Capturing trends in forex

June 30, 2012 07:00 PM

Not all financial markets are the same, particularly when it comes to trends. That means, as a trend trader, you may not be active in the best markets for your approach. Moved by the powerful, often slow-moving, forces that shape macroeconomic conditions around the world, currency relationships are prone to extended moves that produce some of the best trends in trading.

Nevertheless, you must understand properly the methods you employ, their profit/loss tendencies and when and why entry and exit signals are generated. It is not enough to point a traditional trend trading method at a currency pair and hope for the best. Here, we will examine a trend-based strategy that works, how it behaves under different market conditions and, ultimately, survives in the market over time.

A logical base

Although there are few known truths about the markets, there are some accepted tendencies. One is that prices tend to change direction at key levels or when they converge with widely popular indicators, such as moving averages. The theory is that market players are lining up to open new positions or smooth existing ones when markets pass these important levels.

Because of this, prices are prone to experience difficulty breaking through these support/resistance areas and then surge through once support/resistance is breached. Such levels even may play a role in the actions of some large traders and commercial institutions (so-called “smart money”) that square their portfolios with respect to these levels. For example, if price retraces back to a moving average level or a key price level, these well-funded players may use that as an opportunity to enter in the direction of the overall trend.

That said, these levels and indicators have little relevance without context. They must be combined with a viable timing strategy. When such a trigger generates a signal, it will be more significant when the entry price is near an important price level or trend indicator. When this occurs, it is a high-probability entry and should be traded on quickly.

Trade setups

For most traders, uncomplicated price evaluation is in their best interest. Thankfully, trading strongly trending markets with a reliable filter means we don’t have to be overly sophisticated in our timing strategy.

One caveat: While this approach may tempt you to take the opportunity to manage position sizes actively and adjust exposure, it’s recommended that a simple risk-to-reward ratio be employed and maintained. Targeting at least a 1:3 ratio will keep the risk in check while allowing trading profits to compensate for losses over time.

The basic structure of this approach involves a 20-period exponential moving average (EMA) of price to confirm the direction of the trend on a four-hour chart. Then, the commodity channel index (CCI), a common oscillator that measures price deviations from a moving average, is used to identify overbought or oversold situations (see “Defining the CCI,” page 5). Both indicators are available on common free charting software and with popular standalone analysis packages.

The goal is to buy when the CCI is in an oversold area while the EMA is reporting a primary uptrend. Likewise, we would prefer to sell when the CCI is in an overbought region during a primary downtrend.

Although technical in nature, this approach is not rigidly systematic. For example, sometimes the signals are taken when the CCI is winding its way toward (but not recording) an oversold condition in an uptrend. This logic also is true in a downtrend.

While this approach is most useful on a four-hour chart, it can work also in other time frames. However, if this is done, stops and targets must be reduced (for a smaller time horizon) or increased (for a larger time horizon).

“Strategy details” (page 6) summarizes the full logic of this technique.

Trade examples

Several recent trades demonstrate this technique. On these charts, the red vertical line on the left shows where a position was opened, while the red vertical line on the right shows where the position was exited. Although this is too small a sample to reflect this, it is observed over time that short positions tend to perform better than long positions with this technique.

On Sept. 15, 2011, GBP/USD — which was caught in a sustained downtrend — experienced a minor rally. However, on shorter time frames, this move was quite significant. The rally attempted to break the 20-period EMA to the upside, but price failed to continue higher. This scenario was given more serious attention as the CCI 20 was moving up, having left the oversold region. A short position was opened. Of course, as you can see in “Cable trade” (below), there were additional likely sell opportunities available prior to that of our strategy.

Our entry price was 1.5850, with a 1.5950 stop loss. On Sept. 21, we hit our profit target of 1.5550 for a profit of 300 pips.

In “Dueling dollars” (below), the slow but steady NZD/USD, which was in a conspicuous uptrend, experienced temporary weakness on Jan. 13, 2012. The CCI already was in the oversold region when a long position was opened on this pair. The target was hit within two weeks. As you can see, incidentally, an equally profitable signal could have been entered before our trade in this case, as well.

Our entry was 0.7900 with a 0.7800 stop loss. On Jan. 26, the market found our profit target of 0.8200, and we closed out our trade with a 300-pip gain.

Despite the effectiveness of the first two examples, don’t assume this is a golden goose technique. In “Downside drift” (below), the market hit our stop before price moved in the predicted direction. Such outcomes can be painful psychologically, but it’s critical to never widen your stop with this method. If it’s hit, it’s hit. Get out and wait for the next opportunity.

For the record, we bought on Jan. 31 at 1.3138 with a 1.3038 stop loss and a profit target of 1.3438. On Feb. 2, our stop was hit and we closed the trade with a 100-pip loss.

Trading can be simple — though never easy — and because of this simplicity, there is no reason for traders to lack confidence in their ability to trade profitably. Confidence can power results, and this further compels you to trade longer and absent emotion. Over time, this simple two-indicator approach to identifying key entry points in currency trends can make money.

Defining the CCI

The CCI is a technical oscillator that helps determine when an instrument has moved to an extreme high (overbought) or extreme low (oversold) over a defined period. Developed by Donald Lambert, the indicator quantifies the relationship between the instrument’s price, a moving average (MA) of the instrument’s price and normal deviation (D) from that average. It is computed with the following formula:

CCI = (Price – MA) / (0.015 x D)

The CCI normally moves on both sides of a zero line. Typical oscillations occur within the confines of +100 and –100. Readings above +100 signify overextended buying pressures, while readings below –100 signify overextended selling pressures.

The indicator is most effective if its signals are taken during an ongoing trend and in the predominant direction of that trend — not against it.

Strategy details

Type: Directional swing trade technique

Time frame: Four-hour charts

Indicator one: 20-period EMA

Indicator two: 20-period CCI

Markets: GBP/USD, EUR/USD, USD/CAD, USD/CHF, AUD/USD, NZD/USD, EUR/GBP, GBP/JPY

Buy rule: In an uptrend, buy when the CCI is below –100 (oversold) and price has touched (or threatened to break below) the EMA, which would be acting as support.

Sell rule: In a downtrend, sell when the CCI is above +100 (overbought) and price has touched (or threatened to break above) the EMA, which would be acting as resistance.

Stop loss: 100 pips

Profit target: 300 pips

Position sizing: 0.01 lots for each $1,000 (making it 0.1 lots for each $10,000) or 0.1 lots for each 10,000 cents in a cent account (making it 1.0 lots for each 100,000 cents). 

Risk per trade: 1%

Risk-to-reward ratio: 1:3

Breakeven: Move your stop loss to breakeven after you have gained 100 pips or more.

Trailing stop: You may apply a custom-set trailing stop of 100 pips after you have gained about 200 pips or more.

Exit rule: Exit when the initial stop, breakeven stop, trailing stop or profit target is hit.

Maximum signals/week: As an additional risk control measure, refrain from taking more than 10 trades with this strategy during one week.

Mustapha Azeez is a professional forex trader, strategist, fund manager, researcher and coach. He is a senior analyst at FX Instructor LLC. Email him at amustapha@fxinstructor.com.

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