There are numerous scientific studies alleging that forecasting market movements is practically impossible. In 2013, Eugene Fama, Lars Peter Hansen and Robert Shiller got the Nobel Prize in Economic Sciences for a study that questioned our abilities to accurately forecast short-term asset price changes. This raises the question of how traders can gain an edge in the market and consistently profit.
I personally use technical analysis (the study of price action) to identify trading opportunities. I think it is important to distinguish what we are doing as traders - as a technical analyst however, at no time do I attempt to forecast – I think this should be left to economists
As a technical analyst I am assessing probability and trade accordingly. If I see a certain chart pattern or setup on a chart, I try to determine what the most likely outcome is with regards to price. If I can determine that, I can speculate on that probability by opening a trade. I strongly believe in technical analysis and believe it is very effective.
It is critical that individual traders develop their own trading setups that they have confidence will give them an edge.
The reason why technical analysis and developing setups based on technical analysis is so common effective, is that despite the passage of time, human nature and behavior over the years remain constant. All market participants are driven by similar emotions and will often react to situations in the same way. Technical analysts develop an understanding of the way crowds of people will react to certain situations.
There is always a continual flow of new participants into the market and they are generally ignorant of the way the market has behaved in the past. For this reason, the same mistakes and behavioral patterns are often repeated by each new group of market participants. These mistakes and patterns lead to decisions which are either demand or supply for something, which of course determines the price.
For this reason, I believe that technical analysis is less about trading and more about the study of mass psychology. We study the way people react in certain situations in the market and can sit on the sidelines and objectively apply our rules to take advantage. Furthermore, the beauty of technical analysis is that it is equally effective in markets around the world, as human nature is the same around the world.
This is where traders can gain an advantage and defy those who believe it is impossible to beat the market.
Using Trends to Gain an Edge in Currency Markets
Following a trend may be a good idea for the stock market, where a share price may double within a few weeks. However, many currency pairs may remain within a certain range for years in a row and some traders ask whether a trend is indeed a trend in today's market environment
Currency prices do often trade within ranges however sometimes these ranges can be quite large. Over the last couple of years, the EURUSD has moved within a range of almost 10 cents (1,000 pips), the AUDUSD has moved a similar distance, while the GBPUSD has moved higher and lower by over 18 cents in the last 18 months. If you look back even a little further, you will see that the British pound has moved an incredible 50 cents in just three years, as shown in the chart below.
Volatility in markets certainly have an impact on opportunity. Whilst there may be a difference in the way stock prices and currency prices move, this just means we trade them slightly differently.
Therefore currency traders will more likely use trading strategies that look to identify the major turning points and trade with the new direction, understanding that the currency is almost certain to not double (or half) in price. In other words, the trade is highly unlikely to be an open ended transaction as price may at some stage move to the other side of the prevailing range and stop.
The other thing to consider is that all the vast majority of currency trades involve leverage. Therefore you are able to secure a trade size significantly greater than the money you deposit as margin. This allows traders to take advantage of smaller price movements.
Over the last couple of months, the GBPUSD has shown an average daily trading range of approximately 120 pips (1.2 cents). Depending on your trading style, a trading range of 120 pips provides a lot of opportunity, despite that over time, the GBPUSD may not trend for an extended period. You can see the volatility indicator in the chart below.
Another important consideration with using trends is time frame. Over what primary time frame do you conduct your analysis? It is quite feasible that if you look at a chart of a currency pair with two fellow traders your opinions of the prevailing trend may all be different. Yet you may all be correct because the way in which you identify trends (time frame) is different.
A final note about trend trading in general. There is no doubt that there are some traders who trade against the trend and consistently make money. However, they are highly experienced, skilled, decisive and disciplined, and they generally take greater risks when doing so. No beginner trader fits this mould.
Leverage is Double Edged
Many Forex brokers offer excessive leverage of as much as 1000:1 so it is important to determine the appropriate level of leverage for your own trading. It is also important to know whether high leverage violates the rules of the relevant regulators.
Until a forex trader gains adequate experience, using high leverage is probably not ideal as it sharply exposes weaknesses and losses.
The other thing to consider when setting up a trading plan that is right for you is the amount of capital you are prepared to commit.
One of the most common questions I am asked when I present is what I believe is the best initial monetary commitment into Forex trading. Another is how much trading capital you need to trade full time and earn a living.
This is going to be very different for everyone, as everyone’s risk tolerance is different, as well as what people need to live. Someone may deposit 50% of their annual income into a trading account and have no concerns whatsoever whereas someone else may become very uncomfortable with that amount.
Realistically, a lot of people who start trading lose a reasonable portion of their trading capital within the first 12 months. This should be foremost in someone’s mind when they decide to deposit funds.
At the end of the day, you still need a trading plan that you will implement with confidence and part of that plan is a trading strategy that provides you an edge in the market to take advantage of price movements.
About Stuart McPhee
Stuart McPhee has traded for over 20 years and is the author of the best selling book Trading in a Nutshell, 4th Edition. He is one of Australia's most compelling speakers on trading and has personally coached high net worth traders all over the world. Since 2001, he has spoken live in front of tens of thousands of fellow traders from Mumbai to New York, Tokyo to London, Melbourne to Beijing, and many places in between. He has helped countless traders improve their performance with his expertise in technical analysis, trading psychology, risk management, the trading process and developing a trading plan.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.