Sentiment Change Forex Swing Trading Strategy

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Sentiment Change Forex Swing Trading Strategy

In contrast to popular belief, trading is not much of a zero-sum game wherein you are competing against other traders for income and would have to cause the others to lose in order for you to win more. Instead, it is a cooperative type of game. This means for you to make money, you must be in agreement with the bigger chunk of the market. In other words, you’ve got to be in sync with the market’s sentiment for a certain period of time.

Think of it as a game wherein you players have to choose either of two things, up or down, buy or sell. Those who chose the same option as the bigger chunk of the market scores a point. Not only that, the bigger the imbalance between the number of winners and losers, the bigger the winnings. This is especially true with trading. If a big chunk of the market chose to buy a security, commodity or currency at the same time, price would be pushed higher and higher. If a big chunk chose to sell, then price would plummet. Those who chose the wrong side would certainly lose.

This is why market sentiment is very important. Knowing how to get a feel of how the market thinks of a certain price level is very important. It is even more important to get a feel when the market is starting to act on their belief on the fair value of price by taking positions.

Price and Candlesticks as an Indication of Market Sentiment

There are a couple of ways to accurately determine the sentiment of the market: pending orders and price movement.

Pending orders are great determinants of market sentiment. There we would know at what price level a certain trading instrument is good to buy or sell. By entering at these points, we get to enter just as price starts to make a massive move. However, most retail traders like us don’t have access to this. It is probably just the brokers and big banks who could access this information.

The next best option is price itself. This is because price is a function of the collective beliefs of the market on what the fair value should be. Couple it with the element of time, we get to have a great tool to assess market sentiment.

How do we do this? By looking at candlesticks. With price candles, you get to have the information of how much price moved and how fast it moved. Candlestick patterns tell us so much information regarding how the market acted on price. For example, a pin bar pattern tells us how the market sentiment reversed in just one candle. It also tells us that the market is rejecting a certain price point. There are many other candlestick patterns that are quite reliable. Candles such as the Marubozu, engulfing pattern, and more.

Trading Strategy Concept

This strategy will be based on two concepts: price rejection and momentum. These two things are forms of market sentiments that could be observed on price.

To determine our area of price rejection, we will be using the Bollinger Bands’ outer bands. These outer bands, which are determined by a deviation from the mean, are areas of extremes. Price going beyond these areas could be a bit too high. What we need is for price to show signs of rejection around these areas of extremes. This will be determined by the presence of wicks pushing against the outside of the bands. This is because wicks are telltale signs of price rejection. If we see this, then we wait for our next signal.

The next thing we will be looking for is a confirmation that price has a sudden change of market sentiment. How fast? In one time period or candle. Since this is a swing trading strategy, we will be using 4-hour candles. We would have to see price move drastically within 4-hours. This will be determined by a big long candle. Not only should it be a big long candle, but it should also close within one-third of its total length going towards the reverse of the current trend and it should also close below the midline of the Bollinger Band. This is because the midline of the Bollinger Band is a moving average. Since we will be using a 20-period Bollinger Band, we will also be looking at a 20-period moving average with its midline. A close below this is a sign that the market sentiment has changed for the short-term and could be a start of longer-term change in trend.

Indicator: 20-period Bollinger Band

Timeframe: 4-hour chart

Currency Pairs: any major pairs and crosses

Trading Session: any

Buy (Long) Trade Setup Rules

Entry

  • Price should be coming from around the lower outer band (oversold area)
  • Candles should have wicks below showing signs of rejection of the oversold area
  • A long bullish momentum candle should close above the midline and should close within the upper one-third of its total length
  • Enter a buy market order at the close of this candle

Stop Loss

  • Set the stop loss a few pips below the low of the candle

Exit

  • Close the trade as a candle closes back below the midline

Sell (Short) Trade Setup Rules

Entry

  • Price should be coming from around the upper outer band (overbought area)
  • Candles should have wicks above showing signs of rejection of the overbought area
  • A long bearish momentum candle should close below the midline and should close within the lower one-third of its total length
  • Enter a sell market order at the close of this candle

Stop Loss

  • Set the stop loss a few pips above the low of the candle

Exit

  • Close the trade as a candle closes back above the midline

Conclusion

This is a common strategy used by many swing traders.

Some traders use this type of strategy on different timeframes. However, because of the uneven volume of trades on the 4-hour chart due to the cycle of opening and closing of markets, there is often a pent-up number of trades that come in as the home market of a currency opens or as a big market opens. This pent-up volume often allows for a strong momentum candle which pierces and closes beyond the Bollinger Band’s midline. This is a better sign of momentum compared to a slow chugging candle that is often observable on more even volume timeframes.

Another variant of this type of strategy is that some traders enter on the candles with wicks rejecting the overextended price area. Although in theory this should allow you to have more bang for the buck by entering the market a bit earlier, this could also have a lower probability of success. This is because price still hasn’t broken any of the trends, whether short-term or mid-term, and is still well supported by these dynamic barriers. By waiting for the close below the midline, we have waited for the close below a 20-period moving average, which is also the short-term trend. Sure, we have given up a bit reward-risk ratio but should have increased our probability of a win.

Lastly, by waiting for the reversal signal before we close, we could have a widely fluctuating reward-risk ratio. Some trades would have a bad reward due to the shortness of the trend, while other trades would have bigger returns.

Explore how you would trade this type of strategy and make it your own. It is a working strategy that traders use, it all now depends on how you mix and match these parameters.

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