I have been posting weekly summaries of my trading activity ever since I got into Forex in October last year, both as a way of sharing this part of my journey to financial freedom with you all and as a means of ensuring that I make smart, non-impulsive decisions; after all, I would hate to have to share embarrassing losses with you guys, so this forces me to think twice before placing any trade.
Today, I will be giving you a detailed overview of the swing-trading strategy that I use to approach and navigate the exciting world of currency trading. After reading this post, you will have a better understanding of why I love chocolate the inner workings of my method and the thought-process that I employ when deciding whether or not to place a trade.
So without further ado, let’s dive in!
It All Starts With The Trend
Broadly speaking, a currency pair can only be doing one of two things at any given time: trending or ranging. In the case of the latter, price will be moving up and down repeatedly inside a well-defined channel, with a support level at the bottom from which the price always bounces up, and a resistance level at the top from which the price always bounces down. Range-bound markets are relatively safe and predictable, but profit potential is limited. Trading in this kind of market condition is also about as exciting as watching erosion or reading Jane Austen.
Conversely, in a trending market, price will be continuously moving upward (in the case of an uptrend) while forming a series of higher highs and higher lows, or continuously moving downward (in the case of a downtrend) while forming a series of lower highs and lower lows. In my opinion, this kind of market environment is where the real money is waiting to be made, and when you get lucky and catch one of those trends endowed with the momentum and fury of a thousand enraged Achaean myrmidons descending their wrath upon the city Troy, relentlessly churning forward for weeks on end…well, that’s when shit gets really exciting! 😀
My strategy is exclusively a trend-trading strategy. It performs poorly in range-bound markets, which is why I avoid them like the plague. In trending markets, however, it has the opportunity to really shine and can easily net you hundreds, sometimes even thousands of pips. The profit potential is pure awesomesauce.
So how do I figure out whether a currency pair is trending? I use a 120-period SMA (simple moving average). Since I trade the 4-hour charts, a 120-period SMA will give me the average price over the last month of trading (4 * 120 / 24 = 20, and a week of trading is 5 days), which I find to be a good reference point. If the price is located above the 120-SMA, then I consider the pair to be in an uptrend and only look to go long. On the other hand, if the price is located below the 120-SMA, then I consider the pair to be in a downtrend and only look to go short.
The steeper the slope of the 120-SMA, the stronger I consider the trend to be, and therefore the more confident I will be in placing trades. If the slope is pretty flat, or if the price keeps crossing the average up and down without ever sustaining one direction, then I consider the pair to be ranging and I stay away from it.
I also use a 30-period SMA as a sort of second confirmation, as this gives me the average price over the previous week of trading (4 * 30 / 24 = 5). When the price is above both the 120-SMA and the 30-SMA, it tells me the currency pair is in a very strong uptrend and that going long has very good odds of success. Conversely, when the price is below both the 120-SMA and the 30-SMA, it tells me the currency pair is in a very strong downtrend and that going short has very good odds of success. Here again, the steeper the slope of the 30-SMA, the more confident I feel.
Filter Out The Noise With Heikin-Ashi
Traditional candlestick charting is the go-to display method for most traders, and for good reason: it works. Price action is easy to see and visualize, and there are dozens and dozens of well-documented candlestick shapes and patterns that one can use as signals to inform their decisions. However, the one issue I find with traditional candlesticks is that they suffer from a certain degree of noise even on higher time frames, and that noise can easily mess with your mind and often give you false signals. Enter Heinkin-Ashi.
Heikin-Ashi candlesticks are “average price” candles; they are calculated using open and close data from the previous candle combined with the high and low of the current period. This effectively bakes in a moving average directly into the candlesticks, creating a smoother, less noisy chart. If you’d like to learn exactly how these candlesticks are derived, a simple Google search will give you the mathematical formula. Suffice to say, Heikin-Ashi charting makes it easier to follow and stay in the trend, and I find that it creates fewer false signals than traditional candlestick charting.
For this reason, I use Heikin-Ashi candlesticks with my strategy instead of traditional candlesticks. I experimented with another form of noise-filtering charting called “Renko” for a few weeks near the end of last year, but for reasons I won’t get into in this post, I have come to prefer Heikin-Ashi.
Increase Your Odds With Multi-Time-Frame Analysis
I almost exclusively trade the 4-hour charts. They are my bread and butter time frame, as I find they offer a great balance of trading opportunities and minimal management requirements (I only have to look at my trading platform for all of 5 minutes maybe two or three times a day). However, by taking a step back and looking at the bigger picture, I can get some insight as to where the price is most likely headed next and thus increase my odds of placing profitable trades.
When looking to place a trade, I first like to look at a given currency pair’s daily (and even weekly) chart and apply the same principles discussed previously for determining trend direction. If the price is situated above the 120-SMA, then I consider the pair to be in an uptrend and I will only look to go long, and vice-versa if the price is below the 120-SMA.
But it doesn’t stop there. In order for me to enter a trade, the current daily Heikin-Ashi candlestick must also be of the color corresponding to the trend direction. That is, if the pair is in an uptrend, then I won’t place trades if the current candlestick is red, as this means the price is undergoing a retracement. Conversely, if the pair is in a downtrend, I won’t place trades if the candlestick is blue, as this again indicates that the price is in a likely-temporary counter trend.
Ideally, the best scenario is to start trading a pair that is just finishing a retracement on the daily chart, as this gives me a very strong chance of catching the beginning of a resumption of the major trend. That’s not to say that I won’t trade a pair that is currently already trending in the right direction, but I definitely prefer to wait for a Heikin-Ashi daily candlestick to change from red to blue (in an uptrend) or blue to red (in a downtrend) in order to start opening positions.
Once my conditions are met on the daily time frame, I then move down to the 4-hour chart and start trading the pair whenever it finishes retracing against the major trend. It’s as simple as that.
Confirm Your Entry With Stochastics
As a way of further tilting the odds in my favor, I like to use slow stochastics as a final point of confluence to confirm my entries. I’m not going to go into detail as to how slow stochastics (or SSD for short) work since the goal of this post isn’t to give a lesson on basic trading concepts, but suffice to say that the SSD is a popular momentum indicator used by many traders to see when bullish or bearish power is picking up.
So how do I use the SSD? Well, assuming that all my strategy’s conditions are met on the higher time frame, and that there then is a change in candlestick color in the direction of the trend on the 4-hour chart, then I like to see the K line of the SSD cross the D line of the SSD from below (preferably from an oversold region below 20) in the case of an uptrend, or the K line of the SSD cross the D line of the SSD from above (preferably from an overbought region above 80) in the case of a downtrend.
When this happens, I consider the stars to have aligned and I open a trade confident that I have maximized the probability of success to the best of my ability. The rest is up to the market.
Turbo-Charge Your Profits With Pyramidz
The driving force behind this strategy lies in the concept of pyramids. I’m not talking about the Egyptian or Incan pointy thingies here though; I’m talking about trading pyramids, where one adds to their position by opening new trades as the trend keeps moving in their favor. As mentioned, trending markets will often move in wave-like fashion, making a strong advance, then retreating or “retracing” back a little bit, before moving on forward again. The idea is to open a new trade each time the price finishes retracing against the major trend, all the while trailing each previous trade’s stop loss to the most recent swing low (in an uptrend) or swing high (in a downtrend). The following drawings displaying my amazing photoshop skillz should help illustrate what I mean.
Trailing your stop losses is absolutely crucial to the strategy, as this allows you to open new trades, and thus magnify your profit potential, without ever having any capital at risk. That’s right: except for the first trade of the pyramid in which you will be risking your initial chosen amount of capital, your worst-case scenario on each subsequent trade should never be greater than break-even. This is the secret sauce to the method, and if it isn’t applied properly every single time a new position is opened, then it defeats the purpose of the strategy, which is to reduce the risk to zero on any position as quickly as possible.
This means that you won’t always risk the same amount on each trade, since the distance the price travels between each retracement won’t always be the same. For example, let’s say you open the first trade of a new pyramid with $100 at risk, and that by the time the price has moved forward and finished its first retracement, your floating profit right beneath the new swing low (in an uptrend) or swing high (in a downtrend) is equal to $100. This means that you are in the clear to open your second trade with $100 at risk again because if the stop loss were to get hit, you’d break even. On the other hand, if your floating profit at that point is less than $100, then you will have to open your second trade with only as much capital at risk as would make you break even if the stop loss were to get hit. And lastly, if you are lucky enough that your profit at that point is already greater than $100, then you are free to risk more than $100 if you wish, once again up to the maximum amount that would cause you to break even at the stop loss.
As you probably guessed, this means that as your pyramid keeps growing and growing, so does the amount you are allowed to risk (margin allowing). Let’s say that you have 3 open trades in a pyramid with an initial risk of $100, but that your current floating profit is $1000 at the level of your trailing stop. Obviously, you would be free to risk up to $1000 since that is the amount that would make you break even if your stop loss were hit. Increasing your risk like this every time certainly exponentiates your profit potential like crazy, but it also means that you are never actually truly locking profits since you are always breaking even if your stop loss gets it. And of course, it will get hit at some point.
Ultimately, how much you choose to risk per trade as your pyramid grows will be a personal decision that will completely depend on your risk tolerance, the confidence you have in the strength of the trend, and whatever else floats your boat. The more you risk per trade, the more you magnify your future profit potential, but the more you reduce the amount of profits you’d walk away with right now. Conversely, the less you risk per trade, the less you magnify your future profit potential, but the more you secure your current floating profits. As long as you are never at risk of anything more than break-even though, you are free to put as much capital as you wish on the table.
As you can see, unlike most strategies which have specific, pre-determined exit targets, this one looks to milk profits as long as possible. Of course, at some point your stop loss will get hit on a trend reversal or strong retracement (after all, no trend lasts forever), and you will never pocket the full amount of profits that were available at the absolute top or bottom of the trend you were riding with this strategy; however, that’s not a bad a thing. Nobody can accurately predict tops or bottoms anyway, and, more often than not, you will still walk away with far more money than you could ever make with typical, pre-determined risk/reward ratios of 1:2 or 1:3.
Putting It All Together
Now that I’ve explained how the strategy works, let’s run through the steps one more time.
- Find a trending pair on the daily or weekly charts and determine its direction based on its location relative to the 120-SMA. Avoid ranging or chopping pairs.
- If the pair is currently retracing against the major trend, wait until a Heikin-Ashi candlestick changes to the correct color (blue in an uptrend, red in a downtrend).
- Drop to the 4-hour chart and start opening trades every time the price finishes retracing. Place your entries right beneath (in a downtrend) or right above (in an uptrend) the close of the Heikin-Ashi candlestick that changes back to the correct color. Look for a stochastic cross as further confirmation.
- The amount of money you choose to risk on each trade is completely up to you, as long as your worst-case scenario is ALWAYS at most break-even on every trade following the initial one.
- Milk the ever-living shit out of the trend. Don’t use pre-determined exits, just let the market take you out.
A Few More Thoughts
One thing I’d like to mention is that trading is more art than science. Like with investing, it’s up to the trader to customize and individualize his strategy to truly suit his own personality. The fact that there is more than one way to skin the cat is what makes these endeavors so fun and exciting. The strategy I have outlined here could definitely be followed in a completely mechanical manner by placing trades whenever all the conditions are met, however I believe that by exercising some extra judgement, a trader can further improve his odds.
What do I mean by this? I’m simply saying that each situation will be different, and while the conditions of the strategy should always be met in order to open a trade, one need not limit himself to those conditions to inform his decision. For example, you don’t necessarily need to open a new trade on every single retracement that occurs. Maybe the pair you’re trading has been losing momentum and consolidating for a while around a certain level, so you decide that you’ll hold on to your current positions but won’t open any new ones until a clear break of the consolidation back in the direction of the trend occurs. Or maybe the pair has undergone two retracements in a row, and while it hasn’t hit your stop loss yet, you decide not to open new trades until a significant advance back in the direction of the trend occurs.
Another thing you might consider is looking for patterns to get a better feel for might happen. For instance, let’s say you are trading in an uptrend and you notice that your pyramid has been consolidating for a while and has formed what looks to be a classic pennant pattern. Knowing how strongly price can explode out of such continuation patterns you might feel more comfortable risking more capital on a break of the pennant. On the other hand, maybe you notice what seems to be double top forming up and, knowing that such a pattern often marks the end of a bull run, you decide not to open any new positions and to tighten up your stop loss a little bit to protect your floating profits.
One thing I personally do is mixing in fundamental analysis with my strategy. While I strongly believe that technical analysis is all that is needed to trade Forex since I feel that external factors are always reflected in the price action, that doesn’t mean that I completely shun fundamentals. I always keep track of major economic events that are coming up on the calendar so that I can be prepared for the occasional volatility or erratic behavior that might be caused by news. For example, if I know that a certain country’s central bank will be making a decision regarding interest rates during a given week, I might be more cautious about placing trades or risking more money depending on what I expect the decision to be. Technical analysis alone is great, but it certainly can’t hurt to stay up to date with current global events in order to further maximize your edge (and as an added bonus, to not be an uninformed ignoramus who can’t hold a conversation with anyone about anything other than what they ate for dinner the night before).
A sound strategy with a clearly-defined set of rules is obviously crucial to success, but sprinkled with a little bit of intelligent human judgement, I believe it can be made more flexible and adaptable to specific market circumstances, and thus consequently even more profitable than it would be in a purely mechanical context.
So there you have it, homies. My trading strategy explained in detail. I’d like to mention that none of the concepts discussed in this post are groundbreaking. Trend-following strategies have existed for decades, and I’m certainly not re-inventing the wheel here. My strategy is actually heavily based on a trading system created by a gentleman named Edward Monroe, which he outlines in his book Swing Trading with Heiken Ashi and Stochastics. It is an excellent read, and one that I would highly recommend if you are interested in Forex and have a penchant for trend-following strategies.
Anyway, I’m going to end this obscenely massive wall of text here, but please don’t hesitate to drop me a comment below if you have any questions. I look forward to continuing sharing my weekly Forex logs with you all this year, and I believe that a simple strategy such as this one should prove to be profitable in the long run. It’s really nothing more than classic buying low and selling high, while both minimizing losses and maximizing wins.
As they say in the trading world, “the key to success is to cut your losses short, but let your winners run.”