Most traders are reluctant to buy breakouts, for fear of being the last one to the party before prices reverse with a vengeance. So, how can they learn to trade breakouts confidently and successfully? The “do the right thing” setup is designed to deal with just such a predicament. It tells the trader to buy or sell when most ingrained lessons are against doing so. Furthermore, it puts the trader on the right side of the trend, at the times when many other traders are trying to fade the price action. Read on as we cover this strategy and show you some examples of how it can be used.
Do the Right ThingIn the “do the right thing” strategy, the capitulation of top and bottom pickers in the face of a massive buildup of momentum, forces a covering of positions, allowing you to exit profitably within a very short period of time after putting on a trade.
“Do the right thing” employs a rarely used indicator in FX called the commodity channel index (CCI), which was invented by Donald Lambert in 1980 and was originally designed to solve engineering problems regarding signals. The primary focus of CCI is to measure the deviation of the price of the currency pair from its statistical average. As such, CCI is an extremely good and sensitive measure of momentum and helps us to optimize only the highest probability entries for our setup.
Without resorting to the mathematics of the indicator, please note that CCI is an unbound oscillator, with a reading of +100 typically considered to be overbought and any reading of -100 considered oversold. For our purposes, however, we will use these levels as our trigger points, as we put a twist on the traditional interpretation of CCI. We actually look to buy if the currency pair makes a new high above 100 and sell if the currency pair makes a new low below -100. In “do the right thing” we are looking for new peaks or spikes in momentum that are likely to carry the currency pair higher or lower. The thesis behind this setup is that, much like a body in motion will remain so until it’s slowed by counter forces, new highs or lows in CCI will propel the currency farther in the direction of the move, before new prices finally put a halt to the advance or the decline.
Rules for the Long Trade 1. On the daily or the hourly charts, place the CCI indicator with standard input of 20.2. Note the very last time the CCI registered a reading of greater than +100 before dropping back below the +100 zone.3. Take a measure of the peak CCI reading and record it.4. If CCI once again trades above the +100 and if its value exceeds the prior peak reading, go long at market at the close of the candle.5. Measure the low of the candle and use it as your stop.6. If the position moves in your favor by the amount of your original stop, sell half and move the stop to breakeven.7. Take profit on the rest of the trade when the position moves to two times your stop.
Rules for the Short Trade1. On the daily or the hourly charts, place the CCI indicator with standard input of 20. 2. Note the very last time the CCI registered a reading of less than -100 before poking above the -100 zone. 3. Take a measure of the peak CCI reading and record it. 4. If CCI once again trades below the -100 and if its value exceeds the prior low reading, go short at market at the close of the candle. 5. Measure the high of the candle and use it as your stop. 6. If the position moves in your favor by the amount of your original stop, sell half and move the stop on the remainder of the position to breakeven. 7. Take profit on the rest of the trade when position moves to two times your stop.
CCI Setup On Longer Time Frames In the daily chart of the EUR/USD pair (Figure 1) we see that the former peak high above the CCI +100 level was recorded on Sept. 5, 2005, when it reached a reading of 130. Not until more than three months later on Dec. 13, 2005, did the CCI produce a value that would exceed this number.
Throughout this time, we can see that EUR/USD was in a severe decline with many false breakouts to the upside, that fizzled as soon as they appeared on the chart. On Dec. 13, 2005, however, CCI hit 162.61 and we immediately went long on the close at 1.194,5 using the low of the candle at 1.1906 as our stop. Our first target was 100% of our risk, or approximately 40 points. We exited half the position at 1.1985 and the second half of the position at two times our risk at 1.2035. Our total reward-to-risk ratio on this trade was 1.5:1, which means that if we are only 50% accurate, the setup would still have positive expectancy. Note also that we were able to capture our gains in less than 24 hours, as the momentum of the move carried our position to profit very quickly.
In Figure 2, we look at the hourly chart of the EUR/USD between March 24 and March 28 of 2006. At 1 p.m. on March 24, the EUR/USD reaches a CCI peak of 142.96. Several days later at 4 a.m. on March 28, the CCI reading reaches a new high of 184.72. We go long at market on the close of the candle at 1.2063. The low of the candle is 1.2027 and we set our stop there.
The pair consolidates for several hours and then makes a burst to our first target of 1.2103 at 9 a.m. on March 28. We move the stop to breakeven to protect our profits and are stopped out a few hours later, banking 40 pips of profit. As the saying goes, half a loaf is better than none, and it is amazing how they can add up to a whole bakery full of profits, if we simply take what the market gives us.
CCI Setup On Shorter Time Frames Figure 3 shows a short in the USD/CHF. This example is the opposite of the approach shown above. On Oct. 11, 2004, USD/CHF makes a CCI low of -131.05. A few days later, on Oct.14, the CCI prints at -133.68. We enter short at market on the close of the candle at 1.2445. Our stop is the high of that candle at 1.2545. Our first exit is hit just two days later at 1.2345. We stay in the trade with the rest of the position and move the stop to breakeven. Our second target is hit on Oct. 19, no more than five days after we’ve entered the trade.
The total profit on the trade? 300 points. Our total risk was only 200 points, and we never even experienced any serious drawdown, as the momentum pulled prices farther down. The key is high probability, and that is exactly what the “do the right thing” setup provides.
Figure 4 shows another example of a short-term trade, this time to the downside in the EUR/JPY. At 9 p.m. on March 21, 2006, EUR/JPY recorded a reading of -115.19 before recovering above the -100 CCI zone. The “do the right thing” setup triggered almost perfectly five days later, at 8 p.m. on March 26. The CCI value reached a low of -133.68 and we went short on the close of the candle. This was a very large candle on the hourly charts, and we had to risk 74 points as our entry was 140.79 and our stop was at 141.51.
Many traders would have been afraid to enter short at that time, thinking that most of the selling had been done, but we had faith in our strategy and followed the setup. Prices then consolidated a bit and trended lower until 1 p.m. on March 27. Less than 24 hours later we were able to hit our first target, which was a very substantial 74 points. Again we moved our stop to breakeven. The pair proceeded to bottom out and rally, taking us out at breakeven. Although we did not achieve our second target overall, it was a good trade as we banked 74 points, without ever really being in a significant drawdown.
When “Do the Right Thing” Does You Wrong Figure 5 shows how this setup can go wrong and why it is critical to always use stops. The “do the right thing” setup relies on momentum to generate profits. When the momentum fails to materialize, it signals that a turn may be in the making. Here is how it played out on the hourly charts in AUD/USD. We note that CCI makes a near-term peak at 132.58 at 10 p.m. on May 2, 2006. A few days later at 11 a.m. on May 4, CCI reaches 149.44, prompting a long entry at .7721. The stop is placed at .7709 and is taken out the very same hour. Notice that instead of rallying higher, the pair reversed rapidly. Furthermore, as the downside move gained speed, prices reached a low of .7675. A trader who did not take the 12-point stop, as prescribed by the setup, would have learned a very expensive lesson, as his losses could have been magnified by a factor of three. Therefore, the key idea to remember with our “do the right thing” setup is, “I am right or I am out!”
In Summary “Do the right thing” allows traders to trade breakouts confidently and successfully. CCI can put you on the right side of a trade when many others are trying to fade the price action. However, this setup only works if you apply it along with disciplined stops to protect you from major losses if the expected momentum fails to materialize.
Kathy Lien and Boris Schlossberg can be contacted at BK Forex Advisor