Forex Walkthrough

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Short Term - Memory Of Price

Is there anything more annoying than getting stopped out of a short trade on the absolute top tick of the move or being taken out of a long trade on the lowest possible bottom tick, only to have prices reverse and then ultimately move in your direction for profit? Anyone who has ever traded currencies has experienced that unpleasant reality more than once. The memory of price setup is specifically designed to take advantage of these spike moves in currencies by carefully scaling into the trade in anticipation of a reversal. Read on to find out how to use this strategy in your next trade.

The Strategy
The memory of price setup should appeal to traders who despise taking frequent stops and like to bank consistent, small profits. However, anyone who trades this setup must understand that while it misses infrequently, when it does miss, the losses can be very large. Therefore, it is absolutely critical to honor the stops in this setup because when it fails it can morph into a relentless runaway move that could blow up your entire account if you continue to fade it. (For background reading, see Place Forex Orders Properly.)

This setup rests on the assumption that the support and resistance points of double tops and double bottoms exert an influence on price action even after they are broken. They act almost like magnetic fields, attracting price action back to those points after the majority of the stops have been cleared. The thesis behind this setup is that it takes an enormous amount of buying power to exceed the value of the prior range of the double top breakout, and vice versa for the double bottom breakdown. In the case of a double top, for example, breaking above a previous top requires that buyers not only expend capital and power to overcome the topside resistance, but also retain enough additional momentum to fuel the rally further. By that time, much of the momentum has been expended on the challenge to the double top, and it is unlikely that we will see a move of the same amplitude as the one that created the first top. (To learn more, read Trading Double Tops and Double Bottoms.)

Determining Risk
We use a symmetrical approach to determine risk. Using our double-top example, we measure the amplitude of the retrace in the double top and then add that value to the swing high to create our zone of resistance.

Figure 1: The memory of price, EUR/USD
Source: FXtrek Intellichart

In Figure 1 the price pushes higher above the initial swing high of 1.2060, but cannot extend the upward move by the full amplitude of the initial retracement. We see this happen quite often on the hourly charts as well as daily charts. On the dailies, the setup will suffer fewer failures because the range extensions will be much larger, but it will also generate larger losses. Therefore, traders must weigh the advantages and disadvantages of each approach and adapt their risk parameters accordingly.

Rules for the Short Trade
1. Look for an established uptrend that is making consistently higher lows.
2. Note when this up-move makes a retrace on the daily or hourly charts.
3. Make sure that this retrace is at least 38.2% of the original move.
4. Enter short half the position (position No.1) when the price rallies to the swing high, making a double top.
5. Measure the amplitude of the retrace segment.
6. Add the value of the amplitude to the swing high and make that your ultimate stop.
7. Target 50% of the retrace segment as your profit. So, if the retrace segment is 100, target 50 points as your profit.
8. If the position moves against you, add the second half of the position (position No. 2) at the 50% point between the swing high and the ultimate stop.
9. Keep the stop on both units at the ultimate stop value.
10. If position No.2 moves back to the entry price of position No.1, take profit on position No.2, move the stop to breakeven and continue holding position No.1 for the initial target.

Rules for the Long Trade
1. Look for an established downtrend that is making consistently lower highs.
2. Note when this down-move makes a retrace on the daily or hourly charts.
3. Make sure that this retrace is at least 38.2% of the original move.
4. Enter long half the position (position No.1) when the price falls to the swing low, making a double bottom.
5. Measure the amplitude of the retrace segment.
6. Add the value of the amplitude to the swing low and make that your ultimate stop.
7. Target 50% of the retrace segment as your profit. If the retrace segment is 100, target 50 points as your profit.
8. If the position moves against you, add the second half of the position (position No.2) at the 50% point between the swing low and the ultimate stop.
9. Keep the stop on both units at the ultimate stop value.
10. If position No.2 moves back to the entry price of position No.1, take profit on position No.2, move the stop to breakeven and continue holding position No.1 for the initial target.

Short Trades
Let's see how this setup works on both the long and short time frames.

Figure 2: The memory of price, GBP/USD
Source: FXtrek Intellichart


Let's look at a long setup in GBP/USD, which begins to form on November 12, 2005. Notice that prices first rally but then begin to drop, setting up for a possible double bottom. According to the rules of our setup, we take half our position at 1.7386, expecting prices to bounce back up. When this setup is traded on the daily charts, the stops can be enormous. In the case of this long setup, the stop is more than 500 points. The amplitude of the counter-move up is 1.7907-1.7386 = 521 points.

A wide stop is necessary because a trader should never risk more that 2% per trade. On a hypothetical $10,000 account, the trader should never trade more than two mini lots which are 10,000 units where a one-point move is worth $1. This will already violate our "no more than 2% risk per trade" rule because the total drawdown will exceed 7.5% if the setup fails (521 points + 260 points =$780 or 7.8% on a $10,000 account). You can compensate for this risk by toning down the leverage if you are trading the memory of price strategy, although the high probability nature of the setup allows us to be more liberal with risk control. Nevertheless, the bottom line is that on the dailies, leverage should be extremely conservative, not exceeding a factor of two. This means that for a hypothetical $10,000 account the trader should not assume a position larger than $20,000 in size.

As the trade proceeds, we see that the support at 1.7386 fails; we therefore place a second buy order at 1.7126, halfway below our ultimate stop of 1.6865. We now have a full position on and wait for market action to respond. Sure enough, having expended so much effort on the downside move, prices begin to stall way ahead of our ultimate stop. As the price bounces back, we sell the one lot, which we purchased at 1.7126, back at 1.7386, our initial entry point in the trade, banking 260 points for our efforts. We then immediately move our stop on the remaining lot to 1.7126, ensuring that the trade won't lose capital should the price fail to rally to our second profit target. However, on November 23, 2005, the price does reach our second target of 1.7646, generating a gain of another 260 points for a total profit on the trade of 521 points. Therefore, what could wind up as a loss under most standard setups because support was broken by a material amount turns into a profitable, high-probability trade.

Now let's take a look at the setup on a shorter time frame using the hourly charts. In this example, the GBP/USD traces out a countertrend move of 177 points that lasts from 1.7313 to 1.7490. The move starts at approximately 9am EST on March 29, 2006, and lasts until 2pm EST the following day. As the price trades back down to 1.7313, we place a buy order and set our stop 177 points lower at 1.7136. In this case, the price does not retreat much more, leaving us with only the first half of the position as it creates a very shallow fake out double bottom.

We take our profits at 50% of risk, exiting at 1.7402 at 8pm EST on April 3, 2006. The trade lasts approximately four days, with very little drawdown, and produces a healthy profit in the process. On the shorter time frames, the risk of this setup is considerably less than the daily version, with the ultimate stop only 177 points away from entry, versus the prior example where the stops were 521 points away.

Figure 3: The memory of price, GBP/USD
Source: FXtrek Intellichart

Short Trades
Turning now to the short side, we look at the daily chart in the EUR/USD trading a relatively small retrace at the beginning of 2006 from 1.2181 to 1.2004. As price once again approaches the 1.2181 level on January 23, 2006, we go short with half of the total position, placing a stop at 1.2358. Prices then verticalize, and at this point the strategy of the setup really comes into play as we short the second half at 1.2278.

Prices push higher, beyond even our second entry, but the move exhausts before hitting our stop. We exit half of the trade as prices come back to 1.2181 and move our stop to breakeven on the whole position. Prices then proceed to collapse even further as we cover the second half at 1.2092, banking the full profit on the trade.

Figure 4: The memory of price, EUR/USD
Source: FXtrek Intellichart

In another short example of this setup, we look at the hourly chart in the USD/JPY as it forms a retrace between 8am EST March 29, 2006, and 8am EST March 30, 2006. The amplitude of that range is 118.22 to 117.08, or 116 points. We then add 116 points to the swing high of 118.22 to establish our ultimate stop of 119.36. As it trades back up to 118.22 on April 3, 2006, we short half of our position size and then short the rest of the position at 118.78. Prices do not trade much higher and by 10am EST the next day we are able to cover half of our short at 118.22. Just 10 hours later, at 8pm EST, we are able to close out the rest of the position for profit.

Figure 5: The memory of price, USD/JPY
Source: FXtrek Intellichart


This example illustrates once again the power of this setup on the shorter time frames. The small risk parameters and the relatively short time frames allow nimble forex traders to take advantage of the natural daily ebb and flow of the markets. Clearly this setup works best in range-bound markets, which occur a majority of the time.

When This Trade Fails
The gravest danger to the memory of price setup is a one-way market during which prices do not retrace. This is why keeping disciplined stops is so essential to the strategy because one runaway trade could blow up the trader's entire portfolio.

Figure 6: The memory of price, USD/JPY
Source: FXtrek Intellichart


In the preceding example, we see how the daily trend on the USD/JPY pair during the fourth quarter of 2006 reached such powerful momentum that traders had no chance to recoup their losses, and shorts were simply steamrolled. Starting with the initial entry on September 20, 2005, off the countertrend move at 111.78, we proceeded to short the pair at half position value, adding yet another half position seven days later on September 27, 2005, at 113.33. Unfortunately, prices did not pause in their ascent, and the whole trade was stopped out at 114.88 on October 13, 2005, for a total loss of 465 points ((114.88-111.78) + (114.88-113.33) = 465).

Conclusion
The memory of price strategy works well for traders who don't like to take frequent stops and prefer to bank small profits along the way. Although losses can be large when the strategy does miss, it can prevent traders from being stopped out of a short trade on the top tick or a long trade on the lowest possible bottom tick right before prices reverse and move in the trader's favor.

Pivot Points
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