•Do technical analysis indicators tend to lie to you, resulting in losses?

•Are you getting caught up in the randomness of the market?

All of these problems and many others in forex trading can be avoided if you know:

1.  A move is going to happen, and:
2. Which direction the move is likely to occur in

View my recent guest webinar at ForexPros.com to learn the complete strategy!

Of course, this is a lot easier said then done, especially if all that you have are your forex charts and indicators. However, if you look beyond conventional technical analysis, you’ll find that the market leaves behind valuable clues about sentiment that lead to many profitable opportunities.

Sentiment is a valuable tool because it is much easier to determine than just price action itself. Sentiment is usually either bullish or bearish and its turning points are very visible compared to those of price.

One such way of identifying sentiment is by watching how price reacts to news events. Economic news (a.k.a. “fundamentals”) is important because certain high impact news events are factored in to big traders’ decisions to go long or short currency. For very high impact news events, the news release can be in focus both well before and well after the scheduled time for the release. It’s our job as profitable forex traders to take advantage of shifts in sentiment due to these news releases and get in on a move early.

I look for three ways to profit from price behavior due to fundamentals/sentiment:

1. Trading the ensuing momentum after price breaks out of a range convincingly and is supported by fundamental news
2. Trading a turning point in sentiment if price moves opposite of what the news release should dictate
3. Trade the “factoring-in” of price before the actual release takes place

If you want to learn some practical strategies that you can use today, please view the recent guest webinar I was invited to do by Forexpros.

View Webinar 3 on Forex News Sentiment Trading (FULL Video)

Let me ask you some questions:

•Have you ever put a trade on only to see price immediately go against you?

•Does your trading strategy seem to perform perfectly in hindsight, and poorly when you trade it LIVE?

•Do you find yourself sometimes spiraling out of control trying to decide whether you should really buy or sell at a particular time or price level?

All of these problems are linked in some way to not getting the direction right in your trades at the right time. I’ve struggled with this a lot myself and it took a lot for me to finally come to the realization that I needed to find a way to determine the true underlying driving force of price action and to align my trades in the same direction. This underlying driving force I’m referring to is also known as sentiment and is responsible for most short and medium term moves you see in the forex market.

“Catch a wave, dude!”

I couldn’t help to think about the beautiful coastline of California with all of the surfers trying to catch waves. Why? Sentiment comes in waves in a similar way. I figured that if I had a way to figure out when a new wave was possibly coming and how to align myself near the start of the wave, I’d be set and making many forex profits. So here’s what I found.

I used a tool called a currency strength meter, which measures the individual strength of the major currencies. I figured out that there was almost always a situation where some currencies would be weak and some currencies would be very strong, but as time would pass, the weak ones became strong and the strong ones became weak. I noticed that this pattern happened in very smooth, predicatable waves and sought out to buy strengthening currencies and sell weakening currencies and found that 100s of pips per week were available with this method.

So what was actually happening here during these ebbs and flows of currency strength and weakness? Well, money was flowing from weak currencies to strong currencies as the big players were changing their feelings and thus positioning on the market. I realized that what I saw on the currency meter was merely a reflection of the periodic shifts in sentiment of the market. However, unlike price action, it was much smoother and more rhthmic, and told me more information about the market than price action did. I hope you use these forex trading secrets to your advantage. Please watch my webinar that Forexpros.com invited me to do recently, below:

Watch my webinar on Currency Strength Sentiment with ForexPros!

“Buy the rumor and sell the fact”

 Here’s how the big dogs play in the forex market: The big banks and hedge funds have their own research teams of very talented economists who make forecasts on what important economic indicators (such as employment, GDP, and interest rates) are going to come out as. You may have seen the average of these economists’ predictions labeled as “forecast” or “consensus” on forex news calendar sites. The traders from these firms listen to the economists and put on their trades (long/short depending on whether the economic data is likely to have improved/deteriorated, respectively) well before the actual number is released. When the actual number is finally released, they may take off or lighten their position.

Now, these “big dogs” are responsible for moving the market with their really deep pockets. Wouldn’t you like to be riding on their backs and beating everyone else? You know that the majority of traders lose money, and what do the majority of traders do? Instead of buying the rumor, they are waiting for the fact to come out and are buying the fact as the big dogs happily unload their positions for a profit. Now do you see why retail traders lose so much money?

How to discover the rumor before everyone else does and beat the market 

1. Every Sunday, go to a news calendar such as that at Forexfactory.com and  look at what high impact news events are coming out in the coming week (usually in red, but the ones you should look out for are interest rates decisions, GDP, employment, manufacturing PMI, and retail sales)
2. Look for the forecasted number to have a deviation from last month’s number
3. Look at all of the economic data being released for that week on the calendar and also read the financial news (e.g. Bloomberg .com or FT.com) to see what the market is focused on. If the market seems to be focused only on one piece of economic data then you can count on a high possibility of a one-directional move. If there are multiple pieces of focus (e.g. employment data + central bank speech + GDP) then you will likely have choppy price reaction and trading this strategy is not advised
4. If the market seems to be anticipating one event, buy/sell a relevant currency pair in the direction of the forecast at the beginning of the week if it is a super high impact event (e.g. NFP, interest rate announcement) and between 12-36 hours before if it is a generally high impact event (e.g. retail sales). In essence, if the number is expected to be positive for a country, buy it’s currency and vice versa if it’s expected to be bad.
5. Get out up to an hour before the release. Well before is even better because you want to be away from the scene before the newbie traders come in and get cut up.

Example trade

Notice on the calendar we can see that Friday had two pieces of US economic data coming out: Advance GDP and Chicago PMI. The GDP number was supposed to come out at 2.5% vs. 3.7% previous, and PMI was coming out at 56.3 vs. 59.1 previous. These are big differences and indicate weakness in the US economy, prompting us to sell the Dollar. The EUR/USD pair was a good candidate for a trade because there were no other pieces of data that the market would lend a lot of focus to that week (even though German retail sales is normally a focus, GDP and PMI from the US take precedence because they are more significant). If we had entered at the beginning of the week on Sunday by shorting the Dollar and buying Euro (i.e. going long EUR/USD), a maximum of 178 pips, or $1,780 per standard lot could have been made!

Keep in mind that it’s going to take some practice to know which economic data work best with which currency pairs and when the best time to enter, but this is certainly a great edge to have.

The key is getting direction right

I would always have the problem of getting stopped out even though when I eyeballed past price behavior on my chart it seemed like I should be winning a lot more trades. I soon came to realize that to really make money trading forex you need to align yourself to the underlying powerful driving forces in the market- in other words, sentiment. Sentiment is the driver of price in the medium term, and it is based on the changing perceptions and emotions of the human beings that run the market. That’s right- the market is made up of human beings, not lines, stochastic indicators, doji patterns, and economic data. Fortunately for us, predicting the decisions of human beings and thus sentiment is a lot easier than predicting price action. Also fortunately for us, they key to profits is more about getting direction right when sentiment is strong than it is about getting in at precise price levels and times.

Watch the FULL Webinar Replay of the Presentation I did on Sentiment with Forexpros!

Ways to measure sentiment objectively for forex profits

I use a number of different methods to analyze sentiment for a forex currency pair, but here are the 3 most powerful ones:

• Measuring individual currency strength and money flows
• COT positioning
• Price reaction to economic news releases

Measuring individual currency strength and money flows

The principle here is that large funds who deal in FX regularly assess their risk and opportunities for yield. If their collective sentiment shifts, large sums of money will flow from weakening currencies to strengthening currencies for weeks since their loading and unloading of positions are so large that they move the market. The way we can gauge these turning points in sentiment is by comparing individual performance on a currency meter or by manually comparing dozens of dollar crosses, yen crosses, etc. (will not be described here).

COT (Commitments of Traders) Positioning

COT data is released every week by the CFTC government regulatory organization and it tells the positioning of the two largest (and therefore market-moving) players in the market: “large speculators” (i.e. hedge funds and banks) and “commercials” (corporations who hedge their forex exposure). The large speculators are often responsible for the most immediate sentiment in the market and again have large positions that take time to put on or take off, so watching their positions increase or decrease are good indications that a medium term trend is forming.

Price Reaction to Economic News

Let’s make no mistake- economic news is an important driver of the market. When scheduled economic news gets released, you can bet that all the market movers are watching this to determine what their next move is going to be. If economic news comes out better or worse than expected the market usually moves up or down, respectively. When the market starts behaving in an opposite fashion (i.e. going down on a positive vs. expected employment figure) it’s a good bet that the market is shifting and beginning a trend in the other direction.

Please watch the webinar for step by step details on these strategies

Most forex traders I know use charts and technical analysis to make their forex trades, and are taught by so called “gurus” to completely avoid the market when news comes out, and in many cases, to even take off trades before news. My question is, why avoid trading during a period where price action actually behaves sensibly? In other words, price action actually moves due to traders’ reactions to new information about the economic state of a country, rather than some pattern or price level that may or may not have any predictive ability.

 

Save some time and watch for only the high probability trading opportunities

News isn’t something you should avoid. News is the only thing that you know for sure moves the market.  News has a much longer effect than just the knee jerk reaction immediately after the release and the next 5 minutes. The reason why news time has such a bad rap among traders is that many news events create random, whipsawing price action that can easily take out stops. So what does one do? Avoid trading during and after useless news events and only stick with ones that have strong cause-effect relationships (i.e. a surprise in the economic data has a high probability of producing a strong, one-directional move in a currency pair). These are:

• Interest rate announcements, statements, press conferences (including US FOMC minutes)
• Retail sales
• Manufacturing PMI, Chicago PMI, Ivey PMI
• Inflation/CPI
• German ZEW, IFO surveys
• US Employment (Non-farm payrolls), Canadian employment

3 ways to use news in your trading

Analyzing sentiment (and thus direction) using news releases can be a very powerful element of your forex trading strategy. I’m not talking about chasing the market after a news release- I’m talking about professional, calculated, profitable forex trading. Here are some ways to combine forex news trading with technical analysis so that you have a better chance of getting both the direction and timing right during your trades.

1.       Look for breakout due to important news surprise. Out of all the forex technical analysis methods out there, I don’t think any are as powerful as watching how price reacts to weekly (or even daily) highs and lows. All other things equal, if price breaks a high, it’s likely to continue going up, and vice versa for lows. The reason why such a simple strategy as this can result in depleted accounts is because it doesn’t take into account the momentum and behavior of the market. If you consider that the GBP/USD traders are reacting strongly to a surprise in the amount of retail sales in the UK, however, then a sustained upward move beyond the break of the high looks more likely, doesn’t it?  

2.       Trade retracement of a news spike. The easy days of waiting for a surprise in scheduled economic data and buying up a currency are long gone, as the competition is too fierce and brokers have implemented measures to make this practically impossible. However, that’s not to say that we can’t get into the move after the original price spike following the release. If you keep your eye on a 4-hour chart and see a clear break of a recent channel or weekly high after a surprise in economic data, wait for a retracement back down to the high and buy there.  

3.       Fade an “irrational” news move. I can’t tell you how many times I’ve seen price rocket upward 50-100 pips after a release only to come back down to right where it started a few hours later. Usually what happens is one of two things. First, the deviation between the market’s prediction and the actual economic number might be small (e.g. US retail sales is +0.3% vs. 0.1% expected), but nevertheless enough of a surprise to throw the market off and spur buying, or second, the news release turns out to be better than expected while in the recent past nearly all releases have been negative. In these situations I would look for a nearby technical resistance level, such as a weekly high, and short price when it gets to that level. Of course vice versa for the opposite scenario.  

 It’s not like one has to be a genius or have some super trading strategy to achieve forex success. In fact most traders I’ve run into think too much and overcomplicate their strategy. What it really all comes down to is recognizing what has a higher possibility than not preceding a price move in a particular direction, and capturing as much of that move as possible.

Frustrated forex trader

But what do most traders do?

Instead of stalking the market and waiting for a trade to come to them, they chase after the market, trying to find patterns that aren’t really there.  Instead of spending time to really analyze what the driving force of the market currently is and which direction it’s pushing, they take trades that go against the trend, lose big, and find their trading spiraling out of control. Now it’s not really hard to understand why only a small fraction of total traders get the largest fraction of trading profits in this market.

So what’s needed to achieve forex success and profits?

Traders need to stop trying to fight the market and outsmart it by combining dozens of indicators, looking for patterns, and trying to guess tops and bottoms. People forget that the market is made up of human beings, not price charts, economic data and indicators. The forex market especially is driven by a very powerful driving force called sentiment. Sentiment is the degree to which the market feels bullish or bearish about price and it doesn’t depend on the past or the future—it represents the state of the market, RIGHT NOW.

Just think about this for a second. Would you rather rely on:

1. Some price pattern that may have repeated itself in the past but has no guarantee of repeating itself in the future and could just be due to short term randomness of the market, OR
2.  Some economic theory that says a currency pair may go down in the future some time because of the current debt situation, OR
3. An indicator that is based on the immediate state of the market and can tell you immediately when to get in and out?

I hope you realize that #3 is sentiment, which is a blend of technical analysis (#1) and fundamental analysis (#2).  So now that you see the value in it, how do we analyze sentiment in an objective way so we can keep out our emotions and increase our win rate and forex profits?

Methods to analyze sentiment like a pro

I basically look at a combination of price action, positioning data, and economic news releases to determine what dominant direction of the market sentiment is suggesting. Here are the methods:

From the chart:

• New highs and lows. As simple as this sounds, if price is making new weekly highs and holding those levels, bulls obviously are being more aggressive than the bears and confidently believe there’s a reason for price to be valued higher (i.e. sentiment is positive on all lower time frames). Although this sounds rudimentary, you’d be surprised to learn how many traders sell a currency pair after it makes a new high because they think it will respect some resistance level on their chart.
• Large volume bullish/bearish candles. When you see large, full bodied, bullish candles (especially after breaking new highs), rest assured that the bulls are in control of the situation and sentiment is very positive. On the other hand, if you see price attempt to move up, but in several cautious steps, or price moves up and immediately gets rejected from some level, beware: that’s not strongly positive sentiment.

Examples of spotting forex sentiment on a price chart (click to enlarge)

From special tools and economic data:

• COT data. Commitments of Traders (COT) data reveals the positioning of major players in the forex futures market such as large hedge funds and exporters. If they are moving the market and thus determine sentiment, would you want to be on the opposite side of their trades? Check out my post on using the COT to “spy” on the market for more detailed strategies.
• Currency strength meter. Using a forex currency strength meter to find out which currencies are strong and weak on an individual basis can allow you to buy currencies with strongly positive sentiment and sell ones with very weak sentiment. Why? Because money flows from the weak ones to the strong ones—wouldn’t you like to ride that trend? Read about how to use a currency strength meter here.
• Price reaction to news events. Large funds and banks put on trades well before economic data releases (which are scheduled every week) based on their economists’ predictions of how data will turn out. If, for example, the number for employment in the U.S. comes out much worse than expected, we would expect USD/JPY to go down fast. If it doesn’t, or it goes up instead, that is a reflection of positive sentiment in the market. See previous post on using news to gauge sentiment.

I hope that you can pick a couple of techniques from here that resonate with you to really identify and align yourself with the powerful driving force of the forex market: sentiment. Keep in mind that like anything this doesn’t work 100% of the time but it does give you an edge because you’re doing what most traders don’t do: move with the market instead of fighting against it or trying to outsmart it.

Using the Commitment of Traders (COT) indicator to confirm direction

COT data gives you information on the positioning of other major players in the market (see previous post on COT forex trading strategy), so why not combine it with the currency strength meter so that you have two pieces of confirming evidence for making a trade in a certain direction?

Your forex trading edge can be as simple as looking at the net futures positioning for your currency pair of interest (it’s the red line on the COT indicator at Timingcharts.com charts) and ascribing a positive direction if the positioning is net long (number of positions is positive) and ascribe a negative direction for the currency if the positioning is net short (number of positions is negative). Why? The net positioning (a.k.a. “small speculators”) is the difference in the number of currency contracts between the commercial traders and the large speculators, both representing a huge share of market volume. It takes a lot of time for these types of traders to turn their positions around, so their net positioning represents the sentiment of the currency for the medium time frame.

I simply took the technique described in the above paragraph to determine the direction of the pair and compared it to the direction suggested by the currency strength meter, which was used in isolation for my previous strategy. If the two were in agreement of direction I had a confirmation and would look for an entry, depending on my other filter criteria.

Before and after using the secret weapon

Let’s take a look at how the long gamma strategy performed for the EUR/USD pair from 2007 to 2010 (the strategy was backtested using the MetaTrader4 program). I selected a pair that didn’t have exceptional performance with this strategy over this time period (meaning it may have suffered longer and larger drawdowns than desirable) to emphasize how negative aspects of trading such as drawdowns can be alleviated by having multiple edges for confirmation. The first chart shows the equity growth of a $10,000 account throughout the testing period–$24,000 is not bad in that time period, but notice how it suffered a dip (42% of account lost) and just barely made up for it after a lot of time passed.

FX trading performance with just currency meter (click to make larger)

Now let’s look at the same currency pair, strategy, and conditions, except we use COT to help us confirm direction.  Now the drawdown is only 31% (vs. 42 from previous) and the account increases well beyond the initial high in account equity at nearly $25,000. Here we make $265 per trade vs. $196 per trade with just the currency meter. Are you starting to see how important getting the direction right with different indicators is?

FX trading performance with both currency meter AND COT (click to enlarge)

There’s your secret weapon for forex profits. If you can keep adding edges like this to your trading, you will find that your win rate goes up, your expected profit per trade goes up, your drawdowns go down, and most importantly, your confidence soars! 

Similar to the previous case, we’re looking for a massive imbalance to develop in the market. Think of the market as a rubber band. If things are stretched too much and something happens such that one end gets loose, the rubber band corrects itself and moves back to equilibrium. The market is the same way.

How do we capitalize on this imbalance and get in before everyone else does?

Once you’ve done your analysis and determined that an imbalance is present and decided which way it will correct to start the next massive 2,000 pip+ trend, you are ready to consider an entry. But how? Using a technique I call, “Long gamma” trading.

Long gamma trading means you are only taking small losses but are gaining relatively large winners. The disadvantage compared with short gamma trading is that your win/loss ratio will be somewhat lower (just based on statistics), but the good news is that when you win, you win big. So how do we actually trade this? Let’s continue…

Attention signal (Is there an opportunity?)

With long gamma trades we want to first identify an opportunity. The indication of an opportunity is that we are either breaking out of a ranging environment or that a previous trend has become exhausted and is turning around sharply. Remember when we talked about market cycles? We want to make sure conditions are right for entry. Market cycles tell us that price action tends to move from ranging to trending and back to ranging ad nauseum. That means when you see a sideways-ranging period, the longer it exists, the likelier price is to break out in a strong move. Similarly, markets don’t trend forever in one direction, so if we see a large reversal combined with an imbalance we should be prepared for a large move to occur in the opposite direction. When either of these two types of attention signals show themselves, we start looking for triggers to enter.

The trigger for entry

 When an opportunity comes along with these types of strategies, it doesn’t matter precisely what price level you enter at because things are so random. Rather, it’s more important to be aligned with the immediate driving force of the market—sentiment.  Think of it this way—sentiment is like the wind in a boat’s sails: if you have some difficulty starting out it doesn’t matter so long as the wind is blowing. Your trigger is to enter after price has proved that sentiment is in the direction of the unwinding of the imbalance and is starting to form a new trend for you to ride. Here’s how:

1. If price has been ranging on a weekly chart, your trigger for entry is when price breaks out of the range in your direction and closes outside the range. If price has been trending but the trend has reached exhaustion and has turned around on a weekly chart, your entry trigger is when price has moved in your direction for at least two consecutive weeks with larger than average volatility. If you see big candles in the direction opposite of the latest trend, you’re on the right track.
2. Enter the first position at market price.
3. Set your stop loss at 2 * the 14 day average true range (ATR) value to allow plenty of room for randomness- (i.e. for price to “breathe”) so you don’t get stopped out easily by the randomness of the market. If the ATR is 100 pips for today, then your stop should be set at 200 pips.
4. Risk no more than 5% of your account equity. If you have a $20,000 account and your stop loss is 200 pips, you would buy with a max position size of 50,000 or 5 mini lots.
5. Enter a second position after at least 2 days have passed and price has moved a bit away from your first entry (this is to allow the market time and space to move around so that you don’t overleverage yourself)
6. Hold no more than 2 positions at a time
7. Take profits at 3 times the size of your stop loss (e.g. if your stop loss is 200 pips, then you take profits after 3*200 = 600 pips have been reached). This is to maximize the share of the total trend that you capture. Alternatively you could set a trailing stop so that you can follow the trend for as far as it goes.
8. Do not enter if price moves against your direction violently. This means that something is surprising the market and volatility is increasing (which doesn’t suit this strategy). Objectively this means, for example, if you see a big downward candle on the chart when you’re going long that is at least 1.5-2*ATR. When this happens, wait for price to stabilize and start moving back toward the middle of the range while going in your direction. Patience pays off here.

There you have it- how to make money trading forex in high volatility environments. It’s important to combine this strategy with other strategies in your arsenal so that you capture big trends in fast moving markets, and you capture quick forex profits in slow, sideways markets.

The result? Testing the rules of the forex trading strategy from 2007 until 2010 yielded over a 400% return on the AUD/USD pair. Starting with an account size of $10,000 back then using these rules would’ve yielded a balance of $50,931.04 this year. What’s the secret? It’s not that complicated- it uses some of our common forex trading tools that we discussed earlier to gauge the overall sentiment of the forex market.

Here’s how you can do it in a few easy steps:

1. Use a currency meter (such as the CCFp indicator available for Metatrader) on a weekly time frame and wait for AUD to become strongly positive as an individual currency, and for the dollar to become very weak as an individual currency, and get ready to go long (get ready to go short if the reverse happens).
2. Make sure that price is trending and not ranging. In other words, price has been making new highs on a daily chart or the Momentum indicator is showing a value of 102 or greater.
3. Make sure that price has not pulled back more than 2.5 times the daily average true range for the last 2 weeks. This ensures that money is flowing into the base currency of interest with some momentum.
4. Enter at market price, setting a stop loss at 2 times the daily average true range, and a take-profit of 3 times that for a good risk/reward ratio.
5. Enter up to 2 positions at a time, but make sure each entry is separated by 100 pips to give price plenty of room to “breathe” and so that we can account for short term randomness in the market.
6. Get out if the sentiment turns around as indicated by the currency meter before the stop loss is hit.

The results are not based on “curve-fitting,” an evil practice of forex backtesters who keep tweaking their system on past data until they turn a bad system into a good one only to find that it doesn’t work in the future. There were periods where it didn’t work as well, but hey, let’s be honest- there’s no such things as the holy grail. There will be periods where you will have losing trades no matter what strategy you trade- are you prepared to deal with that?

Furthermore, This is only based on one sentiment indicator. Just imagine what things could be like  if you added on other fundamental sentiment indicators such as COT data to strengthen your edge? I’ll comment on the addition of more tools to enhance your forex trading system in a subsequent post so stay tuned.

So there you have it. An objective forex mechanical trading system that is based on how the market works (money flows from weak to strong currencies) rather than some cheap nonsense pattern/moving average-based system. It certainly takes the guesswork out of forex profits!

This video I’m sharing with you is a recording of a live forex options trade done on the GBP/JPY so you can see how we actually analyze and enter trades to make money trading forex.