Wednesday, August 22, 2012

Grid Trading - Basic Concepts


Grid Trading is a type of Forex trading that attempts to take advantage of the natural back and fourth motion of the market by placing orders both above and below the current market price and "catching" profits as the market moves. The appeal of this type of trading is that the model requires almost no forecasting of the market direction. 

This benefit of removing the variable of price forecasting,
however, comes at a cost of complicated money management, trading psychology and grid visualization issues you will need to deal with to trade grids. 
You will also find that, even with grid trading, you cannot completely escape some market analysis. 


The Design of a Basic Forex Grid

While there is no end to the number of grid configurations in use, they all are variations of one basic idea. Let's look at the most basic of grids using the EUR/USD pair. 
To most easily explain the basic premise of grid trading lets use an example. We will make the numbers as simple as possible and take a snapshot of a hypothetical market where the EUR/USD is trading at 1.4100 and we decide to use 10 pip intervals 
The basic strategy of the grid would be to set up buy orders above this price and sell orders below the price at certain preset intervals each with a uniform Take Profit target and no Stop Loss orders. Often two trading accounts are needed make managing the grid a bit easier. 
Remember the price is 1.4100 so we will set orders on both sides of it. 
On one side we would have buy stop orders at 1.4110, 1.4120, 1.4130...
On the other side we would have sell stop orders at 1.4090, 1.4080, 1.4070..
Each order will have a take profit and stop loss attached to it. Now let's place our grid into motion. 



Watching the Grid Function
Let's look at the simplest of all possibilities where the price moves straight up or down. When the price moves up the buy orders will be opened and closed out in profit as the price continues up to their take profit level. If the price turns and moves down sell orders will be opened and closed out in profit as the price moves down. New orders replace positions that are closed out - buys every 10 pips above the market price and sells every 10 pips below. 
Doesn't that sound more fun than trying to figure out what the Federal Reserve is going to do next week? Now, however, it's time to add a bit of real world stress to our grid trading session. Let's look at the very plausible idea that the market price fluctuates up and down. 
As the market moves up we open and close positions, but let's suppose that while a buy position is open the price begins to head down before that position's TAKE PROFIT is hit. This position will begin to lose money and the loss will continue to grow larger as the price heads further down. Even if the price hits your sell order's TAKE PROFIT prices and they begin making money this one "dangling" buy order is still there with a loss that continues to widen. 
Now let's complicate things even a bit further. Let's say the price begins to move up before it hits the TAKE PROFIT of one of your sell orders. The same situation begins to happen in reverse: you have an order sitting well below the market losing money as the market rises (although that dangling buy we spoke about a moment ago will begin recovering as the price moves up). 

Carrying Losing Positions on Grids
As we can see, one of the drawbacks of grid trading is the tendency to get caught with an open position (or positions) far away from the market price on which you are losing money even as other positions profit. In fact, one of the most important aspects of grid trading is your ability - both financially and psychologically - to deal with carrying losing positions for a period of time. Sometimes for an extended period of time. 
The financial aspect of carrying losing positions on a grid is relatively easy to see: the position lowers your account's balance/equity and eats into your margin. You may even find yourself paying swap if the market does not move back and clear it out by the end of the trading day. You must have enough money in your account to ride this out. In fact, the most common problem with grids is that traders accumulate losing positions and get margin called and closed out, which ends the chance of the market moving back in the losing position's favor. 
The psychological aspect of carrying losing positions on a grid may be even more difficult to combat. Most people who employ grid trading do so because it seems like a certainty that the market will move back and fourth (thus generating profit) and because they feel it's a way to trade without worrying about fundamentals. Watching the market price trend away from an open losing position on a grid will be a stark reminder that grid trading does not completely eliminate the need to understand the fundamental position of a given market at a given time. 
Managing a losing position (or positions) at the top or the bottom of your grid is one of the central challenges of Forex grid trading- and one if the biggest stresses on the grid trader. It is also one of the basic critisizisms that critics of the grid trading model point to. 

Money Management and Grids 
Because of the ever-present threat of market movement that leaves losing positions open (and thus raises the specter of a margin call) money management is critical to grid trading. 
First and most basically, you must have a sufficient amount of cash in your account to give yourself room to work with as your grid functions in the ever-fluctuating market. Grids don't blow accounts out because people use too small a lot size and begin conservatively, they blow out the accounts of traders who don't have enough cushion. 
Second, ask yourself for how long and how far you are ready for carry the inevitable hanging position that is sitting at a loss. It is important to remember that you will be dealing with the issue for almost all the time you spend trading a grid. 

Conclusion
Trading grids has become a very popular approach to the Forex market. Grids offer an easy to visualize trading strategy and can easily be automated. Using a grid trading strategy does not, however, eliminate the need to understand basic market fundamentals and current dynamics. 
Money management and an eye on your available margin are critical when trading grids because margin calls are a big danger in a trending market. 
Grids offer a good trading structure but they are not magical profit machines. Trading grids comes with its own specific set of challenges. 

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