From the July 01, 2012 issue of Futures Magazine • Subscribe!

Capturing trends in forex

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.

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