Increase Your Odds: A Basic Technical Approach

Last updated 5/24/2010 12:53 PM EST (GMT -5) 32 Comments

Forex Trading involves high risks, with the potential for substantial losses and is not suitable for all persons. Past performance is not necessarily indicative of future results.

Roger A. Stojsic

Technical Analyst, GFT

The following article will use Doji for the purpose of providing specific and detailed examples; however, the same concepts apply to other candlestick reversal formations like tweezers, shooting stars, and hammers, for example. These basic formations are rather helpful ways of confirming other market reversal indicators such as the geometric, Fibonacci-based patterns we primarily use to identify technical trading opportunities here at FX360.

Doji are neutral indicators that simply represent a “tie” in the never-ending battle between buyers (bulls) and sellers (bears). They form when the open and close of a candlestick are equal or very close to equal and are considered a neutral formation suggesting indecision between buyers and sellers—b ullish or bearish bias depends on previous price swing, or trend. Length of the upper and lower shadows (wicks and tails) may vary giving the appearance of a plus sign, cross, or inverted cross. Completed doji may help to either confirm, or negate, a potential significant high or low has occurred especially when found at support or resistance, after long trend or wide-ranging candlestick.

 Although they may be helpful in identifying/ confirming that a trend reversal may be underway on their own doji are not much help in making sound, high probability trading decisions--as is the case with any single indicator. This is mainly due to the fact that even if a doji does signal the beginning of a reversal it will not give any indication as to how far the reversal may go, or how long it may last.

High probability trades are identified through a convergence of trading signals that help not only identify, but confirm, both entries and exits based on two key components: (1) trend (2) support & resistance. Without having identified those two components in advance, placing a trade based on any solo indicator is nothing more than a coin-toss in terms of probabilities. But when used in conjunction with other forms of analysis, doji can be helpful in either confirming or negating significant high/lows, which in turn help a trader determine whether a trend is likely to reverse, or perhaps continue. In other words, a single doji is a just a small piece of the puzzle in helping a trader determine a higher probability point at which to either or enter and/or exit a position.

Let’s take a look at how doji can be used with other basic technical indicators to make a high probability trading decision. The first things we want to determine are support levels, resistance levels, and trend. The idea is to sell near resistance, and buy near support. Trend helps tell a trader which direction to enter, and which to exit.

The most basic ways to determine support & resistance is based off previously established highs and lows…

Another way to identify more significant levels of support and resistance in terms of trend reversals is based off previously established significant highs (peaks) and lows (valleys). These peaks and valleys help a trader identify the beginning and ending points of price swings, or trends.

Based off these significant highs and lows, a widely recognized form of technical analysis referred to as Fibonacci retracements may be used to identify support or resistance. These Fibonacci retracement levels represent percentage corrections of previously established price swings, or trends. The most common Fibonacci retracement levels are 38.2%, 50%, 61.8%, and 78.6% of the previous swing, or trend.

In the above example, we see the completed doji (point C) has also occurred at the 78.6% Fibonacci retracement level of resistance based on the previous downtrend . In other words, the swing from the low up to the completed doji (B-to-C) is approximately 78.6% of the previous downtrend (A-to-B). In this case, a trader may interpret this doji as confirmation of the Fibonacci resistance and in turn anticipate a forthcoming reversal, or downswing. If the doji fails (a new high is make above the high of the doji), then this would negate the reversal and suggest a potential continuation.

Based on this basic idea, a trader may then decide to enter the market short (place a sell order) with a stop (or sometimes referred to as a stop-loss) placed above the high of the doji and the Fibonacci level of resistance. Since this stop-loss order is meant to close-out a sell entry order, and then a stop buy order must be placed.

What is very important to remember is that the highs, lows, opens and closes seen on a price chart reflect the bid prices of that particular market-- in other words, the price at which a trader may sell. When placing a buy order it is extremely important to account for the spread for that particular market because the buy (ask) price is always slightly higher than the sell (bid) price. In this example, let’s assume the spread on the USD/CHF at the time of this trade is 4 pips.

In order to close the short/sell entry order the trader must place a buy order to either control the amount the trader is willing to lose with a stop-loss or where to take profit with a limit order (or multiple limit orders if multiple profits targets are established). The size of each stop or limit order is based on the size of the entry order, or what is referred to as the traders open position. Although it is not uncommon for traders to have multiple profit targets, it is generally good practice to have one stop order that matches the size of the total open position thus taking the trader completely out of that position.

At this point only half, if that, of the battle is over. What about the profit targets? Well, much like our entries and stops, our limit also should typically be based on support or resistance. This gives a trader a logical point at which to exit the market. In this example, we will use the same Fibonacci analysis based on the rally (swing, or trend) prior to our completed doji to calculate potential levels of support where the projected reversal may stop and change directions. It’s important to remember that levels of support and resistance act a “zones” where prices may fall just a bit short, or just pierce, the levels. In other words, traders may want to allow for a “cushion” just above or below Fibonacci levels. In this example we’re anticipating the market to move down so we may want to set profit targets just above the Fibonacci levels in case the market doesn’t quite reach the actual line we see on the chart (when setting stops, traders will typically allow for a cushion just beyond a levels of support or resistance allowing a bit of room in which the market may pierce that exact level).

No matter how experienced a trader may be no one knows for certain what the market will do next, or how far the market will go. This explains why some traders may choose to have multiple profit targets. One age old trading mantra says, “Cut your losses quickly, and let your profits run.” Although this is an excellent piece of advice it is often misinterpreted and can actually do some serious damage. A trader must “let profits run” to logical profit targets, which generally reflect levels of support or resistance depending on the direction of entry. This is where trend analysis plays a significant role in helping to determine which profit targets, or how many, a specific trade calls for.

The mistake for most traders is the fear of “getting out too early” and as a consequence greed may oftentimes set in. This often leads to giving those profits back, and in many cases turning a winning trade into a losing trade. Multiple profit targets tend to lead to more complicated exit strategies in which stop management becomes essential. One key aspect of successful trading that will help to determine the quality and probability of a trade is the risk vs. reward ratio. In my opinion, this is without question the single most important factor of a high quality trade.

For now, let’s just keep it simple and see what this trade setup looks like using the same USD/CHF example. We will assume the most conservative profit target (set just above the 38.2% Fibonacci retracement level adding 4 pips for the spread). 

Now that we have determined out exits BEFORE entering into the market, we will be able to perform the 2 absolutely essential/crucial components of proper risk and money management. One of my unbreakable rules is to always determine in both entry and exits in advance so that two key elements can be defined; 1) the risk vs. reward ratio, and 2) the amount of risk on the trade. The risk vs. reward ratio, in many cases, will be the determining factor of whether or not the trade is initiated based on the traders’ winning percentage. However, most traders do not know their true winning percentage for one of two reasons.

1.        Lack of consistency

a.        Most traders do not follow the same rules, if any, each and every time they place a trade. This makes it impossible to determine with any degree of accuracy what the true performance is because of the constantly changing variables. Most place several trades, and then “try” something else which brings us to the next point…

2.        Not enough trades have been placed to accurately determine an average winning percentage

a.        This is where the mathematical law of law large numbers comes into play. This law basically states that the more occurrences you have of a specific event, the closer you will come to the true probability of that event reoccurring. Trading is all about probabilities, not certainties. So and understanding and application of this law is essential. Think about flipping a coin 10 times, and getting 8 heads. We all know that the odds of flipping a coin are 50/50. So no one in their right mind would assume there’s an 80% chance of getting heads based off those 10 initial flips. So when dealing with proximity the law of large numbers basically means the more flips the closer you get to that 50/50 average we know exists. Even after 100 flips you may still not see a true representation of those odds because somewhere along those 100 flips you may see 10 heads or ten tails in a row. This is where the law of averages comes into play. Since we know the odd are 50/50, that suggests that if we see 10 heads in a row, well somewhere down the line we’ll probably see 10 tails in a row to average our the 50/50 probability. Funny thing is….let’s say someone sees 20 heads flipped in a row. How many people do you think would be willing to bet money that the next flip is going to be tails? They’re probably asking themselves, “…wow, 20 heads in a row, what are the odds! The next one HAS to be tails!” In reality, the odds are always 50/50 no matter how many heads in a row.

So, part of a solid trading plan may/should include a minimum acceptable risk/reward ratio based on the strategy’s historic winning percentage, for example. The amount of risk (distance between entry and stop-loss) will then help determine the appropriate size trade to place based on a percentage of total trading capital that will be risked per trade. Let’s assume we entered this short trade just after the doji completed, and the stop-loss order was placed 5 pips above the high of the completed doji while remembering to then add 4pips account for the spread. The profit target (T1) might then be placed a few pips (let’s say 5 for this example) above just above the 38.2% retracement of B-to-C since this reflects the first level of potential future support based on the most recently established price swing, or trend (a limit buy order might be placed to automatically take profit at this price level, for example).

Short USD/CHF

Stop: 1.0452

Entry: 1.0417

Limit: 1.0342

Total risk: 35 pips (difference between entry and stop)

Total reward: 75 pips (difference between entry and profit target)

Risk vs. Reward ratio: 1 vs. 2.14 (reward divided by risk)

Assuming the risk vs. reward ratio is acceptable you can then determine the appropriate size trade to place based on your percentage risk per trade as defined by your overall trading plan. As a general rule of thumb most traders do not risk more than 1-3% of their total trading capital (1-3% account balance)…

Total risk: 35 pips

Pip value: $9.60 USD (approximate pip value at time of this particular exchange rate)

Account balance: $10,000 USD

Max risk per trade: 2% or $200 USD

In this scenario, the trader has two options….

1)       Pass on the trade since 35 pips of risk x $9.60 /pip = $336 total risk on trade (over pre-determined $200 max risk per trade)

2)       Adjust lot size to fit within max risk per trade allotment. This would require mini lots….5 mini lots ($4.80 per pip) x 35 pips of risk = $168.00 total risk on trade (within pre-determined max risk per trade)

Let’s see what actually happened on this particular USD/CHF trade…..

This particular trade resulted in a win for a total of $360 USD. Obviously, this is just one example and in no way suggests or constitutes a standalone trading strategy or methodology. However, the real point here is that profitable trading is not about complex indicators or systems. Above all else is good risk and money management. If a trader is disciplined enough to only take trades that offer maximum risk to reward ratio, then it’s easy to see that profitable trading is not about being right or winning… it’s becomes all about the discipline to remain consistent, and to obtain the ability to control your emotions. 

This example demonstrates a trade opportunity with just over a 1:2 risk vs. reward ratio. If that ratio was part of trader’s minimum criteria for placing a trade, then that trader would only need to maintain a 33% winning ratio to break even in terms of profitability. So it is then possible to be profitable over time even when losing more trades than your win. Understanding this in and of itself gives you and edge or advantage against a majority of traders out there. Let go of your ego, play the numbers game and you have a good chance of reaching your goals.

Now, the market may turn at these at these predetermined logical profit targets, or in many cases move way beyond them. A trader will never know this information in advance. What tends to happen in the instances where the market continues to move in a profitable direction after the trader has already closed the trade for profit, the “shoulda, coulda, woulda’s” start to take hold, and greed starts to blind the trader to the truth. The truth is...you made a PROFIT! But when the market continues to move in a profitable direction after the trade has been closed, most traders will no longer look at that trade and think, and “Who cares! I made money on the trade, and I’m happy with that.” Most traders forget about the profit they’ve taken and start to think, “Damn! I got out too early! Look at how much I could have made (or should be making).” This leads to emotions. Emotions lead to irrational, illogical decisions-- especially when money is in the equation. Over time, making trading decisions based on emotion leads to trading suicide (i.e. a zero balance).

In the end, all a trader can do is decide what is logical, understand why those levels are logical, and enter orders accordingly. One of the worst and most destructive habits of nearly all traders is to look back after a trade has completed to “see what happened.”

Comments (32)

JohnStarlo

August 07, 2009 at 05:42 PM ET

I think this is a simple approach and thats good bcause we need help. Its good to get these information, if you could post more articles like this to help begginers like me. I'm trading a practice account but i try to manage it as if it was real (I traded real money before without a strategy and lost). I risk 1.5% if I'm confident and 0.75% if not much confidence. One problem I have is to identify significant support and resistance so that i can know the exact point to place the fib. I set my win/loss ratio at 1:3 minimum and it is working.

I need some advise on my style of trading because I'm about now thinking of trading real money. In fact I leave fib out of it because it has too many S & R points, what I do is trade directly off the last candle stick or a number of candle sticks say the last 10. For example If the last 7 has been trading sideways in comparrison to the average high and low then I try to determine a break out point for long and short (I place both long and short orders). 2 days ago my long order was USD/JPY E-95.346, Stop 94.950, T1 96.824 and T2 97.532. The day closed without it breaking out of the range so I add to the position This time E-95.314, Stop-94.950, T1-96.774 & T2-97.429. I've done this several times and it is profitable, is it buck up or good trading? Another one is if the Daily candle stick has a long wick at the bottom and it close above the open and has some body then my bias is long. After it close then I go long and set my stop at the bottom of the previous candlestick and T1 at equal risk and T2 at 2 times risk. If it work it work if not then?????? As soon as I have an open position then I identify the daily Pivot S1 and R1 points and and set an order very close to one of these points with very tight stop (R1 if my position is long and S1 if my position is short), just to help my position pass that point.

The thing is I try not to confuse myself with too much indicators and I only use style 2 if I don't see Style 1 is not forming. I however use RSI and pivot.

Do you think I'm fooling myself?

rstojsic

August 10, 2009 at 10:59 AM ET

no, i dont think your fooling yourself. i also believe that if something is not broken, then there is no need to fix it. so, if your strategy/plan is working, then go with it. My biggest concern for you is if you have placed enough trades under this set of rules to truly know what the performance is over several months vs several trades, for example. If you haven't done so already, I would keep a trading log (excel spreadsheet, for example) where you log each trade (the entry, stop, and target(s)) along with the size of each trade and of course the results (p/l) of each trade. Once you reach 100 trades, for example, you will start to get a more realistic idea (and confidence) of what your performance will be like over time since you will probably have both a couple winning and losing streaks to factor in. For most new traders performance under a demo account will in NO way reflect what your performance will be like in a live account (mainly due to the emotions of actually trading real money), but keeping a log will help significantly assuming you stay consistent to your trading rules (since this helps keep things more mechanical which reduces some of that emotion). Thanks for the feedback, John, sounds like your definitely on the right path hope this helps!

Jeff Burke

August 10, 2009 at 02:42 PM ET

I'm presently trading the EUR/USD pair at 96% positive trades using the CCI and the Slow Stochastic....

gsxr46987

November 11, 2009 at 03:24 PM ET

Do some research into the Elliott Wave Principle.....Give your self time to learn it and you will see the rewards, also makes placing stops and setting targets a lot easier.

JohnStarlo

August 07, 2009 at 05:48 PM ET

I mean my Win/Loss ratio is 3:1

Ram

August 07, 2009 at 09:46 PM ET

Thanks for the article, Roger. I think this is quite useful for a novice like myself too.

rstojsic

August 10, 2009 at 11:01 AM ET

thanks, Ram, glad you enjoyed it.

Trapper

August 07, 2009 at 11:41 PM ET

Very practical, in-depth and easy to follow. Thanks for making the effort.

rstojsic

August 10, 2009 at 11:02 AM ET

thanks for the feeedback, thanks for reading, and you're very welcome.

sdg66

August 08, 2009 at 03:59 AM ET

Wonderful article, even for a 10-year veteran like me:-)) Well illustrated and elucidated. I've learnt over the years that if you add the noise in your head to the noise in the market, you get a perfectly-seasoned Molotov cocktail that blows you out of the game. Setting profit targets and calculating ratios is one of the most sober things you can do before you take a trade. And, I know (from personal experience, what else?) how hard it is to exorcise the thoughts of notional losses (for closing out a position too early) - it remains one of the toughest bogs in the psychological setup of a trader. In those days of apprenticeship, I felt that the anguish of a loss was sometimes sweeter, and psychologically more manageable, than the on-hindsight repentance for not having let a profitable position run its full course.
Thanks for the wonderful article once again, and for your time, Roger. Have a nice weekend!

rstojsic

August 10, 2009 at 11:04 AM ET

this is great, thank you!

The Mint Man

August 08, 2009 at 06:39 AM ET

Great article Roger. For beginners with prior, but basic knowledge of things like how to find support/resistance lines, candle charts and Fib levels etc. I think they would have got a lot out of your write up. I have read similar things (about doji's) before but your step by step process was very useful in understanding what you were talking about. As a new player in the FX market I will be going over some charts and applying this strategy to see if I can pick some reversals for myself. Thanks mate! Cheers

Phabian

August 08, 2009 at 07:46 AM ET

No Comment for now

rstojsic

November 11, 2009 at 11:51 PM ET

Technically, that counts as a comment doesn't it? :)

The Mint Man

August 08, 2009 at 07:49 AM ET

Just a quick question Roger. In a situation like the trade outlined above, would a move above 70 on the RSI indicator provide a higher probability of a trend reversal?

rstojsic

August 10, 2009 at 01:57 PM ET

i'm sorry, but i really have no idea...i haven't used a lagging indicator in quite some time (i stick to fibs and trendlines). I think brad may incorporate RSI into some of his trades so he may be a better person to ask, but i would say that no matter what you have to have to go back and analyze at least the last 50-100 instances to get an idea (not to mention building confidence in the research process)

spunky

August 08, 2009 at 09:58 AM ET

Thanks Roger , great article , enjoy your weekend

Hope to see articles on time frames, and proper use of trailing stops, in context with this article


regards
Brad

rstojsic

August 10, 2009 at 02:02 PM ET

thanks, Brad, good ideas to add to the list

EL Forex

August 09, 2009 at 08:30 PM ET

Thank you for the article Roger. I follow most of the trades on FX360 and I was wondering:

1)When you hit T1 on one of your trades, do you close a portion of the position and then move the stop to breakeven?

2)Are there times when you will exit the trade before hitting T2 based on something you are seeing (if so do you post something on the website)?

BTW, I made 33 pips last week on one of your trades-Thanks!

Big Weir

August 10, 2009 at 06:45 AM ET

Good Article,

This is how I was first taught to trade, and the key is having a good risk/reward ratio, I remember placing 5 trades in a week hitting only 2 of the 5 (40%) and still came out on top with 80 pip's for the week. Though I like to place my stop near the next sup/res/fib levels now, I still look at the risk/reward ratio.

jorge305

August 10, 2009 at 12:56 PM ET

Hi,

Good article. I am brand new at this and was hoping you could help me with the RSI. What is a good amounts periods to look at on the 1hr chart and on the 1day chart for the RSI? Appreciate your help.

Thanks

The Mint Man

August 11, 2009 at 09:48 PM ET

Hi Roger, Just thought I would let you know that I have put this article to use on two trades over the last couple of days. On Tuesday arvo I bought the EUR/USD. Unfortunately it didn't quite reach my profit target (38.2% of BC) so sensing that it was turning back down I sold out for a small profit of 5 pip... my instinct was proved right as it ended up going down 70-80 pip although my stop was only a fraction of that of course. The second trade was on the USD/JPY (last night AEST) it took a little while to really get going after the doji but ended up reaching my profit target which was 61.8% of the recent (and large) upswing, I felt it had room down to there. I made 70 pip on that one. Since I got out (about 10 hours ago now) it has tracked sidewards, not very far off my exit of 96.11 So I'm quite pleased with that trade. Oh, the risk reward on that was 1:2.3, it would have been much more than that but I gave it a bit more breathing space over and above the high of the doji. Cheers

Enoch Yong

November 10, 2009 at 06:52 PM ET

Roger, this is a fabulous article! I got into forex trading through my friend who happens to be a fulltime trader. What I learned from her is what you are showing in fx360 article e.g. support/resistance level, candle sticks, gartley patterns, butterfly, abcd, head and shoulders, double top/bottom. No RSI or stochastic were used to determine entry/exit points as they were delayed indicators.

I found out that the only "enemy" when trading is your emotion. That's why trading in higher time frames allows me to get out from my trading screens and do something else and come back just to "check" how were the trades going. Trading in lower time frames can be emotional.

rstojsic

November 11, 2009 at 04:35 PM ET

Well said, Enoch, I could not agree more. It’s easy to get consumed by the plethora of indicators and strategies and begin to unnecessarily over complicate or over analyze. In this sense, I find that it is rather important to keep the basics in perspective which is why I enjoy being able to share these thoughts and examples. For me, most important is to remind myself that each trade is just one small step towards a far more satisfying goal that is discipline of the mind. I see this as the most important aspect on path to trading “enlightenment,” if you will, because it resonates throughout other aspects of life. I realize this may sound a bit dramatic, so I’ll stop here before I get too carried away and start referring to astroharmonics and astrocycles :), but i simply cannot deny the many parallels between trading, philosophy and the arts on which we have centuries to reflect upon….which is also why i am such an advocate of geometric pattern recognition as it is rooted in sacred geometry. After all, money is simply a means to an end, and can be extremely dangerous when perceived as the end itself. If money is the only goal and ultimate focus, then will you ever be truly satisfied? Anyway, forgive my rambling and thank you very much the feedback, Enoch!

10double

November 11, 2009 at 07:22 PM ET

Money is the way of our life, not the goal. For that reason, I think Forex is the most honest way of living, making money from money directly. No politics, no pollution, no greenhouse effect, although if has all the links to these problems. I am going to quit my job soon, and going full time on fx trading. Thank you for your thoughts.

10double

November 10, 2009 at 11:40 PM ET

This is a great article! May help people with scientific and analytical minds. I do trading without any technical analysis, just some simple rules. I found to keep it simple and looking at the globe picture of a currency pair can make every trade, I mean every trade successful. no limits, no stops. no win, no quit. I have done over 1000 trades, most of them hold for more then a day. I sleep well with open positions. Trading currency is really a piece of cake.

rstojsic

November 11, 2009 at 04:42 PM ET

Being able to sleep well with an open position when ur first starting out is no easy feat, is it?!? :) thanks for the feedback, 10double.

10double

November 11, 2009 at 06:54 PM ET

You are absolutely right, Roger. My first year of tading was nightmare. Losing, losing, 0 balance! Several times. Now I am pretty much profit evey time. I feel Forex tading is a process of going throught different stage of enlightment. like you are standing in fromt of a 3D picture. when you see the picture, you are at different level of conciousness. I am not sure if you feel the same way.

10double

November 11, 2009 at 12:12 AM ET

Currency trading should be like a fishing, not a police car chasing on LA freeway. Happy finshing, everyone!

Demax

November 11, 2009 at 06:27 AM ET

(Bookmarked!)

..and thank you Roger - I will give that a more thorough read later on.
My quick scan of it noted that you're trying to establish turning/retrace points using doji indicators coupled with other tech indicators to support the potential turn.

The ref to mini-lots should be a no-brainer to everyone who has a grasp of risk management and I use them routinely too. I'll re-read that part to see if I can improve my risk management further. I would add from experience that there may be a case for trying to factor in the volatility of any given pair in determining the risk margin. Not always easy because it can be subjective.

..again .. I only scanned it and it looks to be a definitive article. Try to keep this one where it's easily located please!

payne

November 11, 2009 at 03:33 PM ET

Roger,

Great article! Easy to read...nice graphics...technically sound…good top-down organization from pattern recognition, support and resistance, risk and positioning…all the way in and out of the trade.

rstojsic

November 11, 2009 at 04:45 PM ET

thanks, payne!

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