In this post, I’ll explain the method I follow when qualifying potential trading opportunities. I employ a fundamental and a technical approach which will, if followed with responsibility, honesty, courage, intelligence, and commitment, enable you to identify high-probability trading opportunities.
The beginning of the day
The first thing I do is look at an economic calendar to see which pairs to stay away from and when, generally speaking. Medium and high impact economic data releases such as the Non-farm Payroll, often introduce significant moves in either direction. Unless you know what the outcome of the data release in question is going to be, being in a short term position can be risky, as the market can easily move far enough to take you out of the trade. This sudden high volatility, economic data releases have the ability to introduce, aren’t really my cup of tea, which is why I like to wait until after the market has absorbed the reaction. In other words, I do not trade the news. Additionally, entering positions prior to such data releases can often be a challenge, as the very low degree of market volatility up to a data release makes it tough (with some pairs) to even cover spread expenses – not to mention gain profit.
In Denmark, where I live, people are always talking about the weather. Will the sun shine today or will it rain? Most of the people I know are very well acquainted with the Danish Meteorological Institute (DMI) website, which enables visitors to enquire about the weather for the coming days. I bet there aren’t many Danes who don’t first consult the DMI website prior to choosing which day to have a picnic, as doing so may very well result in less than pleasing results. I’d say that the Danes are very acquainted with what I’ll call the picnic environment. I think I could even go as far as to say that Danes might consider it foolish to even consider having a picnic prior to consulting the DMI about the weather, as it’s just too risky.
Trading is a bit like having a picnic in that it could be considered foolish not to consult the market environment prior to opening a trade, it’s just too risky. In the same way a thunder shower can quickly move in and destroy the perfect picnic, an economic data release can destroy the perfect technical setup. While consulting the DMI website won’t tell you much about which economic data to expect, the following resources (with whom I have no affiliation) will be able to lend insight into anticipated economic data releases:
It’s also a good idea to keep an eye on the national banks for the currencies you trade. Here is a list of the national banks for the currencies I may consider trading:
- European Central Bank (EUR)
- Federal Reserve (USD)
- Bank of Japan (JPY)
- Swiss National Bank (CHF)
- Bank of England (GBP)
- Reserve Bank of Australia (AUD)
- Bank of Canada (CAD)
There are other resources that can be considered in order to stay on top of the macro and micro economic factors, which drive the market. Most banks have research departments that write daily, weekly, monthly, and annual reports, which they provide for their own traders to help them with their trading decisions. Some institutions offer similar information to independent traders, either for free or for a fee. I am in the process of gathering a list of such sources, which I will publish within the coming week or so.
Know which economic data will be released for the coming day and week, and watch out for clouds.
The whole point of having an understanding of fundamentals and thus fundamental analysis, is knowing which directional bias you should be aware of. Will the fundamentals for a given currency introduce a bullish or a bearish sentiment? Look for the meaning in economic reports and know if they’ll drive price higher or lower. Knowing this enables you to open trades, which are in sync with the overall sentiment for a given currency pair.
Are interest rates going up or down? Consider the current situation in Europe for a moment. Interest rates have been cut over and over again, and financial institutions, funds, and speculators have been moving their money out of euros and into other currencies such as the USD and AUD. Is there a relationship between the two? Traditionally, higher interest rates will attract capital, as it increases investor returns – but at the same time, higher interest rates also have a negative impact on growth, which can cause the value of a currency to decrease. Additionally, as the demand for the Euro declines, the price will naturally drop accordingly. This may result in traders buying at the lows, which will bring more liquidity into the market. This extra liquidity is also used by the larger funds to drive price higher before liquidating positions, which adds to the downward momentum.
Ultimately, fundamentals, via a fundamental analysis decide the market flow and technical analysis decide price levels.
This part should be kept as simple as possible. I have defined a number of criteria that I use, which when combined correctly, make opening a trade, technically, very objective. I have made the process very black and white for myself, as this suits my personality very well.
I want to see at least three of the reasons listed below, pointing to the same price level +/- five pips or so. The higher the reasons on the list, the more confident I am about the trade. If I see reasons one, two, three, and four all pointing to the same price level, I will feel confident about the trade. If, on the other hand, I see reasons five, six, and seven all pointing to the same price level, I will most likely begin looking for other reasons. If I don’t find any then I will pass on the trade. It is also very important to note the time of day when choosing entries, which will be a topic of discussion in a future post.
- Supply and demand
- Significant S/R (support and resistance) on a timeframe at least 4x higher (e.g. 15M -> 1H, 1H -> 4H, 4H -> 1D, 1D -> 1W) and fractals
- Daily, weekly, and monthly pivots points
- Round numbers (e.g. 1.2000, 1.2500, 1.2550, 96.00, 96.20, 96.50, 96.80)
- Times of day, which affects volatility
- Fibonacci and overlapping Fibonacci retracements, as well as internal levels and extensions
- Momentum using MACD/signal line crosses
- Candlestick patterns (e.g. engulfing patterns, hanging men, shooting stars, hammers, spinning tops, Dojis)
- 10, 20, 50, 100, and 200 day moving averages (the higher, the more significant)
- MACD for positive and negative divergence
When defining targets, I most often use the same criteria to define levels at which I will exit a trade, as illustrated in the example above. I always ensure at least a 1-to-1 risk/reward ratio, and my stops and targets are based on the volatility and average daily range of the pair I’m trading.
I don’t use indicators other than those mentioned in the list above, and you’ll find that the more indicators you add to your charts, the less successful you will be. Why is this? Indicators tell you about something that has already happened, the latency of which will vary from indicator to indicator. If you have one indicator on your chart and it gives you an entry signal, the signal will have been received at, let’s say, T + 1 (time + 1 indicator). If however, you have three or more indicators on your chart, if and when all indicators give you an entry signal, you will have waited T + n (n being the total number of indicators). People add multiple indicators to their charts, as indicators make them feel a higher degree of confidence when deciding whether or not to enter the market. Ultimately, the more indicators you have on your chart, the higher the risk of the trade, as you end up entering the trade after the move has already taken place.
As Boris Schlossberg and Kathy Lien nicely stated in their book entitled Top 10 Trading Rules:
Trigger Fundamentally, Enter and Exit Technically