ForexSpirit

When I was answering Naed’s questions yesterday in my Reader Q&A post, I was reminded of something I had written on the Moneytec forum earlier this year.

The thread was mainly discussing the book Bird Watching In Lion Country.

Someone had read the book, but didn’t seem to be able to extract cut and dry answers to seemingly routine questions that are covered in other trading books. If you want to view the relevant part of thread you can jump to it here.

The reader’s critique was stated as follows:
[Dirk du Toit's] book does not clearly answer simple questions like:

What do you mean by long term trend? How do you determine it?
When to enter into a position?
When to exit?
How to put stop losses?

I’m going to post my reply here as I feel it offers additional information in line with what I was talking about yesterday.

Here is my response:

I think part of the difficulty in a reader not being able to easily pick out answers to those questions from the book comes from being steeped in the exact entry and exit signals that are part and parcel of using technical indicators. If you’re used to having cut and dry, pin point entries as part of your trading plan/strategy then switching over to an approach that is more fundamental based can seem disconcerting at first.

Being a discretionary, fundamental trader means that the answers to all the questions are very much dependent on the personality of the person doing the decision making. With that in mind, the answers I give are obviously very biased towards my own trading method. Someone might have greater risk tolerance and so might use more gearing, or have a different viewpoint on certain underlying fundamentals and so have a different interpretation of the long term picture. There really is no right or wrong, just what works for you.

Let’s try and answer each of those questions:

What do you mean by long term trend? How do you determine it?
The long term trend is determined by the trader’s interpretation of the major macro economic factors from each of the two currencies that make up the pair that you are trading. I currently only trade the EUR-USD, and so I am primarily concerned with the macro economic factors that affect the US and the EU.

Long term also means viewing the trend you expect over the next year at minimum. My current view is that the dollar will continue to weaken, given the huge deficits and the increasing likelyhood that the Fed will cut interest rates at some point this year. The Euro zone is looking to stay at its current level of strength, with the ECB having the potential for further hike interest rates this year, possible up to 4%.

With these main factors in mind my long term direction is up on EUR-USD. On-going daily and weekly data releases and other factors will strengthen or weaken my long euro bias.

When to enter into a position?
When I say that this trading method is discretionary, I truly mean that. You can enter a new trade whenever you think the time is right. I will generally look to enter a new trade on any signs of euro bullishness. I’ll look to buy euro on continued euro strength. I’ll look to buy when euro makes a rebound after some dollar strength. I’ll normally watch news releases and buy on any euro strength that is seen from them.

How much I will buy depends on where price is within the median grid. The lower price is in the grid the more gearing I’ll use on any individual entry. The grid is normally broken up into four quadrants, each 100 pips in size. I will use a gearing of 4:1 in any made in Q1, 3:1 in a Q2 entry, 2:1 in a Q3 entry and only 1:1 if price is in Q4. [I have updated my gearing numbers since I first wrote this. I have listed my current gearing ratios here.]

I will use both market orders if I want to enter on the spot, or use limit orders if I want to buy any dips that develop in the near future while I’m not screen watching. I’ll generally use two marker levels per 100 pip range for where I place my limit orders, with them spaced 50 pips apart. What levels you use is not really that terribly important and is up to the individual. For example, if your favourite number is 12, you could use every 1.xx12 and 1.xx62 as your limit orders level. Or use the day of the month as your entry level basis.

The reason why that exact number is not terribly important is that the trading method is looking to profit from medium term moves (positions are generally held for several hours if not days). At the very short term price moves are essentially viewed as completely random, with price generally acting randomly plus or minus 30 pips at any given point.

When to exit?
I primarily use profit targets, with the target depending on which quadrant the entry was made in. Since one of the main tenants of the 4×1 method is regular small profits, I stagger my profit targets to take that into account.

On Q1 entries, I’ll look to exit 50% of these entries for 30 pips, 20% of entries for 50 pips, and the remaining 30% of entries for 100-150 pips. With entries in Q1 you are expecting price to gravitate back towards the median line, and so if your long term direction is correct, you will get the necessary moves to extract those 100+ pip moves. Since price can be rather rangebound at times, it is vital to take advantage of these scenarios and extract regular 30 pip profits.

With Q2 entries, I’ll aim for for 50% 30 pip profits, 20% 50 pips, and the remaining 30% for 50-100 pips.

With Q3 enties, I’ll aim for 70% 30 pip profits and 30% 50 pips.

With Q4 enties I’ll just go for 30 pips.

These are just guidelines that I use, and I will exit trades at market price if I feel that dollar bullishness is about to appear and put my trades into the red.

How to put stop losses?
Stop losses are definitely one of those things that will depend on the risk tolerance of the individual. The 4×1 method has you trying to hold trades through some severe dips, so that you give the market time to allow the long term trend to re-establish itself and return your trades to profit.

Obviously, this will not happen all the time, and the market can remain in a retracement or correction for longer than you can remain solvent. It is up to the individual trader to ascertain their own cut off point.

I generally have two guidelines on when to cut my losses. If a trade is 150 pips in the red then I will consider hedging the trade at that point. Sometimes I’ll do this, sometimes I won’t (generally because I like to keep things simple and hedging can act an extra layer of complication). If things progress to 200 pips in the red then I seriously start to look at the posssibility that the dollar strength will continue. If the dollar bulls have the market on the run then I have no problem in exiting my position for a loss. This generally means that trades entered in Q4 are under scrutiny in Q2, and Q3 trades in Q1.

The second main guideline is when the bottom of the grid is being tested. If the bottom of the grid is breached by price and the breach continues then obviously the grid is no longer really valid and needs to be readjusted. In this case, all open trades need to be examined and closed out if they no longer make sense given the new grid placement.

Given all of the above, losing trades are obviously going to be much larger than the daily small profits of winning trades. That is one of the main reasons of looking to have occasional 100+ pip profitable trades resulting from Q1 or Q2 entries. These large trades will be the main counterbalance to the occasional large losing trades. The daily small profitable trades that you grind out then become the trades that allow your trade balance to slowly rise over time.

Hope that helps in clarifying some things.

If it doesn’t, be sure to post a comment asking your question. I’m sure that if you’re not clear on something then there are plenty of others who are wondering the same thing too!