In a world where we are inundated with information, it is virtually impossible for a Forex trader to select the data that is required to choose the proper market direction. A trading system based on technical analysis assumes that all available data has been processed in the price history. The trading system makes its decisions based on this analysis and there have been reams of information written on technical analysis and systems trading. This means that the selection of a technique fitting your requirements could end up being a drawn-out quest. My advice is to start simple. Things will get complicated soon enough.
Keep It Simple
Randomly using technical analysis techniques often leads to disappointment. Investors and traders frequently select indiscriminately from the vast array of indicators and tend to swap from indicator to indicator too often (sometimes even during a position). In other words, it is time for a more disciplined and systematic approach.
An effective technical analysis strategy suggests objective entry moments and doing the ‘cerebral work’ on your behalf while enabling you to disengage your emotions during a position. This is provided that you have gained sufficient confidence in your trading system to ensure its successful application based on a rudimentary knowledge of the theory and on simulations (backtesting) of past trading.
A trading model should be as simple as possible. Entering higher order terms (trading rules) may increase the fit with the price chart and allow price nuances to be followed more closely but the chances of recurring structures will become more unlikely! In other words, the chances of the model tracking a future price trend declines. Even though adding trading rules might initially boost trading performance, burgeoning rules will eventually depress performance.
Trend-Following Indicators
Trend-following indicators are designed for use in trending markets. One of their key features is that they lag the market. Trend-following systems are characterized by relatively low hit rates (± 30 – 50%), together with high average profit / average loss (avgP/avgL) values (± 2–4). System profits are obtained in a relatively small number of lucrative trades. The disadvantage of relatively low hit rates is a higher frequency of losing streaks. Not only that, but indicator lag can also cause profitable positions to evaporate within a single trade. These disadvantages can be very frustrating.
As a result, trend-following traders require a healthy dose of perseverance. Trend-following indicators always lag the trend. It would be great if a signal could be given precisely when the price trend falters or reverses, but indicators require a range of price data to determine whether a trend is turning. This lag applies to all trend-following indicators to one degree or another. The following paragraphs discuss a simple trend following system based on a trailing stop-loss. Using a trailing stop allows you to let profits run while cutting losses at the same time.
Moving Stop Loss (MSL)
The Moving Stop Loss (MSL) is basically an indicator based on the trailing stop technique. The MSL is derived from the previous bars’ closing prices. The stop-loss value applies an adjustable percentage above or below the closing price, depending on the position (long or short). In the event of a limited price correction (which does not reach the stop-loss point), the stop-loss trigger remains frozen at its highest (if long) or lowest (if short) value. A buy/sell signal is given once the price reaches the stop-loss level.
A Moving Stop Loss allows you to adjust stop-loss settings to follow the trend when prices are heading in the right direction. The appeal of the MSL indicator is its simplicity. The straightforward principle of a concurrently moving stop-loss is very appealing, especially to active short-term traders, although long-term position traders also use this indicator as well. However, fervent users know from experience that losses can mount quickly in a sideways trading market. The indicator is easily optimized, but take care to note my warnings on optimization.
Calculation
The MSL is calculated for the following day depending on its current situation (short or long).
Situation is long:
If Close[x] < MSL[x-1] then
situation = short
MSL[x] = Close[x] * (100 + Percentage) / 100
or
MSL[x] = Maximum(MSL[x-1], Close[x] * (100 - Percentage) / 100)
Situation is short:
If Close[x] > MSL[x-1] then
situation = long
MSL[x] = Close[x] * (100 - Percentage) / 100
or
MSL[x] = Minimum(MSL[x-1], Close[x] * (100 + Percentage) / 100)
This is an excerpt from Nov 2011 issue of Forex Journal.
