The plethora of indicators, analytical tools, expert analysis and all manner of information available to today’s trader does sometimes overwhelm even the most cerebral of currency traders. Many traders like to apply a large number of indicators in order to identify the perfect entry or exit signal. Since such a signal does not exist, confusion then reigns with the attendant consequence of unnecessary losses. Therefore, the trader is well advised to concentrate on a small number of indicators and trading tools. I will refer to such trading aids as degrees or dimensions of freedom (DOF). This article describes a trading system with three DOF where the simple moving average is the principal player.
The trading system is applicable to both trending and ranging markets. It comprises three degrees of freedom, i.e. simple moving average (SMA), support/resistance levels and Fundamental event risk.
21 period SMA
The 21 period on daily charts approximates a month of trading days. It is also a Fibonacci number. Such numbers have rendered themselves very useful in growth studies, cycle analysis, physical phenomena, financial markets, etc. The SMA is preferred over others such as weighted and exponential moving averages, because of the simplicity of its construction. A central theme to this trading system is simplicity.
For the purpose of this system, the 21 period SMA is applied to 15 minutes chart. The rationale is that the 15 minutes chart captures intraday activity with good detail while at the same time showing most of the activity within a trading week.
When the moving average is sloping upwards, long trades are implemented. When it slopes downwards, short trades are implemented. Trades entered within a trend are closed upon reversal of direction of SMA, or when the respective trend line is broken.
If the SMA is flat and prices are oscillating around it with amplitude of 50 or more pips, then short or long trades are implemented near the upper or lower limits of the consolidation, respectively. Long trades are closed near the upper consolidation limit while short trades are closed near the lower limit.
If the amplitude of the consolidation area is less than 50 pips, then no new trades are implemented since the momentum is too weak and volatility too low – factors which are inconsistent with high probability trading.
Support and resistance levels
These levels or chart areas may be inclined when defined by trend lines; or horizontal when defined by rate or price readings. The behaviour of the 21-period SMA is interpreted within the context of support and resistance levels.
Fundamental event risk
This is a term coined to refer to the risk posed by release of economic data and other events related to fundamentals. Depending on the probable impact of such data or event, the trader takes necessary precautions by either closing trades or adjusting stop loss orders to minimize probable loses. For example; employment data and interest rate events may precipitate market moves of 50 or more pips within a few minutes. In such cases, the trader would do well to close some winning trades which are within 50 pips of entry point while adjusting stop loss orders to breakeven point where applicable. In case the market moves in the direction of the remaining trades, the trader will realise large profits while minimizing the probable losses if the market moves against the trades.
THE SYSTEM IN ACTION
In order to illustrate the functionality of this system, its tenets have been applied to EURUSD market during an arbitrary period from 4th to 7th September 2012. Support and resistance levels are identified by trend lines which define long term, intermediate term and short term trends. These lines have been so annotated on Figures 1, 2 and 3.
Figure 1: long term trend lines as seen on weekly chart
Figure 2: intermediate term trend lines as seen on daily chart
Figure 3: short term trend lines as seen on 4 hourly chart
The probable trading activity is illustrated on Figure 4. The following should be noted:
a) White ellipses and white rectangles represent chart areas where short trades could be implemented while white rectangles represent areas where short trades could be exited.
b) Green ellipses represent chart areas where long trades could be entered while green rectangles represent areas where long trades could be exited.
c) Chart areas where white rectangles and green ellipses intersect are regions where previously implemented short trades could be closed while opening long trades at the same time.
d) The red arrows represent selling opportunities within a downtrend defined by the slope of 21 period SMA; while the green arrows represent buying opportunities within an uptrend defined by the slope of 21 period SMA.
e) Purple rectangles on the figure represent chart areas where volatility is too low and momentum too weak to warrant entry of new trades.
Figure 4: probable trading activity as seen on 15 minutes chart
SOME EXAMPLES OF PROBABLE TRADES
Example 1: from 0200 GMT on 4th September to 0930 GMT on 5th September
With reference to sell area annotated with the white ellipse between 0200 GMT and 1000 GMT on 4th September depicted on Figure 5, a trader could have sold EURUSD at say 1.2616 with a stop loss order placed at 1.2635. Additionally, the trader could have implemented a number of short trades between 1.2625 and 1.2565, as indicated by the red arrows - while the market was trending downwards.
It is instructive to note that the market had just failure tested the blue trend line which defines a long term trend. There would have been no need to exit any of these short trades until the bearish (purple) trend line was broken on 5th September at about 0930 GMT.
Figure 5: selling opportunities on 4th and 5th September, as seen on 15 minutes chart
Example 2: from 0930 GMT to 1600 GMT on 5th September
After breaking the bearish trend line on 5th September at about 0930 GMT, the market subsequently failure tested the SMA before rallying to test the (blue) long term trend line. Long trades entered between 1.2535 and 1.2565 would have yielded handsome profits, before exiting the same as the market tested resistance near the long term trend line. A closer look at the buy chart areas (green ellipse) and exit chart areas (green rectangle), is depicted on Figure 6.
Figure 6: buying opportunities on 5th September as seen on 15 minutes chart
Example 3: from 1200 GMT to 1800 GMT on 6th September
After failure testing the long term trend line on 5th September, the market entered a narrow consolidation but on September 6th at about 1200 GMT, the market rallied slightly thus increasing the amplitude of the congestion area to an acceptable reading.
In the absence of a trend, trades are implemented near the extremes of the consolidation. Thus, on September 6th at about 1200 GMT, a selling opportunity presented itself. Figure 7 depicts the relevant trading opportunities. On the same day, the trader could have bought the market at about 1400 GMT and exited the long trades when the market reached the upper limits of the consolidation. The short and long trades could have comfortably yielded 50 pips on either side.
Figure 7: selling and buying opportunities on 6th September as seen on 15 minutes chart
Example 4: from 0700 GMT to 2100 GMT on 7th September
The market again entered a congestion area between 2100 GMT on 6th September, and 0700 GMT on 7th September which however, remained above the long term trend line thus indicating a bullish bias in the market. The bullish bias was to be confirmed by the upside breakout at about 0700 GMT on 7th September. This offered an opportunity to buy the market as the breakout was a clear sign of an impending bullish trend on 15 minutes chart. Other buying opportunities presented themselves as the market failure tested the SMA. Figure 8 depicts the said buying opportunities.
On this day, employment data was expected from the USA at 1230 GMT. The trader could have locked profits or placed tight stops some minutes before release of employment data, in order to reduce the fundamental event risk.
The impact of the data was to boost the bullish trend thus offering additional opportunities to enter long trades especially since the SMA was providing good support. These opportunities are indicated with the green arrows on Figure 8.
Figure 8: buying opportunities on 7th September as seen on 15 minutes chart
Timing of trade
One minute charts are recommended for the purpose of timing the entry of a trade. For a long trade, the trader looks for a dip in a bullish trend present on 1 minute chart. Figure 9 illustrates such timing for long trades on September 7th.
Figure 9: timing of long trades on 7th September as seen on 1 minute chart