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echnical analysis tools in and of themselves are useless. Only whenwe apply them to intelligent, logical trading strategies do they provetheir worth and help us make money in the currency market. Whatfollows are several trading setups designed to exploit the value of technical indicators in currency trading. These are generalized setups and by nomeans are a holy grail to untold riches. In fact, I can assure you that all ofthese setups will fail at one time or another. Hopefully, however, thesetrading ideas will fail intelligently; that is, either they will fail frequentlybut with small losses or they will fail with much larger (though not debilitating) losses but only occasionally. Regardless of the outcome, the purpose of this chapter is to show you how to use technical analysis todevelop a methodical approach to trading the currency market. Why ismethod so important? Because it is the only way we can study, analyze,and improve our techniques. Seat-of-the-pants, instinctive trading maywork well for some traders, but ultimately it is extremely limiting. In fact,this is the critical value of technical analysis—for it allows the trader tosystematically apply his ideas to the market and objectively measure theirsuccess.Some of these ideas I trade myself, while others have come from thefertile minds of friends and colleagues. However, as always, I note that notwo traders are alike nor will they trade alike. Therefore I present thesesetups simply in the spirit of sharing. Feel free to experiment and modifyany of these strategies to accommodate your tastes or preferences. Justremember to stay true to the logic of whatever strategy you devise. Intrading currencies, everybody is wrong sometimes. The difference be161
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tween professionals and amateurs is that professionals accept this realitywhile amateurs do not and are therefore doomed to be destroyed by it.
TREND DETECTION/TREND EXHAUSTIONWITH BOLLINGER BANDSWhen does a trend start? For some traders a new trend begins when theold trend ends. The swing high or low of the prior trend is the commencement of a move the other way and thus the birth of a new trend. For othertraders, true trend must display a concerted evidence of directionality—that is, prices must make consecutive new highs or new lows for trend tobe truly in place. Regardless of how one defines trend, the Bollinger band“bands” setup is one of the most flexible tools to implement either strategy.Let’s quickly review the premise behind this trade idea. The classicBollinger bands, invented by John Bollinger, plot the standard deviation ofprice around the 20-period simple moving average.The Bollinger band formula consists of the following:BOLU = Upper Bollinger bandBOLD = Lower Bollinger bandn = Smoothing periodm = Number of standard deviations (SD)SD = Standard deviation over last n periodsTypical price (TP) = (HI + LO + CL)/3BOLU = MA(TP, n) + m × SD(TP, n)BOLD = MA(TP, n) – m × SD(TP, n)Generally we know that price tends to be range-bound 70 to 80 percent of the time. During these periods Bollinger bands serve as very accurate points of oversold or overbought value. Traders can effectively sellwhen prices hit the upper Bollinger band and buy when prices tag thelower Bollinger band. Note how a range-bound consolidation zone inEUR/USD provides several opportunities to sell tops and buy bottoms,harvesting nice profits for the trader. Typically the best time to trade seesaw setups is right after the price has made a major move in one direction,for as surely as day follows night, consolidation follows trend.The basic rules to trade range are:1. Establish at least one swing high and one swing low for the range.2. Measure the amplitude of the range.
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3. Go long the next time the price hits the lower Bollinger band.4. Set a stop at the low of the entry bar plus half the value of the ampli-
tude of the range.5. Exit the long when the price hits the upper Bollinger band and immediately establish a short, placing a stop at the high of the entrybar plus one-half the value of the amplitude of the range (see Figure 10.1).6. Make minor adjustments by recalculating the range value as itexpands.7. Repeat the process until you are stopped out.Between April and October of 2004 this strategy worked exceedinglywell in the EUR/USD pair, registering five consecutive profitable trades.To fully appreciate just how profitable this kind of trading can be, notethat this method was able to bank cumulative gains of 1,000 points in anenvironment in which the currency pair never moved more than 300points either way.Why was this strategy so successful? First, it was implemented after astrong trend move as EUR/USD gained nearly 1,000 points from 2003 to
FIGURE 10.1 Trading Range with Bollinger BandsSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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2004. After trends prices will very often experience a long period of consolidation as the market digests and adjusts to new values. Second, thestrategy used the classic money management technique to control risk. Byusing one-half the amplitude of the range, this trading technique providedenough room to avoid market noise while keeping the reward-to-risk ratioat 2:1. In highly range-bound markets such as that of April to October of2004 this method was extremely profitable, but even in markets where itgenerated only one profitable trade before stopping the trader out, themethod was a net winner because of its 2:1 reward-to-risk money management rules.Going back to Figure 10.1, if we connect every point of entry and exitwe realize that the pattern forms a Z-shaped line. Looking at this line wecan see that this in fact is a horizontal trend. Although this concept mayseem like an oxymoron, if we were to stretch out the Z-shaped line itwould be as long and as impressive as any vertical trend. Thus we cansee that trends need not be vertical to be profitable. Horizontal price action, boring as it may seem to an untrained eye, can be a gold mine to anastute trader using Bollinger bands and proper money management totrade them.
TREND TRADING WITH BB BANDSAlthough the classic use of Bollinger bands is to trade range, Bollingerbands can be extremely effective in trading trend as well. I already introduced you to the concept of Bollinger band “bands” in Chapter 5, butlet’s review the idea once more. In the Bollinger band “bands” setup thetrader superimposes two sets of Bollinger bands. First he lays down thestandard Bollinger bands set to 2 standard deviations and then he applies another set of BB’s set to only 1 standard deviation. The result ofthis exercise is that the trader now has access to a set of very accuratedynamic trend channels. If the price trades in between the two upperBollinger bands it’s in an uptrend; if the price trades in between the twolower Bollinger bands it’s in a downtrend. If it trades somewhere in between the two channels it’s considered to be in no-man’s-land and trendless (see Figure 10.2).Bollinger band “bands” can be used both as a trend detection tool andas a trend exhaustion tool. Let’s first take a look at how we can use theBollinger band “bands” to spot trend exhaustion and consider severaltrading tactics to take advantage of such a setup. If trend is defined asprice trading between the two Bollinger bands, then price leaving the BB
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FIGURE 10.2 Trend Exhaustion with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
channel connotes trend exhaustion. The Bollinger band “bands” trend exhaustion setup is fairy straightforward.1. The price must trade within either upper or lower Bollinger band
“band.”2. If the closing price of the period is either above the precedingBollinger band sell channel or below the preceding Bollinger bandbuy channel, a trend exhaustion signal is generated.3. In the case of a sell channel break, the trader would buy at market atthe start of the next bar, and in the case of a break of a buy channelthe trader would sell at market at the start of the next bar.Here is where the trade becomes very interesting, depending on thetactics the trader employs. The simplest approach is to put on the tradeand place a stop in the case of long at the swing low minus 1 point andminus the spread, which would exit the trade if the swing low was broken. The target on the trade would be the opposite Bollinger band (seeFigure 10.3).
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FIGURE 10.3 Bollinger Band “Band” Trade with Price StopSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
Although this type of trade will generate many stop-outs as pricesrarely make V-shaped bottoms, it carries a very favorable reward-to-riskstructure. Note that in Figure 10.3 the risk is only 50 points but the rewardis 200 points. The trader can be wrong three out of four trades and still beprofitable under such circumstances.Another technique to this setup would call for the following gameplan:1. Enter the setup at market when the trend exhaustion signal is given.2. Place a stop below the swing low.3. Liquidate one-third of the position when the price reaches the 20-period
simple moving average (20 SMA).4. Place stop at break-even point.5. Liquidate one-third of the position at the tag of the opposing 2 standard deviation bollinger band.6. If the price decides to climb the Bollinger band channel, liquidate thefinal one-third of the position if the price bar closes outside of theBollinger band channel zone.
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FIGURE 10.4 Scaling Out of Bollinger Band “Band” TradeSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
This technique is designed to dynamically adapt to various market conditions (see Figure 10.4). Under this strategy a trader will get stopped outfor a relatively small loss if the price fails to make a turn or he will harvest amodest profit if the price makes a reflex retracement to the 20-periodsimple moving average. On occasion when prices make a strong move tothe opposite Bollinger band, the trader will bank meaningful profits on twothirds of his position. Finally, in those very rare instances when the pricemakes a V-shaped bottom and generates a very strong countertrend, thetrader has the opportunity to collect massive profits on part of his position.Essentially by gradually scaling out of the position a trader can take advantage of every possible scenario that the market may present. The malleability of this approach is its most attractive feature.
VOLATILITY STOPOne of the problems with the prior techniques is the large number of stopouts they tend to generate. Prices will very frequently exceed their swinghighs or swing lows if for no other reason than the fact that dealers are
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well aware of those price points and will make stop-hunting forays to collect easy profits. What happens next can be very disheartening as theprice makes a turn in the original direction but the trader is taken out ofwhat ultimately becomes a winning position. For traders who are psychologically comfortable with multiple small stops, the approaches listed earlier present little problem. But for traders like myself, who absolutelycannot stand a constant series of small losses but are more than willing toaccept an occasional large loss, the following strategy to trade trend exhaustion with Bollinger band “bands” may be a much better approach. Instead of using a hard price stop, this method uses a volatility stopgenerated off the Bollinger bands themselves (see Figure 10.5).Here are the basic rules for this setup.1. Enter the setup with one-half position size at market when the trend
exhaustion signal is given.2. At the point of entry measure the distance between the Bollinger band+1 standard deviation and –1 standard deviation.3. Add the value from step 2 to the swing low if trading long or to theswing high if trading short.4. Place stop at that point.
FIGURE 10.5 Bollinger Band “Band” Trade with Volatility StopSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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5. If trade moves to profit, exit at the opposite Bollinger band.6. If trade moves against you, add the second half of the position on the
next tag of the 2 standard deviation Bollinger band.7. Exit the full trade on the tag of the opposite Bollinger band.This is a trading tactic that uses a highly probative approach to priceaction. It assumes that the trend channel break signal provided by theBollinger bands is simply a clue rather than an exact sign of trend exhaustion. As such, it uses a wide stop and a scale-in approach that materiallyimproves the reward-to-risk odds and increases the probabilities of success as well.Why use the bandwidth of +1 SD to –1 SD of Bollinger bands as astop-out value? Because Bollinger bands by their essence measure volatility. Therefore, in highly volatile markets Bollinger bands will be naturallywide while in low-volatility markets they will be quite compressed. Inother words, by using this type of dynamic volatility stop the trader will beable to respond to the present market conditions rather than impose uniform risk-control measures over highly diverse market environments.Note, for example, how in Figure 10.6 this method generates a tight stopcausing minimal damage when the setup fails, but in Figure 10.7 this setup
FIGURE 10.6 Low-Volatility Stop with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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FIGURE 10.7 High-Volatility Stop with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
uses a wide stop that keeps the trader in the trade until it eventually turnsaround and becomes profitable.
TRADING PURE TREND WITH BOLLINGER BANDSAs we have already seen, Bollinger band “bands” present a trend traderwith an elegant natural way to draft trend channels and therefore presentseveral interesting trend trading setups. The simplest and purest setup follows these rules (see Figure 10.8). (Note that these describe a long setup,but the rules for shorts are simply reversed.)1. Price must enter the Bollinger band buy zone.2. Price should close within the buy zone to trigger a buy signal.3. Place stop at the bottom of the entry bar.4. If the trade moves in the right direction, exit only when price closes
below the buy channel.
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FIGURE 10.8 Trading Trend with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
This is a pure trend setup that strictly follows the trend trader’smost important dictum: “Either I am right or I am out.” Trend trading is aclear-cut methodology. Prices must continue to trend or there is no logical reason to remain in the trade. This is why this setup has a very tightstop. Once trend is established, though, a trend trader wants to give itplenty of leeway to fully bloom. As long as prices remain within the uptrend channel the trend trader maintains his position. Note that the stopout rules of the setup call for prices to close below the uptrend channelrather than merely pierce it. This condition prevents too many earlystop-outs, as price will often test the lower bounds of the channel. However if bulls are able to close the bar within the channel that type ofprice action would suggest that directional power is still tilted to the upside. Note also that just like busy office workers hopping on and off anelevator, trend traders can reenter the trend many times during a significant move as conditions turn favorable. Figure 10.9 shows a good example of just such a setup. Between October and December of 2004 theEUR/USD climbed 1,300 points. Several times during this move pricesfell out of the uptrend channel, but persistent trend traders could haverejoined the bulls once price resumed the uptrend and would have captured large pieces of the move.
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FIGURE 10.9 Multiple Trend Entries with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
SCALPING TO TRENDAnother interesting setup for more short-oriented traders also involvesBollinger band “bands” and allows traders to exploit the interplay between the 1 and 2 standard deviation bands. Here is how this trade setsup, and again I will use a long example with rules simply reversed for theshort side.1. Price enters the buy channel and tags the upper 2 standard deviation
Bollinger band.2. If price retraces down to 1 standard deviation Bollinger band, buy atmarket.3. Place stop at 20-period SMA.4. Exit trade on next tag of 2 standard deviation Bollinger band.5. Repeat process.This is a very interesting setup because it utilizes both fading andtrending techniques to make several quick high-probability trades. The
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FIGURE 10.10 Scalping to Trend with Bollinger Band “Bands”Source: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
idea behind this setup is that the underlying power of the move lies withthe direction of the trend. Therefore, by absorbing the opposite side ofany profit-taking move, the trader enters the trend at a favorable price andhas a quick opportunity to bank profit on the next wave up. Note in Figure10.10 how a nimble scalper is able to generate 300 points of gains beforefinally getting stopped out, while a more long-term trader is able to harvest only 100 points of profit.
THE MACD TURNOscillators come in all shapes and sizes, but for my money nothingbeats the MACD histogram for sheer simplicity or accuracy. The MACDturn, which is a setup I like to trade on anything from as small as 15minute bar charts to as large as weekly candlesticks graphs, operateson a deceptively simple premise but actually uses rather fancy moneymanagement to turn it into success. The basic premise of the MACDturn is this: Momentum precedes price. That means in a battle betweenprice and momentum always trust momentum.
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Here is the setup in a nutshell (see Figure 10.11).1. Overlay Bollinger band “bands” on a chart using 20 SMA, 2 standard
deviation, and 1 standard deviation settings.2. Overlay the MACD histogram using standard MACD settings of9-period exponential moving average (EMA) and 12-period EMA.3. For short setups, price must be in the upper Bollinger band channel;for long setups, price must be in the lower Bollinger band channel.4. For a short setup look for the MACD histogram to print a lower highbar indicating that momentum is waning.5. Measure the distance between the low of the most recent bar and themost recent swing high.6. Place a sell stop at halfway between the two points for one-third oftotal position.7. If the trade is triggered, set a take-profit target at 20-period SMA.8. If price moves in the opposite direction of the trade and makes newswing highs but MACD histogram does not, sell another one-third ofthe position at market.
FIGURE 10.11 Trading MACD Histogram Rather Than PriceSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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9. If price continues to move higher but MACD histogram has not ex-
ceeded new highs, sell final one-third of the position on next tag ofupper Bollinger band.10. Stop out only if MACD histogram makes a new high.11. Reverse all steps for long setup.As you can see, the MACD turn setup requires a lot of fancy moneymanagement but it does adhere to one simple trading rule—the trader enters the trade off an indicator trigger and exits the trade off an indicatortrigger. One of the critical mistakes that many technically oriented tradersmake is to use an indicator-based entry but a price-based stop. This is thetrading equivalent of comparing apples to oranges. The MACD turn wasdesigned specifically to eliminate this problem.As I’ve noted many times before, FX is one of the most active stophunting markets in the world. Dealers will always want to probe recenthighs and new lows just to test out market sentiment and to pick up cheapinventory on the buy side as well as get rid of expensive product on thesell side. Therefore price in FX will often take out the swing highs orswing lows, sometimes by only a few points but sometimes by severalhundred. The great value of the MACD turn is that it does not allow thetrader to fall for this common bluff. As long as momentum does not reachnew highs, the trader continues to scale into the trade and therebyachieves a better blended price.The MACD turn, the way I trade it, is a very labor-intensive setup. Itrequires a lot of trade management to actively scale against the positionand then quickly take off trades at the first sign of profit. Often I will evencover the most recent trade with the position and will go short or longonce again if an opportunity presents itself. This setup the way I trade itcan also suffer hideous losses. Basically the MACD turn with the scale-inapproach manufactures many small profits but occasionally producesvery large losses if prices never turn. Just like an insurance company thathopes to offset its few large losses by collecting many premiums (for allthose in the insurance business—yes, I know it’s not a perfect analogy, butplease indulge me), the MACD turn follows the same business plan.There are different ways to trade the same idea that may be more suitable for your style and risk profile. One interesting way to trade the MACDturn is to use a money management approach that is antithetical to theone I use. Instead of using a partial scale-in strategy, a trader can enter theposition all at once, but in the case of a short trade, if the price made anew swing high on the next bar the trader would scale out of the positionone-third of the total value at a time. This strategy may be very useful totraders uncomfortable with the idea of increasing risk as prices move
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against their positions. Instead of suffering ever-larger floating losses fromadverse price movement, this method deleverages the trading accountwhile at the same time allowing part of the trade to remain on the booksin case of eventual turnaround to profit.
THE TAO OF RSIThe Relative Strength Index (RSI) is another indicator that works exceedingly well in the FX market, and it does so on all time levels from 15-minutecharts to daily or even weekly graphs. As I’ve noted earlier in the book,there are myriad ways to trade RSI. Some traders even use it as a proxy forvolume since volume is not reported in spot FX. They view a rapid increasein RSI much like they would a rapid increase in volume as a precursor tofurther price movement. Other traders will prefer to trade the RSI graphrather than the price graph because they believe that the normalizationprocess of RSI provides a truer, more accurate picture of price action.This setup is more straightforward than some of these methods. The Taoof RSI simply uses the original purpose of the indicator to find overboughtand oversold areas and pick short-term tops and bottoms (see Figure 10.12).
FIGURE 10.12 The Tao of RSISource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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Here are the rules:1. Lay out Bollinger band “bands” on a price graph (Bollingers with 20
SMA 2 SD and Bollingers with 20 SMA 1 SD).2. Plot RSI with standard setting of (14,1).3. If the price chart prints three consecutive bars with RSI readings of 70or greater, short on the close of the third bar.4. Measure from the bottom of the first bar to the top of the third bar.5. Add that distance to the top of the third bar and place a stop there.For a long setup the rules are:1. Lay out Bollinger band “bands” on a price graph (Bollingers with 20
SMA 2 SD and Bollingers with 20 SMA 1 SD).2. Plot RSI with standard setting of (14,1).3. If the price chart prints three consecutive bars with RSI readings of 30or less, go long on the close of the third bar.4. Measure from the bottom of the first bar to the top of the third bar.5. Add that distance to the bottom of the third bar and place a stop there.The exit rules for this setup can vary. Here are some possibilities:1. If the price moves in your direction by the value of your stop (i.e., if
you risked 100 points on the trade and it has moved 100 points in yourfavor), move your stop to the break-even point and target the opposite2 standard deviation Bollinger band as exit.This approach is the most aggressive and will result in many stop-outsand scratch trades, as it is very difficult to pick exact turns in the market.The risk/reward on this type of trade, however, will be superb, as the winning trades may likely generate three to four times the amount of points oflosing trades, depending on the market volatility.2. If the price moves in your direction by 70 percent the value of your
stop (i.e., if you risked 100 points on the trade and it has moved 70points in your favor), take profit on one-half of the position, moveyour stop to the break-even point, and target the opposite 2 standarddeviation Bollinger band as exit for the rest.This is the compromise approach that tries to harvest some profitright away, but allows the trader to benefit partially from a large turn in
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the market. It provides the psychological benefit of banking some profitsquickly, which allows the trader to bask in the glow of a somewhat profitable trade, but at the expense of minimizing the full profit potential if thetrade turns into a big winner.3. If the price moves in your direction by 70 percent of the value of your
stop (i.e., if you risked 100 points on the trade and it has moved 70points in your favor), take full profit on the position.This method will never produce outsized profits, but it is the highestprobability method of all three. For traders who don’t mind building theirfortune a nickel at a time, this may be the best approach as it tries to pinpoint the most oversold and overbought points on the price chart and thenquickly skim off any retracement profits that occur. Note, however, that thisstrategy needs to be at least 60 percent accurate in order to make money.Assume you make 10 trades, each with a 100-point stop. Six tradesmake 70 points for a total of 420 points, and four lose 100 points each for–400. The total would be a net profit of 20 points. If the trader was successful 70 percent of the time, the net profit would be 190 points [(7 × 70)– (3 × 100)]—showing the critical role of high probability in the success ofthis trading method.The example also brings out a very important consideration that manynovice traders overlook when testing these strategies. When measuring theefficacy of all these ideas it is very important to stay consistent in yourtrade time frames. For example, in the statement that the strategy requires60 percent accuracy in order to be profitable, the implied assumption isthat the trader will trade all 10 trades on the same time frame, which in thecase of 100-point stops will most likely be the daily chart. Imagine, however, a trader who decides to trade this setup on a 15-minute chart risking15 points for a 10-point target. He makes eight consecutive winning trades,harvesting 80 points of profit. Then emboldened by his success he movesover to a daily chart and decides to risk 100 points for a 70-point target. Unfortunately, the trade is a loser and he is stopped out. His total position after eight successful trades and one unsuccessful trade is a 20-point loss.Furious, the trader stops trading this idea, convinced that it doesn’t work.Unfortunately, this type of sloppy thinking is very prevalent amongmany new traders. The quest for easy money makes many novices abandon valuable technical tools before they properly learn how to use them.Turning back to the Tao of RSI, however, we can see how effectivethis setup can be on any time frame.Figure 10.13 shows the trade in AUD/USD on a 15-minute chart, whileFigure 10.14 uses a daily graph. In both cases the RSI is able to accuratelypinpoint the extremes and allow traders to make profitable turn trades.
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FIGURE 10.13 The Tao of RSI 15-Minute ChartSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
FIGURE 10.14 The Tao of RSI Daily ChartSource: FXtrek IntelliChart™. Copyright 2001–2005 FXtrek.com, Inc.
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TREND DETECTION WITH THREE SIMPLEMOVING AVERAGESUp to now, I have shown you mainly trend exhaustion or turn setups. Partof the reason lies in my own contrarian nature, as I simply find it difficultto trade with the crowd. The other part is simply due to the fact that I genuinely find trend exhaustion easier to spot and trade. After all, it is easy tosee a trend on a chart. However, once a trend is identified there are onlythree possibilities for where the price may go:1. Continuation2. Consolidation3. Reversal
Of the three choices, two can be successfully traded with trend exhaustion methods, providing a nice probability edge, which is why I am muchmore comfortable trading those strategies. There is, however, one low-risktrend method that I like very much, and it comprises my final setup.Here are the rules for the three simple moving average (3 SMA) setup(see Figure 10.15):1. Place 7-period, 20-period, and 65-period simple moving averages on
the chart.2. Wait until volatility declines and 7, 20, and 65 SMAs all compress together.3. As price breaks out in either direction watch for the 3 SMAs to fan outwith the