Welcome to my Masterclass.
In this lesson you will learn what the foreign exchange market is all about and how we are able to take advantage of the worlds biggest exchange.
Anticipating market sentiment
There are four phases to any asset-class market cycle:
You will find these stages in any asset-class, wether it be forex, stocks, bonds, futures or even real-estate. But before we dive into the reasons why these four phases exist and what they tell us, let's first look at why price moves at all to begin with.
When trading any market we are seeking volatility, because without price moving up or down we cannot make any money. In forex specifically, there are only two ways for a currency pair to move up or down. Remember how a currency pair is comprised of a 'base' and a 'quote' pair? EUR/USD for example, where EUR is the base pair and USD is the quote pair.
For it to go up, the base pair has to be stronger than the quote pair, or the quote pair has to be weaker than the base pair. EUR/USD will rally if the Euro is stronger than the USD that is obvious. But it will also rally if the USD if weaker than the Euro.
This means the EUR/USD exchange rate will fall if the Euro is weaker than the USD, or the USD is stronger than the Euro. The biggest moves will occur when the base currency pair is strong and the quote currency pair is weak, or vice versa. This leads to high volatility moves, where you see price skyrocketing or plummeting on the chart.
If both are equally strong, the pair is in balance or equilibrium and price will move sideways. But even if the Euro is strong and the USD is weak, causing the EUR/USD pair to rally, it cannot go up forever. What goes up must come down eventually, and there are four different stages to what is called the 'market cycle'. Throughout this chapter we'll be using the EURUSD as an example to illustrate our points.
WHY DOES PRICE MOVE
So now we understand the underlaying principle of why price on any given currency pair can go up or down. But why does it actually move? It moves because traders are taking actions upon these 'fundamental' differences in strength between economies. Simply put, they buy the EURUSD when the outlook for the Euro is better than the outlook for the USD. And because traders are buying the Euro (and thereby selling the USD), the price of the pair EURUSD will go up. It is that simple. Traders buying a specific currency pair will cause it to move up in price, and traders selling a specific currency pair will cause it to fall in price.
The same goes for all kinds of products. Say a new law in London prohibits cars to enter the city center. This will lead to people selling their cars and buying electric bicycles for instance. Because everyone is selling their car, prices of cars will fall as there are many to choose from, and no-one is looking to buy one. Prices of bicycles on the other hand will rise, as there are many people looking to buy one and there are only that many available right now.
Now coming back to the four phases of a market cycle, let me explain in more detail how they can be detected, what they mean and how they should be treated. As an example we'll use a typical chart of how market prices for properties fluctuate and cause market cycles, as this is to a large extent exactly how all asset-classes behave.
ACCUMULATION PHASE (Recovery Phase)
After a prolonged period of time where property prices have declined, for instance during a recession, prices seem to stop dropping any further. Occasionally a property is being sold for more than it was for previously during the decline. The demand for houses is increasing and not as many people as before are looking to sell their house.
As this cycle continues, slowly the demand is increasing the supply and prices of houses are slowly beginning to creep up again. In this phase prices are not out of control and going through the roof. Investors and smart money is seeking to buy properties cheap, in anticipation of prices going higher mid term.
MARKUP PHASE (Explosive Phase)
The negative market sentiment has gone. Prices are steadily rising and the demand for properties is by far outnumbering the supply. As prices are surging, more and more people are interested to sell they properties as the demand is hot right now and people are expecting to get paid top dollar for their homes.
This cycle continues until the prices of properties are so high, that increasingly more and more people are unable to buy a new home. As the demand decreases prices are beginning to stall.
DISTRIBUTION PHASE (In between Explosion and Recession phase)
Prices are no longer increasing and the demand for homes equals the amount that are being offered. Home owner still try to get top dollar for their houses, only to find out the market is not that hot any more and homes are now being sold under asking price.
Market sentiment is shifting and home owners that have listed their homes are beginning to feel fearful that the market will start to decline, and the value for their asset (home) will decrease. To make sure they will not have to sell when prices drop very quickly, they decide to lower the price of their property just slightly, in order to sell it quickly.
DECLIING PHASE (Recession Phase)
People that have their home for sale, start noticing prices are dropping quickly. They now too are afraid of a hefty price drop, hence they lower their price as well. This creates a snow ball effect, resulting in prices being lowered across the board for properties.
Market sentiment is now full on negative. The demand has disappeared as prices continue to drop. Potential new home buyers want to wait out this steep decline, until the market stabilizes again. Properties that are still on sale are being stunt priced by their owners, just to get rid of them before getting into debt.
At the end of the decline prices seem to have stabilized somewhat. Most people that listed their properties got rid of them and the supply is decreasing. New buyers are noticing that prices are no longer falling, and decide this might be a good time to buy. This is where the Distribution Phase starts again and the whole cycle repeats.
THE FOUR PHASES TRANSLATED INTO TRADING
When we speak about market phases in trading, we are able to identify in what market cycle a currency pair is currently in. As you can imagine we don't want to be trading in a distribution market cycle with a strategy that is build to work in a 'Markup Phase'. Such a strategy is build to buy low and sell way higher. In a distribution phase prices have leveled out and are pretty steady. During this phase you will not be able to make any money using such a strategy.
With the four market cycles still fresh in our minds, lets look at what five trading phases we can identify:
In an uptrend buyers are piling in to buy the EURUSD expecting it to go higher, hence price moves up. Traders will eventually take their profit and sell their position. Where there are clusters of sell orders, and traders are unloading their position for a profit, price begins to stall or decline. When other traders see this halt in price, they might also decide to liquidate their position, causing even more sell orders to come through.
After each leg up, there will be a balancing (consolidation) phase where buyers are selling their position for a profit and price will decline slightly because of it. After price has fallen, new buyers (who perhaps missed the first run up) think price has come back far enough so that they can get in cheap, expecting it to move up again. Once the majority of sellers have unloaded their position and the buyers are taking over again, the second leg up begins, pushing prices even higher. The impulsive leg up is called a 'Impulse' and the balancing phase is called a 'Correction'.
In an uptrend price is making higher highs, and higher lows.
A downtrend is the opposite of an uptrend. The impulses are pushing price down and the correction is caused by traders unloading their short positions. As you know, a short trade is covered by buying the position back. Whenever clusters of traders cover their short positions, price will stall and possibly rally in the opposite direction for a short period of time.
In a downtrend, price is making lower lows and lower highs.
The consolidation phase occurs after an impulsive move up or down. It is a 'cool-off' period where buyers or sellers are unloading their positions and new buyers or sellers are stepping in. Although the overall direction of the market is quite clear, it is uncertain if price will continue to rally or sell-off in the short term, hence price seems very indecisive. Only when price impulsively breaks the previous high or low, the trend continues. Or, price impulsively breaks the consolidation price pattern counter-trend, which can signal the start of a reversal in overall direction.
There are three consolidationpatterns that we at FXCLUSIVE™ will focus on:
We will get into great detail what these price-action patterns mean and how we trade them in our Technical Analysis chapter.
Take a look at this 4 hour chart of EURCAD. It is not oscillating predictively nor does it trade in a range by the look of it, right?
Let's zoom out to the daily chart and see if we can make any sense out of this price action.
We can see that price broke a key support level and impulsed down. After the impulse, price decelerated and created a descending channel whilst approaching the next support level. The channel you see drawn on the daily is actually the price action from the image above on the 4 hour chart. See how by zooming out we can make "sense" of the "consolidating" price action?
In a choppy market the overall direction of the market (a specific currency pair) is not clear, and price just seems to bounce around without any clear direction. Traders call this a "choppy market" or "choppy price action". This is a market we stay out of, until the pair chooses a clear direction with confidence (impulses out) and starts trending in one way or the other.
You might ask yourself, what is the difference between a choppy market and a consolidation period? The answer is that in a choppy market there is no clear trend visible when looking back several days or weeks. Price is not oscillating higher or lower but instead is just bouncing around erratically. When it comes to a consolidation period, you can clear identify that price is oscillating very predictively upwards or downwards. After each impulse up or down, price cools off for a bit, only to resume in the prevailing direction of the trend once the previous high or low gets broken. When you zoom into a consolidation phase price might seem choppy, but when you zoom out you can clearly identify the direction of the market. With a choppy market you cannot.
Take a look at two choppy price charts. Even if we zoom out, price did not create any pattern that could leave a clue what price is going to do next. Therefore we do not have a clear sense of direction and we leave the pair alone until it starts trending or forms a larger price pattern that can be broken to the upside or downside.
It is more important knowing when NOT to trade, than it is when to trade. Trading is all about patience and letting the best setups come to you. Never do we force a trade when the market is just unpredictable. This could mean that during a month we only take 2-3 trades. We've had periods of two weeks without any trades and that is perfectly fine. Because when the market starts moving again, opportunities will be plenty. We just have to be cautious not to overtrade, and give all our gains back to the market, when the market is providing us with the signals we are looking for.
Whenever price moves impulsively in one way or the other, price movement will cool-off and consolidate. In a clear trending market this cool-off period will take anywhere from 3-8 days in general when trading on the daily chart, before price resumes it overall direction. But sometimes price likes to 'hang-around' for longer before traders make up their mind and choose wether price continues its overall direction or price reverses.
When price is consolidating and is oscillating between two easily identifiable levels (highs and lows), price is 'range bound'. Every time price hits the last high, it comes down straight away and every time it it hit the previous low it rallies back up.
When previous lows and highs are respected at least 2 times, we identify such a market as range bound. Traders have identified that whenever price approaches the latest swing high, it will sell off. Because all traders can clearly see this, they act in the same way, fueling the self full-filling prophesy that is trading.
None of our strategies are traded inside a 'range bound' market. But eventually price will break out and that's where our strategies thrive. The longer price stays within a range, the greater the burst out of the range bound structure will be. You see, as price continues to bounce off the highs and lows, the more traders will start piling in to make money on these predictive moves. Let's say price has moved off the highs for 5 times in a row now and has just bounced off the lows for the 5th time as well. Many traders will expect it to bounce off the highs for the 6th time, and place their short (sell) orders at the recent highs once more. But this time "smart money" uses this knowledge to their advantage. As price goes up and once again reaches the recent highs all the sell order of the retail traders will get filled. The smart money will inject a huge amount capital to push price up, far beyond the recent swing highs and higher than our retail traders were expecting.
As they are now holding a losing position they are forced to cover their short order. This means when they liquidate their position, their broker will buy back the position for a loss. This has the same affect as buying the position in the first place. Hence, smart money has bough the market to push prices higher with a lot of volume, and short sellers are covering their position which equals buying as well. This creates a snowball effect, a flood of buy orders pushing price way beyond previous highs. At this time one of our strategies will be armed and we will look for an entry. We do not trade with the dumb money (i.e. retail traders, but piggy back off the smart money i.e. investment banks, hedge funds etc).
The four market cycles can be summarized into two categories:
Trending: uptrend and downtrend
Indecisive: consolidating, choppy and range bound
We make money trading off clear trending markets, as well as whenever price breaks out of an indecisive market with conviction. How we do this we will explain later in this course.