Stop hunting with the great Forex players.The foreign exchange market is the most leveraged financial market in the world.
In equities, the standard margin is set at 2:1, which means that a trader must put at least $50 in cash to control $100 in stocks.
In options, leverage increases to 10:1, with $10 controlling $100. In futures markets, the leverage factor increases to 20:1.
For example, in a Dow Jones e-mini futures contract, a trader only needs $2,500 to control shares worth $50,000. However, none of these markets comes close to the intensity of the foreign exchange market, where the default leverage in most traders is set at 100:1 and can go up to 200:1. That means a mere $50 can control up to $10,000 in cash. Why is it important? First, the high degree of leverage can make FX extremely lucrative or extraordinarily dangerous, depending on which side of the trade you are on.
At FX, retail traders can literally double their accounts overnight or lose them all in a matter of hours if they use all the margin at their disposal, although most professional traders limit their leverage to no more than 10:1 and never assume such a huge risk. But whether they trade with 200:1 leverage or 2:1 leverage, almost everyone in FX trades with stops. In this article, you’ll learn how to use stops to set up the «Stop hunting with the big specs» strategy.
Stops are the key
Precisely because the forex market is so leveraged, most market players understand that stops are critical to long-term survival. The notion of «wait», as some equity investors might do, simply does not exist for most Forex traders. Trading without interruption in the foreign exchange market means that the trader will inevitably face a forced liquidation in the form of a margin demand. With the exception of a few long-term investors who can trade in cash, it is believed that a large part of the participants in the currency market are speculators, so they simply cannot afford to hold a losing position for too long because their positions are highly leveraged.
Because of this unusual duality of the currency market (high leverage and almost universal use of stops), stop hunting is a very common practice. Although it may have negative connotations for some readers, stopping hunting is a legitimate form of trade. It is nothing more than the art of taking losing players out of the market. In forex language they are known as long or short weak. Just as a strong poker player can eliminate less able opponents by increasing bets and «buying the jackpot», large speculative players (such as investment banks, hedge funds and money center banks) like to shoot stops in the hope of generating more directional momentum. In fact, the practice is so common in FX that any trader who is not aware of these price dynamics is likely to suffer unnecessary losses.
Because the human mind naturally seeks order, most stops are grouped around round numbers ending in «00». For example, if the EUR/USD pair traded at 1.2470 and rose in value, most stops would be one or two points from the 1.2500 level instead of, say, 1.2517. This fact alone is valuable knowledge, as it clearly indicates that most retailers should place their stops in less crowded and more unusual places.
More interesting, however, is the possibility of benefiting from this unique dynamics of the foreign exchange market. The fact that the forex market is so stop driven gives room for several opportunistic configurations for short-term traders. In her book «Day Trading The Currency Market» (2005), Kathy Lien describes one of these configurations based on the fading of the «00» level. The approach discussed here is based on the opposite notion of joining the short-term impulse.