What is leverage?
Financial markets are leveraged. For example, in equities standard margin is set at 2:1. This means a trader must put up at least $100 to have control off $200 worth of stock.
This leverage increases to 10:1 when trading options, with $10 controlling $100. With futures trading this leverage increases to 20:1. In other words, with a futures e-mini contract a trader only needs $1000 to control $20 000 worth of stock.
None of the above markets approaches the leverage the forex market has to offer where the default leverage at most dealers is set at 100:1 and can rise up to 200:1. This makes it possible for a trader to control $20 000 of currency and putting down only $100.
This makes the forex market extremely lucrative to trade but as we all know, extremely dangerous depending on which side of the trade you are on.
Forex traders can therefore literally double their accounts overnight or loose it all if they employ the full margin at their disposal.
The high leverage the forex market has to offer makes stops critical to long term survival and most forex traders never trade without employing a stop loss, in most cases traders enter their stop loss together with their initial entry order. Forex traders can not afford to wait out the move as equity and stock traders often do and any forex trader trading without a stop will find his account depleted.
Most forex traders are believed to be speculative and their accounts highly leveraged.
It is for this reason that Stop hunting occurs within the forex market and is simply a method of flushing out the weak longs or weak shorts. In fact, the practice is so common in forex trading that any trader unaware of these price dynamics will probably suffer unnecessary losses.
There is a way to trade Stop hunting:
The human mind naturally seeks order and most stops are to be found around numbers ending in 00. If the GBP/USD is trading at 1.8900 most stops would be within one or two points of 1.8900, this is valuable knowledge as it shows we should actually be placing our stops near less crowded and unusual locations.
This gives us an opportunity also to look for short term trade set ups and cashing in on this stop driven personality of the forex market.
Calculation
Draw lines 15 pips away either side of the 00 number on a one-hour chart. For example if the GBP/USD is approaching 1.8900, draw a line at 1.8885 and also draw a line at 1.8915.
As this method should be traded in the direction of the trade also plot the 200 SMA (Simple Moving Average) as this is particularly effective indicating the overall trend in a single time frame.
When price reaches anywhere near the 1.8900 the theory is that traders will start closing their positions as their stops are most likely to be found here. This mass liquidation of positions will cause price to move even further in that direction, however, as no one knows how many traders there are closing their positions at this stage there is no real way of telling if the size of traders are large enough to trigger further liquidations.
Summary
Stop hunting is one of the simplest setups available to short-term traders and can also be used as an indicator to enter a trade should you be a long-term trader looking for that last signal. Instead of being victims of Stop hunting traders can join the move along with the big institutions.
As mentioned before should you have a long-term approach to the market you could use this trading method and use different exit strategies.
Thank you for joining us in this trading lesson.