Mechanics of Trading Forex
Know your Trading Environment
What does it mean to know your trading environment? The trading environment is the action around a currency pair's price movement.
Like Knowing the Weather
Just like knowing the weather in a city that you are visiting, you should know how the currency pairs are moving before you enter a trade. Another similarity to the weather is that the price movement of a currency pair provides clues and information that can help you determine the trading environment. Just like high pressure forecasts clear skies and dark clouds precede a storm, indicators forecast certain price movements. But the similarities end here. There can be lots of different types of weather: rain, shine, snow, etc., while the Forex trading environment is limited to two types of price movements: range-bound or trending. Lets take a look of each type of trading environment.
Range-bound Trading Environment
In a range-bound trading environment, the currency pair stays within a tight trading zone. The high and low prices of the currency pair move within fairly constant and distinct parameters. The currency pair price will remain within these parameters and often bounce off the walls of the range. Many traders find range-bound trading quite difficult and frustrating since there is no definable trend to help in anticipating price movement.
Look to the Charts
Chartists are often able to determine whether a currency pair is trading within a range simply by looking at the chart. This type of visual information requires the eye of an experienced trader to obtain accurate results. However, there are other, more reliable, ways to determine if a currency pair is trading within a range.
Three Range-bound Trading Signals
A Low ADX level
The ADX (average directional index) measures the strength of a trend. ADX is one of the primary indicators used to determine the strength of a trend. When a currency pair is trading within a range, the ADX level will decline. Conversely, when a currency pair is trending, the ADX level will rise.
An ADX level below 20 is considered low. It is a strong indicator of a currency trading within a range. When the ADX is at 25, the strength of a trend is growing, but still may not be strong enough yet to break out of the range.
Volatility refers to the price movement of a currency pair. When volatility is high, currency prices are moving (or trending) strongly. When volatility is low, prices are staying with a tight range.
Bollinger Bands are one of the best indicators of volatility and price movement. A range-bound currency is indicated when the Bollinger Bands grow together. They can begin to squeeze the currency pair. Bollinger Bands are a great visual tool for determining volatility and trading environments. For range-bound trading, we are looking for Bollinger Bands that are close and tight, leaving only a narrow tunnel in which the currency pair can move.
A trading environment is trending when the currency pair is moving in a strong direction. You have probably heard the phrase saying the trend is your friend. In a trending environment, the currency pair is moving decisively in a particular directionusually up or down. (A sideways trend is more indicative of a range-bound trading environment.) A trend can be visually identified on a chart. However, other tools are available that can help the trader to identify a trend.
A trend is considered long-term when it continues for a year or more. A short-term trend usually lasts less than a month. A medium-term trend is the time between a month and a year. Most traders will focus short-term trends for quick trades, but will look for confirmation from the long-term trend.
Of course, the long- and short-term trends can move in opposite directions. For example, a currency pair may move in a bullish trend for a year (long-term trend) and, during that year, experience several week-long bearish price movements (short-term trends).
Two Trending Trading Signals
High ADX level (25+)
Remember the ADX is the average directional index, which measures the strength of a trend. When the number was below 20 as in the previous example, the trend was weak or nonexistent, which indicates the currency is range-bound. A trending environment will usually have an ADX level that is above 25 and continuing to rise.
Momentum Indicators Confirm Trend
Traders need to know that movement is consistent in the direction of the trend. What are momentum indicators? As the name suggests, they are indicators that gauge momentum. Examples of momentum indicators are RSI (relative strength index), Stochastics, and the moving average converging divergence (or MACD) line. Of course, visually reviewing charts is one of the best ways to establish the trend, its strength, and its momentum.
- ADX : Determine if it is a high number (trending) or a low number (range-bound).
- Bollinger Bands: Determine if they are flaring (trending) or tight (range-bound).
- RSI: Determine if it is a rising number (trending) or a declining number (range-bound).
- MACD: Determine if the line is rising (trending) or declining (range-bound).
Determining the trading environment is the first step toward successful trading. Taking the time to determine the environment can help you to know if you are trading in the right weather. Knowing your time horizon and managing your risk are the next steps in the mechanics of trading Forex.