Currency Secrets

Not all flag formations work out the way as planned. This really isn’t saying anything profound.

However, just as each flag formation has a break point where we know it is likely to continue in the direction of the flag pole it EQUALLY has an opposing break point where when its opposing break point is broken we will see the market retrace back to the start of the pole.

But trading the inverse break does take some knack.

First, we need to know where this break point exists. As a general rule most flag break points occur around the 50% mark of the flag pole, however, experienced traders can sometimes pinpoint earlier entry points and one of these earlier entry points is where the second peak/trough occurs during the consolidation/flag period.

In the case of the GBPJPY and CHFJPY formations yesterday I identified the second peak in both charts. I knew that if these prices were broken it would end the flag formation for how it should normally be traded (being in the direction of the pole).

But what would’ve happened if we’d traded the inverse break?

Entry for the inverse break would’ve been at a move above the 218.31 (+ spread) point, with stops being difficult to place but are generally placed at the low of the flag pole (now can you see why it’s important to have the flag stay within the pole’s range, if we have wicks passing through the extreme it’s hard to not only find entry, but also where to place stops on the inverse). Our target would’ve been the other extreme of the pole being 220.34 which hasn’t been reached on the GBPJPY yet.

GBPJPY chart

On the other chart – the CHFJPY – we would have had entry at the break point of 93.75 (+ spread), with stops either at the low of the flag pole or at the low of the wick that pierced the flag pole’s low. Interestingly the CHFJPY hit its target, being the high of the flag pole at 94.68 (just under 90 pips made).

CHFJPY chart

What tell tale signs were there that the CHFJPY was MORE probable to achieve its target than the GBPJPY?

Interestingly on the hourly GBPJPY chart we have a nice flag formation that has something a little different than the GBPUSD flag formation from last week.

There are several things about this flag formation that I’d like to briefly discuss (a screen capture shot of what I’m currently looking at can be seen here).

As with all flag formations we need to check for any announcements that could cause problems. We’ve already had some semi-important JPY announcements, but they haven’t seem to have done much. We do though have some important GBP announcements being released today, namely, PPI and Trade Balance, and both appear to be somewhat mixed – the PPI seems to indicate that the GBP will weaken, whereas the Trade Balance is slightly positive for the GBP.

Hmm… tough call.

But we’ll move on to our analysis of the GBPJPY flag formation.

As with all flag formations it’s important to gauge what is happening with the market’s activity in the consolidation period after the pole. Notice during the GBPJPY’s consolidation period we have lower lows and lower highs – in fact we have the currency falling beneath the low of the flag pole! This shows me that there is inherent weakness of the GBP against the JPY.

But it causes us problems when trading this formation.

Why?

Well, one way to trade a flag is to place a stop order at the low of the flag pole and wait for the currency to break in the direction of the pole. In the case of the GBPJPY we would place a sell stop order at 217.58 (the low of the flag pole). However, the currency has already bobbed through this area several times and failed to continue the break – indicating strength at this support zone.

So what do we do?

There are two things that I do in these cases:
1. I place a sell stop entry order at 5-10 pips below the low of the failed breaks. The lowest low during the failed breaks was 217.36, therefore, I’d be likely to place an order at 217.29, otherwise…
2. I go at market with my sell entry order if the GBPJPY has an hourly close beneath the 217.58 price. As the GBPJPY has failed several times to close beyond this price this would indicate weakness. However, the bar that forms this close beyond the 217.58 low needs to be a breakout type bar – i.e. it needs to close near the low, and have it’s open near the high (it needs to show that she’s ready to go).

I’m more inclined to do the first strategy as the close beyond the low may see my entry waaay below the low, however, I’m concerned about my risk:reward ratio with the sell stop entry order at 217.29.

Let’s calculate the reward for this trade.

The distance of the flag pole is… 220.34 – 217.58 = 276 pips (50% of this would be 138 pips)

So the reward for this trade would be 276 pips.

What would be my risk?

If my entry was at 217.29 where would I place my stop? Some may be inclined to place their stop at the 50% mark of the flag pole – being 218.96 (+ spread), however, I think this is unneccesary for the way this flag has formed. And my reasoning has to do with the way the flag has formed. I think a better risk stop would be the second high formed during the flag consolidation at 218.31 (+ spread). Picturing this in my mind I know if the market falls to 217.29 and then rallies back above 218.31 the flag would CLEARLY have failed.

Our risk:reward ratio would therefore be 102:276 which isn’t bad (anything above 1:2.5 I trade, with 1:3 being the best).

To improve my risk:reward ratio I’ll likely place a trade now to sell a small amount of lots while the currency is consolidating and place stops for this order around the 218.31 (+ spread) area.

This would mean any movement above 218.31 would indicate a failure for this flag formation and all open sell entry orders that haven’t been hit would be cancelled.

Getting back to the announcement conundrum – I’d probably still trade this formation if everything holds, however, I’ll be keeping a close eye when the GBP announcements are released – I’m hoping there will be no whipsawing action.