The Forex (Currency) market is a huge highly liquid (always buyable and sellable) market enabling traders to make consistent gains when following a sound trading strategy.
There is no better way to learn than with a realistic example trade so that’s what we are going to do below. The trade below will take you step by step through a ‘pin-bar reversal’ trade which is the favoured trade strategy.
The article finishes off with some other trading strategies, but without any examples. The Pin Bar Reversal is the strategy to focus on.
Trade Risk Management
THE GOLDEN RULE: Never risk more than 1% of your trading account
1% (trading account size)
the number of PIP’s we could lose if the trade goes against us
The Stake Size. The Max trade per PIP we can afford to bet on the trade.
For simplicity, an example risk management calculation for a trade on a £100 account with a 20 PIP stop loss would be as follows:-
1% (trading account size) = £1
the estimated number of PIP’s we could lose if the trade goes against us (20 PIPS)
5 pence. The Stake Size.
This is the Max trade per PIP we can afford to bet on the trade.
Risk & Reward
We are looking for a target of at least 2:1 Reward to risk in order to place a trade. There must be the potential of a greater size of the reward compared to the size of the risk, each time we place a trade. Clearly, the higher the better. A sweet spot might be something like 5:1.
Reward to Risk Ratio Calculation:-
Entry price – Target Price (Reward)
Entry price – Stop Loss Price (Risk)
So, for any trade, you take the stake size calculated during risk management and plug it into the Reward to Risk Ratio Calculation. If this is 2:1 or more then the trade can be placed if the criteria below are met.
Swing Trading Strategy
Most strategies out there are either a ‘bounce‘ strategy or a ‘break out‘ strategy. We will concentrate on trading the bounce as it has been shown to have a higher probability, and has a higher risk-reward return than the breakout.
Price action breaks out about 30% of the time but bounces 70% of the time.
Even a dogmatic disciplined approach to trading the bounce can on the balance of probabilities pays off better than second-guessing a breakout. So we Trade the Bounce.
We trade longer-term trades on the daily charts with consistently high reward to risk trades. This frees up time compared to intra-day traders who sit in front of a screen all day waiting for shorter-term trades.
IDENTIFY THE TREND
In an upward trend, the 20-day Moving Average (MA) is above the 50-day MA which in turn is above the 200-day MA. The reverse must be true to identify a downward trend…
Trade the Trend: If you identify a series of higher highs AND higher lows it is usually an ‘upward trend’. We look to trade the ‘bounce’ on the ‘higher lows’. In an upward trend, ‘trade the dips‘. In this upward trend, we do NOT trade the pullbacks from the trend, just the bottom of the pullbacks when they switch back to the upward trend.
THE DOWN TREND
A downward trend is the opposite or converse of the upward trend where we look to make sell trades on the successively lower highs of the downtrend. In a downward trend we ‘sell the rally‘. Once again we only trade with the direction of the momentum so we only look to trade the downward phase from a ‘lower high‘ to the next ‘lower low‘.
Strategy 1: Pin Bar Reversal
A ‘Sell’ Trade Example (US Doller / Canadian Dollar)
The image below is the example trade that we will use to illustrate to entire trade with calculations for trade size, stop loss etc. If you are new, don’t worry about these terms, they will be clearly shown in the example trade
(1) Identify the trend
Firstly, identify the overall trend on the currency pair. As explained above, if the 50-day Moving Average (the red line in the diagram below) is below the 200-day Moving Average (the green line in the diagram below) We have a downtrend, which also reveals on the chart as a series of lower ‘highs’ and lower ‘lows’:-
You can also draw in other moving averages such as 20 day or 100 day but the 200 day and 50 day moving averages are the main two for identifying the trend. The 20 day can add weight to the assertion:-
(2) Draw The Trendlines
Take the ‘straight line’ tool on the daily chart and draw diagonal trendlines onto the chart joining recent highs and lows over the period of two or more months. Draw them from the daily trade ranges, not from the bars themselves, but not all highs/lows will hit the trendlines but most will be there or thereabouts.
In our trade example diagram above (USD/CAD) the pinbar at the end is on the trendline of the higher high made around mid-march. The lower highs and lower lows made over the period of a few months confirms our downward trend.
(2) Identify the ‘Rally’ (downward trend) / ‘Dip’ (updward trend)
In a downward trend scenario, we are looking to sell the rallies in anticipation of the rally losing momentum and continuing the downward trend, so, we are looking for AT LEAST three daily buyer bars (green bars, or blue bars in the image above, that closed higher on the day than they opened).
We can see in our example trade that we have 4 buyer bars before our pin bar reversal day.
(3) Wait for the ‘Pin Bar Reversal’
Once we have identified our rally, we are waiting to see two things in the rally:-
(1) 3 consecutive buyer bars/days. i.e. 3 days where the price went up.
(2) the subsequent day showing us a ‘pin bar reversal‘ i.e. a bar where the open and close price is in the lower third (or half) of the bar (regardless of it being a green bar or a red bar).
NOTE: When we say ‘bar’, this is simply the range of prices traded on the day.
We can see in our example trade that we have our pin bar reversal day.
The ‘pin bar reversal‘ is a signal that buyer momentum is leaving the market and signals the end of the rally and a return to the downward trend that can be traded with a sell trade.
In our current example sell trade (USD/CAD) the red arrow below marks our pin bar reversal…
Ofcourse, the converse applies to the upward trend with a bullish daily bar ‘signal’ (open and close prices in the top third of the daily bar) after at least three ‘seller bar’ days, but I will cover this in the Buy trade example below.
Strictly speaking you is doesn’t necessarily have to be 3 consecutive days of buyer/seller bars. If other factors below check out then maybe 3 out of the last 4 days should be enough to actually place the trade.
(4) Draw Horizontal Lines of Support and Resistance
Pin Bar Reversal on ‘Hard’ or ‘Soft’ Level?
Hard and Soft Levels are horizontal lines drawn at the peaks and troughs on the Weekly and Daily charts over a longer period of time, from a year to maybe 5 years, 10 years, or even longer.
- Hard level is one that has been ‘respected’ during the past year. i.e. one or more peaks or troughs that have not been broken.
- Soft level is one that has NOT been ‘respected’ during the past year. These are usually drawn within Hard levels and will be respected sometimes but broken through at other times (i.e. not respected)
TIP: A quick horizontal line check on a ‘signal’ pin bar is to draw the horizontal bar at the bottom of the pin bar (if its a bullish/buy signal bar) and see if it has been rejected (bounced up from) before. If so, this is an indication of a support level and provides legitimacy for the bullish pin bar.
Both Hard and Soft levels, however, make strong points at which to trade a pin bar reversal, if the pin bar is at or very near the Hard/Soft level. In fact, if you see a pin bar reversal at either of these levels which is also confirmed by the smaller timeframe hourly check:-
* bearish formation for downwards momentum sell trade off of a peak
* bullish for upwards momentum, buy trade off of a trough…
… you do not need the additional ‘technical confirmation‘ trade checks (see step 8)
- Trend(line) Trade (without drawing horizontal lines): YOU NEED:-
Hourly Chart check+
TWO technical confirmations= Trade can be placed
- Hard/Soft Level Trade: YOU NEED:-
Hourly Chart check= Trade can be placed
(5) Identify the Trade Risk to Reward (Stop-Loss and Target)
In an ideal world, we would be looking for a large reward for the potential risk and these can be taken if the setup exists. Reward:Risk of 5:1 and even 10:1 can be taken but 3:1 is a happy medium whereby the probability of achieving the target is in the sweet spot which gives us enough of a consistent return on our trading.
Our trade example image above shows the Entry price, Stop Loss, and Target Price for the trade.
- Entry Price: Just below the pin bar reversal day range lower price
- Stop-Loss: Just above the pin bar reversal day range higher price
- Target Price: …is at the level of the previous ‘swing low’ level of ‘support’ (from which the rally started). If there has been no dip withing the rally itself then just set the target at swing low of the current rally)
The stop-loss is critical to prevent any losses becoming too large. Add the stop loss when you place your trade. The diagram below illustrates the long (buy) trade stop-loss scenario.
Calculate Reward to Risk
As can be seen on our main example trade diagram:-
Entry Price – Target Price (Reward = 245 pips)
Entry Price – Stop Loss (the Risk = 86 pips)
REWARD/RISK RATIO:- 2.8:1
(6) Identify the Trade Size
As can be seen in the full image in step 1 above, we have a fictional trading account size of £10,000. So if we risk 1% on each trade (£100) divided by our risk of 86 PIPs, we place the sell trade at £1.16 (per PIP).
If the trade goes against us and we hit our stop-loss then we loose the £100. If the trade goes in our favour and we hit our target, then we make a profit of £280.
(7) Hourly Chart Confirmation
This is the main additional check and if you don’t see it then probably best to reject the trade. So, for our SELL trade setup confirmation, you can check for the bearish formation on the hourly charts. We are looking for a bearish pin bar reversal to confirm the trade. Either a ‘double top‘ or ‘head and shoulders‘ on the hourly chart:-
So for our example USD/CAD sell trade in this article, you would be looking for something like the below on the hourly chart, and then placing the trade when the neckline is broken
HEAD AND SHOULDERS ON THE HOURLY CHART
(8) Two additional Technical Confirmations (if Pin-bar not on ‘Hard’ or ‘Soft’ Horizontal level
(a) Fibonacci ‘Retracement’ Check
If you’re on the daily chart, select the Fibonacci tool and draw from the most recent major swing low to its corresponding swing high (in an upward trend, converse for a downward trend). If the pin bar is at or near the 0.618 level, it is a common level at which the price action will turn in favour of the trend.
The Fibonacci check can be strengthened by drawing from the previous swing low/high (from the one you have just drawn from) to the current swing low/high. If there is a rejection, in particular at 0.382 or 0.5 in addition to the 0.618 Fib check above, you have what is known as a ‘Fibonacci cluster’ and is a strong confirmation of the first Fibonacci level drawn to indicate a movement back to the trend.
In order not to make this article too long we have a separate article just on the Fibonacci trade check:- CLICK HERE (opens in new tab)
(b) Moving Average Bounce Check
If a pin bar is on or near the 20/50/100 day MA and previous price retracements towards the trend have ‘bounced’ off the same Moving Average level, it is an indication that the same retracement will occur with the current pin-bar.
(c) RSI Divergence
Is The ‘Relative Strength Index’ indicator showing divergence from the dominant price trend?…
(d) Weekly or Monthly pivot point?
(e) Do we have Cyclicity?
Is there a definite pattern of higher lows in an upward trend, which can be joined by a trend-line? Or lower highs in a downward trend, which can be joined by a trend-line?
(f) Big Number Check
Bouncing off a psychological round number? May even include decimals (.1, .5 etc)
(g) Hard/Soft Level Rejection
This is really just the same as the Hard/Soft levels covered above in this article…
(9) Place your trade
As I am trading the daily charts I might place my trade around 10pm GMT.
For our current downward trend scenario then, when the conditions above are met and you see the signal bar (pin bar reversal) you place the sell trade with stop loss just above the signal bar high (signal bar high + spread + 1 pip) and the entry (limit order) just above the low of the signal bar (signal bar low + spread + 1 pip):-
(10) Manage your trade
MANAGE THE STOP-LOSS
The stop-loss level can ‘trail’ your trade if the trade is going in your favour. This moves the stop loss in the direction of a winning trade in order to lock in gains.
Quit the Trade if…
IF THE TRADE HAS NOT BEEN TRIGGERED IN THE FIRST 24 HOURS, SCRAP THE TRADE
Manage the trade objectively. If the trade is triggered, Trail your stop loss as follows:-
Move the trailing stop loss on every second seller bar until you hit the target or are stopped out by hitting your stop loss
MOVE THE TARGET
The exit/target level can also be moved if desired, particularly if the trade is moving fast. As can be seen below, the initial target of the previous swing low was achieved quite rapidly. The trailing stop loss was moved as described above and then eventually stopped out for a good gain.
Strategy 2: The Breakout
‘Break out’ trades are traded most successfully in trending markets and occur when momentum breaks indecision in a ranging/consolidating market to bring price to a new level. As stated at the start of this article, ‘swing’ trading described above has a higher probability of trade success so for breakout strategies might be more for advanced traders.
The Break ‘Long’
If in an uptrend, we only want to buy or go ‘long’ until we reach our target price.
- Look for tightly ranging bars where we can clearly define support and resistance.
- Only buy in uptrend, placing entry a few pips above the resistance level and stop a few pips below the support level.
The Break ‘Short’
Only sell in downtrend, placing entry a few pips below the support level and stop a few pips above the resistance level.
Strategy 3 :Supply & Demand Strategy (Power Zones)
Trades on key levels of support and resistance. Lower probability of trade setup but higher reward than pin bar reversal when the trade is executed. There may be more losing trades than winning trades, but the winning trades tend to be big wins and is, therefore, can be a very profitable strategy…
These tend to be currency pair charts at multi-year high’s and lows and are supported by institutional bodies such as central banks and therefore reliable.
Managing the Supply/Demand trade, we trail the stop loss every 100 PIPS the trade goes in our favour. So in our example above, we move the stop loss up to 9467 if the price hits 9505.
Choose one strategy initially and go with it. I will be using the Pin Bar Reversal strategy. Initially, the simpler the strategy the better!