Opposing Approaches to News Trading

[RichardCox 10]

Opposing Approaches to News Trading

 

For traders that spend time fashioning forex strategies that utilize fundamental analysis in some way, one of the best approaches is news trading. There are many reasons for why news trading allows traders to capture significant gains. For the most part, significant news events mark instances where the market is literally learning new information that might change the supply and demand dynamics for a given asset. This is just as true in forex markets as it is in stock and commodities markets, so it is a good idea to learn some of the techniques that might be used in order to capture profits. Here, we will look at two opposing approaches that can be used to capitalize on the high-volatility price moves that often accompany major news releases.

 

Trading Against Price Spikes

 

When important economic reports are released to the market, the biggest price swings tend to occur when there is a significant level of surprise in that information. For example, if most of the analyst community is expecting an economic report to be strongly positive, prices could fall substantially if the actual results surprise to the downside. In the reverse scenario, markets that receive a positive surprise will likely see rallies generated for the asset in question. When these price moves are substantial there are excellent opportunities to capture significant profits. This requires relatively swift action, however, because markets are usually moving very fast when these types of events are seen.

 

These price spikes create opportunities when the initial movement is followed by a Hammer Candlestick Formation. For those that are unfamiliar with this term, a Hammer is a candle formation that is composed of a small candle body and a long wick that extends far in one direction. Hammers are typically thought of as reversal signals because they ultimately suggest that the prior trend is losing momentum. The resulting pattern then resembles a hammer, and these can be used to establish new forex positions. A visual example of a bullish Hammer formation can be found in the chart graphic below:

 

 

When prices are falling and a bullish Hammer formation can be found, it is generally prudent to consider entering into long positions. When prices are rising and a bearish Hammer formation can be found, it is generally prudent to consider entering into short positions. This can be useful information for those that are looking to trade after significant news events. Consider the following example:

 

 

In the chart above, we can see hourly price action in the USD/JPY. On this day, there was positive news to support the US Dollar and this created an initial rally in prices once that information was made public. Warning signals could be found, however, as a bearish Hammer formation is seen in the following period (shown at the downward arrow). Bullish traders quickly started to exit their positions and this turned the momentum in the bearish direction. What is most important to keep in mind here is that if there is strongly positive news and it fails to generate momentum in the upward direction, there is likely to be little reason in the minds of most traders to buy that asset.

 

So, when Hammer formations occur after a significant news event, it is generally a good idea to trade in the direction opposite of the initial price move. This type of approach becomes particularly useful when the Hammer occurs at a significant point of historical support or resistance. If a news event is positive and prices rise only to form a Hammer at a closely watched resistance level, short positions become much more likely to succeed. If a news event is negative and prices fall only to form a Hammer at a closely watched support level, long positions become much more likely to succeed.

 

Trading With Breakouts

 

Of course, not all news events will result in a reversal. In fact, it is more likely that markets will continue travelling in the original direction as most traders are now reacting to a different paradigm effecting the underlying price of the currency pair. Because of this, it also makes sense to have a strategy to benefit from market continuations once major news events are released. The best approach in these cases is the Breakout Strategy, which will also uses important support and resistance levels in structuring trades. Consider the following chart in the EUR/USD:

 

 

In this example, we can see that the day’s main news event was negative for the Euro, and prices in the EUR/USD were sold heavily in response. Fortunately, there was a clearly defined support level in the price activity that lead up to the economic release. This is significant because a scenario like this gives traders an opportunity to clearly structure trades based on both technical and fundamental analysis. When both of these approaches work in tandem with one another, there is a much greater likelihood that a trade will end in profitability.

 

For those looking to enter into breakout trades into a news event, it is a good idea to have firmly established support and resistance lines leading up to the release. If this cannot be done, it might be a better idea to stay on the sidelines and not enter into a trade. But if these levels can be identified, traders can place limit orders on both sides of the market. Essentially, buy positions would be placed above the market price (just outside of the important resistance level) and sell positions would be placed below the market price (just outside of the important support level). If prices then move forcefully through those areas, one of the trades will be triggered and the other should be deleted from the trading station.

 

“When looking to implement this type of strategy it should be remembered that there are often price gaps that could potentially miss your limit order,” said Brian Johnson, markets analyst at Teach Me Trading. “If this occurs, it is generally a good idea to remove the order as any retracements would likely be indicative of a price reversal.” Additionally, it should be remembered that stop losses should be kept very tight in these types of situations because the enhanced market volatility can lead to quick losses if there is no protective stop loss in place. In many cases, a pip count is the best approach when using stop losses. So, for example a trader might choose to place a 25 or 35 point stop loss on the assumption that a retracement in that amount would likely mean that markets are reversing.

 

Conclusion: There is More Than One Way to Trade a News Event

 

With all of this in mind, forex traders should understand that there is more than one way to trade a news event. The preferred method should depend on a few different factors. for example, traders that are not able to define clear support and resistance levels should not employ the Breakout strategy. Instead, it would be a better idea to watch for Hammer formations so that traders can play the potential for a reversal. In both cases, there is a strong need for tight stop losses because these events create scenarios where the markets are at their most volatile and unpredictable. For these reasons many traders prefer to “wait until the dust settles” and avoid news events. But when these strategies are implemented with quickness and efficiency, there is large potential for gains as market momentum builds.