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Yin and Yang of a Great System pt. 1

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Yin and Yang of a Great System pt. 1

Yin and Yang of a Great System pt. 1

By: Omar Eltoukhy

Last week we looked into some of the nuances in approach that we need to engage in to correctly, profitably and successfully trade instruments outside of forex.  If the SNB announcement should have taught you anything, it’s that being diversified can be a very good thing.  What I mean is I was watching all the markets when the “bomb dropped”.  The Usd/Chf moved for 1000 pips and clearly jumped so many stops that it buckled Alpari who is just one of the casualties of the move.  

While forex saw jaw-dropping, and hedge fund devastating moves, the indices, oil and even gold made a much more gentle move.  Yes, while it is true the DAX did drop over 350 pips in a single hour, that is actually not unheard of on the DAX and we can expect that to happen every month sometimes or more.  Oil moved 400 pips over 3 hours but it was actually quite tradeable and there was a fantastic signal to go long that produced 300 pips in a single hour.

As I have mentioned in the past, since you cannot predict these types of events occurring, the only thing you can do is really limit your exposure to the market in general.  One way to do this is to diversify which markets you trade.  This way, on any given day there is less chance you will be exposed to any single type of market that gets hit hard by a completely unpredictable event.  By extending you reach, you will not be solely focused on any one avenue and always exposed to that single avenue.

Of course, being able to trade these markets outside of forex requires that you do indeed have a strategy and trading method that works.  It would be disingenuous for me to come here and try and create a method specifically for this discussion outside of the one I use already that works magnificently, and it would be unfair to everyone on my team that has invested in the method I use, both time and money for me to simply give it away.  

So, instead I will basically discuss how I created the Triple Threat trading method and the features I employed to make it work the way it does.  That way, you can use your own creativity and understand the structure and approach you will need if you do indeed want to create your own trading method instead of using mine.

There are two key elements of any successful trading system in my opinion, and one of them you will already be very familiar with because it works incredibly well in forex.  That is, of course, Support and Resistance.  The second, you might already be familiar with already because many failing systems that we have all bought use it, but what makes them fail is that they use it independently and singularly instead of combining it with S/R.  That method is called momentum.  

But by combining both elements together in harmony, I have found that you will create the “ideal” approach for trading difficult markets like Gold, Oil and Stock Market Indices.  This week I am going to discuss the first part of this puzzle, and next week the second.  Hopefully it will shed some light into the elements required to make masterful trades in tough markets.

 1 ) Support and Resistance:  THE KING OF STRUCTURE

Support and resistance as you should know is essentially the methods by which we try and understand where the market is likely to react with price action.  Although the tools we use can come in many shapes and sizes the principles are basically the same and quite simple to understand.  Price can only do one of three things:  It can go up, it can go down, or it can go nowhere.  Support and resistance attempts to find areas where price will essentially change course from doing one of those 3 things.  

For example, in an uptrend, we attempt to locate the area where price will come back to (pullback) and then react to (reject) so that we can capture the movement from that area without risking much of our stop.  S/R acts as “walls” for price, and although they are penetrable, they do act for the most part, if correctly chosen as a “bumper” to let price bounce off of.  They are also excellent areas to use for take profits, and to protect stop losses, because as price approaches them, it is likely to slow down, stop, or turn the other direction.  

They can also be used for understanding the strength of a move, by how many of them are broken in a single move, or how many are taken out on a retrace especially in the case of a fib retracement (ie if it only gets back to the 21.4% fib instead of the 61.8% fib before moving again, one could say that the initial move was stronger).

In creating a system to trade the market, we must be armed with a strong understanding of how price action reacts to particular types of support and resistance, and how to use it to understand the market.  Because the market goes through different phases, such as trending, non-trending or choppy, the same s/r areas can be used differently during different market phases.  The important thing when creating a system is to employ S/R that price reacts with consistently although there is not a single type of s/r I have ever seen that price reacts with 100% of the time.  

But we don’t need 100% to make money, just MOST of the time.  So making sure you employ horizontal s/r based on higher timeframes is good, quality placement of trendlines is very important as well as proper placement of fibs can be a boon in creating the “structure” of the market ahead of you.  This way you know the pathway price is likely to take in one direction or the other.  Using EMAs is also excellent because they are like dynamic s/r areas that adjust to price.  

They can also help you determine trend and even market strength.  By using the correct S/R from the correct timeframes to create the overall structure, you will be prepared to know in advance where the market is likely to pause, react, push through, consolidate or reject from and can make trade planning so much more accurate.

Keep in mind that placing too much s/r structure on the chart can be not only confusing, but cause “paralysis through over-analysis”.  If we were to REALLY take EVERY SINGLE pivot, fib, trendline, important EMA, horizontal s/r from EVERY TIMEFRAME and apply it to a chart, it would look like a grid of lines, blurred criss-crossing numbers and you would lose price most of the time.  You would think that every trade you entered would only have about 10 pips or less until it slammed into the next s/r area.  

And guess what?  On some level, that’s true!!  Rarely does price simply blast off 200 pips in a few seconds.  It tends to move, come back, move, come back, etc…. in many variations.  But, the important bigger moves DO happen between important s/r.  So the goal is to only have the most important S/R on the chart.  How do you decide??  Well, it all depends on what style of trading.  If you are trading daily charts, it does not really make sense to have a bunch of 15-minute based s/r on your chart, because you are going for bigger moves.  

And if you are scalping 1-min charts, only having weekly areas will likely leave you with price floating in huge zones that you cannot understand and not allow you good protection for a stop or good targets either.  We must consider the exact types of trades we want to take and then choose ONLY the very best S/R that works MOST of the time to make price react.  In my case, I even had to eventually create a multi-timeframe indicator that scans thousands of potential s/r areas and choose for me which ones to display.

So, my recommendation is take the timeframe you are trading, then locate the important areas of s/r TWO TIMEFRAMES HIGHER.  Use those on your trading chart.  They will likely give you the right balance of information.  It is never a bad idea to look for the really big weekly/monthly areas to have on your chart just in case you run into them if you are even trading smaller timeframes.

My next recommendation is to visualize all the potential price action moves during any given time period that you are trading based on the S/R that is close.  Because you need to have a plan for each of them.  So, even in a trend, if you are getting a pullback, don’t just assume price will stop where you want it to.  

What is your plan if it doesn’t?  Is there another S/R area below you could use?  Could you potentially take a different kind of trade(s) if that area is broken???  Making sure you have every possibility “mapped out” in advance will allow you to use s/r in a much more powerful way.  

The reason is because although you might know which areas of the market are important for price, you can never really know for sure what the market will do when it gets there.  And that brings us to the discussion next week.  Momentum is that answer.

Till then, enjoy my NY outlook today in the forum!!  I will attempt to discuss that very structure and what to do if/when price gets there.  We have a big ECB statement 30 minutes after NY opens, so if you are considering taking trades, then be careful!!  I recommend waiting for the news to release before doing anything at all.

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