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The Smart Money 3-Day-Cycle
You will now see one type of the emotional roller coaster in action with real chart examples and you will learn how to exploit it with your own trading!
As I already mentioned in the previous article "Smart money and the emotional roller coaster" the emotional roller coaster exists in all trend sizes. The upward moves (from valley to peak) and the downward moves (from peak to valley) of the roller coaster presented in this article usually last 3 days. Following chart shows what i mean:
Why do the move phases of this roller coaster have a duration of usually 3 days? Each roller coaster is bound to a specific trend size. The duration of the move phases of the trend size in this article is usually 3 days. Can it be more or less than 3 days? Yes, and it often is. But you can easily exploit the behavior of the smart money without knowing how many days the move phase will last. If you enter your trades on the first or second day of the move phase you will always have a high probability to benefit from a big upcoming move.
As you already know from the article Smart money and the emotional roller coaster the smart money accumulates a short position on rising prices and is forced to reverse the price downward to give (distribute) the short position to the herd with profit. On falling prices the smart money accumulates a long position and is forced to reverse the price upwards to give (distribute) the long position to the herd with profit. Following chart shows this ever repeating cycle of accumulation and distribution:
Real Chart Examples
We will now go through some weeks of real price charts of the pair EURUSD to see the emotional roller coaster and the behavior of the smart money in action. Following chart is the H1 timeframe in a very condensed form:
The emotional roller coaster of this trend size gets visible if we draw following line into the chart:
We can now add the accumulation areas (rectangles) and distribution phases (arrows) to the emotional roller coaster:
To analyze the actions of the smart money we will now go through every accumulation/distribution cycle of the chart. We will start with the part marked with the green rectangle.
After we have zoomed in (the chart below) we can clearly see the accumulation zone in the green rectangle. In the accumulation zone the smart money is accumulating their long position. This is also shown with the bank guy filling his cart. During the accumulation phase we can't know if the smart money accumulates a long or a short position. We can have an idea which side they accumulate but we can't be sure. The first big move to the upside out of the accumulation zone reveals that the smart money has accumulated a long position and has now started the distribution phase. While price is going upwards during the next 4 to 5 days the cart of the smart money gets more and more empty. The smart money sold its complete long position to the public and is now flat or already short positioned.
Each day of the distribution phase is a so called "Level". Level1 is the first move of the distribution phase out of the accumulation zone. Level2 is the next move of the distribution phase and so on. This distribution phase has 5 Levels. As I already mentioned above you don't need to know how many levels the distribution phase will have to exploit the behavior of the smart money. If you enter into the distribution phase at the beginning of Level1 or at the beginning of Level2 then you entered a trade with a very high probability of success and the winning trades can get very big.
Most of the time, as in this example too, the Level2 move is the biggest move of the distribution phase. Because of the recurring big profit potential of Level2 and the very high success rate early in the distribution phase, my preferred entry method is to enter at the absolute beginning of Level2. The green circle in following chart shows my preferred area for the entries of my trades. I can the hold the trade a few hours (small arrow) or even several days (big arrow) if the conditions of the trend are good. I do never enter after Level2. Entries into Level3/4/5 have a lower success rate and a lower profit potential.
We will now analyze the next accumulation/distribution cycle which is marked with the red rectangle in following chart.
After we have zoomed in we can see the price action of this cycle in detail in the chart below. We can see that accumulation phase in the red rectangle had a duration of 7 days. During this 7 days the price formed range. As I mentioned above, during the accumulation phase we can't know if the smart money accumulated a long or a short position. We must wait for the Level1 which drives the price out of the range to know the direction of the distribution phase.
The Level1 of the distribution phase of this short cycle is less obvious to see compared to the Level1 of the long cycle analyzed above. The Level1 didn't break the lower price level of the accumulation zone. But as you can see in the chart below the price action at the end of the accumulation zone formed an ascending trend line (the green line). The smart money did one last stop hunt to the upside (marked with the black circle), then immediately returned the price with a very fast pace and drove the price through the ascending trend line. This price action and the fact the day closed below the ascending trend line confirmed a valid Level1 of the distribution phase. With this knowledge we can prepare for an upcoming Level2 to the downside on the next trading day and get a very good trading opportunity.
The distribution phase in this cycle has 3 Levels. As we can see, the move of Level2 was again the biggest Level of the distribution phase. Because this happens most of the time, I want to emphasize again that I only trade Level2 when I day trade because it has the highest probability of success and the biggest profit potential. The entry would be at the absolute beginning of Level2 marked with the red circle in following chart. I could then hold the trade until the end of the day (smaller arrow) or even two days (bigger arrow)
Based on the knowledge in this section "Exploiting The Smart Money" in 2010 I started developing a semi-automatic trading system called "ForexFalcon Level2 Trading System". The trades which you can see in the section "Best Trades Journal" are all executed with this semi-automatic trading system.