Why countertrend? Forex is a unique market that requires unique applications of known indicators. The fundamental difference between FX and equity markets is they trade in near opposites: equities attempt to reach all time highs, or lows, whereas FX tries to reach equilibrium.
The opposing forces in FX are always in play, even during major trends. This, combined with profit taking, causes major oscillations in FX. FX rates tend to reach equilibrium, or at least they want to. Large price movements tend to retrace at least partially. That can be quantified and codified into trading systems.
We can use the RSI overbought/oversold oscillator in conjunction with Bollinger Bands to find a countertrend or trend exhaustion signal.
RSI on the daily should give a bias. When RSI is above 70 we have a sell bias on EUR/USD. This is not a trading signal, it means we will only look for SELL signals on the hourly charts. When we see one, we know there will be a lot of selling pressure as the pair is overbought on the daily.
On the hourly chart, look for Bollinger sell signals using the following rule:
If the most recent bar is inside of the band after the two previous bars closed outside of the band (chart A), sell.
The second close outside the band provides confirmation. This is very important, otherwise it may produce a false signal! See Chart B.
Chart B provides two sell signals: one on April 21 and the second on April 22. There are two places to take profit. The first is a reverse signal on the lower part of the band, the other, at the simple moving average (red line). The take profits indicators are more discretionary than the entry signals. The system is highly accurate for entry signals but exit signals can take a variety of forms with varying degrees of accuracy. If the system is used to capture 50 – 100 pips only, it will work more than 70% of the time. But in the April 22 signal, if you took profit at the lower band, you would have left 200 pips on the table. It is important to use the CLOSE of the bars and not highs and lows for accuracy.
Bollinger Bands need to be adjusted per cross and time frame. This can be done simply by looking at the chart and adjusting the bands accordingly, until clear signals are shown, or it can be optimized using software such as Tradestation or Metatrader. Optimization in this case is not like ‘backtesting’ in the perspective of exaggerating results, because you aren’t changing the entry signals, you are simply adjusting the indicator based on the pair and time frame. Each pair has different pip values, ranges, and trading styles that will need to be compensated for in the parameters of the Bollinger Bands.
The daily and the hourly time frames are recommended here, however, you could use the hourly and five-minute charts in the same fashion. The point is to have a longer term chart for bias and short term chart for signal generation.
Joe Gelet is the President of Elite E Services FX, a registered CTA. Elite E develops models for the FX markets for institutions, hedge funds, and clients. You can contact Elite E Services at www.eliteeservices.net For an automated version of this system which can be tested and optimized, please register at www.eesfx.com