STOP LOSS

Let’s examine stop losses. First, there is really no such order as a “stop loss.” We’ve called it that because stop orders are most commonly used in this protective manner, but they are still simply “stop” orders. There are three types of stop losses we will want to use at different stages of a trade. They are all going to be stop orders, but the thinking behind each stop (stop loss) order placement will be different. The initial stop we place when entering a trade is known most often as the protective stop loss. This stop loss represents the potential for loss. It’s a risk-based stop, and it’s placed where the trade would no longer be valid. The risk-based stop is the opposite of the entry. If an entry is the reason to get in, then the point of validity/risk-based stop is the reason to get out.

The risk-based stop is the one we all hope we will have the discipline to place and not have to use. Transitioning from a risk-based stop to a breakeven stop is done only when the trade moves in our favor and to the first stop loss. It should become clear right about now that using support and resistance to place stop loss and profit targets is important because a market moves from level to level seeking support and resistance. The way you place your profit target, the thinking behind their location, is what will set your risk management in motion. This is lost on far too many traders. This is how far too many traders let a winner turn into a loser. How do we define a winner? It’s a trade that has reached the first of hopefully two to four more profit targets. How do you manage two to four profit targets? That is done with multiple lots.

Once prices reach the first profit target, the trade is officially a “winner” and should be protected from a reversal that could happen when prices reach the support or resistance that was the profit target. This is a possible scenario when prices reach any kind of support or resistance, and since just about any order you place will be because of the support or resistance it has, then there is the possibility of either a continuation through this level or a reversal.

The psychological trade many traders fall into here is trailing their stop too aggressively. This is usually because they have experienced so many losers during the early part of their trading and learning curve that the slightest profit triggers a fear reaction: I have to take this profit now! Many times the traps that most of us have to navigate through can be avoided with order entry that lets us observe the market rather than being involved with it too hands on once the trade goes live. There is too much temptation, fear, and greed, and the only way we can avoid and manage these emotions is with order entry.

First of all, the only way a trade should and can be extended past the first profit target is to have multiple lots. One lot equals one profit target. A breakeven stop allows for enough wiggles (the typical amount of volatility) that a position must be given in order to compensate for corrections along the way to the next profit target. Trailing stops are most often and incorrectly done by using some sort of fixed pip or percentage. I’ve already explained why stop losses should not be placed with this type of thinking, and the same thing applies to every kind of stop. Trailing a stop is done as a trade moves in the direction we expected it to and reaches profit targets, which then in turn trigger the transition from risk-based to breakeven to finally trailing stop.

A breakeven stop, as the name implies, is where the trade would be stopped out and yield no loss or gain. It’s placed either just below the entry price if the entry is a buy or just above the entry price in a short. The breakeven should be just beyond the entry as to be able to get maximum use out of the support or resistance that triggered the entry. As a trade progresses, if it progresses, the trailing stop is next.

Trailing stops are what we all love because they mean that no matter what, the exit is still a profitable one. But they should not be placed with fixed levels that trail current prices. The same levels that were once profit targets are now going to be valuable levels of support and resistance that the trailing stops will be placed at. Here’s how it works. On the chart there are multiple levels that the trade could travel to as it moves in the profitable direction and these levels are resistance in a buy and support in a short. Remember that what was once support becomes resistance and vice versa, so that now we are looking at a set of levels that can support prices in an uptrend and be a ceiling in a downtrend. This is exactly what we need for trailing stops.

The stop order itself should not be placed at the profit target level exactly but just beyond. So that means that in a buy, the resistance levels that were once profit targets are now support and trailing stop levels. Place the stop order just below the support level. In a short it’s the support of profit targets that have become resistance so the stop order will be placed just above that level. How much above? Three to five pips to account for the spread will do.

ORDER ENTRY

I think there is too much and not enough discussion of order entry. I can and have talked about the mechanics of entering a buy or sell order with limits, stops, or at the market. Mechanics and definitions don’t do the art of order entry enough justice because they make it seem flat and lifeless. In reality order entry is dynamic.

I have seen over the years that most traders use market orders. This is the “get me in” or “get me out” now order. A market order in the wrong hands and if overused is not unlike the lever on the slot machine in Las Vegas. It’s the impulse buy while checking out at the grocery store. The psychology behind the most common use of market orders is little planning and even less trade and risk management. Now I am not saying that all market orders are somehow misguided, but it’s usually only very skilled and disciplined traders that should use this order type with any frequency.

If a trade is planned ahead of time, before price triggers an entry, then it should be logical that if the trade is preconfirmed a few orders can be “parked” in the market. When I say “parked,” I am referring to pending orders such as limits and stops. These orders can be placed well ahead of time and handle the trade entry, risk-based stop loss, and initial profit target.

I don’t think at this point we need another discussion of what stop, limit, and market orders are. I think the main issue is why and how we place these orders. In fact, it’s really more about the job each one of these orders has. We only have three order types, but which we use has more to do with how we want to communicate our wishes to the market.

INDICATORS

How about indicators? I remember a trader long ago trying to explain his stochastic entry methodology to me. First it was based primarily on the indicator itself and not price (first warning!), and it was reliant upon my learning to recognize this squiggle of a move on the indicators lines (second warning!). Okay, I thought, he’s well intentioned, and this shouldn’t take too long. He showed me a few examples, told me it was really easy (third warning!), and off I went to try and put this to work.

I thought I had found a few good instances where the stochastic squiggled in the right way. So I clicked off a few demo trades. It didn’t work, which is to say the trade was a loser. But I know that a losing trade is not indicative of a methodology not working. Nothing wins all of the time. So I did it again, and again, and again. It still couldn’t seem to generate the entries as he had described, so consequently I would wander back over to his station only to see that he was up! All the “wrong” triggers I took were none of the ones that he took.

“What gives?” I asked. “I did it just like you told me to with this little squiggle here.”
“Oh well, you see your trigger didn’t squiggle like this . . . ,” and he proceeded to show me his squiggle triggers.
“They look the same to me,” I replied.
“No, no, no, yours crossed like this but mine crossed like this.”

This is subjectivity. I’m not saying his stochastic squiggle trigger did not work (but I will add that after the stock market boom of the late 1990s and early 2000s ended, so did his run as a daytrader), but I could not replicate it. I couldn’t see it the way he did. Darn subjectivity.

What good would it be if I showed you a bunch of strategies, and you couldn’t recognize them for yourself, by yourself? I’d be wasting both our time. Since I am both a trader and a teacher, objective tools are a must because that’s the only way I can be sure that there is a high likelihood that you will see what I am seeing! The reason so many traders lose more than they win is that most tools set them up for failure due to the fact that there are too many nuances in interpretation and the market just does not set-up the exact same way time after time.

TRADE WITH PRICE

If it isn’t already obvious, I want you to rely on price and price action to make your trading decisions. This isn’t because I don’t respect fundamentals or data—in fact I do—but they are not reliable when it comes to market timing (your entry) and market direction. This is due primarily to the way news filters through the market and is discounted. Discounting is the process by which news and data is factored into the market, often well ahead of the actual information or data that is released or confirmed. The markets are always forward looking. This means that what traders think may happen is what moves the market.

One simple way of seeing this at work is looking at data releases and the way market participants factor in the forecast or consensus of a report and the way they react to the actual data. So it’s not enough to simply see that a news event has beat or missed expectations (the consensus). You must also factor in to what degree the number beat or missed its mark and also know beforehand how much the consensus was discounted into the

market. The very act of trading news requires that you understand price action. You will notice with frequency that “good data” can make a market sell-off and “bad data” can make a market rally. Again, the data is not compared month to month, or whether the number was positive or negative, but rather it’s compared to what traders expected the number would be. So is trading news and fundamentals a level playing field? Heck, I forget if it is level or not . . . it’s hard enough to even find the field itself! Another factor that makes fundamental analysis unrealistic for not just Forex in Five trading but for most traders is that it is time consuming to gather and analyze the data, all the while knowing that you may not even have the complete picture, or all the data, or even the correct data. Then you must take the last step and determine how much of what data is already factored into price. And I’m not overcomplicating this. This is the process. Instead do what I do, focus on two numbers, the consensus, which is what is most widely baked into the cake (discounted), and the actual, which you’ll find out when everyone else does. This brings up another issue with trading news, the order entry. I will go into detail about order entry in the next chapter, but I want to mention here a few salient facts.

Let’s be realistic. I am not some hotshot trader at a bank or a pit trader with instant access to the market. I am a home office–based, private trader. I can’t trade as anything but that. Nor should I try. I am not privy to all the latest market intelligence, and I can’t delude myself into thinking that I know something that the market doesn’t. Order entry during economic news releases is insane at best and stupid at worst. Order entry platforms have a terribly inconvenient tendency to freeze during these volatile times. Spreads widen, the market jumps. I don’t want to be in the mix during these times but I can still take advantage of trading the moves that are generated during releases. You see the follow-through may come from the release itself, but more often than not, you will have an opportunity to setup and enter a market in advance of the release—if you watch price action, that is. It’s not that common really for prices to make sharp reversals from economic releases. More often the data simply hits the accelerator in the current direction. Weak gets weaker, strong gets stronger.

Are there advantages to being a small trader? Sure. I am nimble, and the market won’t see my trade size coming. Frankly, it doesn’t care. I can watch the big boys make the moves, and I can react to them knowing that the moves they make are large. I can move under the radar, in and out, and do it all over again. Why have I relied on trading price? It’s the only level playing field, and there’s just too much news and fundamentals out there to paint a complete picture and act on it with confidence. I’m never going to know everything, although I try to convince my husband that I do.

MARKET MEMORY

This is a simple concept and one rooted firmly in trader psychology. It is also vitally important that you use this concept when setting up your trades, finding support and resistance, significant highs and lows, and last but definitely not least, getting a correct and consistent reading of the Wave clock angle on each time frame. Let’s discuss the importance of how you determine what you look at on your chart. Now this is the first time we’re actually discussing charting. Before now it’s been mainly trends and relationships, but here we are going to start getting very detailed about chart set-up because, after all, this is how you are going to interpret price action and understand the market’s movement.

One of the reasons you and I have spent so much time discussing concepts is because without this foundation there will come a time that you may abandon these methods because you quite simply don’t understand why you were doing it this way in the first place. I think the only way I can prepare you for the rigors of the market is to teach you the why and the how. All instruction without concept is simply going through the motions. I need you to understand why you are doing your analysis in a particular way so that when things get tough you can stand firm knowing that there is a reason for the approach, and moreover you will have more confidence. Most traders simply adopt a methodology because they learned it somewhere and likely from a source they had some trust in. But it’s not enough for you to have trust in what I am teaching or that I know what I am doing. If you cannot do this on your own, what’s the point? You need to have trust in the instruction as much as the instructor.

Market memory is related in many ways to my not using multiple time frame confirmation. Most traders rely upon looking at many time frames so that they can identify key support and resistance levels. If I were to ask you right now to look at a chart, any time frame you wish, how would you determine how much data you would include in the chart? For most traders, this is completely random or determined by what is comfortable to look at, which again is completely random. The problem with this is that without an understanding of how much price action to view on a specific time frame, you are likely to miss relevant levels and move and totally misread the market’s current cycle.

So you might ask, What’s the problem with looking at multiple time frames? Well, first of all you should know by now that each time frame could and probably is moving at a different market cycle. Second, what is support on the 30 minute chart may not even register as support on a 180 or 240 minute chart. Third, and this is the main reason, it opens up a Pandora’s Box of allowing you to begin looking for reasons to stay in a losing trade. If a 30 minute chart moves against you, it’s just too easy to jump to the 60 or the 240 or even the daily time frame to justify your position. I’ve seen it far too often. If you set-up a chart on the 60 minute time frame, you manage it from the 60 minute time frame. The only way you can do that is to make sure you are looking at and making your analysis from a complete market memory.

Each time frame has a specific market memory. The reason is that short-term time literally have short term memories, while longer time frames, like the 240 minute or the daily (also known as the end-of-day chart), require more data to make a decision because monthly and yearly high and lows matter. This is partly due to the number of candles you get per day on different time frames. We already discussed the brick-by-brick approach to time frames so you already understand the number of candles we get per day. To make a decision on a longer-term time frame, I am simply going to need more calendar days to generate a sufficient number of candles on the chart in order to see significant highs, lows, rallies, sell-offs, support, and resistance. But what is sufficient?

I began asking myself the same question years ago and started seeing some obvious clues in the way specific time frames respected certain price levels, depending upon how long ago the level was established. I was mainly interested in how far back I could go and whether or not traders reacted to older highs or lows. I began to see that each time frame had a general “memory,” which is basically a limit to how far back support and resistance would be respected. The easiest to figure out was the daily.

Traders are very aware of 52-week highs and lows, and this not only allowed me to determine that the market memory for a daily chart was one year, it also made it very clear that these 52-week highs and lows were psychological levels. So for a daily chart, you need one year of price action on your chart. It is also in this view, the complete market memory, that you will take your clock angle reading of the Wave.

Reading the Wave can be subjective if you do not look at the clock angle within a specific amount of data. The X axis (horizontal) and the Y axis (vertical) are affected by your charting platform. Most charting platforms will try to automatically squeeze in the closest recent high and low from the current price. This “auto scaling” means that you will not have complete control of how much data is on your chart, but we’re not looking for nor do we need that much accuracy. In fact, market memory is really designed to be more of a guideline to keep a trader from putting “too much” or “too little” price action on a chart.

If you were to expand the horizontal or X axis of your chart you would also be flattening out the angle of the Wave. Squeeze in too much on the X axis and you could and will most likely artificially steepen the Wave. So, yes, market memory as applied to the clock angle of the Wave is very important.

For the 30 and 60 minute charts, the market memory is two weeks. This two-week view will represent the significant highs and lows as they pertain to the 30 and 60 minute chart. By the way, even though we haven’t yet discussed it, there are other very easily identified levels called “psychological levels” that are observed beyond that of what is included in the market memory, and we’ll talk about those shortly. And I know I mentioned this already, but if you cannot fit two weeks exactly into your chart view, you can simply err on the side of slightly more rather than slightly less.

Since I trade the 30 minute, 60, 180, 240, and daily charts, those are the market memory settings I will get into detail here. But you can apply this psychology to any time frame so I will also include a few other settings on some popular requests that I get. The 180 and 240 minute charts should include a look back of no less than one month. With these two time frames I have no problem with going out as far as 8 to 10 weeks although one month/four weeks will be absolutely fine and effective. Personally, due to the way my charts typically compress on my charting platform, I am usually looking at four to six weeks.

The most popular requests I get for alternate time frames are the 5 and 10 minute, 120 minute, and weekly. For the 5 and 10 minute time frames, work with a 3 to 5-day market memory. For the 120, use the same settings as the 180 and 240 minute charts. Finally, for the weekly, which actually I do refer to for big picture trades and significant longer-term highs and lows, it’s a five-year market memory.

So let’s review because I’ve thrown a lot at you here. The main reasons for using market memory is to make sure you are looking at the most relevant price action and reading the Wave for the most accurate clock angle reading. When it comes to Forex in Five trading, the chart set-up, making sure you are looking at price action in its proper perspective, will add up to quicker and more importantly, more accurate analysis.

A WISH

If there is only one thing you get (I do sincerely hope you get more than that) out of this book, it’s the concept of market cycles. It’s my wish that when you think of me, you think, “Yeah, that’s The Wave girl and her market cycles.” I hope you get so sick of me talking about them that you are bludgeoned into using them! I hope that you see that unless you know what cycle your strategy was designed for, your success will be hit or miss.

I hope that you take the time to understand what cycles your strategies are designed to take advantage of and also your indicators. There is not a more important concept than this, and the great part is that it will work and improve anyone’s trading because it applies to every type of entry there is. Most of the time when I see traders struggling, it’s because they don’t know when to apply a particular strategy. They continually feel like they are buying when they should be selling and selling when they should be buying! And that’s because oftentimes they are!

Market cycles let you know the difference between a correction and a reversal. They let you know whether a support or resistance level should be bought or sold. They let you know when the market is range bounce waiting for a breakout and when you should trend follow. I am standing on the shoulders of giants whose words seem to have been lost or forgotten by too many traders. I hope that you will see that the single best thing you can do right now, at this exact moment, is understand that without first identifying the cycle of the market, you are at best simply guessing at how you should trade the market.

EUR/USD.USD/JPY.

EUR/USD. The euro is the base currency here, and the U.S. dollar is the second currency. When looking at quotes of the EUR/USD, also called the “fiber,” you are seeing how many U.S. dollars you will need for each euro or conversely how many euro you will get per U.S. dollar. So if the quote is 1.2600 that means you need 1.26USD for each euro. An uptrend in this market reflects a strengthening euro and/or a weakening U.S. dollar. A downtrend reflects a strengthening U.S. dollar and/or weakening euro.

USD/JPY. The U.S. dollar is the base currency in this pair and the Japanese yen is the second currency. This pair is most often called the “dollar-yen.” When this pair is trending up, it is reflective of a stronger U.S. dollar and/or a weakening Japanese yen as higher prices reflect that the U.S. dollar gets you more yen. Lower prices indicate that the yen is stronger against the U.S. dollar or that the dollar is weaker against the yen.

Realize that one side of the pair can be enough to move prices higher or lower. The Japanese yen does not necessarily need to strengthen for the U.S. dollar to be weak against it . . . a simple move lower on the U.S. dollar would be enough. This is why data from each country involved in the pair is important and impactful. Additionally, because all the pairs have one thing in common—the U.S. dollar—the U.S. market and data coming from the United States is going to affect market psychology for these pairs.

GBP/USD. The British pound/U.S. dollar is called the “cable.” Traders seem to have a habit of giving everything a nickname. By now hopefully you are starting to see that the first currency in the pair is the base currency and when paired with the U.S. dollar, higher prices indicate base currency strength and/or U.S. dollar weakness.

USD/CHF. The U.S. dollar/Swiss franc is another pair where the U.S. dollar is the first or base currency. When the U.S. dollar is the base, then higher prices equate the U.S. dollar strength and/or second currency weakness, in this case the Swiss franc. When the “swissy” is trending higher, that means that each U.S. dollar is worth more and more Swiss francs. A lower trending swissy indicates Swiss franc strength and/or U.S. dollar weakness.

So as we round out the final two pairs, both of which are comm dolls, we can see that the USD/CAD (also known as the “Canada”) has the U.S. dollar as the base currency, and the AUD/USD has the U.S. dollar as the second currency. Since these currencies have a relationship with both the U.S. dollar and also a commodity, I refer to these as “split personality” pairs. There will be a triangular relationship. For example, the AUD/USD (Australian dollar/U.S. dollar) has of course a relationship to the U.S. dollar, but it also has a relationship to precious metals, namely gold.

We can add a seventh pair to this list with the NZD/USD (New Zealand dollar/U.S. dollar) pair as it moves very similarly to the “aussie” and has a comm doll relationship to the same commodities as the aussie. Additionally you will see a relationship to the Continuous Commodity Index. Frankly, it is almost impossible to look at the forex market without considering secondary cues and confirmation from the commodity futures market. I certainly use these to my advantage, and I will teach you to do the same a little bit later. I consider myself lucky to have started my trading career in the futures market, and I encourage all forex traders to use this connection, since it is one that when correctly applied will give you more understanding of price action in the most widely traded forex pairs.

MARKET CYCLES

Market cycle analysis is nothing new. When I first began learning how to trade, most of the books and articles I read were written in the early 1900s. Richard Schabacker and Charles Dow were my teachers. I have always thought that the basic gears of the market are basically unchanged. These men lived in a time before much of the regulation we see now in the financial markets, before computers and systems, before streaming data and charting, yet the reasons why what they did still works is because human behavior remains the same no matter what kind of technology is wrapped around it. It doesn’t take long before the successful trader realizes that at the core of trading is understanding her own mind and understanding the mind of the market.

Specifically, when it comes to market cycles, we’re talking about the mind of the market. The market is a gauge of psychology. Price does not represent the actual worth of a company or commodity or currency but rather the perception of its worth. This perception is affected by economic releases and fundamentals, and discounting these into price. Now if you think that somehow by not exhaustively researching this type of data you’re missing something, think again. All this is represented in price, and price action creates the cycles of the markets.

Cycles are representative of the psychology of the market. When traders and investors are greedy, markets rally. When they are fearful, markets fall. When they simply don’t know what to think, markets consolidate. It is vital that we understand this rhythm because it is how we will decide how to enter the market.

All strategies are based upon an underlying market environment. There are just four environments or cycles:

1. Accumulation
2. Distribution
3. Mark up
4. Mark down

Accumulation is one of two varieties of sideways markets. You’ll have an easy time knowing the difference once you understand the psychology behind it. Accumulation is the quiet market—it’s on the back burner. There’s likely little news or traders are waiting on news and no one wants to be the tall poppy. The range is narrow as the market creeps along sideways. What’s narrow? Remember, narrow is relative to the market’s current range and typical personality. Each pair has a unique price action behavior so what would be narrow on, for example, the USD/CAD can be very different when compared to the GBP/USD.

When you look at accumulation markets, the Wave should be sideways or traveling at what I call “three o’clock.” That’s right, just like the minute hand on your watch or a clock. When the Wave is traveling sideways you have a visual confirmation of the fact that prices are not trending higher or lower but rather have found a balance between support (buyers) and resistance (sellers).

Distribution is the second type of sideways market. The psychology behind distribution is not as simple as that of accumulation as the psychology behind it involves two distinct groups. Most commonly distribution is associated with the exhaustion of an uptrend and the turmoil often seen once a group of traders exit the markets as another group buys into the selling. What is different however is the fact that the move essentially is over or at stalling and therefore the market cycle “turns over” from the trend to a sideways direction.

Since there is not a bullish bias in forex as there is in stocks and futures, and by bullish bias I mean a predisposition to buy and look for an increase in the value of the market, you can also find distribution at the end of a downtrend as well. Again, it is simply representative of one group of traders exiting the market while another gets in, believing the trend is still in place. Regardless of where the cycle occurs, it is very much the collision of buyers and sellers, and it’s this collision that creates a more volatile and wider range. When the market enters distributions, the main difference you will notice, as compared to accumulation, is the volatility. The Wave will be sideways but can travel not only at the three o’clock angle but also at what is known as a “two to four o’clock angle.”

Two to four o’clock angles are unique to distribution and are more easily identified by what they are not rather than what they are. Let me explain. If a market is trending, it will be doing so at either a twelve to two or four to six o’clock angle. We already know accumulation is three o’clock. This means that its price action is sideways and the Wave is attempting to transition to three o’clock but is unsuccessful. We can be on the lookout for the two to four o’clock angle. It can’t be flat, and it can’t be trending. So essentially, it is a process of elimination, and we identify this two to four o’clock by what it’s not.

A few other things to look out for on sideways markets, whether it be accumulation or distribution, is solid support or resistance. “Solid” simply means that the touchpoints that make up the horizontal or static level are within five pips or less. More than five pips and the level can still be considered static, but now it would be “soft.”

Transitions between any of the four cycles are probably the toughest to deal with. These transitions will look as though one cycle is ending and another is possibly beginning. This is where you are most likely to want to have some sort of definitive way of saying that a new cycle is now set. But it’s not that easy. It’s not going to be as easy as my saying count three candles and if all three are traveling at the set clock angle you can say the transition is complete. But I just did, but that’s not all I want you to do. It’s more than the mechanics of counting candles. You must develop a feel for the rhythm of the market, and I know with time and practice you will. The market is just not that mysterious. It’s not more mysterious than human behavior, and while humans are certainly entertaining, we’re nothing if not predictable, and thus so is the market.

Mark up is just a fancy way of saying uptrend. Uptrends should be defined by support, which is a series of lower highs. Support is the key to maintaining an uptrend even within the context of pullbacks. Pullbacks or corrections are part of a healthy trend, and it’s these moves lowering within an uptrend that actually help perpetuate it. Think about it a moment. If you are waiting for an opportunity to buy into an uptrend, first I must say “kudos” because most people just buy the new highs and that is not an effective way to enter a trend. But if you are one of those smart and patient few who wait for a correction to enter a trend, then you know by your acting—buying into the market—you are in effect supporting the uptrend. An uptrend can be identified by the Wave traveling up at twelve to two o’clock. Once the trend is underway, it will probably seem unnecessary to confirm an uptrend with the Wave, but please do not let your guard down. It’s the slight nuance in the Wave, the transitions I explained earlier, that are so important to notice. The initial sign of an uptrend, its very earliest stages, are probably the most difficult to recognize without the assistance of a visual tool like the Wave. So make and keep the good habit: Confirm all trends consistently—no matter how obvious the trend may look—with the Wave’s clock angle.

Confirmation of an uptrend being intact within the corrections that occur can be easily done with the Wave. Look for prices to respect the support of the three lines of the Wave, most especially the bottom line. If prices break down through the bottom line of the Wave while moving up at twelve to two o’clock, that’s the first sign of transition or a potential turnover.

Mark downs, surprise, surprise, are a downtrend. The Wave angle you are looking for here is four to six o’clock. Downtrends are evidence of fear, and fear creates selling. Pullbacks within an uptrend are selling as well, but this is profit taking, and if it is true profit taking and the uptrend is intact, the lower prices of the correction will invite buying. Downtrends are different in their psychology because the emotion is much more extreme. People sell when they are fearful, and fear can come from bad news (most common) but also uncertainty. When in doubt, most traders will get out. When it comes to downtrends, gravity applies. Prices fall much faster than they rise. Because of this it is especially important that you stay sharp when waiting for bounces within the four to six o’clock Waves.

Trends in the forex are not as straightforward as trends in what I will call “single markets” like stocks and futures. If I am trading a stock, the price reflects the rise or fall of the perception of value of that company. The same can be said for commodity futures. If the market generally sees the value of crude oil is going up, it will generate buying. The consideration to buy or sell is determined by a single entity. It’s different when you are trading forex pairs.

They are called pairs for a reason. You are trading a relationship between two currencies. Uptrends and downtrends are not necessarily reflective of fear and greed in the way they are in “single markets.” Let’s examine this because it’s very different from the way most markets operate, since there are two separate markets that are being compared, and it’s the relationship between the two that is traded.

To understand trends in the forex market, we have to break down the pairs into the base currency and the second currency, so that we can understand on which half of the pair the fear is and which half of the pair the greed is. Pairs are quoted in a specific way, and for the purposes of Forex in Five trading and keeping with the most traded pairs, we discuss the same six pairs I listed earlier, the U.S. dollar–correlated majors and comm dolls.

SINKING, SOARING, OR SIDEWAYS?

Real-time trend identification is vital to all traders. I don’t know about you, but I don’t want to wait for two, three, or four touchpoints to develop so I can identify a trend or wait for a channel to triangle to completely form before I can begin to decide if the pattern is occurring in a sideways market. It takes too much time, we give up too much potential profit, we end up being among the last to the party, and worse still there is no definitive way we can say that the lines and levels we are watching are occurring in the correct market cycles. Those are the issues all traders deal with on a daily, if not hourly, basis.

The main issue is this: Before beginning any analysis we must identify the direction of the market. This is no small task to do in real time across multiple time frames. The Wave is the only tool I know of that can do this. Frankly, because most traders don’t know how or know of any tool to be able to confidently recognize a trend, they simply don’t discuss it and therefore apply their strategies somewhat randomly. Swing traders treat all markets as trending; momentum traders approach all markets as rangebound. You get the picture. If all you have is a hammer, the entire world is a nail.

TIME FRAMES

Anytime someone asks me, “What’s such-and-such market doing, Raghee?” I answer it by asking “Which time frame?” That must be the first consideration. A five-minute chart could be behaving very differently from a one-hour chart and different still to the four-hour or even the daily. The daily chart is the most psychologically significant, but we should never assume that’s where the trade or the action is! The easiest way to begin understanding what it means to analyze any market across multiple time frames is to view short time frames as the building blocks to larger time frames.

I trade forex off one of five time frames: the 30 minute, 60 minute, 180 minute, 240 minute and daily or end-of-day chart. Sometimes I’ll look at a time frame as short as the 15 minute. But frankly, anything smaller than that begins to make less sense when you factor in the cost-per-trade in forex. With five, maybe six viable time frames to consider, there are not only the individual market cycles to consider, but there are risk/reward issues. Consider that daily charts, due to the fact that a single day’s trading will represent a wider range from high to low than a 30 minute or 180 minute time span can, inherently has more risk because of it. So it’s not enough to find a trade on a specific time frame; you have consider the risk that comes with it and whether the risk is appropriate for your account size and risk tolerance.

No daily chart is going to trend higher or lower or consolidate without the smaller, intraday time frames moving it there. That’s the heart of the “brick by brick” philosophy. It takes two 15 minute candles to make a 30 minute candle, two 30s make a 60 minute candle, three 60s for a three hour or 180 minute candle . . . see where I’m heading? It’s the smaller time frames that dictate the direction of the larger time frames; it’s cumulative. For those of you who use multiple time frame (MTF) confirmation, this is my reasoning for not using it.

I started out trading fully embracing the multiple time frame confirmation philosophy. I did it really for no other reason than I was told in book after book, that it’s what I should do. So what is multiple time frame confirmation you ask? Generally, it’s the process of confirming the overall direction of a market with a comparatively larger time frame. For example, confirming the direction of a 30 minute chart with the direction of the 180 minute or 240 minute chart. When you consider the “brick by brick” philosophy, this is a backwards way of confirming market direction. Remember that moving from smaller time frames to larger time frames is cumulative. Smaller time frames are the building block, the bricks, which build the larger time frames.

At any given time there is a very good chance that each time frame will have slight differences not only in direction but also the quality of that direction. The 60 minute chart may be in an uptrend but the 30 minute’s uptrend might be stronger or steeper or correcting to support better. It’s these differences we compare to determine which time frame we will setup and trade. Here’s another point to consider. Once you choose the time frame you will set-up, confirm, and manage the trade from that time frame alone. Later on, we’ll be discussing market memory, and this will take care of many of the issues traders have when treating a time frame in this manner. Most of the issues stem from a concern over not knowing all relevant points, support and resistance, on the chart. It’s that feeling that you’re not seeing everything you need to be aware of. Working from the market memory, coupled with psychological numbers, will help take care of this entirely.

There is some value in MTF, but I believe it’s limited to comparing intraday time frames to the overall or “daily” time frame. For many traders, trading against the daily time frames is trading against the overall psychology of the market. Now, if there is a clear direction on the daily, this certainly can be a filter. But it’s not a required one.

IDENTIFY THE TREND

You are not your entry strategy. If only I had a dime for every time someone has told me, “I’m a swing trader” or “I am a breakout trader” or—and this one is my favorite—”I am a contrarian.” Let me translate for you what each of one of these trading statements really mean.

“I am a swing trader.” This actually has two different meanings. First is “I enter trades and stay in them for anywhere from three to five days.” Okay, interesting, but does that mean there is some kind of alarm you set—an egg timer maybe—that goes off at a three- to five-day setting? And when it does go off, is it a mad scramble to the exit button? How do you determine if the trade is fully cooked at three days or five?

Second, and at least this one has more merit is “I am a trend trader.” Frankly, I have fewer issues with this translation as it is a partial truth. But first, how do you recognize a trending market? Sadly for most “swing traders or trend traders” every market is treated and thought to be a trending market, which we know of course is just not the case.

“I am a breakout trader.” To a breakout trader the whole world is a buy through a ceiling and a short through a floor. And if the markets were kind enough to consolidate and break out with that much predictability, everyone would be a trader, have six-pack abs, a full head of hair, and children that clean their room after finishing their homework every night. Breakout traders see the markets always as a coiled spring waiting to be sprung, and while this is actually an effective strategy in a sideways market, like any good strategy, it must start with the correct market cycle to be applicable.

“I am a contrarian.” Here’s the translation. “I pick tops and bottoms in trending markets mainly because I am not sure how to trade a trend and follow it. Instead, I choose a subtle form of revenge trading, looking to buy new lows and short new highs in between my hours of playing in oncoming traffic because I missed the move in the cable from 1.7000 to 2.1000.” The bottom line here is that you are not simply a swing, breakout, or contrarian trader. You are all three, and the market will tell you when you use which one . . . if you know what to look for.

ANALYZING THE MARKET

I’ve set up some pretty lofty expectations, haven’t I? So how serious am I about doing this in approximately one hour a day? No joke. No hype. I mean it. Time spent does not equate to success. In fact, I’ll go so far as to say that if you were to reduce the amount of time you spend analyzing and trading—starting today—your returns would improve. Why? Well, Las Vegas knows why. They don’t build billion-dollar casinos because they look majestic in the desert. While almost everyone you and I know tells us that they always leave Vegas a big winner, money in their pockets, someone has got to be telling a whopper because I’m pretty sure that the water bill alone at the Bellagio is enough to make my eyes cross. Now if you think I am comparing trading to gambling, I am, just a little.

While it may be blasphemy in certain circles, comparing trading and gambling there are similarities that it would do us good to notice. What I have observed is the time spent sitting at a casino will eventually empty your wallet if you don’t know when to walk away, and I don’t even gamble. The fact that most traders don’t know when to stop does draw some similarities to their gambling cousins. Is trading gambling? Sure, professional gambling. I’ve worked with a professional gambler; he was written up in Forbes and was one of the most disciplined guys I have ever met. He regulated his diet on days he worked, which is to say the days he would gamble. He had a strategy, stop loss, money management . . . the works! I can’t dismiss that as merely gambling. There are trends in games like craps just as there are trends in the EUR/USD or crude oil. Yes, I know there are differences, but I think we can learn a lot from professional gamblers, and I believe the main lesson is this, given enough time, the house will always win. Not because they are better, but because they are patient and will play every hand, every card, every roll. They know they are better funded than you or I. And that alone lets them be wrong longer. They wait us out.

Gamblers make small decisions by noticing the small nuances. Who hasn’t watched 14 hours straight of the World Series of Poker marathon and noticed how the players size each other up? I’ve watched players at the craps table, and they will vary their bets according to hot streaks—is that much different than trading a trend? My point in all this is that much of trading is psychological, and you are already in many ways equipped to trade. You just don’t know it yet. So what are those nuances traders need to notice to play the market? They are visual tools, but instead you will use a price chart. Price is how we measure market psychology. It’s a gauge of exactly what the buyers and sellers are thinking and doing.

So how do we know when to sit and play and when to watch? That’s the key, isn’t it? Well, playing more is not the answer. Observing helps. So does becoming a student of price action. Learn to watch price action without feeling a compulsion to play. That’s discipline. The next step is knowing when to rejoin the game. For us, traders, we can rely on financial centers opening, closing, market overlaps, and scheduled news releases to signal those times. That’s part of it. While we want to join the game at the right time, the other half of the equation is the market behaving in a way that we can capitalize on.

The three most common mistakes losing forex traders make are:

1. Risking too much on a single trade
2. Trading during the doldrums between the London close and Sydney open and overtrading during Asia without regard to the European open
3. Trading at the moment of news releases

And those are just a few examples. But the topic here is how to analyze the market quickly, and sometimes it’s just as effective to discuss what not to do because you and I are going to spend the better part of the rest of this book discussing what to do.

The lesson here is not that I want you to be Vegas or Wall Street; we lack the capitalization. But I do want you to begin noticing what losers do. Vegas, Wall Street . . . they know what losers do, in fact they count on them. Losers behave the same way. They congregate in little herds of losers because they think and behave the same way. You know the old saying: If you can’t find the sucker in the room, it’s you.

Knowing when you play or walk away is a function of knowing what will make us act. I call them “decision levels.” The market seduces traders. It’s a siren song that is hard to resist when you feel that the next price could be a reason to act. The reason why Forex in Five traders will be able to resist is that price becomes our ally; specific price will cue our interest and begin analysis, and then, maybe, trigger a trade. Most traders make knee-jerk reactions because they incorrectly believe that any and all price moves are an invitation to trade. Watching the market this way is both unproductive and exhausting. Knowing that you have a price at which you have planned to act is instrumental to your success in trading.

CONFESSIONS OF A CHART JUNKIE

I still love charts, and they are still my bread and butter to finding, setting up, and managing trades. For every knucklehead who asks me: “You know what you find next to a sunken ship?”

“I give up.”
“A chart.”
“Ha ha.”

I know that there is no way that trading news or fundamentals can work, without an understanding of how much or how little the news has been discounted into the market. So the battle lines are drawn: fundamental traders versus chartists. I don’t think it has to be that way. I think a hybrid of each, knowing which to use when, is the ultimate solution. But I didn’t always think that way.

My chart junkie ways started like most. An interest in learning how to trade and a charting subscription sent to my home each Monday. This was back when I hated weekends because the markets were closed. Yeah, I needed help or at the very least a hobby. There was little else I could get my hands on at this time in the history of mankind because there was really no Internet to speak of, and those giant mochaccino-lands with books didn’t exist. So it was me, glued to a fledgling channel hardly anyone watched called the Consumer News and Business Channel and Schabacker’s “Technical Analysis and Stock Market Profits.”

I would sit for hours poring over about 30 end-of-day charts of the futures market. A pen and ruler and calculator was as sophisticated as it got. Forget streaming data and intraday charts; this was old school. You know there’s nothing like going over printed charts manually with pen and ruler. If I sound like I am pining for the days of yore, I guess in some ways I am.

But it wasn’t perfect. And I’m here to tell you that the bell curve of your trading will follow a path similar to mine, similar to a lot of traders and would-be traders. As with anything new and exciting, you can’t get enough. Not unlike your first car, first home, first puppy, or new love. It’s all-consuming, and that’s what makes it great. You’re going to dive headfirst into that new charting software, demo trade the heck out of that new order entry platform (and start convincing yourself that the practice trades are real), read every book written on the subject of trading, attend seminars, watch CNBC, and nod as though you understand most of it, discover dead Italian mathematicians (Fibonacci), and probably start making a series of the worst trades ever made. Then and only then will you really start to learn. Sadly and typically, the pain must come first. Now, with your bruised ego, you do all of the above again. Only this time there’s doubt and fear, and that’s when you think that someone else has the answers. Here’s a quick tip: They don’t.

Most traders want to know everything. Pursuing that is, of course, insane. But we all get crazy for a bit, overcompensating for the fact that we know that we don’t know nearly enough. As we begin to try and apply too much, naturally we begin that process of whittling away what doesn’t work and what we don’t understand. If we continue to do this, eventually we find that we’re not looking to add but rather subtract until we find the handful of studies, tools, and whatnot that will finally conclude our search of “what works.” That’s closing the gate. Keep the stuff that you want out, and keep what you need in.

The quicker you can recognize where you are along this bell curve, the better and the sooner you can get to closing the gate, the closer you will be to becoming a trader. That’s a fact! There is a common thought that you should never stop learning, and it’s true, but knowledge is depth, not breadth. Knowing more is not always useful, knowing better, knowing deeper, with more understanding is.

It’s more tempting out there in the world of trading, investing, and the markets than ever. Today’s streaming data is more affordable than ever, and the charting platforms that you can find for free online are better than the platforms I used 10, 12 years ago and paid $800 a month for. The indicators are seemingly unlimited, fast, and instant. But you know what, most traders still stink, I mean really stink: losers to the tune of about 90 percent plus. So it’s not technology that’s going to make us better traders. You can use my approach to trade any market and any time frame, forex, futures, and stocks!

One of the biggest mistakes I see with traders is that they fail to understand that no market is an island. There’s no such thing as a market that trades inside a bubble. Markets move one another and are connected across so many fronts: forex to futures to stocks and back again. I don’t consider myself just a forex trader. I trade futures, stocks, options, and I do this not because with price I can level the playing field, get an unfiltered read on market psychology, and trade liquid markets. I do this because it makes all my trading better. You’ll learn more about the futures-forex connection when we discuss my Forex Market Pulse and the specific relationship forex has to the U.S. dollar, Dow Jones, crude oil, and gold.

EMPLOYEE MINDSET

When you become a trader, you become your own boss. Now for entrepreneurs or those of you with a natural entrepreneurial spirit, this will not be a major adjustment. For those of you who have been employed by someone else for most of your adult life—I won’t kid you—that first step is a lulu.

Traders live in the results economy, which is to say that we get paid not for time spent doing something but for results and results only. Believe me when I tell you that the market does not care one bit that you or I spent six months or a year learning how to trade, or that we spent the better part of an evening analyzing charts or news and fundamentals or that you got up at 2 A.M. to trade Europe. Notice I didn’t say “we” in that last sentence, because I just don’t get up at those silly hours of the morning. Not being rewarded for effort and time is difficult for many new traders, and the lack of return for the hours can be very frustrating for the unprepared. So here I am—preparing you. This is a particularly tough habit for people with the employee mindset to overcome because time spent doing something is the measuring stick they are familiar with. If that isn’t enough, there are other considerations, too.

It’s not my objective to make trading sound simple and easy, because it’s not. It’s not because the skill is particularly difficult, but rather that we humans love to complicate everything. There are challenges to trading just as in any other skill you are trying to acquire. I mean really, who here plays golf? Could anything be harder or more painful with the exception of childbirth? If you don’t practice what I am going to teach you or think you are going to buy a piece of software that tells you what to do, then seriously, please give this book to someone who is going to use it.

All I am telling you is what I have learned the hard way. A smart person learns from her own mistakes. A wise person learns from the mistakes of others.

Full-Time Trading = Full-Time Job

I don’t know about you, but I have never wanted to work on Wall Street, or in an exchange, or for a bank, or be a fund manager, or manage other people’s money for that matter (by the way, I tried it and hated it). That’s not to say those are not important or fulfilling jobs. It’s just that I have never been much of an employee. I’ve always wanted to work for myself, and that really is just my way of saying I want to dictate when and how hard I work. You’re probably not that different from me. Who doesn’t want that freedom? That’s what trading is to me, freedom. There are plenty of ways to make a good living in this world. But I can’t throw a 90 mile-an-hour fast ball, I can’t sing or dance, and I always kick myself for not thinking of putting bird seed in a balloon and selling it as a stress relieving grip ball. Oh well.

So it ain’t just the money! Trust me when I tell you that trading is the hardest way to make an easy living I can think of.

I am a part-time trader. I think that people who are employed as traders are professional traders or full-time traders, but there goes your freedom out the window. I have never been great at answering to anyone as my mother will attest. And I do like to sleep in from time to time, as a few of my friends will attest when they have called me in the morning only to wake me up!

So really by that definition I am a part-time trader and darn proud of it. Does that mean that I treat my trading as a hobby? Definitely not! But consider that forex, which is the main topic of this book, is a 24-hour market. I don’t know about you, but I like to sleep, cook, train, golf, play a little Wii, read a book, maybe write a book, talk with friends, do a little blogging, dive, ride my motorcycle, go out to lunch with friends, go fishing, travel, you know, have a life! So obviously there are going to be times that I can’t be in front of my computer and more often, don’t want to be!

Let me tell you now that I was not always so enlightened. When I first started getting into trading, I was totally addicted. Addicted to the action, the charting, getting my hands on everything and anything trading related, and going at it 16 hours a day. No joke. And I’ll tell you the whole tale later, but suffice to say, I’m a chart junkie. My trading wasn’t better with my eyes glued to dual monitors. My friendships weren’t better, and I’m pretty sure my husband thought I had lost my mind. Although he still might be holding that opinion.

So I eventually unplugged and embraced the life of a part-time trader. You can and should do the same.

There are a few things that will make it clear once you understand them. Just a few simple things are all you are going to need. I will show you how to use time frames to your advantage as well as the prime trading times for each pair. I’m going to lay it all out for you.

The forex is a 24-hour market, so do full-time traders ever sleep?
Okay, so now you may be thinking, “Raghee, won’t I miss trades if I only watch the market part-time?” And I will answer, “Yeah. You, me, and everyone else.”

Even full-time traders have to sleep, eat, and well . . . you know. And believe me when I tell you that I have known quite a few traders with computers in the restroom. So trading forex is all about picking your spots and knowing when the market is most likely to move. This luckily is not completely unpredictable. Markets, like people, have a natural daily rhythm. As a trader, I count on it. In many ways, trading forex is trading the opinions of seven different financial centers: Sydney, Tokyo, Hong Kong, Singapore, Frankfurt, London, and New York. These seven represent the major financial centers around the world, and each has its own psychology, volatility, liquidity, and rhythm. You can find a time to trade. It’s really going to be more a function of your personal schedule. I will tell you though that all financial centers are not equal. Some are more important (New York) and larger (London) than others. Since the six most traded pairs are U.S. dollar–correlated (they reflect strength or weakness versus the greenback)—EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD—the “best” trading time is the overlap between Frankfurt, London, and New York which makes the forex “prime time” 7 A.M. EST to noon EST. What if you can’t be in front of your computer then? I’ll show you how to trade it anyway, and that goes for any financial center. With proper and well-thought out order entry and a firm grasp of time frames you can handle just about any market.

Just accept it now; you are going to miss the occasional trade. The sooner you can come to terms with that fact the less likely you will chase trades, and the less likely you are to revenge a trade. And if you didn’t know it already, doing that will empty your trading account at a nauseating pace.

SHORTING

The real value in trading has always been the fact that traders can profit in both up and down markets. This has always been one of those ideas that people have a hard time wrapping their brains around. Even though I spent a good deal of time telling you that you can always find a bull market in forex, that’s not where I want you to stop looking for opportunities. I’ll let you in on a little secret. Gravity applies to the markets too. Prices always fall quicker than they rise. It’s a function of fear and panic. And, yes, you can profit from it. But before you think of me as some heartless trader preying upon fear, remember that trading and investing must have participants willing to sell. I’m not sure where this concept blipped off the radar, but it’s one that the general public doesn’t seem to get: For every buy there is a sell. The reason prices move higher or lower is based upon where the transaction takes place. However, there still must be a buyer and seller willing to do a deal in order for a trade to take place.

Let’s discuss it in terms that most people can visualize, the housing market. When a house goes up for sale you have a seller, that’s the current homeowner. This homeowner is hoping that there is demand—and lots of it! More demand for the house, and the price at which they can sell (think of it as where the trade will be done at) will be higher. Less demand, and the price at which they will likely sell will be lower. The stock, futures, and forex markets work the same way. When there are plenty of homes for sale and not as many buyers, that’s a buyer’s market. If you were to plot that on a chart, the trend for home prices would be down. Now take that same scenario and apply it to a stock. Let’s use IBM. If IBM came out with a bad earnings report, or if a new product line flopped, or a problem was found in server design—any one of the myriad of issues that can hurt a company and a stock—the value of IBM would likely go lower over concern for what these issues mean to IBM sales and profits. What if you could profit from prices heading lower? We all know we can profit from prices moving higher as good news is discounting into a stock and both traders and investors buy in expectation of more success, profits, and sales from IBM. But what if events go the other way?

I’m going to warn you that you may need to reread this until you get the mechanics of what I am going to explain implanted in your mind. It may take some time to click, but once it does, it’s going to open a whole new world to you and your trading opportunities. I remember the first time I was introduced to the concept of shorting. It was foreign and took me a week to understand. Conceptually it made sense, but it wasn’t until I understood order flow that it made total sense. I began to see why it was such an important concept and a viable position to take in a downtrending market. Funny enough, I actually thought for a short while that it was illegal until my broker walked me through what I am about to explain to you. Remember that while you read this, until people are willing to sell and short the market as we know it, it would not exist. I’m not trying to be dramatic, it’s just plain fact.

I could just say that when you are shorting a market (stocks, futures, or forex) you’re selling it at a higher price and buying it back at what you hope to be a lower price for a profit. But selling something you don’t own doesn’t necessarily make sense, does it? And for those of you who are already familiar with shorting, I am probably preaching to the choir, but come along for the ride here regardless. You may find out a few things about order flow you didn’t know before.

I am going to use a stock example again, because time and teaching literally thousands of traders has taught me that using this as a frame of reference seems to be one that most people feel comfortable with, and the mechanics apply to any market. Let’s take our old friend IBM again. Big Blue is heading lower, and as a trader you understand that one of your
options would be to take a short position in IBM with hopes that it will head lower still from your selling price. How, who, and why?

The how of shorting is basically a process by which your brokerage will allow you to borrow shares of IBM. So that’s where you get the stock to sell: You are getting it, borrowing it, from your broker! Next is taking these borrowed shares of IBM and selling them into the market. Who will buy it from you? The markets are divided into two groups, buyers and sellers, also known as the bid and ask, respectively. Buyers bid on a stock they want to buy and like all buyers they would like to pay as little as possible. The ask, or sellers, are on the other side. They own what the buyers want, and of course they would like to sell it for as high a price as they can get. How much they will get for it depends upon whether it’s a buyer’s or seller’s market, just like real estate.

Imagine two lines of traders, one of buyers and one of sellers. These two groups are lined up by placing the bidder or buyer who is willing to pay the most for IBM at the front of the “buyer’s line” and the seller who is willing to sell for the least amount at the front of the “seller’s line.” The difference between the highest bid and the lowest ask is the spread. Starting to make sense?

At the front of each line are the two participants that are closest to being able to get a deal done. So who gets their price? Well, that’s determined by the overall direction of the market. The seller will have the advantage if prices are heading higher (more demand) while the buyer will have the advantage if prices are heading lower (more supply). In the trading world this balance can go back and forth from moment to moment. Since we are talking about shorting, we’ll assume that the overall market psychology is bearish. This means that the overall direction of the market is heading lower and that the buyers are able to have their way, which means that the trades are generally being done at lower prices.

So since you are shorting and you have your borrowed shares of IBM, you are on the ask or “seller’s line.” You have a price that you would like to sell these shares for, and your hope is that you can find a buyer and that prices will head lower after you sell your shares.

So how do you profit from such a position, and why would anyone buy it from you? The first part is easy. Since you borrowed the shares from your broker, all the broker expects is that you return the shares to them. It’s much like borrowing a book from the library. The library made you get a card so you are “approved” to borrow a book, and they expect you to return it. The broker in this case is typically going to let you have those shares borrowed out for pretty much as long as you need them. When you sold IBM, you collected a certain price per share from the buyer knowing that at some point you are going to need to buy some IBM sooner or later to return what you borrowed. Let me say that again, because here is often where the wheels fall off the wagon for a lot of folks.

You sold your borrowed shares of IBM into the market, and the buyer of those shares gave you, for sake of keeping this simple, $100 per share. Now you have this $100 per share, and that’s half the equation here of this short position. Now based on your analysis you think that prices should head lower, and by golly, they do! $98 . . . $93 . . . $88 . . . $87 . . . $84 . . . until they level off at your target of $80. So you sold at $100 and prices sold off to $80—a $20 difference. Remember, your broker wants their shares back at some point, and you’ve decided today’s the day and $80 is the price. So you execute another order. Your first order was a SELL. Your second order is a BUY. This will allow you to realize the $20 profit and return the shares of IBM back to your broker, thus closing out your short position. You sold these shares at 100 and are buying them back at 80, so the difference is yours.

I had also mentioned the “Why?” Why would someone buy these shares from you? Well, that’s what is so wonderful about the markets. There are always going to be contrary opinions. Without them there would be no market. When I think I see a buying opportunity, there is someone out there who thinks that I am out of my mind and that there is a selling opportunity. Without both sides of the equation, buyers and sellers, there would be no market; there would be no investing, no trading, nothing! So next time you hear about someone shorting the market, remember, there had to be a buyer for that trade to be done and without both types of market participants there would be no liquidity. We’ll talk later about liquidity and how the forex is the most liquid market on the planet and why that’s so important to us as traders. For now though, I hope your mind is starting to see the opportunity in playing both sides of the market.

And by the way, my shorting example of IBM has nothing to do with anything happening in the market. I have been an investor in IBM for many years. It is the first stock I ever owned. My father, a proud IBMer, worked for them until the day he passed away.

A BULL IS ON THE LOOSE!

One of the more appealing aspects of the forex market, beyond the 24-hour always open trading, is the fact that there’s always a bull market somewhere amongst the pairs. The idea of buying a stock or futures contract or a forex pair is much more familiar to most people, especially since most of us are already familiar with investing. Investing and trading do have two completely different mindsets. For investors, the whole idea is ownership: to own more shares of a company or mutual fund or even ETF (electronically traded funds). Most people incorrectly believe that trading is buying low and selling high . . . wrong! That is actually investing. Now, of course, investors do hope that their holding will increase in value, but that is secondary to ownership.

Traders don’t own anything; in fact, they don’t want to because the goal in trading is to profit from price movement. Instead of owning, traders control shares, contracts, lots, or pairs with leverage. Now what does all this have to do with playing U.S. dollar strength or weakness? Traders understand that in order to profit from price movement they must buy and short. That’s right, “short.” After all, trading means making money in up and down markets. If you were only to play one side of the market you would consistently miss opportunities to benefit from when the U.S. dollar moves a pair lower.

Consider this move. The U.S. dollar gains strength on the euro. The resulting move on the chart would be weakness, a sell-off and even a downtrend in the EUR/USD (euro/U.S. dollar). In order to profit from this relationship a trader would have to short or sell the EUR/USD. Here’s another example, one that has hit closer to home for most people. Crude oil has been on a rollercoaster as of late, reaching new highs and selling off to significant lows. In fact, over the course of less than six months, crude oil has moved over $100. Crude oil has a strong correlation to the commodity currency of the U.S. dollar/Canadian dollar (USD/CAD). The USD/CAD is affected by U.S. dollar movement but as with all forex analysis, you must consider the other side of the pair, in this case the Canadian dollar. The Canadian dollar or “loonie” is affected by crude oil prices because Canada is a huge exporter of oil. When oil strengthens, this helps the loonie strengthen. If oil weakens, it can take the loonie down with it. So as the crude oil market sells off, the loonie has been weakening against the U.S. dollar, which results in a downtrend on the chart of the USD/CAD. The only way to benefit from that movement in the forex would be to short the USD/CAD and profit from the weakness.

FILL IN THE BLANKS

In case you’re new to forex, here’s the one line synopsis of what the foreign exchange market is: How many - will I get for - ?

How many yen will I get per U.S. dollar?
How many U.S. dollars will I get per euro?

So basically depending upon the strength or weakness of the U.S. dollar you may be able to get more or less of another currency in exchange. I think of it as the airport analogy. Let’s say we all jump on a flight to Paris and upon landing we look to exchange our pocketful of U.S. dollars for euros. The forex rate will dictate what we get.

Traders and investors track, analyze, and use this price movement to determine whether they feel this rate will go higher or lower.

That brings us to commodity currencies or “comm dolls.” Maybe you have heard a little about what these pairs are and how they behave. My take is a little different, so let’s start with the basics. Generally speaking, commodity currencies are just what their name would suggest: a currency pair that has a strong correlation back to a particular commodity. Simple, right? Well, not so fast.

The Australian dollar/U.S. dollar, New Zealand dollar/U.S. dollar, and U.S. dollar/Canadian dollar are the three pairs you will most commonly call “comm dolls.” Let’s use the U.S. dollar/Canadian dollar or “canada” as an example. The “canada” has a relationship to the energies complex, meaning crude oil, heating oil, natural gas. It moves, however, with a strong correlation to crude oil. Why? Well, consider that the country of Canada is one of the world’s leading exporters of crude oil (from www.eia.doe.gov/ pub/oil gas/petroleum/data publications/company level imports/current/ import.html).

You better bet the supply and demand of crude affects the Canadian economy. But is that the end of the story for commodity currencies? No, not even close. You see this pair has a correlation to the U.S. dollar as well. Remember it’s the U.S. dollar/Canadian dollar pair. We not only have to consider the impact of crude oil on the Canadian dollar itself but also how the U.S. dollar is moving against the Canadian dollar.

I am going to go into great depth later on about these relationships and my Forex Market Pulse. For now, though, think about this: Does crude oil affect the Canadian economy alone? I think we have seen what high crude oil prices have done to the U.S. economy as well. So bottom line? All pairs that have a relationship back to the U.S. dollar will have a certain amount of impact from crude oil. And that means that all U.S. dollar pairs can be considered comm dolls to a certain extent. Now that’s not something you will hear from most traders, but I’m here to tell you that’s the way it is.

So, there’s always a bull market somewhere in the forex. When you consider all the different countries, commodities, and the relationship they have with one another, it’s easy to begin to understand that while some currencies are being beaten down, others are rallying in comparison or are considered safe haven currencies. This is why you will always find that some pairs are heading lower while others are ripe for buying.

Making Money in Up and Down Markets

People like to buy. That seems to simply be a fact of human behavior. One of the things that most traders and investors look for are markets that are heading up and will continue going higher. I can no more tell the future than anyone on Wall Street, and my guess is that your crystal ball is at the repair shop as well. So what can we do? Given the widespread preference for buying, the best thing to do is find a market where you can find a bull market no matter what. That’s the forex market.

This is where the U.S. dollar comes in. The six most popular pairs in the forex market are either U.S. dollar–correlated majors or U.S. dollar–based commodity currencies also known as “comm dolls.” You didn’t think I was going to let you sound like a newbie now, did you?

Let’s briefly discuss the difference. U.S. dollar–correlated majors are the euro/U.S. dollar, the U.S. dollar/Japanese yen, the British pound/U.S. dollar, and the U.S. dollar/Swiss franc. The four pairs trade against the U.S. dollar. The reason these are “correlated” is that the movements of these pairs have a strong relationship to the U.S. dollar, which we can track with the U.S. dollar Index. We’ll talk in the next section about the relationships in detail, but for now keep in mind that the forex is a game of comparison. Is the U.S. dollar gaining or losing ground to another nation’s currency?

If it seems as though I am spending an inordinate amount of time driving this point home it is because I think far too many traders forget that trading forex is a very tangible thing. It personally affects our everyday lives and the everyday finances of corporations and banks. Our world and collective economies are not isolated, and the global economy is now more intertwined than ever. Anyone who for a moment bought into the theory that somehow the U.S. economy was dislocated from Europe, Asia, and the BRIC countries (Brazil, Russia, India, China) should now know different after witnessing a cataclysmic global slowdown. My point here is that forex, the relationship between different currencies, is at the heart of the worldwide financial system and the more you understand this relationship the better overall trader you will become. Now who said forex trading couldn’t make you a better person?