Tutorial: Forex Trading Rules
OverviewThe MACD combo strategy involves using two sets of moving averages (MA) for the setup:
- 50 simple moving average (SMA) - the signal line that triggers the trades
- 100 SMA - gives a clear trend signal
Rules for a Long Trade
- Wait for the currency to trade above both the 50 SMA and 100 SMA.
- Once the price has broken above the closest SMA by 10 pips or more, enter long if MACD has crossed to positive within the last five bars, otherwise wait for the next MACD signal.
- Set the initial stop at a five-bar low from the entry.
- Exit half of the position at two times risk; move the stop to breakeven.
- Exit the second half when the price breaks below the 50 SMA by 10 pips.
Wait for the currency to trade below both the 50 SMA and 100 SMA.
- Once the price has broken below the closest SMA by 10 pips or more, enter short if MACD has crossed to negative within the last five bars; otherwise, wait for the next MACD signal.
- Set the initial stop at a five-bar high from entry.
- Exit half of the position at two times risk; move the stop to breakeven.
- Exit the remaining position when the price breaks back above the 50 SMA by 10 pips. Do not take the trade if the price is simply trading between the 50 SMA and 100 SMA.
The second trigger occurs a few hours later at 1.1945. We enter the position and place our initial stop at the five-bar low from entry, which is 1.1917. Our first target is two times our risk of 28 pips (1.1945-1.1917), or 56 pips, putting our target at 1.2001. The target gets hit at 11am EST the next day. We then move our stop to breakeven and look to exit the second half of the position when the price trades below the 50-hour SMA by 10 pips. This occurs on March 20, 2006 at 10am EST, at which time the second half of the position is closed at 1.2165 for a total trade profit of 138 pips.
Figure 1: Moving Average MACD Combo, EUR/USD |
Source: FXtrek Intellichart |
Positive and Negative OscillationsWhy can't we just trade the MACD cross from positive to negative? You can see by looking at the EUR/USD in Figure 2 that multiple positive and negative oscillations occurred between March 13 and March 15, 2006. However, most of the downside and even some of the upside signals, if taken, would have been stopped out before making any meaningful profits.
Why can't we just trade the moving average cross without the MACD? Take a look at Figure 2. If we took the moving average crossover signal to the downside when the MACD was positive, the trade would have turned into a loser.
Figure 2 |
Source: FXtrek Intellichart |
One thing to keep in mind when using daily charts: although the profits can be larger, the risk is also higher. Our stop was close to 200 pips away from our entry. Of course, our profit was 521 pips, which turned out to be more than two times our risk. Furthermore, traders using the daily charts to identify setups need to be far more patient with their trades because the position can remain open for months.
Figure 3: Moving Average MACD Combo, USD/JPY |
Source: FXtrek Intellichart |
Short Trades
On the short side, we take a look at the AUD/USD on hourly charts back on March 16, 2006. The currency pair first range trades between the 50- and 100-hour SMA. We wait for the price to break below both the 50- and 100-hour moving averages and check to see whether MACD has been negative with the past five bars. We see that it was, so we go short when the price moves 10 pips lower than the closest SMA, which in this case is the 100-hour SMA. Our entry price is 0.7349. We place our initial stop at the highest high of the last five bars or 0.7376. This places our initial risk at 27 pips. Our first target is two times the risk, which comes to 0.7295. The target gets triggered seven hours later, at which time we move our stop on the second half to breakeven and look to exit it when the price trades above the 50-hour SMA by 10 pips. This occurs on March 22, 2006, when the price reaches 0.7193, earning us a total of 105 pips on the trade. This is definitely an attractive return given the fact that we only risked 27 pips on the trade.
Figure 4: Moving Average MACD Combo, AUD/USD |
Source: FXtrek Intellichart |
From a daily perspective, we take a look at another short example in EUR/JPY shown in Figure 5. As you can see, the daily examples date farther back because once a clear trend has formed, it can last for a long time. If it didn't, the currency would instead move into a range-bound scenario where the prices would simply fluctuate between the two moving averages.
On April 25, 2005, we saw EUR/JPY break below the 50-day and 100-day SMA. We check to see that the MACD is also negative, confirming that momentum has moved to the downside. We enter into a short position at 10 pips below the closest moving average (100-day SMA) or 137.76. The initial stop is placed at the highest high of the past five bars, which is 140.47. This means that we are risking 271 pips. Our first target is two times risk (542 pips) or 132.34. The first target is hit a little more than a month later on June 2, 2005. At this time, we move our stop on the remaining half to breakeven and look to exit it when the price trades above the 50-day SMA by 10 pips. The moving average is breached to the top side on June 30, 2005, and we exit at 134.21. We exit the rest of the position at that time for a total trade profit of 448 pips.
Figure 5: Moving Average MACD Combo, EUR/JPY |
Source: FXtrek Intellichart |
When the Strategy Fails
This strategy is far from foolproof. As with many trend-trading strategies, it works best on currencies or time frames that trend well. Therefore, it is difficult to implement this strategy on currencies that are typically range bound, like EUR/GBP.
Figure 6 shows an example of the strategy's failure. The price breaks below the 50- and 100-hour SMA in EUR/GBP on March 7, 2006, by 10 pips. The MACD is negative at the time, so we go short 10 pips below the moving average at 0.6840. The stop is placed at the highest high of the past five bars, which is 0.6860. This makes our risk 20 pips, which means that our first take-profit level is two times the risk, or 0.6800.
EUR/GBP continues to sell off, but not strongly enough to reach our take-profit level. The low in the move before the currency pair eventually reverses back above the 50-hour SMA is 0.6839. The reversal eventually extends to our stop of 0.6860 and we end up losing 20 pips on the trade.
Figure 6: Moving Average MACD Combo, EUR/GBP |
Source: FXtrek Intellicharts |
by Kathy Lien and Boris Schlossberg
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