How to Fade False Breakouts With the Boomerang Strategy

Posted 06/05/2009, 9:00 am EST by Ed Ponsi from tradingmarkets.com

Forex traders can use "The Boomerang" strategy to fade false breakouts.

Most forex trading strategies are based on a market tendency. For example, the currency markets have a tendency to form strong trends, and many trading techniques seek to capitalize on this trait. Other strategies are based on breakouts from an opening range, which are likely to occur during times of high volume and liquidity. One area that has been neglected is the tendency for the currency markets to drift quietly at certain times of the trading day. This begs the question, is it possible to use this less obvious market tendency to our advantage?

After the U.S. forex trading session ends, and prior to the beginning of the Asian trading session, there is a stretch of several hours during which the overall volume is normally low. This illiquid time of day occurs around 5 p.m. New York time. While it is true that traders from Australia and New Zealand are active at this time of day, the big three centers of world currency trading, Great Britain, the United States, and Japan -- lie mostly dormant. It is during these hours that many currency pairs tend to drift aimlessly, and the low volume environment renders any movement, especially a breakout, highly suspect.

What is the Boomerang Strategy?

Why are breakouts that occur on low volume considered unreliable? In all forms of trading, a breakout that occurs on high volume is respected because when traders are willing to put real money into a trading vehicle such as a stock, commodity, or currency, it shows a high level of commitment to that position. The increase in volume is a reflection of that commitment. While the currency markets are far too vast to allow for the collection of exact volume figures, it is understood that volume normally increases or decreases at certain times of the trading day. Therefore, breakouts that occur during times that are known to be liquid are more reliable, and those that take place during times of illiquidity are much less dependable. Since any movement that occurs at this time (5 p.m. New York time) is unreliable and likely to retrace, we can create a strategy that is designed to capitalize on these false breakouts, by 'fading' or trading against them.

The Concept

Since 5 p.m. Eastern time is considered by many to be the beginning of the forex trading day, it is also the time that many market makers have chosen to charge or collect interest. We need to take this fact into consideration, because currency traders who pay no attention to interest charges and credits might be surprised at the amount they are paying, while those who do focus on this aspect of trading are often area able to use interest credits to their advantage.

In order to avoid interest rate charges, orders should be entered just after 5 p.m. Eastern time when using this strategy. This will equate to 22:00 Greenwich Mean Time (GMT), which is the standard measurement of time used by currency traders. It is important to note that GMT does not recognize Daylight Saving Time, which is known as "Summer Hours" in the U.K. Therefore, the time of day for order entry for this strategy will be 21:00 GMT when Daylight Saving Time or Summer Hours are being observed.

Why do forex traders use Greenwich Mean Time as a reference point? Imagine that you are in the western United States, on a conference call with several traders located in London, New York, and Singapore. One participant mentions that important news is expected to hit the wire at 10 am. This can create confusion, because you may not know which participant made the comment, or where that person is located. Therefore, you would not know if that person was referring to noon in London, noon in Singapore, or noon in New York. However, if a one of the participants states that important news is due to come out at noon GMT, there can be no misunderstanding about the intended meaning. All of the traders on the conference call will be prepared for possible short-term market volatility at the time of the news release.

The specific trading vehicle designated for this strategy is the Euro/ U.S. Dollar currency pair. EUR/USD is attractive for short term trading strategies because it has a tight spread. When dealing with short-term strategies, every pip matters and a slightly wider spread can mean the difference between success and failure. For this reason, trading platforms that feature variable spreads may be problematic, because spreads tend to widen during illiquid times of day. Since the strategy is implemented at a time of low liquidity, a fixed-spread platform is recommended when using this strategy.

The Setup

The plan entails the simultaneous entry of a sell order above the market and a buy order below the market. The purpose of the sell order is to 'fade', or trade against, a move higher and the buy order is entered to fade, or trade against, a downward move. In either case, the trader assumes that any directional movement will be short lived since there is unlikely to be much volume behind it. The short-term movement is most likely caused by an order or group of orders that would not have the power to move the market under normal circumstances. Such orders can and often do move the market when trading conditions are 'thin'. This movement should be followed by a retracement of the exchange rate, and it is this retracement that the trader seeks to capture.

The sell order will be located 15 pips above the 'opening price', and the buy order will be 15 pips below the opening price. Since this strategy is only designed for the EUR/USD currency pair, fixed-pip parameters can be used. If other currency pairs were eligible for use in this strategy, it would be impossible to use fixed parameters because of differences in volatility and in the spread among the various pairs. For our purposes, the opening price will be the price indicated at 5 pm Eastern time, as described earlier. The protective stop for the buy order and for the sell order will be 15 pips away from the entry point, which creates a risk-reward ratio of 1-to-1 (one pip of risk per one pip of reward) for this trade. This is a brief 'slingshot' style of trade that is designed to capture a quick profit and is intended for use at one specific time of day only.

If no orders have executed within two hours after the open, all open orders must be canceled. The reason why the orders must be canceled at this time is because Asian trading markets tend to become active around 19:00 Eastern time, and as a result an increase in volume and volatility should be expected. Since the strategy is designed for use in a low-volume trading environment, the increased activity from traders in Tokyo, Hong Kong, and other Asian market centers will create a trading environment that is too liquid for this particular strategy. When this additional liquidity enters the market, any movement in currencies is more likely to have real volume behind it, and therefore may not retrace. A strategy that fades breakouts would be inappropriate under these circumstances, since there is a chance that institutions or other large traders may be committed to the move.

This method of trading is simple but effective, because exchange rates rarely make big moves during the 'dead zone' between the U.S. and Asian sessions. In order for the protective stop to be reached, the exchange rate for the EUR/USD pair would have to move 30 pips in one direction - 15 pips to trigger the entry, plus 15 more pips to trigger the stop - a move which would be rare at this illiquid, non-volatile time of day.

Rules for Entering The Trade

Let's take a look at the strategy in action using the five-minute chart. On February 26, 2008, the EUR/USD pair opens at 1.4991. The trader places a sell order 15 pips above, at 1.5006, with a stop at 1.5021, and a buy order 15 pips below, at 1.4976 with a stop at 1.4961. Within 25 minutes, the exchange rate rises to 1.5012, easily executing the sell order at 1.5006. The trader cancels the buy order, but leaves the stop in place at 1.5021. The target is the "opening price" of 1.4991, which is reached within 30 minutes of the entry (see figure 1).

Figure 1: EUR/USD pops up to the entry point, then quickly fades back.

Figure 1: EUR/USD pops up to the entry point, then quickly fades back.

Source: FXtrek IntelliChart, Copyright 2001-2008 Fxtrek.com, Inc.

On August 5, 2007, the EUR/USD currency pair 'opens' at 1.3510. Immediately, two entry orders are placed, a buy order at 1.3495 with a stop located at 1.3480, and a sell order at 1.3525 with a stop positioned at 1.3540. Just two candles later, the exchange rate quickly dips to 1.3789, easily executing our buy order at 1.3595. The trader immediately cancels the sell order, but keeps the protective stop in place at 1.3480. The exchange rate immediately bounces back toward our entry point, and several candles later, at 17:45 Eastern time, the pair has climbed as high at 1.3819, easily executing our exit order at 1.3810. The entire duration of the trade was just 35 minutes. The pair continued to rise after the exit point was achieved (see figure 2).

Figure 2: EUR/USD quickly reaches the entry point, then bounces higher.

Figure 2: EUR/USD quickly reaches the entry point, then bounces higher.

Source: FXtrek IntelliChart, Copyright 2001-2008 Fxtrek.com, Inc.

Here is another example; on May 10th, 2007, the EUR/USD currency pair opened at 1.3487 at 17:00 Eastern time. The trader places a buy order at 1.3472, with a stop 15 pips below at 1.3457. The trader also places a sell order at 1.3502, with a stop 15 pips higher at 1.3517. Just under an hour later, at 17:50 Eastern time, the exchange rate dips to 1.3471, creating an entry. At this time, the trader cancels the sell order, but the protective stop at 1.3457 remains in place. At 19:15 Eastern time, two hours and fifteen minutes after the original orders were placed, the exchange rate for EUR/USD climbs to 1.3489, allowing the exit order to execute (see figure 3).

Figure 3: Five-minute chart of EUR/USD on 5/10/07 shows the open, entry, and exit.

Figure 3: Five-minute chart of EUR/USD on 5/10/07 shows the open, entry, and exit.

Source: FXtrek IntelliChart, Copyright 2001-2008 Fxtrek.com, Inc.

This tactic can make a nice addition to a trader's arsenal of techniques; it is intended for those 'quiet times' when trading opportunities are rare. The intention is to get in and get out quickly, and while the gains are not particularly large, the percentage of winning trades should be high because of the market's tendency to drift at this time of day.

One more important point to consider - this strategy assumes that interest will be charged or credited at a particular time of day. While many market makers charge or credit interest at 17:00 Eastern time (5 pm), this is not a uniform practice. Rules for the payment or collection of interest vary from on market maker to another, so be sure to check with your broker for these important details before attempting to place a trade using this strategy.