Trading concepts- Applying the right initiative to maximise returns
The key to successful trading in the forex markets is knowledge and interpretation. Without market knowledge, the interpretation of the direction of the trend, the breakouts and trend reversals would be vague, thereby leading to immense risk and volatility to the portfolio, whereas applying sound knowledge enhances better interpretation of the forex markets thereby minimising risk and maximising profits.
Trading concepts are somewhat similar to trading strategies and are employed by traders around the world to analyse, interpret and execute forex moves accurately. The concept used can vary depending on certain rationale such as the using multiple concepts, time duration of each trade and the profit objective.
Whatever the trading concept, it can be altered to deliver positive returns and should be monitored on an ongoing basis. Following are some of the steps that should be followed before the trading concept is implemented on a real-time basis with tangible capital.
a) It is back tested and generates positive returns over an extended period of time.
b) The concept fits the trading style and pattern of the trader
c) The formula works under different market conditions
d) There are no major variations in the risk to reward ratio
e) The principles are followed dedicatedly without any deviation from the applied rules
f) The concept applies to the entire trading cycle; from entry to exit
Forex trading concepts can be derived from global fundamental data or by analysing charts and can sometimes be a combination of both.
Following are some of the trading concepts that have been applied successfully
Fundamental analysis-
This form of trading concept relates to analysing the global macro- economic data emancipating from individual countries and regions from time to time. Fundamental analysis can be categorized into
a) Economic data
b) Financial data
c) Political data
Among the three categories mentioned above, the date and timings of the economic and financial data are known in advance and are eagerly anticipated. The outcome of these data may vary from the forecasted view, which is where the trading concept comes into play.
Political releases, on the other hand are not very frequent, not known in advance and the releases when they happen may be abrupt causing immense volatility in the forex markets.
Trading fundamental announcements-
Trading fundamental announcements can be vital as they can cause enormous volatility in the forex markets. Normally, prior to a major fundamental event, forex markets loosen up since it is difficult to predict if the actual announcement is on expected lines and the nature of forex volatility post the announcement.
Largely, important global fundamental announcements are common but there a few which are specific only to a particular country.
Mentioned below are some of the key fundamental announcements with a brief description
(i) Central bank announcements-
The announcements can be in the form of increasing, decreasing or maintaining interest rates at prevailing levels, buying sovereign debt and intervention in the forex markets.
The monetary policy measures of the central bank are aimed at controlling money supply, inflation and unemployment which are vital parameters for economic growth.
Announcement- In the US, the FOMC meets eight times a year to review the monetary policy and announce interest rate decisions, while in Europe, UK and most of the developed countries, the Central bank reviews monetary policy measures and announces its decision on interest rates every month.
(ii) Fiscal policy-
Just as monetary policy is a tool used by the central bank to achieve economic growth, fiscal policy is an instrument used by the Government to balance growth and inflation.
Fiscal policy comprises of
a) Revenue- Which the Government collects from its citizens in the form of taxes
b) Expenditure- Which the Government spends on infrastructure, education and healthcare, subsidies to the poor and salaries to Government employees.
Depending on the current condition of the economy of a country, a Federal Government has the ability to choose the fiscal policy at its discretion. Fiscal policies are of three kinds and can be devised to be a
a) Balanced policy-
A balanced fiscal policy is one in which revenue is equal to expenditure. This fiscal policy is used when the economy is growing at a steady pace with inflation and other important economic parameters within the prescribed limits
b) Expansionary policy-
An expansionary fiscal policy is one in which revenue is less than expenditure.
This fiscal policy is used when the economy is stagnating due to high unemployment, declining house hold spending leading to lower demand for goods and services and thereby lower inflation.
The purpose of this policy is to persuade spending by cutting direct/ indirect taxes, which reduces costs of consumption goods/ increases disposable income and thereby encouraging economic growth
c) Contractionary policy-
A contractionary fiscal policy is one in which revenue is greater than expenditure.
If an economy is booming beyond expectations, it leads to a rise in money supply and inflation. To slow down the pace of growth, the Government enacts measures such as increasing taxes and reducing Government expenditure leading to surplus funds with the Government.
The purpose of this policy is to discourage spending by increasing direct/ indirect taxes, which increases the cost of consumption goods/ decreases disposable income and thereby slowing down economic growth
(iii) US Beige book-
Is a report on the current health of the US economy in the various districts of the US and is published by the 12 district federal banks in the US. The report is the basis for the Federal Open Market Committee meeting 2- weeks later.
(iv) Minutes of Central bank’s policy meeting-
Are transcripts of the policy meeting held to discuss the initiatives that need to be taken, the arguments of central bankers and the number of members who voted in favour or against a policy decision
(v) Gross domestic product (GDP)-
GDP is the monetary value of all finished goods and services produced within a country. It is the sum of investment goods, consumption goods and government expenditure. It also includes the value of exports- imports.
Announcement- GDP figures are announced quarterly.
(vi) Tankan survey-
Is an economic survey of Japanese businesses conducted by the Bank of Japan to determine the current economic trend and future outlook which then forms the basis for formulating the next monetary policy action.
Announcement- The outcome of the survey is announced quarterly.
(vii) Industrial production-
Is a measure of the output from the manufacturing sector such as factories, mines
and utilities.
Announcement- Monthly
(viii) Producer/ Consumer price index-
PPI measures the average prices received by domestic producers for their produce.
CPI measures the average prices paid by consumers for a select basket of goods and services.
Announcement- Both these figures are announced monthly.
(ix) Unemployment rate-
Is the percentage of total labor in the country that is unemployed.
Announcement- The data is released monthly.
(x) Treasury International capital system (TICS)-
Is the purchase of financial instruments usually long- term securities by foreign investors.
Announcement- Data released monthly
(xi) Retail sales-
Is a compilation of sales of consumer goods including food, clothing, autos and energy across
retail stores. The data is based on sampling.
Announcement- Figures released monthly
Technical analysis-
This method of trading concept is applied to analysing historical charts and chart patterns and their corresponding volumes.
While using technical analysis, one can either be looking for a continuation or reversal pattern as both are very important in identifying a trend. One should also be knowledgeable to identify a near- term and long- term chart pattern.
As there are innumerable chart patterns available, one should test the patterns and signals provided by them and identify the ones that have a high success ratio to a particular forex pair. The charts can also be combined with technical indicators as an additional tool to confirm the trend.
Following are some of the chart types that have demonstrated a high success rate not only in terms of providing accurate buy/ sell signals but also in achieving the profit targets.
Reversal patterns-
Are chart types that indicate the end of particular trend and the beginning of a new trend in the opposite direction.
Description-
If a reversal pattern is formed during an ongoing uptrend, it signifies the end of the uptrend and the beginning of a downtrend
If a reversal pattern is formed during an ongoing downtrend, it signifies the end of the downtrend and the beginning of an uptrend.
Following are some of the highly successful reversal chart patterns that are commonly used
(i) Bullish engulfing-
The bullish engulfing is a two- candlestick reversal pattern that appears after a long downtrend usually lasting a few months to a few years. The pattern symbolises a change in sentiment from the bearish overtone and is identified by the following
Candle-1 Bearish candle
Candle-2 Bullish candle
Concept:
Day- 1 normally comprises of a large bearish candle, represented by candle- 1.
On day- 2, prices open below the closing price of day-1 and engulf candle-1 (close above the opening price of candle-1) by the end of the trading session, signalling a reversal.
How to trade-
Buy at the open on day-3 with a stop loss below the low price of candle-2
EUR- USD DAILY CHART
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CANDLE-1
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CANDLE-2
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(ii) Bearish engulfing-
It is the opposite of a bullish engulfing pattern and occurs after a prolonged uptrend.
The pattern symbolises a change in sentiment from the bullish overtone and is identified by the following
Candle-1 Bullish candle
Candle-2 Bearish candle
Concept:
Day- 1 normally comprises of a large bullish candle, represented by candle- 1.
On day- 2, prices open above the closing price of day-1 and engulf candle-1 (close below the opening price of candle-1) by the end of the trading session, signalling a reversal.
How to trade-
Sell at the open on day-3 with a stop loss above the high price of candle-2
GBP- USD DAILY CHART
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CANDLE-1
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CANDLE-2
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CANDLE-2
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CANDLE-1
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(iii) Piercing pattern-
Is a two- candlestick bullish reversal pattern that occurs at the end of a prolonged downtrend. The pattern symbolises a change in sentiment from the bearish overtone and is identified by the following
Candle- 1; Bearish candle
Candle- 2; Bullish candle
Concept:
Day-1 normally comprises of a large bearish candle, represented by candle-1.
On day-2, prices open below the closing price of day-1 and by the end of the session the bullish candle (candle- 2) closes above halfway of the previous day’s candle, signalling a reversal.
How to trade-
Buy at the open on day-3 with a stop loss below the low price of candle-2
USD/ CAD- DAILY CHART
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CANDLE-1
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CANDLE-2
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(iv) Head and shoulders/ Inverse head and shoulders-
Is a bearish reversal pattern which occurs after a long uptrend and is a very reliable reversal pattern once it is completely formed.
Concept:
The chart comprises of three troughs and peaks with the middle peak (head) being the largest while the remaining two peaks (shoulders) are of almost equal in length. A neckline is drawn connecting the three troughs which act as an important support. Once prices close below the neckline of the right shoulder, the chart pattern indicates a trend reversal.
Inverse head and shoulders is the opposite of the head and shoulders pattern and is formed at the end of a long downtrend and signals a bullish reversal.
How to trade-
Sell if prices close below the neckline of the right shoulder with a stop loss above the neckline.
Buy if prices close above the neckline of the right shoulder with a stop loss below the neckline.
EUR/JPY- DAILY CHART
(v) Double top/ double bottom-
(v) Double top/ double bottom-
Is a bearish reversal pattern that occurs at the end of a long uptrend. It is also called a ‘M’ formation and is very easily identified.
Concept:
A double top consists of two peaks and two troughs having almost similar highs. A neckline is drawn connecting the two troughs, which forms an important support. Once prices close below this support after the formation of the second top, the chart pattern confirms the trend reversal.
A double bottom is a bullish reversal pattern that occurs at the end of a long downtrend. It is also called a ‘W’ formation. It is the complete opposite of a double top pattern.
How to trade-
Sell if prices close below the neckline of the second trough with a stop loss above the neckline.
Buy if prices close above the neckline of the second peak with a stop loss below the neckline.
Chart illustration of a double bottom-
USD/ CHF- DAILY CHART
(vi) Evening star-
It is a three- candlestick bearish reversal pattern that occurs at the end of a prolonged uptrend.
Candle- 1; Bullish candle
Candle- 2; Bullish or bearish candle
Candle- 3; Bearish candle
Concept:
Day-1 is represented by Candle- 1 which comprises of a large bull candle
Day-2 is followed by a gap up opening represented by candle-2 and can end the session either as a doji, small bullish or bearish candle.
Day-3 comprises of a gap down opening and the session ends with a large bearish candle which normally eliminates most of the gains on day-1 and is represented by candle-3.
How to trade-
Sell at the open on day- 4 with a stop loss above the high of day- 2
GBP- JPY DAILY CHART
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CANDLE-1
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CANDLE-3
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CANDLE-2
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Continuation patterns-
Are chart types that indicate that the ongoing trend will continue after a brief consolidation or sideways movement.
Description-
If a continuation pattern is formed during an ongoing uptrend, it signifies a brief consolidation in the trend before the resumption of the uptrend.
If a continuation pattern is formed during an ongoing downtrend, it signifies a brief consolidation in the trend before the resumption of the downtrend.
Following are some of the continuation patterns that have demonstrated a high success ratio.
(i) Triangles-
Are of three types and can be classified as symmetrical triangles, ascending triangles and descending triangles. A triangle pattern normally takes a few weeks to a few months to be completely formed.
Concept:
In a symmetrical triangle, the consolidation is a combination of lower highs and higher lows with the fifth point normally resulting in a breakout.
Draw a trend line connecting the highs and another connecting the lows. The converging trend lines represent a symmetrical triangle, complete with supports and resistances.
In an ascending triangle, the consolidation is a combination of higher lows and horizontal highs with the breakout in the direction of the uptrend.
In a descending triangle, the consolidation is a combination of lower highs and horizontal lows with the breakout in the direction of the downtrend.
How to trade-
Buy if prices close above the resistance with a stop loss below the resistance for a symmetrical triangle in an uptrend and for an ascending triangle.
Sell if prices close below the support with a stop loss above the support for a symmetrical triangle in a downtrend and for a descending triangle.
AUD/JPY- WEEKLY CHART (Symmetrical triangle in an uptrend)
(ii) Flag/ Inverse flag
Are short- term chart patterns that normally take a few days to a few weeks to be completely
formed.
Concept:
Flags are formed during a consolidation period after a sharp uptrend and consist of lower highs and lower lows. Two parallel trend lines are drawn connecting the highs and the lows, which form the resistance and support correspondingly.
The buy signal is triggered once prices close above the resistance with large volumes
Inverse flags are the opposites of a regular flag pattern and are formed during a sharp downtrend. They comprise of higher highs and higher lows. Two parallel trend lines are then drawn connecting the highs and the lows, which form the resistance and support correspondingly.
The sell signal is triggered once prices close below the support with large volumes.
How to trade-
For flags, buy if prices close above the resistance with a stop loss below the resistance.
For inverse flags, sell if prices close below the support with a stop loss above the support.
CAD/AUD- DAILY CHART (Inverse flag)
(iii) Pennants/ Inverse pennants
Are short- term chart patterns, appear very similar to triangle patterns and normally take a few days to a few weeks to be completely formed.
Concept:
Pennants are formed during a consolidation period after a sharp uptrend and consist of lower highs and higher lows, similar to a symmetrical triangle. Two trend lines are then drawn connecting the peaks and troughs correspondingly. The converging trend lines represent a triangle, with supports and resistances.
The buy signal is triggered once prices close above the resistance with large volumes.
Inverse pennants are formed during a consolidation period after a sharp downtrend and consist of lower highs and higher lows, similar to a symmetrical triangle. Two trend lines are then drawn connecting the peaks and troughs correspondingly. The converging trend lines represent a triangle, with supports and resistances.
The sell signal is triggered once prices close below the support with large volumes.
How to trade-
For pennants, buy if prices close above the resistance with a stop loss below the resistance.
For inverse pennants, sell if prices close below the support with a stop loss above the support.
EUR/USD- DAILY CHART (Inverse pennant)
(iv) Diamonds-
Are medium- term chart patterns, which appear very similar to a diamond and normally take a few weeks to a few months to be completely formed.
Concept:
This pattern is formed during a consolidation period and is identified when prices are initially making higher highs and lower lows. Once the peak is formed, prices converge by making lower highs and higher lows.
The trend- lines connecting the peaks and troughs complete the diamond with corresponding supports and resistances.
How to trade-
Buy at the break of the highest peak with a stop loss well below the trend line representing the resistance.
AUD/JPY- WEEKLY CHART
(v) Falling/ Rising three- methods
Short- term continuation candlestick pattern that occurs during an ongoing uptrend/ downtrend.
Concept:
During an uptrend, there a large bullish candle on day- 1
This is followed by three small bearish candles within the large candle (the small bearish candles do not close below the open of the large bullish candle), represented by days- 2, 3 and 4.
On day- 5, another large bullish candle is formed which closes higher than the candle on day- 1, indicating the continuation of the current uptrend.
In falling three- methods, the exact opposite would occur in a downtrend.
How to trade-
For a rising three- method, buy at the open on day- 6, with a stop loss below the low price on day- 1.
For a falling three- method, sell at the open on day- 6, with a stop loss below the high price on day- 1.
GBP/JPY- DAILY CHART (Falling three- methods)
How to maximise profits by applying trading concepts-
a) All trading concepts and applications have their limitations and cannot assure positive returns every time they are implemented. If they work on a majority of implemented trades, they are considered to be a winning concept.
b) The risk- reward ratio should always be greater than 1, in favour of the latter.
c) Concepts should be modified to be more compliant if constraints are detected.
d) Multiple concepts can be applied depending on the size of positions, nature of data that is likely to be announced and expected volatility.
e) Be patient for the markets to settle down while trading major economic events, since markets can be very volatile and vague, immediately after a major data is announced.
f) While placing stop losses, place them a little away from the supports/ resistances to avoid whipsaws.
To be a successful trader, a good trading concept is fine but not adequate. One needs to understand trade management, which is very critical once a trade is initiated.
Before a successful trading concept is implemented, identify the possib variations and outcomes of a trade so that once a decision is made to implement a trade, you are aware of all the possible outcomes and are well prepared to address them.