A Simple 1-2-3 Method for Trading Forex
Jody Samuels, FXTradersEDGE.com
Welcome to this mini Forex Foundation course, your roadmap to trading the Forex Markets. My name is Jody Samuels and my trading career began on Wall Street in the early 80’s. Today I run fxtradersedge.com, a comprehensive program that offers courses and numerous coaching and trading services.
Trading Pub asked me to explain what makes Forex a great market to trade so I thought I would start with some basic terminology and history, to show you how the market has evolved as one of the fastest growing markets to trade. I will then switch gears completely and talk about a strategy which is very easy for a new Forex trader to grasp. (It is even good for advanced traders!) The strategy is called the 123 continuation and reversal pattern and we will show how to use it during trend and end of trend cycles.
What is Forex?
Foreign Exchange Trading is known as Forex, or by the acronym FX.
Today we are going to talk about the transactions of the foreign exchange market known as the spot market. This market involves a worldwide electronic network of banks, brokers and other financial intermediaries.
Unlike the stock exchange markets, Forex has no physical location – it’s completely electronic. This ensures that transactions happen in seconds directly with the market makers. All profits are settled immediately in cash.
Figure 1: The Forex Spot Market
The Lingo in Forex is about pips and lots. What is a pip? If we look at the EURUSD at 1.1355, the pip is the last decimal place. When we talk about a move in the EURUSD of 5 pips, we are referring to a move from 1.1355 to 1.1360. The pip is 1/10,000 of a decimal place. A 100 pip move is from 1.1300 to 1.1400. If we look at the USDJPY at 117.30, the pip is also the last decimal place. If the USDJPY moves 1 pip in the market, it moves from 117.30 to 117.31. The pip is 1/100 of a decimal place. Nowadays, brokers quote to 5 decimal places in the EURUSD and to 3 decimal places in the USDJPY. For example, the EURUSD would be quoted as 1.13556 and the USDJPY would be quoted as 117.308.
Currencies used to only be traded in specific Lot or Unit sizes. If the unit is USD, a standard lot is $100,000. A Mini lot is $10,000. And a Micro lot is $1,000. Today brokers allow traders to vary the Unit size without sticking to the standard Lot sizes. If you are wondering how a small investor can trade $100,000 without depositing that amount of money, it’s because of Leverage. The broker where you set up your trading account will require margin to trade $100,000. That margin will vary according to the leverage the broker is willing to offer. At 50:1 leverage, the amount required to trade $100,000 is $2,000. The broker “lends” you the rest. Of course, any losses or gains on the position will be added to or deducted from the balance in the account.
Why trade Forex?
The Forex market has evolved faster than any other financial market in history. According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world’s foreign exchange markets reached almost $1.5 trillion in 1998, increased to $1.9 trillion of daily trading in 2004, and skyrocketed to an unprecedented level of almost $5.3 trillion in 2013.
However, foreign exchange transactions existed a long time before that. Let’s learn a little history together.
Between 1876 and 1931 currencies gained a new phase of stability because they were supported by the price of gold. The Gold Standard replaced the age-old practice in which kings and rulers arbitrarily devalued money and triggered inflation. The Gold Standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. The Gold Standard prevailed until WWI, was reinstated in1925, and broke down again in 1931 following Britain’s departure in the face of massive gold and capital outflows.
Beginning in 1944, countries operated under the Bretton Woods Accord. A total of 44 countries met in New Hampshire to design a new economic order. The Bretton Woods Conference of 1944 established an international fixed exchange rate regime in which currencies were pegged to the United States dollar, which was based on the gold standard at a fixed value of $35 per ounce.
However, heavy American spending on the Vietnam War led to persistent U.S. balance-of-payments deficits and steadily reduced gold reserves. Finally, on August 15, 1971, President Nixon announced the suspension of converting dollars into gold, unilaterally devaluing the U.S. dollar and effectively ending the Bretton Woods Accord.
After the Bretton Woods Accord, the Smithsonian Agreement was signed in December of 1971. This agreement was similar to the Bretton Woods Accord, but it allowed for a greater fluctuation for foreign currencies. The US trade deficit continued to grow, however, and the US dollar needed to be devalued beyond the parameters established by the Smithsonian Agreement and this resulted in its collapse in 1973.
In 1978, the free-floating system was officially mandated. This had occurred by default because no new agreements surfaced. At the same time, Europe gained independence from the dollar by creating the European Monetary System. This lasted until the introduction of the Euro in 1993.
Finally, the first on-line trade happened in 1997 which marked the beginning of the retail market.
Who Trades Forex?
An acronym I developed is the Be RICHeR network and this network trades Forex.
Figure 2: Who Trades Forex?
The Banks were involved in the Forex markets at its inception in the 1970’s.
The Retail Forex Brokers came on the scene after 1997.
Investment Management Firms have foreign exposures from their stock and bond portfolios and they transact with the banks.
Corporations in their daily, monthly and yearly foreign exchange transactions deal with the banks. The Central Banks are also key players managing their currency exposures and dealing with investment banks.
Hedge funds manage a variety of asset classes, including currencies, and they transact with Banks.
Finally, we have eRetail, dealing electronically through trading platforms of retail Forex Brokers.
When you take your first currency trade, you too will become part of this Be RICHeR Network! Welcome.
Tradable Markets on a Forex Platform
In the Forex market, there is a Universe of Currency pairs to trade which include the USD pairs and the Crosses. On the majority of Forex trading platforms, one can trade CFD’s as well as currencies. A CFD, or contract for difference, is a product whose price is based on the underlying instrument and is considered an over-the-counter (OTC) product, which is not traded on any exchange. CFD’s include stock indices, metals and energy products. For most brokers, the lists of offered instruments continues to grow. Now, Forex trading platforms are beginning to add CFD’s on stocks and ETFs as well. As retail traders, we have the ability to trade all of these instruments on Forex trading platforms. The number of markets quoted will vary from broker to broker.
Capture the “Flavor of the Day or Week”
Once we understand which markets can be traded on the trading platform, how do we decide which markets are trending? One way to do that, is to look at several markets at once to compare them. In this example we are looking at the major USD pairs to see if there is a particular trend in these pairs. Then we can do the analysis and decide which pairs to trade and when. Scanning charts like this is done to capture the “Flavor of the Day or Week” in order to stay with the trend. In the example below, the USD pairs that have the cleanest price action include the commodity currencies, the USDCAD, NZDUSD and AUDUSD. The three other pairs – the EURUSD, USDJPY and the GBPUSD – illustrate choppy, sideways markets which are not high probability charts for the upcoming trading session.
In addition to scanning the charts for clean price action, it is necessary to review the news releases to be prepared for events which could move the markets. An understanding of the fundamentals is key to relating the price action to the economic backdrop affecting the markets.
Figure 3: Scanning the USD Pairs for Opportunities
The 123 Pattern as a Reversal Trading Strategy
Now we are going to move into the trading strategy section of this course. The simple trading strategy that I have selected is the 123 strategy for continuation trades and end of trend trades. First we are going to look at the 123 pattern as an end of trend, or reversal trading strategy, also called the 123 top and bottom pattern.
The 123 top and bottom pattern is a very powerful pattern that signals a trend reversal. It can also be used as a trend continuation, which will be described shortly. First, the reversal pattern.
Scenario 1: In an uptrend, the market hits a new high, labelled point 1. Price then pulls back to a short-term support level, labelled point 2. Finally, price moves up to an area between points 1 and 2, labelled point 3. It then reverses down again and begins a trend in the new direction.
Trade Entry: The pattern is complete when the price trades below point 2. At a 123 top, the strategy is to sell on a break of point 2. The measuring objective is the distance between point 2 and point 3 projected below the break at point 2. The stop loss is set just above point 3 but a more conservative stop loss is above the start of this move, at point 1. This is a choice that the trader must make and only by trading it over and over again will the trader feel comfortable with the choice of a stop loss.
An optional sell is at point 3, only if point 3 is at the 50% retracement level of the move from 1 to 2. Also watch for reversal candlestick patterns at point 3 to trigger the entry.
Figure 4: 123 Reversal Trade Entry
Figure 5 summarizes the 123 top and bottom trade. We just looked at scenario 1 which is the 123 top. Now we will discuss the opposite scenario of a 123 bottom.
Scenario 2: At a 123 bottom, the market hits a low at point 1, trades up to point 2, trades back down to point 3, and back up through point 2 to begin a new uptrend.
I like to see point 3 retrace at least 50% of the move down from point 1 to point 2. I also learned that if the pattern has between 10 and 20 bars between points 1 and 3, it is more likely to succeed. What I have to say about that is back test and see for yourself. I take most of my trades based on this pattern alone. It is very powerful. You can also use this pattern on a smaller time frame once the market reversal is identified. You will get a closer entry to point 1 and will therefore be able to take a larger position, using the same money management rules.
Figure 5: 123 Top and Bottom
1. 1. The 123 formation is classified as a major reversal pattern and is one of the best indicators of a trend reversal. They are found on every time frame. The swing or position trader will look for these patterns on the weekly, daily and 4-hour charts. The day trader will look for 123’s on the hourly and 15-minute charts. The momentum trader will trade these patterns on the 5-minute, 1-minute and tick time frames.
2. 2. Stop losses for 123 tops should be set above point 1 initially, and positions need to be sized accordingly so as not to exceed the risk limit for the trade. Another option is to place stops above point 3. However, the odds are increased of being stopped out early. It is better to take a smaller position and leave the stop above point 1. Stop losses for 123 bottoms are set below point 1, or alternatively, below point 3.
3. Optional: On a 123 reversal using any time frame, wait one or two candles for confirmation. Ideally price will come back and retest the breakout or breakdown point for a safer entry. This helps to avoid whipsaw.
At this point in the video we look at more 123 reversal examples using market data.
The 123 Pattern as a Trend Continuation Strategy
We have just completed the section on the 123 reversal pattern as confirmation of the end of the trend. However, while the end of trend 123 top and bottom is a great entry method for taking reversal trades, most of your trades as swing and day traders will be trying to get into a trend move – getting into the trend in the middle of it. You may have heard that “the trend is your friend” so now we will learn a method to get into a trend move using the 123 trend continuation pattern.
How do you get into the trend in the middle of it? The safest trades you can make are the ones where you are trading in the direction of the current trend. In other words, if the trend is up, you should be long – and if the trend is down, you should be short. If you miss the start of the trend, you still need a method to enter a confirmed trend during its progress. I am going to suggest two entry methods using the 123 pattern for trend continuation called internal 123’s.
Figure 6: 123 Trend Continuation Trade Entry
Draw your 123 points as price moves in the direction of the new trend. Enter on a break of the newly established point 2 with a stop above point 3. Follow the market up or down, depending on the trend.
Draw your 123 points.
Enter at point 3 (once price turns down) with a stop above the new point 1.
Figure 7 illustrates both the 123 reversal and the 123 continuation, back to back, on the same market, the 4-hour USD/CAD.
Figure 7: 123 Trend Continuation Trade Entry with 123 Reversal
1. When the “Trend is your friend”, we need to make sure we get into the trend at various points along the way. Why? The safest trades are taken in the direction of the current trend. Trade entry is easily done with the internal 123 formation.
2. In a trend, the first 123 pattern is the reversal pattern that occurs at market tops and bottoms. The second and third set of internal 123’s continue to confirm the uptrend or downtrend.
3. Take note how each point 3 becomes the new point 1 for the next internal 123 pattern. In a very strong trend, point 3 will not always retrace to at least the 50% mark, and that’s ok. It is more important for that to occur with reversal 123’s. In a strong trend, the retracements can be as shallow as 23.6% or 38.2%.
4. If you miss the initial reversal 123 pattern, look to get into the subsequent internal 123’s. Preferred entry is on the break of point 2. However, alternatively, you may enter at point 3. And, wait for the candles to start trending again before entering.
5. Profit taking is recommended along the way for day traders. Position and swing traders may hold the positions and trail the stop every time we trigger a new trade. The stop would then be placed above the new point 1, and previous stops would be moved to the new point 1. These positions would be considered “add-ons” for position and swing traders.