Breaking into the euro

October 31, 2014 07:00 PM

The forex market has swung into action recently with big moves taking place in the U.S. dollar. After a period of historically low levels of volatility, these recent trends are music to the ears of momentum traders. 

With the Fed’s taper due for completion, the market is shifting toward the anticipation of a normalization of rates through increases. This is driving investment into the U.S. dollar (NYBOT:DXZ14). The funding for that investment is coming from areas of the world where the there is an expectation of future easing as a result of economic weakness, as from the European Central Bank. Therefore, we have diverging monetary policy between the Fed and the ECB. Diverging markets are what creates strong FX trends as capital hustles towards the higher yielding currency.

As a result, the trend in the EUR/USD since its May 2014 high has been relentless and swift. As the trend developed, volume increased to levels that we haven’t seen since 2012.

In addition to the fundamental backdrop and strong trend that has developed, the EUR/USD is both the most actively traded currency pair and the most inexpensive to trade. By the time you factor in the spread cost plus commission, the average cost to trade is approximately one pip. 

Trading opening range breakouts 

Opening ranges are like duct tape—there are a lot of different uses for it, and you can alter it to fit your needs.

Trading opening ranges on a breakout is a popular method  as there are many different variations one can make to the strategy. For example, you could trade an opening range for the day week or month. Because we are trading the EUR/USD, let’s focus on the opening range of the European trading session. 

For those unfamiliar with opening range breakouts, the concept behind this strategy is to mark off an opening range high and low and then establish breakout trades based off those identified levels. The objective is that if prices are going to trend, they’ll do so after the opening range has been established, when the liquidity typically comes online.

The European trading day begins at 3 a.m. EST. Therefore, we’ll block off the first hour of European trading, from 3 a.m.–4 a.m. ET to establish our opening range. 

We will look for breaks on the chart after 4 a.m. ET to the European close at 11 a.m. ET. It is during the London and U.S. trading sessions when the EUR/USD spreads tend to be the tightest.

The chart time frame isn’t as important because this strategy is based on certain times of day. However, you can utilize any chart time frame of one hour or less so you can incorporate any of your favorite technical studies into the plan.

Many traders will include a buffer to shield against false breaks (Tony Crabel calls this the "stretch"). Some buffers involve more complex calculations, some of which can produce buffers as large as 10% of the range. The EUR/USD opening range on average runs 20-40 pips, which translates to 2-4 pips if you are using 10% as a buffer. Using a buffer is a double-edged sword, as it can delay your entry into a profitable breakout as well as save you from entering in a losing trade through a false breakout. 

The risk management on the trade is simple. Use the opposing side of the opening range as your stop loss. Take profits minimally at the same distance as to your stop loss. This ensures a minimum of a 1:1 risk/reward ratio. With a 1:1 ratio you will want slightly better than a 50% win ratio to perform better than breakeven on the strategy.

Those are minimum thresholds to consider. Implementing a trailing stop or using a better than 1:1 risk/reward ratio will alleviate the pressure on the win ratio giving you more room to the upside.

“Breaking to profit” (right) shows that on Oct. 9, 2014, the opening range was established at 1.27513 – 1.27914. We’ll use a 0.5 pip buffer, which means our stop entry order to buy, is at 1.27919, and our stop entry order to sell is at 1.27508.

These orders will be OCO and stop loss on the long entry is 1.27513 with a minimum take-profit level of 1.28325. Likewise, the short trade would have a stop loss of 1.27914 and a minimum take-profit level of 1.27102.

Once the orders are set, wait for one to trigger between 4 a.m. and 11 a.m. ET. Eventually, the short trade did trigger and produce a solid profit. 

There is a plethora of ways to modify an opening range breakout strategy. By using multiple lots one could scale out, setting a breakeven level and holding a portion of the position for a larger move and improving risk/reward levels. 

With the diverging monetary policy story there will likely be increased volatility and opportunities trading the EUR/USD. 

Jeremy Wagner is head forex trading instructor at FXCM.

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