Trying to pick tops or bottoms with no indicator support is one of the least constructive ways of trading. However, the seven-day extension fade is a strategy that does just that. Here we'll go over how this strategy works and show you some examples of successful and failed setups.
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What is It?
The seven-day extension fade is based on the premise that after seven days of consecutive strength, a currency pair's move is due for a retracement. This number is drawn from our observation of daily market activity. Often, at the beginning of a week, a new trend will emerge. If the trend is strong enough, it can last for several days with virtually no retracement.
However, after seven days of consecutive strength, which encompasses almost a week and a half of uninterrupted directional movement, prices need to pause. Generally, people think in groups of sevens. It is well documented that many psychologists believe most human beings have the best retention rates on numbers that are in groups of seven or less. This is part of the reason why phone numbers here in the U.S. only have seven digits, aside from the area code of course.
So, although five or six days of exhaustion do work, the seven-day reversal pattern is more accurate. Moves that last for eight days happen occasionally, but are very rare. This is where discretion can be used effectively. If the fifth or sixth day of exhaustion coincides with a key technical level, the move may stall at that point. However, looking for only the highest probability trades, the seven-day method is preferable. Even though the setup is rare, when it does occur, it is significant.
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Because sentiment tends to be much more intractable in the market throughout the day, the setup is not nearly as reliable on hourly charts. Trends that last eight hours before reversing are fairly common, while we rarely see trends last eight days without any retracements on daily charts.
Finally, a very important condition of this setup is that every candle in an uptrend must be positive, and every candle in a downtrend must be negative. If the sequence of seven candles is interrupted by a neutral candle, a candle where the close = open, then the count must start from scratch.
The rules for this strategy are fairly simple because it is based solely on price and candlesticks. The accuracy of the strategy increases when the seventh candle coincides with a key technical level.
Rules for a Long Trade
1. Look for seven consecutive bars of weakness, where each bar's close is below the prior close.
2. Buy at the open of the next bar.
3. Place stop at the low of the seventh bar minus 10 pips.
4. The first target is the amount risked. Move the stop on the remaining half to breakeven.
5. Second target is three times the amount risked.
Rules for a Short Trade
1. Look for seven consecutive bars of strength, where each bar's close is above the prior close.
2. Sell at the open of the next bar.
3. Place stop at the high of the seventh bar plus 10 pips.
4. The first target is the amount risked. Move the stop on the remaining half to breakeven.
5. Second target is three times amount risked. Examples - Long Trades
The first example is a daily chart of the NZD/USD (Figure 1). The currency pair begins its downtrend on Dec. 15, 2005, which lasts for exactly seven days. We enter at the open of the candle on the eighth day, placing our entry price at 0.6723. We place our stop at 0.6690, which is 10 pips below the previous candle's low of 0.6700. This means that we are risking 33 pips on the entire trade. We immediately place our first target exit order at entry plus the amount risked, or 0.6756.
The reversal occurs on the second day and our exit order is triggered. We then move our stop to breakeven and place our second take-profit order at three times the amount risked, or 0.6822. This order gets triggered five days later, allowing us to capture 66 pips on the trade for a 2:1 risk-reward ratio.
|Figure 1: Seven Day Extension Fade, NZD/USD|
Figure 2 shows the same strategy on a shorter time frame chart for the EUR/USD. We see the EUR/USD begin to sell off on April 2, 2006, at 7 p.m. ET. The sell-off deepens and continues for seven consecutive hours, or almost one entire trading session. After the close of the seventh hour, we place an order to buy at the open, or 1.2047. Our stop is placed at 1.2022, which is 10 pips below the low of the prior candle. Our first target is our entry price plus the 25 pips of risk, which then equates to 1.2072. Our second target is 1.2122, which is the entry price plus three times the amount risked, or 75 pips. Both targets are hit between the European and U.S. trading sessions, earning us a total of 50 pips on the entire trade.
|Figure 2: Seven-day extension fade, EUR/USD|
Examples - Short Trades
Finding examples on the short side, especially on the shorter time frame, is generally easier than finding examples on the long side. Most sell-offs tend to last closer to five or six days instead of seven. This could be due to the fact that most traders, having primarily come from the stock market, are more ingrained to buy than sell, because of the market's age-old, but defunct, uptick rule.
The first example on the short side is a daily chart of USD/CHF (Figure 3). We see that on Jan. 28, 2005, USD/CHF begins trending upward. The move lasts for seven days, at which time we initiate a short position on the open of the eighth candle. Our entry price is 1.2243, and our stop is 10 pips above the high of the previous candle, or 1.2272. This means that we are risking 29 pips on the trade. Our first target is then our entry price minus 29 pips, or 1.2214. It is reached on the very same day as our entry, at which time we immediately move our stop to breakeven and place a take-profit order for the second half at 1.2156, which is our entry price minus three times the amount risked, or 87 pips. The second target is hit the very next day, and we end up earning 58 pips on the entire trade.
|Figure 3: Seven-day extension fade, USD/CHF|
The example of a seven-day extension fade strategy shown in Figure 4 is actually a double hitter. We are looking at an hourly chart of the GBP/USD from March 2, 2006 to March 3, 2006. The first scenario of the strategy unfolding can be found on the left side of the chart.
|Figure 4: Seven-day extension fade, GBP/USD|
We see that the GBP/USD begins to rally shortly after the open of the U.S. trading session. The rally lasts for exactly seven candles, right up until the U.S. market close. At 5 p.m. ET, or the eighth candle, we place an order to sell at the candle open, putting us into a GBP/USD short at 1.7547. Our stop is 10 pips above the high of the previous candle, or 1.7557. The risk here is tiny, only 10 pips, which means that our first target is also very close at 1.7537.
The second target is three times the amount risked, or 1.7517. The first target is hit within the same bar. The second target is reached three hours later, earning us 20 pips on the entire trade.
In the second example on the right hand side of the same chart, we see that the GBP/USD begins to rally shortly after the release of the stronger than expected U.K. service sector Purchasing Managers' Index (PMI) report. The rally lasts right up until the 10 a.m. ET U.S. economic releases, totaling seven consecutive hours.
At 10 a.m. ET, the market was expecting the University of Michigan Consumer Confidence Index (CCI) and the non-manufacturing ISM report. The stronger ISM number turned the market bullish dollars and the GBP/USD began to collapse. Without even anticipating the economic figures, at the close of the seventh bar, we go short GBP/USD at 1.7584 with a stop 10 pips above the previous candle's high, or 1.7594. Since our risk is only 10 pips, our first take-profit of 1.7574 is easily achieved. With the strength of the reversal, our second take-profit order at 1.7554 is also hit within the same hour, earning us another 20 pips on the entire trade.
The risk for both of these trades is small, which makes the take-profit lower as well. However, in both examples, the more nimble take-profit levels also helped us catch the near bottom of the moves. The retracements did extend in both examples during the same hour but ended by the next candle. (For more on economic indicators, read Economic Indicators For The Do-It-Yourself Investor.)
When the Strategy Failed
|Figure 5: Seven-day extension fade, USD/CHF|
We will take a look at the hourly charts for an example of a failed trade, because many readers might be too impatient to wait for the rare, yet potent, seven-day extension fade on daily charts and instead opt to implement them on hourly charts.
Figure 5 is a USD/CHF chart from March 2, 2006. We see that USD/CHF begins to sell-off immediately after the U.S. market open. The sell-off continues to seven candles and on the open of the eighth candle, we place an order to go long the currency pair at 1.2991 with a stop 10 pips below the low of the previous candle, or 1.2974. Unfortunately, the weakness extends for another bar before it actually reverses, and we get stopped out for a loss of 17 pips. The loss is small and manageable, but more importantly, it highlights how some bouts of weakness can extend for eight candles before fully retracing. This is where discretion comes into play, as some traders may opt to try the trade again at the open of the ninth candle.
|Figure 6: Seven-day extension fade, AUD/USD|
There is also one more point that we want to bring up that is illustrated in the hourly AUD/USD chart shown above. We count seven candles and look to enter at the open of the eighth candle. However, we see that the open is already at the low of the previous candle, which tells us that the move is set to continue for at least another bar; therefore, we choose not to take this trade. At bare minimum, we want to see the open be at least five pips above the low of the previous candle to show that we are buying into some sort of strength.
The Bottom Line
As illustrated in many of the examples above is when we catch a turn; it usually extends for more than three times risk. Therefore, this is certainly a strategy that can involve more discretion in which traders may want to trail their stops using a two-bar high to capture more gains. Alternatively, if you find the fade setup on the daily charts, you may want to trail your stop using hourly charts. The whole premise of this strategy is based on the saying that "what goes up, must come down." We are looking for exhaustion based on the need to bank profits; it may happen in five bars, most times after seven, or occasionally not until the eighth bar. It is not a question of whether it will happen, but simply a matter of when. (For more ways to use the seven-day extension fade read Play Foreign Currencies Against the US Dollar - And Win.)