Rules for the Short Trade
The advantage of this strategy is that it has a slightly positive risk-reward skew of about 1.15:1. To fully understand why, simply use a 100-point segment to calculate the ratios. A trader with a 100-point stop above the swing high would enter at about 33 points above this high, or approximately one-third of the way up. Traders who like Fibonacci numbers may prefer to enter at 38.2% above the swing high, but for matters of simplicity we chose one-third as target entry. That means that the risk on a 100-point segment is approximately 134 points ((100-33) x 2 units). The reward on this strategy is about 150 points. Target No.1 is 50 points, and target No.2 is 100 points. 150/134 is approximately a 1.15:1 risk-reward ratio, which means that even at 50% accuracy, this setup has a positive expectancy.
The Strategy at Work
Now let's take a look at how this setup works under real price conditions.
|Figure 1: The memory of price, EUR/USD|
|Source: FXtrek Intellichart|
On March 29, 2006, we mark a retrace segment in the EUR/USD that extends from 1.2105 to 1.1979, or 126 points. As the pair breaks to the upside, we short one-third of the way through at 1.2148 at 10am on March 30, 2006. The trade moves slightly against us but then starts its turn, and at 1am on April 3, 2006, it reaches our first target of 1.2084. We move our stop to breakeven as soon as the first target is hit and then stay in the trade.
In this case, the trade reaches our first target but stops us out at the breakeven point on the second half of the position, which is in line with our strategy of never letting a winner turn into a loser.
|Figure 2: The memory of price, GBP/USD|
|Source: FXtrek Intellichart|
Finally, here is an example of a long trade using the same idea. On March 3, 2006, we see a strong countertrend segment in the GBP/USD that runs for 169 points from 1.7314 to 1.7482. We enter a buy order at 1.7258, one-third of the way down with our stop resting at 1.7314 minus 169 points, or 1.7145. The trade barely moves against us after we enter in our long position, and we then watch as the price continues to rally, letting us take profit on the first half of our position - at 1.7342 on April 3, 2006 - and then take profit on the rest of the position at 1.7426, for a total gain of 252 points.
The Bottom Line
The memory-of-price strategy works well for traders who don't like to take frequent stops and prefer to bank small profits along the way. Because losses with a traditional memory of price strategy can be substantial when the strategy does miss, this variation has a risk-reward ratio that more traders are likely to find acceptable. At the same time, it may be less accurate that the classic memory-of-price strategy.
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