6. Analysing Financial Markets
You will never know what way the market will move at the time you place a trade and this will not change no matter what analysis you undertake. So you must not approach the analysis seeking to engage in prediction because, if you do, you will fail. Fortunately you don’t need to engage in prediction.
Van Tharp put it well when he wrote:
you don’t need prediction to make money. You just need
wins that are bigger or more numerous than your losses
which need to be smaller or fewer.
The problem with applying this thinking to Binary Options trading is that we already know that, because of the payout ratio being less than 100%, a trader’s wins are always going to be smaller, not greater, than the losses. This immediately breaks a major requirement of most trading systems that concentrate on ensuring that wins are perhaps 2 to 3 times the size of losses. But with Binary Options we can also be fairly confident that our win rate will be higher than it would be with other instruments, even if we don’t know what we are doing. So the whole emphasis is on ensuring that the wins are more numerous than the losses. For typical payout ratios, to be profitable you will need to ensure that more than 57% of your trades are wins.
Let’s say you manage this across 100 trades in a month with $10 at risk each time representing 2% of your trading fund. With an average 78% payout you will have a profit of €14.60. Does this sound low? But this would be a return of just over 2.9% on a fund of €500 in just a month. Continue to do this every month for a year and your fund will have grown to €686, an increase of over 37% per annum and your fund will have almost doubled after 2 years. Of course, you might do much better, but when you recognise that it would be an outstanding achievement for a trader to earn and maintain this level of return then you are approaching this business with realistic expectations.
So, how are you to get your win rate up from the expectation of 50% that would be achieved with random trading to the minimum of 58% that is required? Traders make profits on a trade when they trade in the direction in which the market moves while the trade is open. That is obvious but the essential requirement is to shift the focus of attention away from predicting in which direction the market will move to deciding in which direction to trade.
We start with understanding what the market has been doing and find a market that is doing something that we consider to be suitable for trading. We need to know its direction as we need to trade in this direction. If a market is moving in a definite direction it is trending. So, we need a market that is trending. This is not prediction since we can observe a trend. Of course, every trend eventually ends. So, your system must be able to react to signals that the trend is weakening to ensure you don't trade at these times.
There are various definitions of what might be considered to be a trend, the most usually repeated being a definition that a trend is a sequence of higher highs and higher lows, or the reverse. While this is true it is not a sufficient foundation on which to build a trend following trading system. If we are going to follow the trend we need to have more than just a vague notion of what we mean by a trend in the market. In fact we need to define in considerable detail what qualifies as a trend.
One of the first things we need to do is define the time period we are considering. The 4x4.com strategy recommends looking at 4 different time periods for the analysis. These should be related to the time period across which the trade is expected to be open and related to each other by (approximately) a constant scale.
So, for example, if you intend to trade an option with an intraday expiry of 1 to 4 hours then you should look at a
These timescales are related to each other by a factor of 4 – I know that there are 24 (that would be 6 by 4-hour charts) and not 16 hours in the day but markets experience quiet periods and so parts of the day in almost all markets see little movement and low volumes.
If you intend to trade with an expiry with a short period – let’s say 5 minutes or less – then you might look at a 4 hour chart to find the underlying trend, a 1 hour chart to assess the trend’s behaviour, a 15 minute chart to see if there is a potential set-up in the near future and perhaps a 3 minute chart to time the entry. On the other hand, if you are looking to trade a long term expiry i.e. it will be held overnight and possibly for a number of days, then a 1 week chart, a 1 day chart, a four hour chart and a 1 hour chart would be suitable.
Assume we are dealing with an intraday expiry of 1 to 4 hours. In this case, the following questions are asked:
Let’s look at these stages in more detail according the Binary Options 4x4 plan.
It is generally not sufficient just to look a chart to see if there is a trend and there is a range of indicators that can be used to identify if a market is trending. These include:
This is just a selection, you can take your pick. Contrary to what might sometimes be claimed, there are few set rules in relation to this analysis and the values that are required. What matters is that the analysis is consistent and that the indicators are understood.
The 4x4 model uses a range of indicators in 3 templates to identify a trend. These are scored and the scores are aggregated and weighted to provide a single number, in form of a percentage, that rates the trend. Basically, if the market scores below 40% then a trend following approach will not work well with this market.
If the market scores above 40% then it moves on to the next stage which is the start of assessing the trend. If the market passes all tests then it will be considered for trading.
Should the trend be traded?
This is first examined on the daily chart and then part of the analysis is done on the 4 hour. A visual analysis is sufficient here as we have identified a trend, now we are just assessing it and not trying to second-guess the results of our analysis. There are three key points to watch out for. First, do indicators such as ADX confirm the trend. Second, is the market trading outside the Bollinger band. If it is then it may be overly extended and we should wait until we see a pullback and recovery.
The third stage is to see if there is a potential set-up. A set-up is set of rules for entering a trade. It can be considered to be a set of criteria that a market must fulfill before we can enter a trade. This may be a particular set of values on specified indicators or a particular pattern.
The approach that is used by BinaryOptions4x4 and involves detailed rules for over a dozen set-up and these details are all supplied to members. An overview of one such set-up is provide in Chapter 8 below to give you an idea of what is involved. The set-ups are rules, but there always remains some element of discretion on the part of the trader in deciding on a trade. The purpose of a set-up is not to remove the trader from the picture but to act to guide the trader towards the best possibilities in a consistent and cohesive manner.
That is the exact opposite to what happens with random or emotional trading.
Making the Decision
So far we have only identified a potential trading opportunity: we still need to make a decision. To guide this, the examination of the 4 hour and 1 hour charts should also incorporate a process to see if we can find a reason not to take the trade. If we cannot now find a reason not to trade then we go ahead and trade. Notice that you are now looking for a reason not to trade. You already have reasons to trade. If you cannot find a reason not to do so then the decision is made.
Among the reasons might be:
Timing the Entry
The remaining requirement is to time the trade entry. The precise requirement here will depend to a large extent on the set-up involved as each set-up has timing-related rules. One good generic rule is to enter a trade when many indicators and conclusions from your analysis are supportive without any major contradictions.
Your analysis to date will have ensured this on longer term charts. On the shortest timescale you can look for the following:
The point here is that you are simply timing your entry to improve
your chances of success. You are not deciding whether or not to trade, although you may find a reason to delay taking the trade and then find later that the opportunity has passed. If this happens, don’t worry. There are always plenty more opportunities. But learn from what you did.
Keep Records of Your Trades
The final requirement is to keep a record of your trades. This should include data such as the time, strike price, instrument, expiry time and price, and performance. You should also note any comments you may have or anything that occurred to you in deciding to take the trade, possibly as a comment on one cell of the spreadsheet. Your recording should also keep a running total of overall performance, your risk taking and the level of returns you are earning.
The purpose of keeping this record is to help you learn, not simply to keep an account of the trades. It would also be very useful to see if a losing trade would have been profitable is taken over a slightly different time horizon. So design this record in the way that best suits you and review it regularly.