being reached rises to 73%.

If it breaches the lower level of this sector the same rules apply, albeit with different probabilities. A move down to 3565 has a 77% probability with a secondary target at 3538 which has a 54% probability. If the primary target is reached before 13:15 BST then the probability of the secondary target being hit rises to 68%.

The entry points (if any) are determined by price action and momentum so I am not able to predict levels or times of entry ahead of time. If/when I do enter, I will provide my best estimate as to the time the next likely target level will most likely be reached - if it is reached at all.

I will explain my reasons for any exits earlier than projected time/level at the time of exit.

 

eur/usd current mode is Long.

I'm not trading the dead spot, but you could reasonably take a long punt to the upper sector boundary at 3619 from here 3607 with a stop just below the median level at 3601. 12 pips profit for 6+pips risk ain't my kind of thing but it's a potential better than 1:1 reward/risk for those hungry for some action. And of course, a potenitally good entry for getting on board to the primary target if it should develop.

 

I'm not a big fan of data releases. They offer the trader a bad deal. While random chance suggests news releases should favour your trade 50% of the time, the house edge, the zero/double zero on the roulette wheel, is the brokers spreads. They will widen around major news times and basically pay for the brokers' lunch, birthday, christmas, vacation, holiday home, yacht etc.

I try to get out if at all possible ahead of major news. It will depend on where I am in my trade, distance to stop and target and a number of other factors, which I will expand upon when the situation requires it.

USD has a bunch of data at 13:30 which I'd prefer to avoid and a secondary slew at 14:45 which I'd probably sit out. (All times London/BST).

You're running a business. A trading business. There are times of day where it's more expensive to do business. You have the luxury of deciding when to do business. It is entirely appropriate you reduce your operational expenses at every opportunity.

 

Re: the above. Don't fall victim to the delusion your broker is out to get you. He's not. He wants everyones money equally. He wont be targetting your specific stops, honest. Even if you're A book (especially if you're A book!).

Just be aware of the game and the rules and play them wherever possible to your advantage.

 

What fx derivatives do you trade?