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Bulkowski's Book Review: Forex Patterns & Probabilities

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Candles Chart
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As of 02/20/2019
  Industrials: 25,954 +63.12 +0.2%
  Transports: 10,627 +9.81 +0.1%
  Utilities: 746 +2.71 +0.4%
  Nasdaq: 7,489 +2.30 +0.0%
  S&P 500: 2,785 +4.94 +0.2%
Tom's Targets    Overview: 02/14/2019
26,000 or 24,600 by 03/01/2019
10,900 or 9,900 by 03/01/2019
755 or 725 by 03/01/2019
7,700 or 7,050 by 03/01/2019
2,825 or 2,650 by 03/01/2019

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners.

I love books that are engaging, clearly written, and with tips that are useful. Forex Patterns & Probabilities, by Ed Ponsi, is one such book. I know almost nothing about Forex, so it was a pleasure to be introduced to it without being overloaded with incomprehensible terms and techniques. The following are excerpts from the book that I found important. In several places, I use the word price. You can substitute exchange rate instead, because that is what you are looking at in the Forex markets.



The Basics

Ed Ponsi begins with reviewing the basics of the Forex market. Here is a short list of some of them.
  • Partial fills are rare, except for the biggest traders.
  • Slippage is rare in the currency market.
  • There are no specialists in the Forex market.
  • The spread between bid and asked is often fixed within a currency pair.
  • The Forex market does not have an uptick rule for short sales.
  • Pip is an abbreviation of "percentage in point" and it represents the smallest increment of price change.

He lists the major currencies and their nicknames:

EUR = euro, called the "single currency"
GBP = Great Britain pound, called the "cable or sterling"
USD = U.S. dollar: "greenback" or "buck"
JPY = Japanese yen
CHF = Swiss Franc: "Swissy"
CAD = Canadian dollar: "Loonie"
AUD = Australian dollar: "Aussie"
NZD = New Zealand dollar: "Kiwi"


Popular currency pairs:

EUR/USD: Euro/U.S. dollar
GBP/USD: Great Britain pound/U.S. dollar
USD/CHF: U.S. dollar/Swiss franc
AUD/USD: Australian dollar/U.S. dollar
USD/CAD: U.S. dollar/Canadian dollar
NZD/USD: New Zealand dollar/U.S. dollar
EUR/JPY: Euro/Japanese yen
EUR/GBP: Euro/Great Britain pound
GBP/CHF: Great Britain pound/Swiss Franc
EUR/AUD: Euro/Australian dollar

On page 31, Ponsi lists the times in which the 24 hour trading markets become active. Later he discusses a trading setup based on the lull between activity.

Forex MarketBecomes ActiveBecomes Inactive
Australia/New Zealand2100 GMT500 GMT
Japan/Asia2300 GMT700 GMT
Europe/Great Britain700 GMT1600 GMT
United States/Canada1200 GMT2100 GMT

GMT is Greenwich Mean Time and it is either 4 or 5 hours ahead of the U.S., depending on whether or not daylight savings time is observed.

As a general introduction to trading...

  • Ponsi discusses what he calls the "proper-order" of moving averages. He uses the proper order to help identify when a currency pair is trending. The order is: 10 period simple moving average (SMA) is above the 20 SMA, which is above the 50, which is above the 200 in an uptrend. In a downtrend, the order is reversed: 200 is above the 50 which is above the 20 which is above the 10. I assume that this also applies to exponential moving averages, which he uses later in the book.
  • He says that Fibonacci techniques work well in the Forex market because everyone uses them. They become a self-fulfilling prophecy.
  • On page 45, he starts to discuss trading when he suggests that beginning traders use a demo account for at least several months before going live, and if you run into a rough patch when trading real money.
  • Start by trading one currency pair (in a demo account) with a narrow spread, such as the EUR/USD. He says that the "Japanese yen pairs have their own 'personalities' and are more likely to find support/resistance at round numbers." Later in the book, he expands on this topic. He says that if you trade the USD/JPY pair, then try EUR/JPY because it is more volatile with quicker moves.


Commodity Currencies

Ponsi terms a commodity currency as a currency that shares a strong relationship with the price of a commodity. He gives some examples... The USD/CAD has a persistent long-term trend, which Ponsi favors. He says that there is a strong relationship between the USD/CAD pair and the price of oil. The Canadian dollar often tracks energy prices: rising as energy rises and falling when energy weakens.

Another pair with a stronger relationship to oil is Canadian dollar/Japanese yen (CAD/JPY). He says that Canada is a major producer and exporter of oil and so it benefits from high energy costs while Japan is an importer of oil. When the cost of energy goes up, the yen tends to fall.

For gold bugs, try the AUD/USD pair. The Australian dollar often tracks the price of gold, with gold sometimes leading the Aussie.


On page 60, Ponsi says that "Fighting trends is a common cause of failure for prospective traders, so we must resolve that we will trade only with the trend and never against it. Can a trend be too strong? A huge run-up in a stock, commodity, or currency can potentially lead to a steep-correction."

To determine trendiness, he suggests using the ADX indicator. "High readings indicate strong trends; for example, the ADX indicator's giving a reading above 35 and rising would be an indication of a strongly trending market."

The Forex market trends more than other types of markets, such as the stock market. Why? Ponsi explains that often problems with a company (stock) can be fixed by the next quarter or two but when a country's economy runs into trouble, it can take years to recover. That's why some trends can last years, and that is also why you can trade with the trend.

He warns not to try and guess when a trend will reverse. "While it is possible to turn a profit on a countertrend move, the trader who consistently trades in this fashion is stacking the odds against himself and asking for trouble." I have also found that to be true, and it is one reason why I do not favor the rise-retrace type trade even though I use it on occasion.


Multiple Time Frame Setup

On page 69 of the book, Ponsi discusses rules for using different time frames when trading. When receiving conflicting signals from multiple indicators, do the following (based on the hourly chart, as an example):

  • Find the trend using a longer-term chart (if on the hourly, switch to the daily), employing trendlines, ADX, or moving averages and checking for "proper order."
  • Many times, the trend will be obvious and if it is, then others will see it, too, creating a self-fulfilling prophesy.
  • If the trend is up, go long. If trending down, go short. If you can't tell, then do not use this technique because it is only for trending markets.
  • If the trend is up, go back to the shorter time scale chart (from the daily chart back to the hourly), and look for a support zone where you can enter once the exchange rate reaches it or if an oscillator such as the RSI says the currency pair is oversold. After buying, place a stop below the support area.
  • For a downtrend, go to the shorter time scale chart and look for the pair to rise to a resistance area or an oscillator saying the pair is overbought. Go short and place a stop above the resistance area.

Getting Out

Ponsi suggests scaling out of positions using your risk added to the entry price as the first exit point. For example, if you enter a pair at 1.0010 and have a stop at 1.0000 then the risk is 10 pips per lot. When the exchange rate rises to 10 pips of profit per lot, you would sell a portion of the position. If he has two lots in the trade, he will sell half of the position. For three lots, he sells a third. That is what he means when he sells a portion. Then he adjusts the stop to break even. This locks in a small profit and reduces or eliminates the risk on the remaining position.

For the other portion(s), he uses support or resistance to determine when to sell those, each portion being sold at consecutively higher (lower when short) levels. If the pair approaches support or resistance, meaning it need not hit it exactly, he will consider exiting a portion at the time.


The FX-Ed Trend Technique

On page 99, he discusses what he calls the FX-Ed trend technique. Use this technique when the trend is both strong and persistent. Begin by identifying the trend. Use four moving averages, 10, 20, 50, and 200. The first should be above the next and so on, forming the "proper order" as I have discussed before. For a downtrend, the 200 should be above the 50, and so on.

Once the trend is in the proper order, and let's assume an uptrend here, look for the exchange rate to be above the 10 day exponential moving average (EMA) for at least 10 bars (candles) and then buy. For a downtrend, the rate should be below the 10 day EMA for at least 10 candles. Use this filter to gauge the commitment of the big boys -- the institutions. If they are buying in an uptrend, the exchange rate will remain above the 10 day EMA and that is the type of trend you want to trade (it is the entry signal). If the rate cycles above and below the EMA, then the smart money is teasing you so avoid trading.

Ponsi discusses the reasons for such a strong trend and it relates to interest rate changes for the pair. One rate rises and the other falls or remains steady, giving players an incentive to buy on the widening interest rate differential.

Use a volatility stop based on the average true range (ATR) to protect your position. Since this trade technique is based on the exchange rate remaining above the 10-day EMA (for uptrends), he places a stop below the EMA equivalent to half the daily ATR, trailing the stop, and never lowering it. He writes, "Since we are trading within an uptrend, we will not lower the stop under any circumstances. We will keep the stop beneath the 10-day EMA, at an amount equal to 50 percent of the daily ATR, until the exchange rate finally breaks down and reaches our stop."


The Channel Setup

Ponsi discusses channels, where the exchange rate rises or declines following two parallel lines of trend. When the exchange rate is near or touches the top of the channel, it is a resistance area. That is a good time to close out a portion of the position. He does not recommend exiting the full position, just a portion of it. With the remaining portion, use the ATR stop as described above. That is, place a stop below the 10-day EMA at half the daily ATR, in pips.

If the exchange rate again rests on the 10-day EMA, and if you already sold half (or a portion of the trade), then you can re-buy that portion, providing it does not exceed the size of the original position.

Ponsi likes the 10-day EMA because he says that institutions add to their position when it nears the line. (I suggest you experiment with different EMA settings and find one that works best for your pair.) He also says that there is evidence that the 10-DAY EMA works but there is no evidence that the 10-hour or 10-minute shows the same support or resistance role as the 10-day EMA. He writes, "The big institutional players tend to be oriented to daily and weekly charts, and are rarely concerned with intraday time frames."

He warns that if you find yourself wishing or hoping for an outcome that seems in doubt, then you should exit the trade immediately and re-evaluate your trading method. He adds that every trade should use a stop, properly placed, and that you never average down (buying more as the exchange rate drops).

He gives this tip: "If a pair repeatedly fails after numerous attempts to breach resistance, it reveals the presence of a large seller in the vicinity. I can 'lean' on this seller, meaning that I will join him in selling this pair at resistance." Once price pierces that resistance, then do not try to trade it because the reason for such a trade has disappeared.

Ponsi recommends that you not place an order at support or resistance levels. Instead, he recommends that you back away the entry point to help guarantee that you are trading with the trend. In other words, when the exchange rate drops to support and then begins the journey upward again, buy. Place your stop beneath the support area. For selling short, the concept is similar, only reversed. Sell once the rate starts declining again and place a stop above resistance.


Intraday Breakouts

He begins discussing chart patterns, such as ascending and descending triangles. I don' particularly like the examples he gives for his triangles because they include too much white space. I like price to bounce between the triangle trendlines more often than what he shows. However, I don't trade the FX market, so maybe that is what works, and that is what a typical triangle looks like.

He says that when trading triangles, use the trend before the consolidation pattern begins as the likely breakout direction. If price was trending down before the triangle, it will probably trend downward after the trend resumes.

My tests of ascending and descending triangles in stocks say otherwise (see my Encyclopedia of Chart Patterns book). More reversals appear for both ascending triangles (578 reversals versus 514 continuations) and for descending triangles: 592 patterns acted as reversals versus 574 acting as continuations. Thus, I would err on the side of caution here. Just because he says it is likely without giving evidence is no reason to believe it is true. Proving such an assertion using numbers would certainly help his case. Again, I used stocks and not the FX market and my patterns are better formed than his, so his claim could be true. If the FX market trends as much as he says it does, then that also supports his claim.

Time-of-Day Filter/Setup

During times of the day when volume drops, it is easier for large institutions to push price around, forcing orders to execute and commission generated. Ponsi says that these moves tend to be brief. Earlier, I listed the times when the various markets open and close. Knowing that the London session has the highest volume, breakouts there are probably valid ones, especially if they occur early in the session (volume and liquidity is highest then). He says that if the breakout occurs late in the Asian or U.S. markets, it has a higher likelihood of being a false breakout. An astute trader can fade (trade against) these short-lived trends.


Flags and Pennants Setup

He describes what flags and pennants look like and says that the key to trading flags or pennants is the height of the flagpole, or the strength of the move just before the pattern begins to consolidate. To enter a trade showing a flag or pennant, measure the height of the flagpole and take 10% of that. Add the result to the top of the flagpole and that becomes the entry price. For example, if the pole is 100 pips tall, then add 10 pips to the high of the flagpole to get the entry target.

For a stop, use 25% of the flagpole height subtracted from the entry price. Using 100 pips as the pole height, place a stop 25 pips (per lot) below the entry price. Note that the stop is measured from the entry price and not the flagpole top.

For price targets and exits, sell a portion of the trade once price climbs by the amount risked. Then raise the stop to break even. For example, if the stop (risk) is 25 pips per lot then look for a target 25 pips higher than the entry price. The next exit would be the height of the flagpole added to the top of the pole (and not the entry price).


The Squeeze Play Setup

Ponsi begins the chapter with an interesting statement: "most good trading strategies begin with a market tendency; traders notice that the market tends to behave in a certain way, and then they create a strategy that seeks to capitalize on this tendency."

One example is volatility. Markets tend to run in cycles of high volatility followed by low volatility (you can see this in stocks by using Bollinger bands). Option traders, for example, write contracts when the volatility is high and buy them back when volatility returns to normal.

Another example is interest rates. "Lower interest rates tend to cause the underlying currency to weaken," he writes, "because fixed income investors want the best possible yields for their investments. These investors will often pull their funds out of a country to find more attractive yields in another part of the world." When the Federal Reserve raises interest rates, it strengthens the dollar, making U.S. fixed-income securities more attractive to overseas traders and investors. These inflows strengthen the underlying currency. Thus, if you can correctly anticipate which countries are changing interest rates, you can trade on it.

Returning to volatility, enter a pair when volatility is low. You can graph the ATR and when it drops, it signals that volatility is dropping, too. He suggests the daily ATR calculated using the 14 period default. Even though volatility suggests a breakout is close, it does not predict a breakout direction. Ponsi suggests using trendlines and trade in the direction of price pushing through one of those. Draw your lines along the peaks and another following the valleys. Often, the shape will resemble a symmetrical triangle. After the breakout, place stops below the top trendline for long trades and above the bottom trendline for short ones.

For price targets, use round numbers (most any number ending in a double zero), Fibonacci retracements, and other support or resistance zones.


Other Setups

Ponsi discusses several additional trading setups for the Forex market, including using round numbers ("the first bounce is usually the best bounce,") in combination with the 20-period moving average, the difference between interest rates in a pair, and the boomerang where you fade a false breakout and refines the technique for the EUR/USD pair.

Near the end of the book, he has a chapter titled, "The Forex Playing Field." He makes an interesting case when he advocates trying to hit home runs instead of singles. He writes,

"It's hard to earn 100 pips," goes the rationale, "I'll just try to make 10 pips on each trade." It seems to make sense; surely, it is easier to earn 10 pips than it is to earn 50 or 100 pips. What if I told you that instead of making things easier, this trader is in fact making his life more difficult?

He justifies this using math, and it goes something like this (and I am borrowing from his example). If you are trying to make 10 pips of profit with a 3 pip spread, you have to earn 13 pips to reach your target. If the trade is a loss, the pair need only drop by 7 pips (7 pips + 3 pip spread = 10 pips total) to reach the 10 pip risk target. Thus, the ratio is 13 to 7 or near 2 to 1 against.

Now, suppose you are looking for a 100 pip profit. To win by 100 pips, it would take 103 pips when you include the 3 pip spread. For a loss, it is 100 - 3 or 97 pips. Thus, the ratio is 103/97 or 1.06 to 1 against. That's almost 50-50. Which would you rather trade?

He also mentions trading coaches or instructors that advocate taking many small gains. Why? He says that they ask you to open an account with a particular broker or market maker. In doing so, "you may have signed an 'introducing broker' waiver that allows said trading coach to collect a small cash payment every time you place a trade." The more you trade, the more he makes.

One final quote and it's a good one: "Amateurs are concerned with how much money they can make, and professionals are concerned with how much money they can lose."

-- Thomas Bulkowski


See Also

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners. I used to have a handle on life, but it broke!