February 5, 2010

Knowing When to Trade

When beginner traders set out to learn the foreign exchange markets, the first type of strategy they're likely to find on web sites and books are trend following methods. Unfortunately, the market spends as much time in tight consolidating ranges as it does in smooth, identifiable trends. Knowing when to trade a profitable strategy is as important as knowing how to trade it.

This is one of many reasons that novice traders tend to achieve extremely low win rates, among other factors -- misunderstanding of price action and volatility, information overload, and misuse of indicators are the other most common problems but that's a discussion for another time and place. From the close of the New York trading session (10pm UK time) until the open of the Frankfurt European session (7am UK time), most of the major currency pairs tend to range. They occasionally trend but this is extremely rare -- rare enough that it should never be expected, so traders should never use trend following day trading methods during these hours. The times of day that are most prone to intraday trending movements are the early hours of the Frankfurt (Central European) and London (UK) sessions, which begin at 7am and 8am UK time, respectively) as well as the morning hours of the New York session (8am till noon, Eastern Time.)

It's important to note that the global interbank Forex market trades for approximately an hour longer than the stock exchanges, so the New York currency trading session ends around 5pm Eastern Time or 10pm UK time. These aren't exact times since the interbank FX market is not a centralized exchange, but most of the major market participants adhere by these times due to the largest banks' work hours (8am to 5pm in each region's local time zone.) Also, while many traders like to use GMT as the universal time zone standard, the GMT times for Forex market hours are actually not correct for the entire year -- British Summer Time and America's Daylight Savings Time shifts all of the sessions in the summer so it's actually more accurate to give these times in terms of "UK time" and "Eastern (NY) Time" than GMT.

Obviously, if your core trading method capitalizes on major daily and weekly trends rather than intraday (day trading) trends, then the trading session hours are almost irrelevant to you -- but even for longer term traders, the currency markets are still more likely to range, in terms of a weekly or monthly view, than it is to constantly trend in one direction. So swing and position traders should also take note of what to do, and what not to do, during ranging markets... just on a much larger scale.

For day traders, the criteria is a little simpler since ranging methods can be employed during hours that are statistically expected to range (NY close until Frankfurt open) while trend-following strategies can be employed during the hours most likely to produce directional trends (early European and UK session, and early NY session.)

To day trade range-bound Forex markets, take note of the daily, weekly, and monthly highs and lows. Also take note of any sideways channels that might be visible on hourly candles (or bars.) When entering a trade in these market conditions, keep in mind that the price is far more likely to fail at the break of a new high or low than it is to break out, even if the initial test of a high or low appears to break it by up to 10 pips. If anything, these "fake outs" are opportunities to fade (trade in the opposite direction of) the short term momentum for a quick profit, depending on your particular trading style and risk management approach.

Even though I would rarely mention indicators, it's worth noting that Bollinger Bands can be very helpful for beginners as a visual heads up during ranging markets. From my experience, Bollinger Bands on the 5-minute chart set to 50-period moving average (a very commonly used moving average for many time frames, including the 5-minute candle/bar chart), and 3 standard deviations, is a decent visual guide to range boundaries on most of the major pairs during ranging hours.

Just be sure that your actual entry and exit is based on actual price action and not the indicator itself. For example: "Past the top Bollinger Band, price failed to break the last 5-min candle high, and then broke the 5-minute low, so I will enter short" (good) is a valid price action based reason to enter... but simply "the candle passed the top Bollinger Band" alone (bad) is not a good enough reason for a price action based trade entry. The difference is that the first (good) example uses the indicator as a visual guide to volatility while entering on something that's grounded in reality (recent price action), but the second (bad) example is just the reasoning of a fool who finds significance in a technical indicator that a very small percentage, if any, of the real market movers are actually looking at.

The main problem at hand is that most beginner traders are introduced to trading strategies with the abundance of trend-following methods taught on web sites and in books, both free and for sale. While many of these trend following methods have decent risk-reward ratios (and some are even based on pure price action, with positive expectancy over the long haul), many of them simply produce far more losing trades than is absolutely necessary if followed, as is, at virtually random times and market conditions.

The currency markets spend more time in ranges than in clearly defined trends so every trader should be aware of how to trade (or avoid) consolidating, range-bound, price action.

Just knowing the market hours that are the most likely to produce trends, and those that are more likely to be range-bound, is a giant step toward consistent profitability for most beginners to the foreign exchange market.

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