Constructing a Forex Trading System - Part 2

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CONSTRUCTING A FOREX TRADING SYSTEM - PART 2

 

View Part 1 here ...

 

To make money trading forex, we need to sell at a higher price than we bought, in a rising market. And the opposite applies in a downtrend. We could use pure price action to do this, and we could introduce more advanced concepts such as support and resistance (or as some put it – supply and demand) – levels. And we could introduce such things as Pivot Points, and Fibonacci levels. But right now I am going to take the route of indicator-based trading for the purposes of this example, (and leave the extra tools for another day) because this is an easy and uncomplicated approach.

 

We are not discussing the best or the worst way. This article discusses the basic construction of a system. Don’t expect any new or startling revelations here – this information is common knowledge. But I lay these foundations now, in order to build later. What we need to be understanding, is the principle of mechanical system construction and operation. No work is ever going to be complete, and it is quite possible – even likely that - I will either update this post, or expand on it in another article.

 

OUR STARTING LINE-UP OF INDICATORS

 

We can not trade without trend or momentum in play. There are several indicators available to measure these – MACD, ADX, RSI, CCI, PSAR, and even the simplest of all – the EMA cross. You can research these yourself, and make some choices based on personal feel and results of testing. There are good oscillators available too – Stochastic and CCI are usually classed as Oscillators, but when used on the lower TF with higher period settings, such as 21-period, or even30-period, they begin to act as momentum or trend indicators.

 

My preference is for MACD and RSI. Some prefer ADX, CCI, or other indicator.

 

There are countless indicators available for the Forex Trading industry, on hundreds of proprietary trading platforms. Simple is best. If you don’t accept that now, the market will surely reveal the truth of that to you in the future.

 

MOVING AVERAGES

 

Indicators are placed automatically in their own “window” below the main price. Some indicators are right at home alongside the price bars or candles. Moving Averages are one kind. This is not the place to be describing a moving average, or their types. But here we will use the Exponential Moving Average – available on all charting packages.

 

We intend to use three EMA’s of different lengths. The idea is to allow them to indicate when to enter and exit trades, without giving too much profit back. Without going into detail, we will be using the 5EMA (Green); 13EMA (Yellow); 34EMA (RED). These are Fibonacci numbers, and actually mean nothing – it’s a quant choice. But hold on – there is more to this. What Fibonacci actually gives us here, is a slow, medium and fast EMA, and this is ideal for our system.

 

There are inherent problems with using this simplest of approaches – in a word: whipsaws! On their own, we would have a method that would give us profit, but over time ranging or consolidating price, would take back that profit. And it is for this reason that we rely on indicators that provide a filter, to screen our setups and confirm higher probability opportunities.

 

MACD … developed by Gerald Appel in the late 1970’s.

 

We’ll be looking at the version that employs a histogram to enhance visual interpretation. The default is 12-26-9. You may change to a personal setting that improves the indication of momentum.

 

RSI

We shall use the 9-period settings - long enough to filter out “noise” and short enough to remain responsive. For faster signals, shorten the period, but beware an increase in false signals and whipsaws. On the 4H Tf, the 9-period RSI is adequate.

PUTTING IT TOGETHER

 

The default settings of indicators are effective on the 4H TF – but optimum period settings can be added. There is very little that is new, under the “forex sun”, but don’t let that stop you from experimenting. “Tweaks” can be very meaningful if you do them to “own your system.”

 

I have developed my own indicator-based personal system. It is not difficult, and you can’t damage anything through trying. Believe it or not, having a good system does not guarantee successful trading- that is only one part of the process.

 

We want to capture the change of trend, or at least find an appropriate entry. Fast-moving indicators are not necessary – we are not attempting to scalp. In many of the trades signalled, there may be a significant drawdown before the trade actually begins to move in the direction of the signal. This is the dichotomy of trading – trading the pull-back to the main trend - and it is the single most difficult mechanism for traders to negotiate.

 

4H candles show a wick or shadow – frequently on both ends of many of the candles – that form, as evidence of the ebb-and-flow nature of trading price movement. There is always time to take an entry, so no haste is required. A good way to fine-tune an entry at the 4H level, is to drop down to the next level – the 1H on MT4 charts – and find the best entry there.

 

And similarly, one of the best things a trader can do to boost success, is to find out what the higher TF trend is. We are trading the 4H TF, so we need to know what the Daily trend is. Remember, the higher TF is the dominant one.

 

To construct your trading chart, you will need a trading platform that offers decent charting. I have found that the MT4 platforms are free, functional, and offer a very large range of “in-house” indicators. In fact you will find these basic indicators we are discussing, in every MT4 platform. Look for a platform that has only 5 trading days – based on the NY close.

 

Currently I can not upload charts to the Blog. But when I get this function, I will update.

 

The next Blog entry will be about locating good trends and trades, and analysing the indicators to help us nail the entry.

 

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Posted in my Blog: http://forexapplepie.com/