The long-tail trading strategy

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The long-tail trading strategyThe Long-Tail Trading Strategy

The following trading strategy makes use of a specific reversal bar, the Long-Tailed Hammer, which tends to give high probability signals of reversals of the trend. When correctly identified and used in conjunction with a measure of volatility, such as the Bollinger Band. the long-tail candle can be a useful starting point from which to initiate a trade, with a high probability success rate on most major Forex pairs.

How to define?

The long-tailed hammer, the dragon-fly doji, the pin-headed hammer are all names for a specific type of candle which has a longer-than-average range and a shorter - than-average body – sometimes a very small or pin-like body.

This type of set-up, when it occurs at the end of a down-trend, often outside the parameters of the expected trading range is a very strong signal of the exhaustion of that down-trend and possible reversal from bear to bull. The pictures below show examples of such a candle:

The above is a Long Tail hammer which occurred recently on the aussie. As can be seen from the picture it successfully marked exhaustion of the previous down-trend and preceded a strong rally up in the pair.

Another long-tail on the aussie – note how the entire candlestick formed outside the extremes of the lower bollinger-band emphasizing the exhaustion of the down-trend.

Other indicators

Now that we have looked at some examples of long-tails let us look at the other key element of the strategy, the use of bollinger bands.

The Bollinger Band is an envelope around prices. It is calculated by taking the 20-period simple moving average and then marking two lines, one above and other below which sit at 2-standard deviations from the mean. Theoretically prices move within the bands for 95% of the time. This means that when they stray outside the bands there is a high probability they have reached an extreme and will revert to the mean – or in layman’s terms move back inside.

This strategy requires a that the long-tail form at the lower edge of the bollinger band, more specifically that at least 50% or more of the range of the long-tail lies below the bottom line of the band.

How to trade the long tail

I am now going to outline some suggestions as to how to trade the long-tail. These are by no way definitive and individual traders can alter them as they see fit.

Normally traders advocate waiting for confirmation after a hammer candle, with confirmation coming in the shape of a second strong bullish candle, however, the long-tail is such an exceptionally strong reversal signal on its own that I would advocate entering with a long position before confirmation. This also has the added benefit of minimizing risk.

Another obvious place to enter a long position would be the high of the long-tail, and this would be valid, but I also think it could be unnecessarily late and again – depending on stop placement – probably more expensive in cases of failure. Instead I would advocate placing the stop at the top of the body of the long-tail, that is at the level of the close for a green long-tail or open for a red. It is very rare for the market to take off and gap higher so this entry-point takes advantage of that fact.

Stop placement

We have discussed entry but what about stop placement and more importantly stop management?

Normal practice would be to place the stop just below the bottom of the long-tail candle or the equivalent to the average true range away, however, in order to minimize risk and preserve capital I advocate placing the stop at a Fibonacci 76.4% of the range of the long-tail, which means 76.4% down from the high of the long-tail candle. The tighter stop, is again based on the fact that the signal is so strong.

Stop Management

One possible method of reducing risk further is to move the stop up after the first up-day following the long-tail. There are then several possible ways of managing the stop and exiting the trade.

One method involves leaving the stop at break-even and waiting a set number of days before taking profit. 4, 5 and 10 days seem to work well form back-testing, with 10 days sometimes leading to large accumulations.

Using the Bollinger-Band Centre Line

The final method is to use the centre of the bollinger band, that is the 20-day MA and move the stop up using that. This method is illustrated on the long-tail chart from EUR/JPY above and works in the following way:

The trade triggers at the entry-point established above (at the high of the body). The pair rises and the trade begins making money. After the first up-day the stop is moved up to the entry-point at break-even. The exchange rate rises and reaches the 20-day moving average line of the bollinger band – the centre line. If it manages to close above the line, the stop is moved up to the lows of the candle which closed above it (moving stop A in the diagram above). If it does not manage to close above the line the stop is left at break even. If the market rallies but then falls back below the 20-day line, and then rallies once again above it; the stop is moved up to the low of the candle which closed above it as in b) (moving stop B in the pic above). With each break of the 20-day line and recovery rally above it the stop is moved up again locking in more and more profit, until an eventual concerted move down triggers the stop.