Trading the rainbow

16 September 2008 (15:37) | Journal | By: Colin McGinley

I occasionally listen to Rob Booker’s Trader Radio broadcasts. A couple of months ago, Josh, one of the regular contributors and a trader who works in the same office as Rob stated that he traded off 5 second charts. I thought he was completely nuts.

The only other snippet I remember from the exchange was that he was able to rack up a sizeable trading history in a very short time due to the incredibly compressed timeframe from which he was trading from. He was able to accumulate statistically significant trading records in days and weeks rather than months. This meant that a change to a trading system could be verified as being beneficial, ineffective or detrimental in a relatively short span of time.

About two weeks ago I was aimlessly browsing the Forex Factory threads killing some time. These days I very rarely latch onto anything that is touted or debated on forex discussion forums. The signal to noise ratio is so low that it is more often than not a complete waste of time.

On this particular day something shiny caught my eye. Intrigued, I dug a bit deeper.

What had gotten my attention was a scalping approach that was incredibly discretionary. Along with some basic rules which I’ll detail in a minute, the evangelist of the system, going by the moniker of LinuxTroll, recommended trading on 5 second charts. It was probably this facet of the approach that hooked me into looking at the method further. Was this the approach that Josh was trading?

In my early trading days I spent plenty of time looking at 5 and 15 minute charts. I never even seriously contemplated scalping as brokers at that time were notorious for making sure that traders did not scalp. The brokers obviously needed several seconds to match up or offload a new trade and thus were not happy if you traded in and out of a position before they had hedged themselves successfully. If you got tagged as a scalper the broker would require all your trades to be manually vetted. This obviously resulted in massive slippage which destroys one of the key edges of being a scalper.

Over time my trading time frames moved up. I began to view the shorter time frames as pure randomness. A chaotic vortex where it is all but impossible to harness an edge.

I am now looking to seriously re-examine that belief.

Let’s examine the basic setup for scalping that LinuxTroll recommends:

  • Pick one currency pair and focus solely on it.
  • Identify and trade during a short time window.
  • Add the rainbow indicator and monitor the chart using a timeframe less than 30 seconds.
  • Identify the direction of the current move you see on the screen.
  • Scalp – enter and exit trades quickly using substantial but not excessive leverage.

Now I’ll detail how I’ve approached each of these criteria.

I have chosen to focus on scalping EUR/JPY. It is a more volatile pair than the EUR/USD pair that I normally trade which can bring both pros and cons to scalping. Bigger moves can lead to larger profitable trades but it also means larger adverse moves.

I have attempted to trade both short and long term strategies on the same currency pair before and it was never something that I was comfortable with. In evaluating scalping I knew that I had to pick a different currency pair. EUR/JPY along with GBP/JPY are often recommended for scalping. Since I have more experience monitoring the euro currency I have plumped for EUR/JPY.

When trading such an exceedingly short time frame you must be focused on every move that the market makes. If you watched every tick eight hours a day I’m sure you’d go crazy. It is much better to give the markets your undivided attention for a short, specific period of time. If you’re only going to be trading for a brief time then it makes sense to pick a period when prices are likely to move. The various market opening time periods are thus prime candidates to consider.

Since I’m based on the East coast of the United States I have to immediately discount the Frankfurt and London opening hours as I like sleeping an uninterrupted sleep. That effectively leaves the Tokyo and New York openings. The Tokyo open normally overlaps with the end of my working day, commute home and evening dinner. I can’t guarantee that I’ll be able to be in front of a computer to trade. So the New York open it is.

Having picked the New York open I started to trade from 6:00 to 7:30 EST. I felt it might be most beneficial to be able to get up and trade first thing. After my trading was done I’d be able to get on with the rest of my morning. What I have found out very quickly in the past 10 day is that the market is effectively dead between 6:00 and 7:00 EST. The Asian traders are gone for the day and the European traders are seemingly out for lunch. This leads to a listless, rangebound market. Not prime scalping territory.

I have thus switched the time I’m actively trading to between 7:00 and 8:00 EST. I’m not sure if it’s because the Europeans traders are back at their desk or the early risers in New York have made it into the office but movement is definitely better during this hour.

Since it was the pure craziness of hearing that someone was trading from 5 second charts that is the time frame that I have decided to scalp from.

The form of scalping that I am trying out is often called rainbow scalping due to the indicators that are added to the chart. A slew of WMA (Weighted Moving Average) lines with periods ranging from 1 to 156 in increments of 6 are colour coded to produce the rainbow effect. I’m not a huge fan of indicators in general, especially ones that are used to generate buy and sell signals. The rainbow is primarily used to determine the strength and direction of the current trend. It is thus not an affront to my indicator sensibilities and I am keeping it on my charts for the moment to see if I can derive additional benefits from its presence that long time users champion.

I seem to primarily focus on price action and thus the rainbow indicator acts as support or confirmation of any trading decision I might make. While the rainbow with its various moving averages presents a colourful picture of any unfolding trend it is just as easy to spot that trend with the naked eye given enough screentime and experience.

With all these pieces of the puzzle in place it is then up to the individual trader to determine their own entry and exit criteria. In such a fast moving timeframe it is imperative that any such criteria are simple. I’m a big fan of keeping things simple.

The key to the whole approach is spending enough screentime observing and learning the movements of your chosen currency pair during the timeframe you’ve picked so that you can select and hone the simple trading criteria that work best for you. You only need to have a couple of setups in your trading toolbox. After that it just comes down to patiently waiting for those setups to appear and executing your trades.

I’m excited about giving this style of trading some serious time and energy. It might ultimately not be suitable for me but I think it’ll be a hugely rewarding experience either way. It gets me out of the trading box that I have been in for a long time now. I’m still continuing to trade on EUR/USD using my more long term approach but I think it’ll be very educational to rip up the rulebook from that style of trading and try something totally different.

Probably the only persistent concern I have is how this might affect my discipline. On the one hand, flailing around trying out different systems shows a definite lack of discipline. While I haven’t gone to that degree, even just trying out a new system shows a certain lack of discipline. This is especially apparent and noteworthy when my main, longtime trading method is experiencing a drawdown. The temptation is always there to just chuck it in and try something different. To temper any discipline schism it is important to remind myself that I’m going to have to demo any new method for a considerable period of time before even contemplating going live with it – three months of consistent profits at a minimum. Even when going live I would want to start small and slowly bump up to any decent sized trades. My EUR/USD trading method is going to have to pull in the bacon for quite a while yet, and there’s no reason why it couldn’t continue to function if I decided to go live with a scalping approach.

On the flip side, learning to scalp might even significantly enhance my discipline. Patience, decisive decision-making and fast action are all critical components of scalping. Hopefully coming to grips and mastering these skills at very short time frames will aid me when making longer term trades.

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Comments

Comment from FX
Time 2008-09-17 at 04:32

I’m following your blog for quite some time now. Didn’t comment because I trade very short term and your trading methods so far were just only interesting for me. Now when you write about scalping methods here I come. I would be very interested in some trade screenshots if you care to share. I’ve saw before some of the forums with rainbow scalping but for my taste with too little charts and setups. Mainly they say just watch and put in screen time to define your setups.
I trade using mostly 1min parallel with 10sec charts. For me it’s too hard to focus only on sub minute t/f because 1min and 5min give overall picture where are points of acceleration for b/o or bounces.
If you want check out my blog please do on http://forexintradaytrading.blogspot.com/ I put screenshot for like every trade I do.

Comment from Colin McGinley
Time 2008-09-18 at 15:26

I’m sure I’ll be posting plenty of screenshots when I start to record my trades. For now I’m just trying to lock down the patterns and setups that I want to focus on.

Comment from Jaymanicus
Time 2008-09-28 at 21:43

I was a scalper before I became a swing trader. Occasionally, I try scalping methods just to see if they work. So far I haven’t found one that works for me, but in practicing I’ve noticed that I have improved in very specific skillsets. They are mainly related to cognitive speed, coding and pattern recognition. And it’s a lot of fun besides. Lemme know if you’re interested and I’ll send you some of my trading journals from that time. (I have also sent them to FX above.) Scalping is one of the best ways to develop a mental map, or a heuristic map if you will, of the instrument traded in a way that longer time frames cannot. But I suspect that you already know this.

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