Forex and Stochastic Divergence

As we've spent a couple days looking over the ways to use the stochastic indicator, I hope you have found this helpful. Today we will be returning to the same, but with another tweak.

We've talked already about stochastic over bought and over sold indicators, today let's talk about stochastic divergence. this is an important concept, and one that we will use in the discussions of other indicators to come.

A divergence is when you have two items that formerly moved in one direction together, but now are moving separately. Look at the chart at the top of the blog.

You'll see the price action in the upper frame and the stochastic indicator in the lower one. Look at the areas expressly identified by the blue rectangular boxes and the trend lines.

this is a daily chart of the eur/usd. Remember how I said yesterday that the longer time frames provide the best signals. I will say it over and over. because one of the most common mistakes that new traders make is trading on too short of a time frame. The shorter the chart time, the faster you'll lose your money.

On this chart we see the very end of 2009, and the first quarter of 2010. the outstanding feature of this chart is the fall from the peak at 1.5100 to the current level of 1.3200. That's a drop of 1900 pips. Had you ridden this from top to bottom, that would have been worth $19,000.00 in a standard account. that's a payday.

And believe it or not, the stochastic indicator helped to forecast this movement by the divergence we are talking about today. The blue shaded areas are the time frame from mid October through mid December.

Notice how in that time period of the blue boxes, that the price was still rising. that is clearly reflected by the rising trend line. Then look at the stochastic indicator. You can clearly see that it had declining peaks, contrary to the rising peaks in the price action. this is the divergence. Price headed higher, with stochastics headed lower, forecasts lower prices.

Although we don't show it here, the opposite is true also. Lower price valleys, along with higher stochastic valleys, will often forecast rising prices.

This can be used on smaller time frames as well, just remember the caveat, that smaller time frame produce less reliable signals.

Divergence...one of the keys to forecasting price movement.

Until next time...Happy Trading!

Bill

Trading Forex with Stochastics...Part 2

In the chart above, I have labeled for you three important stochastic trade indications. each one netted 200-400 pips. I know it is a little blurry, but this is a four hour chart of the eur/usd that includes today's trading activity. Also note, that if you pull up a chart of the eur/usd daily, you can see that it is plainly in a DOWNTREND. As we'll discuss today, the stochastice should be used to trade with the trend.

Last time we spent a good deal of effort to consider the stochastic oscillator. We talked about over bought and over sold territories, and how to use stochastics as a trading tool...when to enter a trade.

Let's refine this a little bit more. As the stochastic oscillator rises and falls, on first glance at any chart, it looks like an infallible indicator. But always remember, there is no such thing. Stochastics are most effectively used when combined with the trend. We talked about identifying trend early on at this blog so we won't repeat all that here. But if you search for it, the topic should be one of the very first ones. If you haven't read it, you should.

So when we combine the indicator with the trend, we find it will filter out a lot of bad trades. In other words, if the trend is up, you only want to be buying the currency pair anyway. Selling in an uptrend can be very costly. So only use the stochastic when it gives a buy signal in an uptrend. That is, it falls below the 20 line, and then turns upward, with the fast line crossing above the slow one.

In a downtrend you would do the same. This does not eliminate all bad trades, but it serves as a good filter.

Also remember that a stochastic can be used on any time frame chart, but the longer the time frame, the more reliable the signal (also the larger stop loss that must be used).

Finally, exiting a trade that you entered with a stochastic. If you really love this indicator, then you'll want an exit strategy after your trade has turned profitable. Once the pair has reached the far side of the indicator scale, is a good method. So if you bought during an uptrend when the s.o. fell below 20 and then turned up, you would sell when the indicator passed 80 on the top side. You may want to combine this with a trailing stop loss, which we'll talk more about tomorrow.

Until next time...Happy Trading!

Bill

Trading the Forex Using Stochastics

Today's post is on one of the most commonly used indicators available. It's called the stochastic Oscillator. That's actually just forex jargon for saying that a certain pair is either overbought or over sold.

Remember, all currencies are bought and sold in pairs. The stochastic measurement is based on the first currency listed in the pairing. So that if the indicator is reading over bought, and you are looking at the EUR/USD, it is the euro which is overbought and the US dollar which has been over sold.

The theory behind stochastic oscillation is that a currency pair is a lot like a rubber band. You can only push it so far in one direction before it snaps back. If the euro is overbought, that means it will reach an extreme, and then reverse, moving in favor of the dollar.

A stochastic indicator is read as following. Usually the indicator has two lines, a red and a blue. The red one is referred to as the "fast" line, the blue one as the "slow". In the course of an uptrend, they will both be rising, and the red will be above the blue. They are plotted on a scale of 0-100. Anything over 80 is considered to be over bought. Anything below 20 is considered to be oversold. An overbought currency is thought to be ready for a pullback. An oversold currency, ready for a retracement upward.

The pair of lines give a trading signal when the red crosses the blue. So if the pair has been in an uptrend, and they pass the 80 mark, you would look for them to curve back down, what I commonly refer to as "rolling over", when the red crosses back down below the blue, (the fast line crosses back down below the slow line) and they fall back under 80, you have a change, or a reversal or a pullback. As a rule, you could look for the two to continue falling until they pass below the 20 mark. You could use that as an exit.

HOWEVER, please be aware, that stochastic can remain over bought for an extended period of time. They can also remain oversold for an extended period of time. So it is possible to see an overbought currency pair go on to rise another 100 pips. So the next question is this. Do you get out if the rise continues...or do you stay in "knowing" that it has to turn around sometime?

Here are 2 answers, based on 2 different strategies. Because there is no one perfect way to trade. You can make money in the forex a lot of different ways. you just have to plan your strategy before you get in, and stick with it rain or shine (assuming, of course, that your strategy is a sound one).

So if you have entered the trade based on the parameters that I just gave you, and are now short the eur/usd, if you do not like to carry losses or draw downs, you will want to formulate an exit even before you enter. You do this by looking at the last swing high in the eur/usd. Now that may be a few number of pips away, or it could be many. Usually it will depend on the time frame of the chart you are looking at. If you are using an hourly chart, it will be further than on a 5 minute chart. But remember, the longer the time frame on the chart, the better and more reliable the signals are. So if you think about that, here's what it means. If you trade on shorter term time frames, you WILL have more losing trades, than on the longer term charts. But they will be smaller losses. If you use longer term charts, your losses will be larger, but there will be fewer of them. Also, it is important to remember that your profits are usually smaller on shorter time frame charts. So it is important to know what kind of trader you are. What amount of risk you can tolerate. And how long you are willing to hold your draw downs...both in the amount of time, and also in the number of pips. I have thrown a lot of variables at you, and we're not finished yet. So if you don't like holding draw downs, you want to form your exit strategy by means a stop loss.

However, I don't mind draw downs my self, so I will let the trade work against me sometimes several hundred pips. The big difference is, I do know my ultimate stop loss, and I will keep adding to my losing position at important resistance points as the pair continue higher. Thus, even if I have gotten in early by way of a false signal, I can still increase my position, and when it does hit its final reversal point, I may have 3 or 4 positions when it does reverse. So even if it doesn't get to my original entry point, I'll still have a winning trade, because my other positions have paid off handsomely. Again, the one caveat is this, you have to be willing to accept draw downs. Often the trade will turn quickly, and moves rapidly into a profit. But then you're out fairly quick, and you haven't necessarily spent a long time looking at a trade in the black. but you still get the win. If these approaches make sense to you, then head on over to www.thefxtradingmsters.com.
Sign up for the trial subscription and see how we do it month by month.

Drop me a comment or question about any of this if it's unclear.

Until next time...Happy Trading!

Bill

Forex and Interest Rates

If you follow my trading very long, you will know what great stress I put on interest rates, and their fluctuations as set by central banks around the world. Please do not mistake that as a love for central banking. The truth is, the Fed, since its' inception nearly 100 years ago, has done more to destroy the American Economy than liberal, socialistic programs and taxes combined.

Since 1913, the dollar has lost 95% of its purchasing power. All of that has been single handedly engineered by the Fed. Destruction of purchasing power means that more American dollars need to be used in order to buy the same amount of foreign goods. It also results in the transfer of American wealth to foreign economies. Ever wonder how the Chinese economy came to own America? Just look at the history of the Fed.

But be that as it may, we have to trade within the parameters of what we are given. At the present point in history, central banks govern the interest rate cycles. It is important for us to know how they affect the value of a currency.

Running contrary to the well known equity cycle where the Fed lowers rates and the stock market takes off headed higher, an interest rate cut affects a currency in an adverse manner. Here's why.

If the US has an interest rate at 5.25%, but the Eurozone has an interest rate of 4.0%, the best place for investors to park their money would be in the US; because they would receive a higher rate of interest from the T-bills. But if the US cuts its rate to say 5%, this adversely affects the dollar because it now has intrinsically less attraction. True it is still a full point higher than the Euro, but as interest rates travel in cycles, and a cut seldom occurs alone, an interest rate cut may cause a severe dollar weakness as currency traders may well forecast that future meetings will actually produce an interest rate lower than the European counterpart. Additionally, if the Eurozone was in an expansion mode while the US was contracting, rate increases in the euro, combined with rate cuts in the USD, whole produce a real change in affection. Now all the big money would be flooding into the Euro in anticipation of getting a better rate of return there.

Therefore, the pricing mechanism for a currency (as regarding interest rates) is exactly the opposite of what it is for stocks.

This also helps explain why trading in the forex has been so challenging in recent years. As interest rates have fallen to historically low levels, and have held there, trying to find a good currency is like trying to judge first place in an ugly contest.

But also this has produced the anomaly called risk aversion/risk appetite. In the absence of real rate fluctuations, and a real fear of a double dip recession world wide, items of news that should be good for the dollar, end up crushing it. But items that should be bad news for the dollar end up causing it to appreciate. Confused yet? You should be! Such is the affect of a central bank on the money of a nation. Everything gets turned on its head.

Basically, the US has operated for generations as the funding currency for all the worldwide economies. They produced stuff, and we bought it. When we couldn't afford it, we refinanced our houses, paid off our credit cards, and started over. But with the Great Depression II of 2008, this cycle came to an end. Lenders wouldn't lend. Borrowers couldn't borrow. The US no longer supplied money to purchase all the world's widgets. So as our economy crashed, everyone else's followed. Until the US recovers, there won't be any real recovery anywhere else.

Thus, bad news for the dollar, meant bad news for the world, and scared money flowed into the only place it felt safe; US Treasuries. This demand for US dollars increased the value of the dollar, even while the economy was in a tailspin. Thus, the US wins first place in the ugly contest: round one.

We are slowly attempting to emerge from this scared money mentality, but it is not easy. Nor will it happen over night, if it happens at all.

Until next time...Happy Trading!

Bill

A Day In the Forex...

Do you remember the old country music song,"Some days are diamonds, some days are stones..."?

Whe a day starts as a stone, here is something important to remember...DON'T TRADE. All professions have particular challenges that face them. The particular challenge of a trader is his mental attitude. Now don't get me wrong, you can still have a bad trading day even if you have a great attitude. But on the other hand the odds of having a bad trading day when you have a bad attittude are like 99.44%.

This leads to another interesting point. I've never met a good trader who was a pessimist. I'm sure there probably are some, and I have certainly never met every trader in the world...but it is hard to stay at this work when you have a very positive outlook, I can't imagine sticking with this if your natural disposition is to always look on the dark side of things.

Afer all, when you have a string of 4 or 5 losses, even a great outlook starts to feel gloomy. Some professions have technical challenges, some have physical challenges, some have mathematical challenges. Our challenges are different. It generally is not the outside problems that will afflict us as much as it is our inner ones.

It is often said that trading runs on fear and greed. That is not the whole story, but there is truth to it. And the truth is this. Amateur trading runs on fear and greed. Only amateurs let those emotions get in the way. But I will be truthful...even the most professional of traders sometimes get emotional. So how do we avoid getting emotional, over money, one of the most emotional topics in the world?

First, you must reign in your expectations. If you are planning to get rich enough to retire after a year or two of trading, I can promise you, you will be giving your money away (to more expereinced traders). The advertisements that promise you retirement sized riches in no time at all, are only pipe dreams. They will force you to risk so much of your account, that eventually you will blow it all out.

Second, lower your leverage. You can always tell when you have too much at risk in your trade when you sit and watch every pip. Of course, that's not a very scientific, or calculated, way to evaluate your leverage. So what is good measure for your investment? Generally I recommend that you not have any more than $1 per pip for every $10,000 in your account. That means if you enter a trade, and you have an expectation of hitting 200 pips as your price target over the next several days, then you could have a 100 pip stop loss. This would give you a 2-to-1 reward to risk ratio. That's pretty good. Even then if you are only right on 50% of your trades, you are still making money on a regular basis. But also, you can leave your trade to do its work, knowing that even if you hit your stop loss, you've only risked 1% of your account. Many traders will allow a risk of 2-3%. This keeps you from being too emotionally involved with the trade.

Third, set limit profit targets. And be satisfied when you reach them. Don't cry when your profit target is reached and the market keeps moving in your favor. Just get your profit and get out. The more time in the market, the more likely you are to incur a loss.

Fourth, make a long term plan. Have an average gain in mind. My system allows me to shoot for 10% monthly. That's much higher than I can get anywhere else. But sometimes I don't make it. Other times I make more. So set your targets, make your goals and adjust them as necessary.

Until next time...Happy Trading!

The Peculiarity Of Forex Pairs

One of the most confusing theings to new traders when they come to the forex market for the first time is seeing how the markets are traded in pairs. All of the major pairs are traded involving the US dollar.

When you look at a forex chart, in the corner you will find the pertinent information displayed. Let's say you are interested in trading the most liquid currency. That would be the Euro. But as "trading" implies, you are setting one thing of value against another. In this case you are trading the Euro against the US dollar (USD). In the information area of the chart, you will see EUR/USD. That tells you the currency pair. you will also see a number such as 1min, 5min, 15min, or 1H 4H or 1D. This tells you the time frame of the chart. We'll deal with time frames another day. For now let's continue to tackle the pairing pickle.

When you look at the EUR/USD chart, if the price action is going upwards, that means the Euro is rising against the dollar. If you see the chart heading downwards then the Euro is falling against the dollar (and the dollar is rising against the Euro). So if you are buying, or going "long" the Euro, it means you expect the Euro to go up and appreciate versus the dollar. If you are looking for the dollar to appreciate against the euro, you would be looking for the price action on the chart to go downward.

All currencies are traded in pairs that way, although not all charts will follow the same pattern. In this case the euro is listed first in the pair. But in some pairs like the USD/JPY (dollar vesus Japanese Yen) or USD/CAD (the US dollar versus the Candian dollar) the charts are opposite, because the USD is listed first. If you are looking for our dollar to strengthen, the you are looking for the chart to move upward, just the opposite of the euro.

All of this seems a bit confusing, but I've found it helpful to think of it this way. When buying a stock, I'm actually doing a paired trade just like in the currencies. I'm buying the stock but selling my dollars. I do that because I believe that the stock will appreciate faster than the dollars, which means I can sell the stock for more than I paid for it. When I sell the stock, I am buying dollars. Because I believe that the stock will depreciate faster than my dollars will, and I can buy the stock back later on at a lower price.

Currencies are the same way. The whole forex market trades in pairs. You buy the one you think will appreciate faster than the other. And you can also sell one and buy the other, in a technique called short selling, or shorting. We'll talk more about that tomorrow.

Until next time...Happy Trading!

Bill

How to Fund Your Forex Account (on a fixed budget)

We're going to take a break from the technical discussions on forex trading for a bit and concentrate on another area which is actually more fundamental to most people.

In a era of belt tightening, cutting back and saving money, many folks ask me where they can find money to fund a trading account. If you budget is already stretched to the max, trying to set aside funds for trading can be frustrating.

But today I have begun featuring a company that really can help. The group is called Project Payday. You can see their add featured on the right. Even if you're just looking for some money to add to your regular budget. It's great for stay at home moms and dads, or anybody who likes goofing around on the computer.

They will show you how to make $50 bucks in your first hour of putting the program to work. And guess what? It works. It takes a little work. They're not just giving money away. But whatever time you will put in, you will make money.

So if you're looking for extra funds, for your trading account, or family vacation or whatever, this is a great place to start. I'm a member myself, and I wouldn't recommend it otherwise.

Until next time...Happy Trading!

Bill