The goal of this lesson is to help you identify low-risk/high-reward trading opportunities.
You will learn to spot conditions where your trades will have ‘an edge.’
Remember, trading is about probabilities, so if you can have a systematic way of spotting good trades, it will help you win in the long run.
In this lesson, I’ll take you through several methods that you can use.
First, let’s take a moment to understand how this fits into your rules-based trading plan.
Where this lesson fits in a ‘rules-based’ trading plan
In the last two lessons, you determined how many trades you need to take and how much you will trade to meet your objectives.
You can access these lessons here:
In this lesson, you will learn to identify the ‘set-ups’ for your trades.
These are the factors that will give your individual trades an edge.
In the following three lessons, you will learn to time your entry, where to place your stop-loss and how to take profit.
Think of this as the market analysis step, compared to the next lesson, when you will plan exactly where to enter a trade ie. the stalking step.
So, what type of trades should you be looking for?
What type of trade you are looking for
You can use the methods in this lesson to identify opportunities where you can enter low-risk/high-reward trades.
You are not looking for trades that have a high win rate. Don’t fall for this trap.
Rather, you are looking for trades where you can take a small loss if you are wrong, and have the potential for a big win if you are correct.
Remember, Market Wizard Paul Tudor Jones suggests going for a 1:5 risk/reward ratio.
Legendary currency trader Bill Lipschutz suggests you need to work out how to make money if you are only right 20% of the time.
This lesson is not about finding trades that win all the time.
Run for the hills away from anyone who is promising super high (90+%) win rates.
They are likely using a strategy that does not use stop-losses and takes small profits, often adding to losing positions (called a mean reversion or Martingale strategy.)
These systems work great until they don’t and your account blows up.
In fact – it’s better to do the opposite and take lots of small losses, add to winners and let profits run as much as you can.
Ok, let’s get stuck into the different techniques.
Technical set-ups
Technical analysis is all you need to develop a winning trading strategy. In particular, short-term traders may focus solely on technical analysis.
The trading strategy I showed you at the start of this course was solely based on technical analysis.
Later you will learn a few key fundamental analysis methods you can combine with the technicals to help you develop high-conviction trading ideas.
This ‘combined’ approach has led to the most profitable trades of my career, as I traded them at a larger size and held onto them longer due to my fundamental conviction – even though the technical set-up was the same.
In this lesson, you’ll learn how to find three types of opportunities.
- trending (bull or bear market types)
- rangebound (sideways market types)
- contrarian (picking tops and bottoms)
Market types are the framework for when to apply these technical methods.
Remember, you don’t want to use the same approach for all market types, rather you should apply the correct approach for the market type you’re currently facing.
How to test your rules.
You should come away from this lesson with some ideas that you would like to test.
You then want to define these as rules.
Such as ‘during daily bear/bull market types, wait for a pull-back to the mid Bollinger Band and a reversal candlestick pattern.’
Next, test these ideas by looking at previous chart examples.
See how often your particular example occurs, if the trades move in your favour, and by how much.
If you think the idea has potential you can keep it in your plan for future testing once you have refined your entry and exit rules.
In a future lesson, I’ll cover a simple way for you to test your full trading system including all your rules.
Later, when you are live trading, you will track how well your trading system captures these opportunities.
Higher timeframe analysis
You may have heard the adage: ‘The trend is your friend.’
This holds true to this day.
I am always looking at the higher timeframe to identify the trend first.
For example, if I am trading on the daily charts, then I want to enter into trades that are in the same direction as the trend on the weekly charts.
To do this, I am simply looking at the Bollinger Band midline.
If the price is trading above it, then I consider it an uptrend. If it is below it, then I consider it a downtrend.
If I am day trading, I like to be entering trades in the same direction as the trend on the daily charts.
Alternatively, you can use the Supertrend indicator with the settings three and seven to find the longer-term trend.
Here at MarketMates, we’ve developed our own versions of these popular indicators, which we are happy to share with you free of charge if you use TradingView for your charting. You can get them both here.
Now let’s look at how to identify opportunities on the main timeframe you are trading.
Set-ups during trends
Once you identify a bullish or bearish market type, you can look for pullbacks in the trend, which are temporary price corrections within the overall trend.
You can do this using the following methods:
- Bollinger Bands: The middle band acts as a potential support level in uptrends, and resistance in downtrends. A pullback towards this middle band can signal a buying opportunity in uptrends and a selling opportunity in downtrends. You can use other indicators if you prefer as well.
- Support and resistance levels: These are price areas where the price has historically bounced off. A pullback that finds support at a key level can be a good opportunity for buying in an uptrend. Conversely, a pullback that meets resistance at a key level can be a good entry point for selling in a downtrend.
- Chart patterns: You can look for chart or candlestick patterns that indicate the trend is likely to continue.
Here is an example on EUR/USD of pull-backs towards the mid Bollinger Band, and candlestick patterns indicating a trend change.
This may seem relatively simple. The challenge is having the discipline to wait for the pull-back and then hold on when the trade goes your way.
In the next lesson, we’ll go through how to time your entry once you have identified the pull-back.
Set-ups for range bound markets
Rangebound markets provide some of the best trading opportunities, in particular, if they occur within a longer-term trend (as mentioned above).
This is my bread-and-butter approach to trading – which I call low volatility breakouts.
Here you wait for a sideways quiet market type, and then a breakout.
These present good opportunities as the low volatility expands into a strong trend – like a coiled spring.
Alternatively, you can trade failed breakouts.
In this instance, you are looking for key support and resistance levels at the bottom or top of a range.
In the next lesson we’ll cover exactly where to position your entry point to trade these set-ups.
Finding contrarian set-ups
Contrarian trades are when you buy or sell against the existing trend.
These provide lucrative trading opportunities as you can get in very early on a new trend.
The challenge is that trading against the trend can mean you get stopped out often, and you will likely have lower win rates.
To identify when it can be good to take a contrarian trade, you can use an overbought/oversold indicator.
When a currency is overbought or oversold and then starts to reverse, it can be an early indicator of a change in direction.
We have built our Market Type indicator to show when the market is overbought or oversold (as it often happens after bull or bear volatile market types).
Here is an example on EUR/USD.
You can also use the RSI or a similar overbought/oversold indicator.
Once you get overbought or oversold conditions you can now wait patiently for your entry point.
I have also found double tops and bottoms useful for finding contrarian opportunities.
These patterns will clue you in that the probabilities of a trend change have increased.
We’ll cover timing your entries for these contrarian opportunities in the next lesson.
Time of day
For day traders, the time of day can be an important set-up.
The markets act the same way at different times of day.
For example, if you are trading EUR/USD, breakouts and reversals often happen during the European and London market open.
This makes it a good time to trade if those are the opportunities you are looking for.
You may also limit yourself to trading at a certain time of day because of time constraints in your personal life. You can’t watch the markets 24-hours a day!
Fundamental set-ups
Fundamental analysis is the study of economic factors that impacts the price of the currency.
Unlike technical analysis, which can be used on its own, fundamental analysis is best used in conjunction with technical analysis.
While there are lots of fundamental factors that can be considered, for the purposes of finding trading opportunities, I find these the most important.
- upcoming news events
- market sentiment (the one BIG THING)
- interest rates and Central Banks
- risk-on/risk-off
Before we look at these four factors, it’s important to understand how fundamentals are priced in.
The market will price in fundamentals
Fundamental analysis can be tricky, as the market often ‘prices in’ the fundamentals, so when you get news you think is positive for the currency, it may actually go down.
This is because certain assumptions are sometimes already in play.
For example, if the market expects the New Zealand Central Bank interest rate to rise by 0.5%, and it only rises by 0.25%, the price of NZD may actually fall, even though the interest rate rose.
An art (or process) not a science
In my experience, using fundamentals in your trading is an art not a science.
This is because what is important often changes.
To deal with this ambiguity, you can treat fundamental analysis like a process.
Review each of the factors listed in this lesson on a weekly basis.
The goal of doing this is to develop ‘high conviction’ in a trade.
For years, I would write down a summary of these factors each week.
By the end of this writing, I would have a clear idea of what I wanted to focus on for the week.
I will also listen to analysts I trust for their ideas.
Sometimes this process would result in high-conviction trade ideas.
I would then wait for a technical set-up in line with my fundamental conviction before entering the trade.
Upcoming news events
The trading week will be peppered with data releases and other news events, some more important than others.
For example, news events could be:
- interest rate announcements
- speeches from officials
- economic data releases (such as GDP, non-farm payrolls (NFP), or employment numbers)
- major policy or election announcements, like Brexit
You can look for news events in the week ahead that are likely to move the market.
These are often easy to identify as most forex calendars will list high-impact events.
Alternatively, market analysts write free reports that discuss what upcoming events you should be on the lookout for.
If the news is different from what the market expects (a surprise), it can lead to swings in the currency price.
Note that algorithms run by hedge funds also play a role in trading around news events, often causing wild, sometimes irrational swings, immediately as the news is released.
This can make news trading challenging, despite the opportunity.
Here are some ways to use news as a set-up.
You can:
- look to predict the news event’s outcome, and place a trade beforehand
- wait for the news event, and enter the trade based on the announcement (be wary of slippage)
- wait for the reaction to the news event, and place the trade several minutes or hours later.
I like to have the trade on prior to news, as that provides the opportunity to capture the full move, although it does lead to slippage on the stop-loss on occasion.
Market sentiment
Market sentiment refers to what the overall attitude of traders is to a currency pair.
This is often driven by the BIG THING that is moving the market at the time.
For example, during BREXIT the GBP/USD was sold heavily, with traders being concerned by little else.
Sometimes, the BIG THING can be a major event such as COVID, at other times it may be more about economic factors such as inflation or deflation.
To determine market sentiment, you can read market analysts, as well as notice what news is moving the price.
If lots of market analysts are talking about the same thing, it could be what market sentiment is currently focused on.
If there are large moves on inflation data, while employment data barely moves the market, then inflation is what sentiment is focused on.
Once you feel you have clarity on market sentiment, then look for trades that align with your idea.
For example, during BREXIT, you could look for technical points to sell GBP/USD.
In mid-2024, as I write this, sentiment is heavily focused on interest rates and Central Bank policy.
Interest rates and central bank policy
You can think of currencies a little like bank deposits and loans.
For example, if you buy the AUD, then it is like having a deposit in an account in AUD, for which you earn interest.
If you are selling it against the USD, it would be like having a loan in USD, on which you pay interest.
If you earn more interest than you pay, then you have a positive carry.
In other words, you will earn money just for holding your position.
This makes currencies particularly sensitive to interest rates and hence central banks.
Central banks are so important to currency traders as they set interest rate policy.
In a sense, this can simplify fundamental analysis for us, as the central bank will talk about the important factors in their decision-making, such as inflation or stability of the financial system.
When looking for trading opportunities, try to understand what the central bank is focused on, then dig into this.
For example, if the central bank is focused on inflation, and then you think inflation will not rise as much as forecast, it could mean the central bank will need to change its view.
If this is different from the market consensus, then you will have a trade opportunity.
What is important is the difference in monetary policy between the two currencies.
If one central bank is hawkish (raising rates) and another dovish (lowering rates), then the paths of the two currencies should be different.
When one becomes more dovish or hawkish than it was, then you have an opportunity, if the market has not already priced this in.
Again, analysts can help you with this. In particular, I like research from local banks who are highly clued-in to what their local central bank is thinking.
A tip for finding these opportunities is to look at what bond markets are doing.
Bond prices move based on interest rates, so if interest rates go up, then bond prices drop and vice versa.
So, for example, if US Treasury Bonds drop in value, it is bullish for the USD.
Always look for the bond market to lead the forex market.
Other factors may temporarily cause currency pairs and bonds to diverge, but over time, interest rates will tend to win out.
Risk-on/risk-off
There is a phenomenon in financial markets called ‘risk-on/risk-off.’
Essentially, when stocks are going up, it is termed ‘risk-on,’ which is bullish for higher-yielding currencies, such as AUD and NZD or emerging market currencies
When stocks are going down, it is termed ‘risk-off,’ which is bearish for the above currencies and bullish for USD, JPY and CHF.
Normally, risk-off happens suddenly when unexpected news causes a rapid sell-off in equity markets.
Here is what happened to the AUD/USD during the stock market collapse due to COVID fears in 2020.
If there is a risk ‘event’ then you can look to short risk-on currencies and buy risk-off currencies.
Final thoughts
As a trader, you have a variety of market analysis techniques available.
Select the ones that work for you.
You want to make sure they:
- Fit your psychology
- Fit the other elements of your system
- Give you an edge
Remember that market analysis happens separately from your entry. Here you are looking for set-ups for your trades that have an edge.
These will then be turned into a list of rules in your rules-based plan.
In the next lesson, we will look at exactly when to enter into trades, once your set-up conditions have been met.
Till next time,
Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Jack D. Schwager – Market Wizards: Interviews with Top Traders https://www.amazon.com.au/Market-Wizards-Interviews-Traders-Updated/dp/1118273052/
- Bill Lipschutz – Investopedia: The Most Famous Forex Traders Ever https://www.investopedia.com/articles/forex/100515/these-are-most-famous-forex-traders-ever.asp
