Now that you've looked at deconstructing a pattern, we're now going to discuss pattern selection. Pattern selection will help you to nail down what is most important to being a competent pattern trader. As with most things, there is an 80 – 20 rule where as 20% of what you learn here will provide 80% of the results. In other words, there are a few key components that we must select to focus on to decide whether a pattern is worth trading.
Advanced selection will help you decipher what is important versus what is not important. While this may sound simple I can tell you from many years of live trading experience as well as discussing trading in real time with traders every week that a lot of traders unintentionally as opposed to more important ideas, which we will discuss.
The Low Hanging-FruitIt is not uncommon for traders to want to force a trade even if the probability of the move is low. What makes a low probability trade? Simply put, when the two currencies that are in focus for the trade are either collectively week, collectively strong, or in the middle of the pack it would be a mistake to expect a big move. Rather, we should look for low hanging fruit to trade.
So what does fruit have to do with trading, you may ask? Finding the low hanging fruit is the idea of taking a present imbalance in the markets and expecting that imbalance to continue.
You were recently introduced to finding the strong weak currency pair to trade. We will expand this idea into buying stronger currencies relative to weaker currencies and then applying your timing methodologies of technical analysis or pattern analysis.
Hedging Overconfidenceover the years, finding strong currencies to buy and selling them against obviously weaker currencies has proven to be a favorable approach when compared to blindly buying or selling a pair regardless of its relative strength.
However, a trader should not presume the relative advantage will stay forever as markets ebb and flow over time and last week’s strongest can turn into next week’s weakest. This means we need to learn how to hedge overconfidence.
This is nothing different than what hedge fund managers do who manage multiple asset portfolios. Naturally, they’ll enter a trade when an edge is evident or and assets is priced considerably below book value due to mass irrationality by market participants. But these advanced market participants understand that while an entry is important, the edge must remain such that they don’t find a cheap asset getting cheaper or their edge completely dissolving. What many traders find helpful is implementing a weekly review.
Weekly ReviewsA weekly review is a simple approach of analyzing the fundamentals, technicals, and the sentiment or positioning analysis of the market you’re trading. In spring of 2015, the fundamentals that drove the long USD trade that many market participants were in began to deteriorate. This was seen through week GDP readings, retail sales, and deteriorating consumer sentiment reports.
When looking at the technical picture, a trader can get as simple or advanced as they choose.
A simple approach could be looking at a moving average acting as support in an uptrend or resistance in a downtrend. A more advanced method could be utilizing complex technical tool like Ichimoku or Elliott wave. Either way, price is the ultimate indicator in the printing of price is one of the few facts in the market and when the price disagrees with your analysis or edge it’s often time to bow out.
When looking at sentiment, volume or positioning analysis, a trader is looking to see whether or not the market is loading into the position or exiting the position. Volume is a simple visualization of what direction the market is favoring.
When volume shows a breakout relative to prior volume against your trade you likely want to shorten the leash because enthusiasm is building on the opposite side.
Selecting the right market can take a lot of trouble out of the trading process but it is no magic cure. Risk must always be managed and you should review your edges to ensure they are remaining in your favor.
Happy Trading!
