Forex Traders: Should You Trade Trends or Ranges?
12/09/2010 12:01 am EST
Whether trading stocks, futures, options, or forex, traders confront the single most important question: Trade trends or ranges? And they answer this question by assessing the price environment; doing so accurately greatly enhances a trader's chance of success. Trend and range are two distinct price properties requiring almost diametrically opposed mindsets and money management techniques. Fortunately, the FX market is uniquely suited to accommodate both styles, providing trend and range traders with opportunities for profit. Since trend trading is far more popular, let's first examine how trend traders can benefit from FX.
What is a trend? The simplest identifiers of trend direction are higher lows in an uptrend and lower highs in a downtrend. Some define trend as a deviation from a range as indicated by Bollinger bands. For others, a trend occurs when prices are contained by an upward or downward sloping 20-period simple moving average (SMA).
Get in Early
Regardless of how one defines it, the goal of trend trading is the same: Join the move early and hold the position until the trend reverses. The basic mindset of a trend trader is "I am right or I am out." The implied bet all trend traders make is that price will continue in its present direction. If it doesn't, there is little reason to hold onto the trade. Therefore, trend traders typically trade with tight stops and often make many probative forays into the market in order to make the right entry.
By nature, trend trading generates far more losing trades than winning trades and requires rigorous risk control. The usual rule of thumb is that trend traders should never risk more than 1.5%-2.5% of their capital on any given trade. On a 10,000 unit (10K) account trading 100K standard lots, that means stops as small as 15-25 pips behind the entry price. Clearly, in order to practice such a method, a trader must have confidence that the market traded will be highly liquid.
Of course, the FX market is the most liquid market in the world. With $1.6 trillion in average daily turnover, the currency market dwarfs the stock and bond markets in size. Furthermore, the FX market trades 24 hours a day, five days a week, eliminating much of the gap risk found in exchange-based markets. Certainly, gaps sometimes happen in FX, but not nearly as frequently as they occur in stock or bond markets, so slippage is far less of a problem.
High Leverage, Large Profits
When trend traders are correct about the trade, the profits can be enormous. This dynamic is especially true in FX where high leverage greatly magnifies the gains. Typical leverage in FX is 50:1 (for US-based traders), meaning that a trader needs to put down only $1 in margin to control $50 of the currency. Compare that with the stock market, where leverage is usually set at 2:1, or even the futures market, where even the most liberal leverage does not exceed 20:1.
It's not unusual to see FX trend traders double their money in a short period if they catch a strong move. Suppose a trader starts out with $10,000 in his or her account, and uses a strict stop-loss rule of 20 pips. The trader may get stopped out five or six times, but if he or she is properly positioned for a large move—like the one in EUR/USD between September and December 2004 when the pair rose more than 12 cents, or 1,200 pips—that one-lot purchase could generate something like a $12,000 profit, doubling the trader's account in a matter of months.
The Market Always Wins
Of course, few traders have the discipline to take stop losses continuously. Most traders, dejected by a series of bad trades, tend to become stubborn and fight the market, often placing no stops at all. This is when FX leverage can be most dangerous. The same process that quickly produces profits can also generate massive losses. The end result is that many undisciplined traders suffer a margin call and lose most of their speculative capital.
Trading trends with discipline can be extremely difficult. If the trader uses high leverage, he or she leaves very little room to be wrong. Trading with very tight stops can often result in ten or even 20 consecutive stop-outs before the trader can find a trade with strong momentum and directionality.
NEXT: Learn the Benefits and Risks of Range Trading|pagebreak|
Bound to a Range
To avoid such frequent stop-outs, many traders prefer to trade range-bound strategies. Please note that when I speak of “range-bound trading,” I am not referring to the classic definition of the word “range.” Trading in such a price environment involves isolating currencies that are trading in channels and then selling at the top of the channel and buying at the bottom of the channel. This can be a very worthwhile strategy, but, in essence, it is still a trend-based idea; albeit one that anticipates an imminent countertrend. (What is a countertrend after all, except a trend going the other way?)
True range traders don't care about direction. The underlying assumption of range trading is that no matter which way the currency travels, it will most likely return back to its point of origin. In fact, range traders bet on the possibility that prices will trade through the same levels many times, and the trader’s goal is to harvest those oscillations for profit over and over again.
Clearly, range trading requires a completely different money management technique. Instead of looking for just the right entry, range traders prefer to be wrong at the outset so that they can build a trading position.
Putting It into Practice
For example, imagine that EUR/USD is trading at 1.3000. A range trader may decide to short the pair at that price and every 50 pips higher, and then buy it back as it moves every 25 pips down. His or her assumption is that eventually the pair will return to that 1.3000 level again. If EUR/USD rises to 1.3500 and then turns back down to hit 1.3000, the range trader would harvest a handsome profit, especially if the currency moves back and forth in its climb to 1.3500 and its fall to 1.3000.
However, as we can see from this example, a range-bound trader will need to have very deep pockets in order to implement this strategy. In this case, employing large leverage can be devastating since positions can often go against the trader for many points in a row, and if he or she is not careful, it can trigger a margin call before the currency eventually turns around.
Solutions for Range Traders
Fortunately, the FX market provides a flexible solution for range trading. Most retail FX dealers offer mini lots of 10,000 units rather than 100K lots. In a 10K lot, each individual pip is worth only $1 instead of $10, so the same hypothetical trader with a $10,000 account can have a stop-loss budget of 200 pips instead of only 20 pips. Even better, many dealers allow customers to trade in units of 1000 or even 100-unit increments. Under that scenario, our range trader trading 1000 units could withstand a 2,000-pip drawdown (with each pip now worth only ten cents) before triggering a stop loss. This flexibility allows range traders plenty of room to run their strategies.
In FX, almost no dealer charges commission. Customers simply pay the bid-ask spread. Furthermore, regardless of whether a customer wants to deal for 100 units or 100,000 units, most dealers will quote the same price. Therefore, unlike the stock or futures markets, where retail customers often have to pay prohibitive commissions on very small size trades, retail speculators in FX suffer no such disadvantage. In fact, a range-trading strategy can be implemented on even a small account of $1,000 as long as the trader properly sizes his or her trades.
Whether a trader wants to swing for homeruns by trying to catch strong trends with very large leverage or simply hit singles and bunts by trading a range strategy with very small lot sizes, the FX market is extraordinarily well suited for both approaches. As long as the trader remains disciplined about the inevitable losses and understands the different money management schemes involved in each strategy, he or she will have a good chance of success in this market.By Boris Schlossberg of BKForexAdvisors.com