One of the most crucial practices all traders must indulge in is being conscious of the environment they are trading in. If you are a trader, you really need a checklist to help you classify your trading environment. This way, you can determine whether the market is range-bound or it is trading. Keep in mind that defining trade parameters is an essential discipline of trading. Many traders try to pick the top within a trend, but they wind up with unprofitable trades consistently. So, you need to understand how to define the trading environment of a currency pair.
There are various ways for traders to determine if a currency pair is trending or range trading. Although many people do it visually, yet it is helpful for traders to have set rules for keeping themselves out of trades that may be fading or stop traders from getting into a range trade in the middle of a possible breakout.
Look for the following four major factors to classify a currency pair’s trading environment.
Risk reversal is flipping between calls and puts
A risk reversal has two options on the same currency – a call and a put. Both options have the same sensitivity to the underlying spot rate and the same expiration, which is one month. They are quoted in terms of the difference in volatility between the two options. In theory, both options must have the same implied volatility, but in practice, these volatilities differ in the market often. You can see risk reversals as a market polling function.
A number strongly in favor of calls or puts indicates if the Market prefers calls over puts or vice versa. If the number is strongly in favor of puts versus calls, then the reverse is true. Therefore, you can use risk reversals as an alternative to gauge positions in the forex market. In an ideal environment, the volatility of far-out-of-the-money calls and puts should be the same.
However, this is a rare case because the sentiment bias is generally there in the markets, and it is reflected in risk reversals. In range-bound environments, risk reversals are likely to flip between favoring calls and puts at nearly zero or equal. It indicates that the bulls and bears have indecision among them, and the markets have no strong bias.
ADX less than 20
The Average Directional Index is one of the major technical indicators that are used to decide the strength of a trend. When ADX is less than 20, it implies that the trend is weak that usually has the characteristics of a range-bound market. An ADX that is less than 20 and trends downward offers further confirmation that the trend is not only weak but will probably also stay in a range trading environment for a longer period.
Decreased implied volatility
You can analyze volatility in many ways. One of the ways is tracking short-term versus long-term volatility. Short-term volatility usually falls after a burst above long-term volatility. When it happens, it generally indicates a reversion to range trading scenarios. It is usually time for volatility to blow out when a currency pair experiences sharp and quick moves. It reduces during the time of narrow ranges when trading is also very quiet in the markets. You may track volatility by using the Bollinger bands that offer a fairly decent measure to decide volatility conditions. A narrow Bollinger band implies that ranges are small and the markets have low volatility. On the contrary, a wide Bollinger band reflects large ranges and indicates a highly volatile environment. In a range-trading environment, you need to look for fairly narrow Bollinger bands perfectly in a horizontal formation.
Momentum consistent with trend direction
Apart from utilizing ADX, it is also recommended to use momentum indicators in order to find a confirmation of a trend environment. Traders need to look for momentum to maintain consistency with the direction of the trend. What most currency traders do is look for oscillators to point in the direction of the trend strongly. For instance, when it is an uptrend, trend traders look for the moving averages, stochastics, RSI, and moving average convergence/divergence (MACD) to all point strongly upward. In a downtrend, however, traders look for the same indicators to point downward.
The momentum index is used by some currency traders, but only to a lesser extent. Perfect order in moving averages is one of the strongest momentum indicators. A perfect order refers to the condition when the moving averages line up perfectly. For example, in an uptrend, the 10-day SMA is greater than the 20-day SMA, while a 20-day SMA is greater than the 50-day SMA. The 100-day SMA and the 200-day SMA are beneath the shorter-term moving averages. In a downtrend, however, you can call it a perfect order when the shorter-term moving averages stack up below the longer-term moving averages.
Along with these four major factors, additional crucial factors in classifying a currency pair’s trading environment are:
- ADX Greater than 25. As mentioned earlier, the Average Directional Index is one of the primary technical indicators that you can use to determine the strength of a trend. In a trending environment, traders look for ADX greater than 25 and more. However, if ADX is sloping downward even though it is greater than 25, especially off of the extreme 40 level, you must be careful of aggressive trend positioning because the downward slope may be indicating that the trend is waning.
- Options (Risk Reversal). With a trending environment, traders look for risk reversals to favor calls or put strongly. When one side of the market is loaded with interest, it usually indicates a strongly trending environment. It may also imply that a contra-trend move is most likely brewing, considering the fact that risk reversals are at extreme levels.
Once you are able to determine whether a currency pair is range-bound or trending, you can proceed to the next step of trading and decide how long you will hold the trade.