This strategy works best on strong trends, but can also be used to find entries during weaker trends as well although strong trends are always the preferred environment to trade in. Used in conjunction with paying very close to the price action and strength, this strategy gets very advantageous prices and allows for large profit potential. An additional benefit is that risk can also be kept quite small.
A trend is not just a relentless move in one direction; it moves in waves, but makes overall progress in one direction. A downtrend starts with a move down, a smaller pullback and then another move lower and so on. The main waves (in this case down) are called impulse or primary waves. As long as the impulse waves are stronger than the pullbacks the trend is likely reasonably healthy.
Strength is determined by distance and speed. Figure 1 shows a strong trend. Notice the impulse waves (in this case down) cover much greater distance than the pullbacks and also have greater velocity than the pullbacks. This shows that sellers are much more interested in selling than buyers are interested in buying.
Figure 1. EURUSD 1 Minute Chart
There is a lot of information on the chart. The left side shows the strong downtrend which we want to be a part of by going short (buying puts). As we move further right on chart the pullbacks get stronger and the moves lower get smaller. This is our indication the downtrend is likely over, or that at least conditions have changed enough that we don’t want to keep taking short positions using the following strategy.
This strategy simply capitalizes the waves structure of trends, as well as slowdowns on a pullback to enter in the direction of the trend. By waiting for a slowdown during a pullback risk can be kept small and the profit maximized.
Here are the basic rules assuming a downtrend, like shown in figure 1 and 2.
- Enter only in the direction of the dominant trend
- Apply Bollinger Bands or a similar indicator to your chart (I use enveloped for a 1 minute chart as described in Forex Day Trades – Oct 7, which covers a different variation of this strategy).
- Only take trades that are near the midband of the Bollinger Bands.
- Only enter when there is a pause of three bars or more.
- The closer entry is to the top of the three bars, the lower risk, but you can enter anywhere inside the 3+ bar slowdown (for an uptrend, ideally enter near the bottom of the slowdown if possible).
- Place a stop several pips beyond the highs the slowdown (for a uptrend, stop is a few pips below lows of slowdown).
- The slowdown of the pullback should have been preceded by a sharp move lower (see figure 2 for the basic idea–for trades 3 and 4 these are still considered to be preceded by a sharp move lower).
- Take profit at approximately 1.5 or 2 times your risk, OR, base your target on the distance of average price runs, as discussed in Make a Little Money Before a lot of Money.
- If there is evidence that the trend is weakening, you can still take the trade but if the price moves in your direction and then quickly fails, get out (the fourth trade in figure 2 is an example of this).
Figure 2 shows the same downtrend we saw before. Now Bollinger Bands have been applied, as well as small boxes which mark relevant slowdowns and trade opportunities.
You enter somewhere in the slowdown box–preferably near the top (for downtrend) since the risk will be less. Place a stop just above the highs of the box. This will depend slightly on volatility and the time frame you are trading on. For 1 minute chart I place a stop about 2 pips above the slowdown. For a 5 minute chart I put the stop about 3 to 5 pips outside the slowdown.
Figure 2. EURUSD Trades on 1 Minute Chart
This strategy does require that you adapt to changing market conditions and realize when the trend is likely over. The first two short trades would have worked out very well. Regardless if you took a profit at 2X your risk (meaning if your risk was 3 pips you take a profit at 6 pips) or held for more as the price accelerated, these trades were strong trend trades.
The third trade is a loser. We get short and very shortly after are stopped out. Notice this slowdown is only 3 bars, so it is very possible this trade would not have been taken at all. The overall trend is still possibly down though. This may just be a bigger pullback after a strong move lower. So a fourth short trade is taken. It moves onside but then fails to move lower.
Since we already know, based on the third trade, that there is some buying strength, we don’t bother to wait for our stop to get hit and bail on the fourth trade with a small profit, breakeven or small loss. Depending on the entry point is still likely possible to extract a small profit on this trade. We are aware of the possibility that the downtrend is over because the pullback was much stronger and the moves lower have lost their strength.
Once again, the fourth trade is only 3 bar slowdown, therefore it is possible that you may not have been able to take this trade at all, especially if you were waiting with an order near the top of the slowdown.
Define personal rules for yourself about how you will enter on slowdowns so there is no question in your mind on how you will handle these types of situations.
How to Read the EURUSD discusses more on managing trades while they are underway.
In hindsight it looks easy to spot these trades, but in real-time it takes a lot of practice to determine when the market is strong and when trend may be changing. Also depending on where you enter, your risk can vary quite a bit. There is a fine balance between making sure you get a position if you want one, but not getting a worse price than you need to. For exits I usually have a target set at approximately 2X my risk. I will then adjust this slightly based on daily conditions and the whether the trend seems to be weakening or strengthening.