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Short Side Basics & Price−Volume Rules

Thu, Jun 29 2006, 11:48 GMT
by Bill Young

TradeSphereFX

Short Side Basics

Short selling in FOREX means to sell a currency with the expectation that the price will drop and you can buy it back at a profit. But if the price increases, you will be forced to buy or cover the position at a higher price, incurring a loss. In each currency pair transaction, you will be buying one currency and selling the other half of the currency pair.

The Risks of Short Selling

Short sellers theoretically face unlimited risk because there is no limit to how high a currency’s price can go. For example, if you short or sell the EUR/USD @ 1.2025 and the price rises by 10 pips ( a pip is the smallest tradable increment in FOREX), you will lose 10 points per contract. Because of the additional risk of the short sale as opposed to the long trade, you must be extremely disciplined about selling short and decisive about cutting losses when a short position goes against you. Protect your trades at all times by using stop-loss targets. Never leave a trade unattended, and never execute a trade without a plan. Your plan is your lifeline to survival. Trading is a business, and all successful businesses are based on well-defined plans.

Benefits of Short Selling

Short selling adds consistency to trading by giving traders the potential to profit in down markets. There are always currencies that are falling, even when the market is bullish. However, very few currencies rise to any great degree when the market is bearish. Whether it's profit-taking in a bull market or liquidation in a bear market, short sellers can always find opportunities to sell short for a profit.

One aspect of price behavior to consider when looking for short selling opportunities is the differences between up moves and down moves in the market. When a pair rises, it often increases slowly due to incremental profit taking throughout the rise. By contrast, when a pair declines, it often does so very quickly and sharply. As a short seller, you want to be positioned to take advantage of a drop in the price.

This contrast between upward and downward price movement can be compared to a car going up a hill, over the top and down the other side: It moves up rather slowly, requiring a great deal of power to make the ascent. As it moves down the other side after reaching the peak, it does so, picking up speed and momentum much more easily than during the up hill climb.

Similarly, price will often rally gradually, with increasing volume providing the "power" to make the upside move. As price begins to reach a plateau, look for the volume to begin to decrease. This is often where short traders will attempt to execute the short trade, looking for the reversal of trend to begin to occur.

When the price reverses to the downside, it will often do so with much more momentum and force than the up move. As the price sell offs, particularly in panic selling, volume will increase until the selling begins to subside. At this point, buyers begin to move back in and short traders take their profits. Volume speaks volumes

Volume is one of the most useful indicators to determine trend strength and warn of potential reversals, and whether traders are buying on weakness and supporting price or selling into strength and limiting price. Volume has a direct relationship to price. The more buyers (increasing volume) the higher the price goes. The fewer buyers, the better the chance for market makers to lower the price. There are six simple rules to learn to interpret price and volume movements:

1. Increasing volume on increasing price indicates increasing buying pressure and a possible price advance.
2. Increasing volume on decreasing price indicates increasing selling pressure and a possible price decrease.
3. Decreasing volume on increasing price indicates easing buying pressure and a possible price plateau or reversal.
4. Decreasing volume on decreasing price indicates a slowing of selling pressure and a possible price plateau or reversal.
5. Higher-than-normal volume (spikes) at price highs indicates selling into strength and a price ceiling.
6. Higher than normal volume (spikes) at price lows indicates buying on weakness and price support.

Burn these into your brain--they are the most reliable measures you can use to determine an instrument’s strength and direction and can potentially give you several minutes advantage over other traders to enter your short sell order and maximize your returns. For the short seller looking to position near the top of a rally, a progressive decrease in volume as price continues to rise will be the first indicator of a potential trend reversal. It will occur before any other indicator begins to suggest an impending price reversal.

Short Selling at Resistance

Many currencies tend to move within trading ranges during the day, or during specific times of the day, bouncing off support at low points and retreating from resistance at high points. When you recognize that a pair is fluctuating within a trading range, you can place short limit orders at or just under the resistance level of the range to take advantage of the pair’s profit taking off that resistance; you can cover at the support level. Make sure the volume has been decreasing as the price nears the established resistance level. If the volume remains constant, or begins to increase, a potential move through the resistance level could occur. Breakouts above resistance levels (or below support levels) are often explosive and accompanied by high volume. Think of support and resistance levels as floodgates that are closed tight. When they open, they release an extreme amount of pressure.

Market Movement

In the course of the market transactions, there are really only two types of transactions. The first is a positive transaction and the second is a negative transaction. Without it appearing that this article is trying to over simplify market activity and the various movements of the market, when the market is really examined, there are really only two types of transactions. In other words, there are successful transactions and then there are those that are not successful. If you have ever thought about it, I am sure you have asked the question what did that trade work or not work. What could have been done to make it successful?

Obviously placing the trade in the opposite direction would have worked. But seriously, what is it in your decision making process that could have been done differently to have made a positive outcome of the trade? One area could have been with regard to trader psychology It is a known fact that better than 98% of traders lose money. So, since 98%+ lose money, there must be something about where they are placing the trades that is the issue.

The component of the trade must be taken into consideration. The components are two primary items: 1) Entry Price and 2) Protective Stop Price. It can be reasonable to say that since 98%+ traders lose money, it can also be reasonable to expect that better than 98%+ of all trades are stopped out. Thus by conclusion, it seems to be a high probability that the market moves based on stops, thus the market moves to where the stops are located.

History is a wonderful event. Charting is simply an expose’ of History and it can read like a road map, showing exactly where it has been, but more important, the natural areas of human reaction. Let me explain: The market moves up to a certain price point level, stops and reverses and moves the opposite direction for a short time period, then stops and reverses again. In this example, does the market have buying pressure or selling pressure? Is the market in an up trend or down trend? Not sure? Well you’re not alone. Most of the traders in the above example were confused also. Initially when the traders placed their “Long side” trade, they took a position and then placed Sell Stops to protect their position. The market moves downward in the opposite direction of the position triggering the stops. Once all the stops were cleared out, the market lost momentum and reverses. So, now everyone who was initially long has been closed out of their positions. Now for those traders fortunate enough to have been short, begin to cover their positions and take profits, which also begin to trigger the buy stops of those traders who are short when the market reverses to the upside. This process is a constantly repeating cycle. Market moves in the wrong direction, triggering stops. The market then reverses when the stops have dried up and begins to trigger stops in the opposite direction. This is the basis of the saying, “The Market moves to where the stops are located.” Co-incidentally, major swing points or major reversal price points are used as major placements for stop positions. Next time you look at a chart, consider looking at it from this point of view, ie. “ Where are the stops located?.”. You just may begin to look at charts and what they represent in a bit of a different light.

Published on  Thu, Jun 29 2006, 06:48 GMT

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