Have you ever heard the following expressions in trading?
1. Buy a dip
2. Buy high, sell higher
Both of these are different ways for a trader to enter the markets they are trading that are trending higher. These entries can be used in any market, but certain types of entries will work better in the Forex markets due to the 24-hour trading session.
Each type of entry has a set of rules including a method for entry, a first profit target, and a stop loss. Let's examine both of these strategies and explain how and when to use them effectively when trading Forex from the long side:
Buy High, Sell Higher:
When a market is in an uptrend, there are two ways to enter to join the trend. The first method is to buy when price makes a new high, or a higher high which is called a breakout entry. The goal of this strategy is to buy high, sell higher. The Forex market is based on trading the economies of different countries. Since the economy moves from cycle to cycle, expansions (aka uptrends) and contractions (aka downtrends) tend to persist for long periods of time. This strategy will be successful as a method of entering a trend already in progress. Buying high and selling higher is very successful in a runaway bull market that offers few opportunities to buy any retracements or pullbacks.
For example, a very popular breakout strategy with simple rules for entry in the Forex market would be to buy a "close" a few pips above the previous candle's high for long entry. For active traders, a 15 minute candle is a good time period. For a less active trader, a 60 minute candle will work. When the 24 hour Forex market becomes quiet between the hours of 12:00 PM EST and 9:00 PM EST, a larger time frame chart such as a 180 minute chart or 240 minute chart can be used. Many traders use some form of a breakout strategy in the Forex market with success provided they correctly identify the major trend and enter the breakout trade in that direction only. Where the strategy fails is when price extends the trading range by a few pips, and then reverses back inside the range stopping the trader's position out for a loss. This unfortunate position is known as buying the top. A logical stop loss for this entry would be the pivot low of the congestion area preceding the breakout. The first target can be a supply (resistance) level above price that is at least three times the amount of the stop loss (3:1). Trend lines or moving averages can be used as a trail stop.
Buy a Dip:
Another way to enter a trend as either a continuation entry or a possible reversal entry is to wait for a retracement of a successful breakout to occur, and buy a pullback to the origin of the breakout which is called buying a dip in an uptrend. The traders who were a part of the initial breakout will sell if price stalls to take a profit which can lead to a pullback entry. Once a successful breakout occurs as indicated by a close above the breakout area, many traders become interested in buying a pullback to the origin of the breakout. The main advantage to this entry is that the risk to entry is small. The biggest drawback to a pullback entry is that the pullback may not happen, and then a pullback trader has no method of entry. Let's take a look at our new BFF (best-friends-forever for those of you who do not have teenage daughters), the AUDUSD. On the 15 minute chart below is an example of both types of entries - the pullback and the breakout. Near the bottom of the chart was a great opportunity to buy a pullback in the AUDUSD to join the recent strong rally discussed in last week's newsletter. The downside was that the trader needed to be in front of the computer at 12:00 AM CST in order to make the trade. For the trader who missed the pullback entry due to something silly like sleeping, the next best entry was the breakout trade that occurred near 3:30 AM CST. A breakout trade was entered once the AUDUSD rose past the previous candle's high, and as it rallied past a prior resistance level. The initial stop loss was placed below the pivot low of the consolidation area preceding the breakout, and the profit target was determined to be the supply level above current price.
A few hours later, the AUDUSD rested at higher levels allowing the stop loss to be raised to the pivot lows of the new congestion area.
The breakout trade is working because the trend is up and the position is long.
In next week's article, we will discuss the sell, the breakdown entry, and the short the rally entry as a way to enter a downtrend.