Trading forex
You don't have to be a physicist to make money trading forex. You need only a simple, straightforward approach that identifies short-term trends and keeps you in for the ride. Here, we look at a basic strategy that combines two well-known and accessible indicators.
Not only are the forex majors among today's most liquid and widely traded markets, but historically they also have been excellent trending markets. Frequently, most trading profits booked by many of today's top trend-following firms are generated trading the forex markets.
While trend is always a function of time, the best trending markets exhibit strong directional movement across a multitude of time frames. The six major forex currency pairs include the dollar in relation to the pound sterling (USD/GBP), the euro (USD/EUR), the Japanese yen (USD/JPY), the Canadian dollar (USD/ CAD), the Australian dollar (USD/ AUD) and the Swiss franc (USD/CHF).
Here, we'll outline a simple short-term forex strategy that combines a major Japanese candlestick reversal pattern with the relative strength index (RSl) for the entry signal. This entry criterion is complemented with a basic trailing stop exit mechanism. When properly synchronized into a trading system, these components produce the basis for high probability entry signals coupled with an aggressive low-risk exit strategy.
THE INDICATOR
The RSI was developed by J. Welles Wilder Jr. in his book "New Concepts in Technical Trading Systems," published in 1978. While RSI has many applications in both charting analysis and system development, the focus for this strategy is merely on the oscillator's 70/30 interpretation. Traditionally, when RSI is above 70, a market is becoming overbought, and when RSI is below 30, it is becoming oversold.
For this strategy, however, the default parameters of 70/30 were found to be suboptimal. In essence, the 70/30 thresholds generated too few trades to be effective over the time horizon we're studying. A better pair for this horizon, used in conjunction with this particular Japanese candle formation, is 60/40. In other words, a short entry is signaled when the RSI value is 60 or higher, and a long entry is signaled when the RSI value is 40 or lower.
However, for comparative purposes, system results based on both RSl input pairs will be shown.
THE CANDLE PATTERN
Candlestick charting provides a wealth of insight into deciphering the bullish and bearish sentiment within a market. If you know how to interpret them, candlestick price formations can illuminate effective continuation and reversal price signals.
As evidenced by Thomas Bulkowski's recent book, "Encyclopedia of Candlestick Charts," candle reversal patterns are not all created equal. Certain patterns are more effective than others at identifying major price reversals. In testing this system, a Japanese candle reversal pattern that statistically yields higher predictive short-term reversals was focused on the morning and evening doji star price pattern.
This distinctive doji star candle pattern is composed of three price bars.
In the case of the evening doji star, the first bar begins as a long white bullish candle. The second price bar gaps higher on the open, trades in a small range, and closes roughly at the bar's opening value. This price action forms the doji star. The third price bar gaps down on the open and ultimately develops into a long black candlestick that closes below the midpoint of the real body of the first bar, completing the bearish reversal. (See the first chart in "Doji patterns," right.)
In the example of the morning doji star, the same price dynamics are simply reversed. The first bar is a long black candlestick that extends the existing downtrend. The second price bar gaps lower and forms the doji star. The third and final completion bar is the long white bullish candle closing above the midpoint of the real body of the first black candlestick (See the second chart in "Doji patterns," above).
In his research to unearth the name origin of various candle patterns, candlestick expert Steve Nison discovered that the morning and evening doji star patterns were originally called the three river morning star and three river evening star. According to legend, this term originated from a 16th century military campaign led by feudal leader Nobunaga Oda, whose forces forded three consecutive rivers in a fertile rice valley and thereby secured a decisive victory later resulting in the unification of modem Japan. Given the extreme difficulty of this military conquest, the analogy speaks volumes as to the formidable support and resistance wall that forms at the mid-point of this unique candlestick price pattern.
RISK & MONEY MANAGEMENT
The last component of this system involves managing the risk during the trade with an initial stop loss that converts into a trailing stop and moves steadily in the direction of the trade.
Following a buy signal, the initial stop is placed three pips below the low of the completion bar. As the price moves higher, defined as successively higher highs and higher lows, the trailing stop is moved three pips below the low of each successive price bar one bar prior to the current bar. By definition, if during a trade an inside bar forms (meaning the entire range of this price bar is contained within the prior price bar's range ) , until this condition is resolved, the trailing stop remains three pips below the earlier low.
