Crazy Candlestick Pattern

I just thought I'd point out this rather rare candlestick pattern from last week's EUR/USD daily charts. This unusual creature emerged on May 29, undoubtedly in response to some piece of news I wasn't paying attention to at the time:


What you're seeing here is a 100 pip range, and a closing price just 1 pip above the open. In candlestick parlance it looks like a Doji Star to me, or possibly a very narrow Spinning Top. This is just about the clearest illustration of market ambivalence and uncertainty you'll ever see: the price aggressively testing both short and long directions and then settling back within 1 pip of where it all started. The upper shadow is also substantially longer than the lower one, and you can see how the next day the price headed lower in response to such a dramatic failure to make any progress upwards.

This is also the perfect illustration of an intraday whipsaw or range-based trading opportunity. If you had your stop-loss set at a safe distance and your limit order at a modest, realistic exit point, you could've made money on either a short or long trade. But I wouldn't plan on one of these showing up on a regular basis.

Hoping for Whipsaws

Strange as it sounds, my current trading system has me looking forward to days with extreme price swings, or whipsaws, which I used to anticipate with dread. The key to this change in perspective was shifting my strategy from primarily trend-based trading to a system that looks for profits in ranging behavior as well. The result is that a whipsaw no longer looks like one of the nastiest patterns on the chart, but instead is a potential opportunity to grab some easy pips as the market swings within a semi-predictable range.

One essential part of my whipsaw-friendly strategy is a take-profit target of just 33% of the previous day's trading range in whatever direction I place the trade. Using a fairly modest limit order like this dramatically increases the chances that a wildly ranging day will also be a profitable one. By combining this take-profit strategy with a significantly wider stop-loss, my trades also allow for swings in the wrong direction that reverse and come back around to hit the take-profit a lot more often than they're taken out by the stop-loss.

Whether this strategy will work over the long-term is still an unanswered question (just like it is for any trading system) but results in both backtesting and live trading so far look good. I'll provide a periodic update on how the system's working (or not working) after it's logged some more live trades. Now bring on the whipsaws!

Home, Home on the Range

If you've watched the forex markets for any length of time you've probably noticed that they spend an awful lot of time in ranging activity, ping-ponging back and forth between support and resistance levels without breaking above or below them. So if you've come to forex expecting high drama every day, it's a good idea to adjust your expectations and get as comfortable with range-based trading as you are with the trend-following strategies that are often assumed to be the most profitable. Because if you have a trend-oriented mindset and keep looking for price breakouts that don't materialize, you're going to be (a) disappointed and frustrated (b) losing more money than you make.

Advantages of knowing the likely trading range and trading within it are:

• You'll tend to place more conservative, higher-probability trades.
• You'll have a realistic sense of where to place your stop-losses and limit orders.
• You'll be able to make money from the kinds of whipsaws that could otherwise prove very costly.
• You won't be as bored by ranging price behavior because you'll accept it and even expect it as a normal state of the markets.

Here's a chart of some ranging activity from the week of March 21-26 that could've proved challenging to the trend-following trader and profitable for the ranging strategist. Looks kind of like a giant, week-long whipsaw, doesn't it? Depending on your trading mindset, this could be a very pretty or a very nerve-wracking picture:

Of course, forex markets do move in trends as well as ranges, and being able to switch to a trend-based strategy quickly will be a key factor in developing a consistently profitable trading system. Let's say you currently have a range-oriented trade in progress, and all indicators are suddenly pointing to an emerging trend. What do you do? First off, if you're on the wrong side of the trade, don't panic - the best strategy may be the simplest, just letting your current trade end however it's going to end based on your original parameters, and then place your next trade based on the new market conditions.

If you're lucky enough to be on the right side of the trade and you've got a limit order placed at a point of likely resistance (and it hasn't been hit yet) move it outward in regular increments in the direction of the trend, thereby increasing your potential profits. You'll also want to move your stop-loss up, maybe even setting it at the break-even point so at the very least you won't lose money. Also consider switching to a trailing stop-loss that will follow the new trend up as far as it goes, locking in profits all the way.

And after that? Be ready to shift back to your range-based trading strategy. Following a dramatic market trend you'll often find yourself back home on the range - and that's not necessarily a bad thing.

Improve Your Trading Odds - Aim Lower

One of the simplest ways to improve your odds as a trader is to get less greedy. Leave more potential money on the table and satisfy yourself with a smaller profit after each trade. After a bad run of trades in ranging market conditions, I've switched to a take-profit strategy that aims for just 33% of the previous day's trading range. It's far more likely to make money off of a whipsaw than my previous approach, and in combination with my signal flipper I have high hopes it'll improve my profitability and trading consistency over time. I can't exaggerate how much a run of bad trades can affect your confidence - but fortunately adjusting your goals and strategies, and seeing them work, can really help bring it back!

Risk/Reward Ain't Always What It Seems

It's very easy to get caught in the illusion that a tight stop-loss and a generous take-profit/limit order are going to earn you profits in that ratio. You know, setting your stop at 20 pips, your take-profit at 50 pips, and waiting for those consistent profits to start rolling in. This is a newbie error I made plenty of times before learning my lesson. What I've found since then is that a very generous stop-loss and a conservative take-profit strategy is often more consistently profitable.

A case in point: I'm currently running a GBP/USD trading system that features timed exits of around a week, take-profit at 100 pips, and stop-losses set at 300 pips. Yes, 300 pips. Sounds a bit weird, I know, but the key here is that those stop-losses almost never get hit. What's far more likely is that the price will advance 100 pips in that week, or the trade will time out if it doesn't (and sometimes with a profit). In fact, I could probably run the system without a stop-loss at all and the results would be similar, thanks to those timed exits - I'll have to backtest that notion soon, though the idea of trading without any stop-losses makes me nervous.

In general I've found that stop-losses work best for me in extreme emergencies, when the market is acting wilder than usual and hence could lose me more than usual. So for my trading style it makes sense to set them at the outer limits of the likely trading range, rather than squarely in the middle of the range where they're likely to get hit by a whipsaw or retracement.

Whipsaws and Fake-outs

Some of the most frustrating and costly market phenomena a trader is likely to see are whipsaws and fake-outs. Actually these are pretty much the same thing, with the difference that calling it a fake-out attributes a negative intention to the market, essentially accusing it of messing with your head. And a whipsaw or fake-out can indeed have a serious impact on your confidence in yourself and your trading system. If you spend your days looking for price break-outs and trends and instead you get a string of these nasty up-and-down spikes, you may wonder why you got into trading in the first place. The past couple weeks have been a vivid case-study in whipsaws and fake-outs, which is why they seemed like a good topic for today.

So what is a whipsaw/fake-out, exactly? It's a point in the market where the price moves dramatically up or down, and in the early stages may look identical to the start of a new trend. Then, instead of continuing the trend or leveling off, it'll suddenly dive back down (or up, in the case of a downward spike) to a price close to where it started. If you've watched forex charts for any length of time, they've almost certainly crossed your path. But if you're new to the currency markets, or aren't sure exactly how to spot one, here are a couple from the past week's EUR/USD market.


What causes them? Well, almost by definition they are points when there is insufficient momentum in a particular direction to sustain a trend. Because market sentiment is ambivalent, divided fairly evenly between longs and shorts, the price is unable to continue its break-out and falls back to where it started. If you've placed your limit/take-profit orders at an optimistic price point in anticipation of a strong trend, you're likely to find the whipsaw comes nowhere near them and lands you back within a few pips of your entry price, and a few pips poorer thanks to spread costs.

The most dangerous whipsaws include price spikes in both directions, which after convincing you to place a trade in the direction of the first spike, then turn around and take out your stop-losses with the second spike.

If we broaden the definition a little bit, stop-hunting could be considered a type of whipsaw that's staged by a broker within their own trading platform with the specific goal of hitting their clients' stop-loss orders. If you see a whipsaw on your broker's charts but not on anyone else's, chances are you got stop-hunted.

That's not to say you can't make money on a garden-variety whipsaw or fake-out; I have no idea if it's possible during stop-hunting. If you're good at identifying markets in which they're likely to emerge (like the current one), you can adjust your trading strategy accordingly by placing your limit orders at levels closer to the entry price than you would in a trending market. You might also try combining these more modest limit orders with a tight trailing stop to help prevent all your profits evaporating when the price suddenly changes direction.

Or, if you're like me and find whipsaws and fake-outs too nervewracking, unpredictable, and costly to play with, you can work on filtering them out of your trading by avoiding market conditions when they occur. In my experience these tend to be in range-bound markets with low volatility and little notable economic news to fuel a true break-out. I'm sure someone out there is getting rich off these things, but it's definitely not me!