Forex Trading Systems Types of Trading Systems

There are basically two types of Forex trading systems, mechanical and discretionary systems. The trading signals that come out of mechanical systems are mainly based on technical analysis applied in a systematic way (technical indicators, chart patterns, etc).

On the other hand, discretionary systems use experience, intuition or judgment on entries and exits.

Which type produces better results? Or more importantly, which one better fits your trading style?

In this section, we will try to answer the question above. We will first analyze the pros and cons of each system approach.

Mechanical Systems

Advantages

• This kind of system can be automated and backtested efficiently.
• They have very rigid rules. Either, there is a trade or there isn’t.
• Mechanical traders are less susceptible to emotions than discretionary traders.

Disadvantages

• Most traders backtest Forex trading systems incorrectly. In order to produce accurate results you need tick data.
• The Forex market is always changing. The Forex market (and all markets) has a random component. The market conditions may look similar, but they are never the same.
• A system that worked successfully in the past doesn’t necessary mean it will work in the future.

Discretionary Systems

Advantages

• Discretionary systems are easily adaptable to new market conditions.
• Trading decisions are based on experience. Traders learn to see which trading signals have a higher probability of success.

Disadvantages

• They cannot be backtested or automated, since there is always a decision to be made based on judgment.
• It takes time to develop the experience required to trade successfully and track trades in a discretionary way. In the early stages this can be dangerous.

Now, which approach is better for Forex traders?

It is advisable to always start trading a mechanical system, as you gain experience, you will realize which signals produce better results but this requires time and experience, so start first with a mechanical system. Another point you should take in consideration is if you are a trader that finds it hard to follow your trading signals, then you are better off using a mechanical system, where your judgment won’t play an important role in your system. You only take the trades that your system signals.

If the psychological barriers that affect every trader (fear, greed, anger, etc.) puts you in unwanted scenarios, you are also better off trading mechanical systems, because you only need to follow what your system is telling you, go short, go long, close a trade. No other decision has to be made.

On the other hand, if you are a disciplined and experienced trader, then you are better off using a discretionary system, because discretionary systems adapt to the market conditions and you are able to change your trading conditions as the market changes. For instance, you have a target of 60 pips on a long trade, the market goes up quickly reaching 50 pips in your favor in a few minutes, allowing you to change the target level to 100 pips. These kinds of decisions are nice to adapt once you have enough experience, however it could be dangerous at early stages.

Does it mean that trading a discretionary system has no rules? This is absolutely incorrect. Trading discretionary systems means that once a trader finds his/her setup, the trader then decides what to do. But every trader still needs certain rules that need to be followed, such as the size of the position, conditions that have to be met before thinking to get into the market, and so on.

Whether you choose to be a discretionary or a mechanical trader there are some important points you should take in consideration:

1. You need to make sure the Forex trading system you are using totally fits your personality. Otherwise you will find yourself outguessing your system (develop it yourself).
2. You also need to clearly define your rules and most importantly have the discipline to follow them.
3. Take your time to build the perfect system for you. It is not easy and requires time and hard work, but in the end, if done correctly, it will give you consistent profitable results.

Forex Trading,Some Points to Take in Consideration

Here are some important points you need to take in consideration while creating your trading system.

1. Always be skeptical about your own ideas, focus only on results. Sometimes is easy to track trading opportunities, what is hard is to capitalize on them and make money from them. The performance of any trading system should be measured with actual trading (either demo or an account with limited funds).

2. Sometimes you lose even when you have followed your system to the rules. Losses are part of the game, there is no possible way to avoid them, and we need to learn to lose. So if you have followed your system 100% and took a loss, celebrate it! The only way to stay ahead of the game is by rigorously following your system.

3. Sometimes while trading large positions you can lose control of your emotions. Don't be overly aggressive with the market and follow a well planned money management technique. It should tell you what you are going to risk on your next trade.

4. Try to understand why your system works, this way you will develop the required confidence in yourself and your system.

5. There will always be some “indicator” that could have kept you out of a losing trade. But remember your system is not designed to win all your trades, but to win most of them.

6. When you finally created your system, describe it in simple and logical terms. If a 15 year old kid is not able to understand it, then something is wrong with it.

7. Use only 2-3 indicators: one indicator to identify the trend and one or two indicators or variables for entries and exits. The more indicators you use, the more complicated your system becomes. Most of the time “the simpler the system the better performance it will have”. Also use non-correlated indicators, do not choose two indicators that are supposed to measure the same market condition.

8. Test your system over large data samples (over 50 trades) and in various market conditions, this way you can see under what conditions your system works better.

9. If you decide to trade several currency pairs, try non-correlated pairs. For instance, if you trade long the Euro and long The Pound, your are likely to get the same result on both of them, elevating your risk if the market goes against you.

10. News trading? Determine whether you are going to keep your trades open during important news announcements. If you are trading for the short term you are likely to keep tight stops, and an important news announcement might hit your stop loss level.

11. While you are in a trade, open your mind to every possibility, sometimes you don't see or ignore evidence against your trade.

Forex Trading Systems Creating a Trading System

It is very important to have a system that perfectly fits your personality, otherwise you will find it difficult to follow and it will be hard to generate consistent results. Nevertheless, how do we know if the system we are trading is the right for me? On the last section of this lesson, we will find out the proper steps that need to be followed in order to make sure our system fits us.

Most traders have problems with the system they are using because they did not develop it. A system that works for one trader does not mean that it will work for all traders. The system creator “created it” based on his personality and unique circumstances (trading capital, risk profile, etc).

If this is your case, you need to follow the same rules and re-create and tweak the system until it fits your needs as a trader and personality.

In order to create a successful system you need to take care of the following steps:

1. Types of systems

2. Trading styles

3. Choose the concept of trading

4. System Conceptualization

5. Testing and live trading

Forex Trading Systems- Introduction

By now, you should know that it is important to trade based on a trading system; otherwise, it will be very hard to generate consistent profits from the Forex market. Trading systems tell you where to get in and out the market.

When you devise a system, you look for certain moves and what indicators, patterns or price behavior caught that move, then you create a set of rules; when these rules are present in the future they signal a trade.

Most systems are based on price patterns or technical indicator readings (technical patterns). However, we must not forget something: patterns (whether chart or technical patterns) are never the same, they are only similar. In order for two patterns to be the same exact pattern the same traders need to be involved on both patterns, and not only this, they have to be in the same mood so they behave in the exact same way. We know this is almost impossible since there are just too many variables that need to be accounted for. Take for instance, how many traders are waiting in the sidelines? How many traders will get out of the market sooner than they have planned? How many of them will take partial profits? And so on...

This tells us that there are no certainties about the outcome of every single signal. Even though we don't know the outcome of any individual trade, the outcome of a set of trades is predictable; we also know that if we follow rigorously our system we will be ahead of the game in the long run. When our system signals one trade it only tells you that there is a higher probability that the market will go in the intended direction, probabilities will play their part.

So we know two important things:

• We don't know in advance the outcome of any signal
• If we follow our system rigorously, we will be ahead of the game

What is interesting is that we do not need to know what is going to happen next in order to make money in the Forex market, we only need to make sure we have a well-developed system and follow it rigorously.

However, before we apply this knowledge we need to develop our own system. In this lesson we will show you how to effectively develop a system the fits your personality.

The following topics are covered in this lesson:

Creating a Trading System - 

                                                     Important information about trading systems.

Types of Trading Systems - 

                                                           There are two types of trading systems; we will review their advantages and disadvantages. 

Trading Styles -  

                            Review of the trading styles you might adopt to develop your trading system. 

Trading Concepts -

                                     Not all trading concepts are for every trader, choose the one the better fits you. 

Trading System Conceptualization -

                                                                         After choosing our trading style and concept, we need to begin our system conceptualization. 

Testing and Live Trading - 

                                                       Once we created our system we need to test it and see if it really fits our personality, a few tips to do an effective testing. 

 Some Points to take in Consideration - 

                                                                          Before taking any action please take these important points into consideration.

What is forex?

What is forex? Why trade forex? 

 

The foreign exchange market – or forex for short – is the buying and selling of currencies, and it’s one of the fastest growing markets in the world. From 2007 to 2010, forex market activity increased by 20%, with average daily turnover reaching nearly $4 trillion in April of 2010.

 

 

Forex trading works much like it does with stocks, you buy low and you sell high. The benefit of trading forex is that you don’t have to choose from thousands of companies or sectors. Plus, you can make things even simpler than choosing which company to buy.

For example, most people, even those that are new to forex, have an opinion on the US dollar and the US economy. They can easily take their opinions and translate them into a forex trade. Buying or selling US Dollars as simple as they buying or selling a company’s stock.

Also, another advantage of the FX market is that it doesn’t begin at 9AM and end at 4PM. Trading takes place 24 hours a day, 5 days a week. For most people 24 hour trading means they can trade before or after work. Plus, you have the flexibility to make your trades online.

 

 

Plus, you can buy and sell at any time, in up trends (also called bull markets) and in down trends (also called bear markets).

Technical Analysis, Technical Indicators, Time-Frames

There are different periods in which a currency pair could be charted: monthly, weekly, daily, hourly, 30-minute, 5-minute, etc.

Each timeframe has its unique trend; this is the reason why there is no absolute trend for any currency, take the following charts for example.

EURUSD Hourly Chart

[Chart 30]

EURUSD Daily Chart

[Chart 31]

In these charts, a swing trader focusing in the 1H chart could assess: well there is no trend (ranging market) right now for the EURUSD while a long-term trader could assess: the trend for the EURUSD is clearly up. Which trader is wrong? No one, both of them are correct. Both of them have effectively determined the trend in the timeframe they are focusing on.

Of course, the market condition in the 1H chart is most likely to continue for the next couple of days while the market condition in the daily chart is likely to continue for the next month or so.

The same goes when we use indicators. Sometimes the same indicator could be signalling the opposite signals on the same currency pair on different time frames.

Take for instance the following charts:

GBPJPY 15 Minute

[Chart 32]

GBPJPY 4H

[Chart 33]

On the first chart (15min) the stochastics are in an oversold situation however, at the same time, in the 4H chart the stochastics did give a sell signal (crossing from the overbought territory to the neutral territory). The reason for this simple, remember all indicators go back n-periods to make a calculation, in this particular case, the 7 period stochastics in the 15 min chart went back 8 candlesticks to complete its calculation (1.75 hours). The stochastics in the 4H chart also represent 8 candlesticks but those 21 candles represent around 1.5 days worth of data. The market conditions are completely different during those periods.

Obviously, it is better to trade when many timeframes indicate the same market condition (i.e. both, the 15 min and the 4H chart indicate an oversold condition). When this happens, the probability of success of the given signal increases enormously.

Is important to realize that the longer the timeframe the more impact it will have in the market. For instance, an oversold condition in the 4H chart is more important than an overbought condition in the 15 min chart. More important because the “signaled market condition” will last for a greater time in longer time frames than in the shorter time frames.

Which timeframe should I use?

When trying to decide which timeframe to trade in we must take in consideration two important factors: the time dedicated to your trading and your personality.

How much time a day/week are we going to dedicate to our trading? Obviously if you have a day job and do not have the possibility to monitor your trades, then it would be better to focus on the 4H or 1H chart, and even daily charts can work out. If there is a possibility to monitor your trades then you can use the 30 min charts.

On the other hand, if you are a full time trader, then you have the possibility to trade shorter timeframes such as the 5 or 15 min charts.

However, we must almost consider that when you are a full time trader there is a chance that trading shorter timeframes does not fit your personality. The same goes for traders with a day job, there is a possibility that trading the longer term just will not work. I have a friend who started trading the FX market using the 1min chart. His trading wasn’t going the way he expected so he moved to the 15 min, then to the 30 min and finally to the 1H charts, where he felt most comfortable trading (and of course profits also increased).

So to summarize, you should use the time frames that better fit your personality and time requirements, and the best way to know which one fits you better is by trading as many time frames as possible, then choose the one you felt most comfortable with.

Technical Analysis, Technical Indicators, Pivot Points

In a few words, a pivot point (PP) is a level in which the sentiment of traders and investors changes from bull to bear or vice versa.
Why PP works?
They work simply because many traders and investors (including bank and institutional traders) use and trust them. It is known by every trader that the pivot point is an important measure of strength or weakness of any market.
There are several ways to calculate the pivot point. The method we found to have the most accurate results is calculated by taking the average of the high, low and close of a previous period (or session).
Warning – some pretty boring maths ahead. The good news is that almost all charting platforms will automatically calculate this for you and draw the lines on in whatever pretty colour you like. But as this is the ADVANCED course we think you should have a basic idea of how they are calculated.
Pivot point (PP) = (High + Low + Close) / 3
Take for instance the following EUR/USD information from the previous session:
Open: 1.2386
High: 1.2474
Low: 1.2376
Close: 1.2458
The PP would be,
PP = (1.2474 + 1.2376 + 1.2458) / 3 = 1.2436
So, what does this number tell us? It simply tells us that if the market is trading above 1.2439, Bulls are winning the battle pushing the prices higher. In addition, if the market is trading below this 1.2439 the bears are winning the battle pulling prices lower. In both cases this condition is likely to sustain until the next session.
Since the Forex market is a 24hr market (no close or open from day to day) there has been an ongoing battle deciding at what times we should take the open, close, high and low from each session. From our point of view, the times that produce more accurate predictions is taking the open at 00:00 GMT and the close at 23:59 GMT (obviously the high and low in between those hours).
Besides the calculation of the PP, there are other support and resistance levels that are calculated using the PP as a reference.
Support 1 (S1) = (PP * 2) – H
Resistance 1 (R1) = (PP * 2) - L
Support 2 (S2) = PP – (R1 – S1)
Resistance 2 (R2 ) = R1 + (PP – S1)
Where, H is the High of the previous period
L is the low of the previous period
Continuing with the example above, PP = 1.2436
S1 = (1.2436 * 2) - 1.2474 = 1.2398
R1 = (1.2436 * 2) – 1.2376 = 1.2496
R2 = 1.2496 + (1.2436 – 1.2398) = 1.2338
S2 = 1.2436 – (1.2496 – 1.2398) = 1.2534
These levels are supposed to mark support and resistance levels for the current session.
In the next chart we have calculated the PP and the support and resistance levels for September 5th.
S2 = 1.2616
S1 = 1.2579
PP = 1.2545
R1 = 1.2508
R2 = 1.2474

[Chart 1]

Vertical lines separate sessions (4th and 5th of September). As we can see, the market went rapidly below the PP level. From that point on, we should be careful with longs, and start thinking on shorts, because the sentiment of traders and investors is turning to “net short”.

Notice how the PP represents a resistance on early September 5th. Notice also S1 rejected twice the price as it approached the S1 level representing good trading opportunities. Finally, S2 marked a good support, this indicates weakness on current bears, which tells us that the sentiment is not as strong as it was at the beginning of the trading session.

On the example above, the PP was calculated using information of the previous session (previous day). This way we could see possible intraday resistance and support levels. But it can also be calculated using the previous weekly or monthly data to determine such levels. By doing so, we are able to see the sentiment over longer periods of time. In addition, we can see possible levels that might offer support and resistance throughout the week or month. Calculating the weekly or monthly pivot point is mostly used by long term traders, and as we said, it gives us a good idea about the longer term trend.

Technical Analysis, technical indicators, Relative Strength Index (RSI)

RSI is an extremely popular oscillator developed by Welles Wilder in 1978. It measures the strength in which the market trends up or down (the ratio of up and down candlesticks for a chosen period of time). The values of the RSI oscillate between 0 and 100. A value close to 100 indicates the market has been trending up sharply, while values close to zero indicate the market has been trending down.

As the RSI approaches to extreme levels, the indicator becomes less sensitive to price fluctuations, making the indicator to go back to neutral levels.

RSI Usage

Usage No 1 - Overbought/oversold conditions. Values above 80 are considered overbought and values below 20 are considered oversold. As the market reaches higher levels, there is a possibility that every bull interested in the instrument has already taken a position (this took the RSI above the 80 level). At this point weak longs start taking profits and closing out positions. This gives the market a chance to retrace, letting the RSI get back to neutral levels, breaking back down the 80 level as the price sells off. The same is true for a downside move, as the RSI reaches the oversold territory (below zero), bears start to take profits, giving the RSI the strength needed to get back to neutral levels, making the price rally.

[Chart 16]

Remember overbought and oversold signals are triggered then the indicators returns to neutral territory from an overbought or oversold condition. These types of signals tend to work better when the market is ranging.

Usage No 2 – Divergence. Like other indicators, the RSI is also used for divergence trades but probably the RTI is the best indicator to measure and trade off divergences. When prices reach new levels and the indicator fails to make comparable highs/lows, divergence is present.

[Chart 17]

In this chart we clearly see how the market reaches lower lows while the indicator is unable to replicate those lower lows (it makes higher highs). This indicates that the market isn’t as strong as it was at the beginning. As other trading signals, when the divergence is present it could signal a trend reversal, retracement or a consolidation period.

Usage No 3 - Trend indicator. When the values of the RSI are above 50 it indicates that the average gains are greater than the average loses (uptrend). Readings below 50 indicate that the average loses are greater than the average gains (downtrend).

[Chart 18]

The basic rule would be: when the RSI is above 50 the market is to be considered in an uptrend, when the RSI is below 50 the market is considered to be in a downtrend.

It is important to mention that when using the RSI in this way, it is advisable to choose longer periods [i.e. RSI(40) or RSI(80)] .

Technical Analysis, Introduction To technical indicators

In this , we will review the most important technical indicators used to trade the Forex market.

Technical indicators are no more than a series of data points plotted in a chart that are derived from a mathematical formula applied to the price of any given instrument. In other words, indicators are just a different way in which price movements can be represented over specified periods of time (they offer us a different perspective).

Some technical indicators are used to confirm price action (lagging indicators), others are used to predict price action while some others are used as an alert or warning of a possible break on price action.

A) Lagging indicators - These indicators follow the price action, in other words they confirm what the price just did. The signals that come out of this type of technical indicators usually happen after the change in price begins. These types of indicators are also called trend-following indicators and work best during trending markets, where they allow traders to catch most of the move. During trendless conditions (sideways or ranging market) these types of indicators give many false signals.

B) Leading indicators - These indicators try to predict future price movements. They give signals before the actual price movement begins. These kinds of indicators work best during consolidation periods or trendless markets. During trending conditions, only signals in direction of the existing trend are advised to be taken. During up-trending conditions, leading indicators help us identify oversold conditions (price has falling enough and it is ready to continue its trend). During downtrending conditions, they help us identify overbought conditions (price has rallied enough, and now it is ready to continue its trend).

When using leading indicators it is also advisable to wait for the actual price movements before taking the indicator signal.

Most important lagging indicators: Moving Averages (MA) and Moving Average Convergence-Divergence (MACD).*

Most important leading indicators: Relative Strength Index (RSI), Stochastics, Commodity Channel Index (CCI) and Momentum.*

*Some of these indicators can be used both as a lagging indicator and as a leading indicator.

Sensitivity vs. Consistency

                                       Before going through all the indicators it is important to understand the relationship between these two concepts. Every indicator represents price movements over a chosen period. Each indicator gives you the option to decide on how many periods you want to go back over to do the calculation. If we shorten the period, we will get more and earlier signals, but at the same time, the percentage of false signals will also increase. If we increase the number of periods, false signals will decrease, but the signal will get us in a trade later, giving up some profits.

It is up to the trader to select the approach that best suits his or her trading personality, trading style and objectives.

Then  we will cover the following topics:

1- Moving Averages - 

                               In this section, we will review moving averages, what they tell you, common uses, etc.

2-Moving Average Convergence-Divergence (MACD) –

                                            MACD is a popular indicator that can be used in several ways to our benefit. 

3-Commodity Channel Index (CCI) – 

                                             The CCI is an indicators that quickly reacts to the price action. 

4-Relative Strength Index (RSI) –  

                                            This indicator measures the ration of bull and bear candlesticks, the information is then plotted and can tell us several market conditions. 

5-Stochastics (STC) –  

                               We will review the best overbought/oversold indicator. 

6-Momentum (MOM) – 

                                            Trying to measure the strength/momentum of the market can help us take better decision. 

7- Bollinger Bands (BB) – 

                                          This volatility indicator developed by Bollinger shows us how far the market could go during “normal conditions”. 

8- Average Directional Index (ADX) –  

                                               The ADX is an indicator that measures the strength of the trend in any market. 

9-Fibonacci Retracements – 

                                             Once the market has retraced, the Fibonacci retracements can help us determine where could the retracement could end. 

10-Pivot Points (PP) –  

                                PP is a popular technique that shows us the sentiment of the market and other useful information. 

11- Important Considerations about Technical Indicators –  

                                What’s inside indicators, how should we use them? Do they generate accurate signals? 

12-Time-Frames –  

                               The combination of time-frames is critical to have good results.

Technical Analysis - Introduction to Candlesticks

Japanese candlesticks give us a better understanding of value, or more precisely, the interpretation of value given to any instrument by investors and traders than any other type of chart. They also help us have a better understanding of the psychology of traders and investors driven by fear, greed and hope, since all these characteristics are represented in price movements.

Before going through candlesticks patterns and how to trade based on them, we should first understand what different candlesticks represent by themselves.

Long candlesticks 

Long candlesticks describe strong buying/selling pressure. Price had a sharp advance/decline from the open price (traders were aggressive).

When we talk about “long” candlesticks, we are referring to the body of the candlestick.

But, long compared to what?

We know it is long when we compare the action of any candlestick with the length of previous candlesticks. A “long” candlestick must be clearly identified in order to be a valid pattern, should there be any doubt, it is probable that the candlestick is not long “enough”.

Short candlesticks 

Short candlesticks could represent two things: not much volume or periods of indecision (demand meets supply.)

Short candlesticks are also compared to previous action to assess the validity of the candlestick.

Marubozu 

Marubozu candlesticks are strong candles. They have no shadows, this means that the open price equals the low/high of the period and the closing price equals the high/low of the period.

The interpretation of this kind of candlesticks varies depending on where it was formed. If a bullish marubozu appears in a downtrend, it could signal a short-term reversal (bulls took control of the situation from the first minute to the last.) If a bullish marubozu appears at the top the range, it could signal a final push up, it all depends on preceding candlesticks. The same is true for a bearish marubozu.

If the marubozu breaks through an important support or resistance level, the market is likely to continue on the way of the “break through”.

Doji candlesticks 

Doji candlesticks represent periods of indecision, or fierce battle between bulls and bears.

Doji candlesticks are formed when the open price and the close price are virtually the same (or very close). Ideally, the open and close prices should be equal, but remember, the important thing to capture here is the essence of the candlestick.

For instance, when the close and open price is similar, it shows us that as the price went up, sellers took control of the situation, and when prices went down, the buyers the control of prices.

Doji candlesticks alone are considered neutral, but should be a warning. If for instance, in a downtrend a doji candlestick is preceded by a long bull candlestick, then it could mean a possible reversal.

Spinning tops/bottoms

Spinning tops and bottoms have small bodies and long shadows usually larger than its body.

Spinning tops/bottoms, as dojis, represent periods of indecision and intensive action between bulls and bears, with no clear domination.

Spinning tops/bottoms are considered neutral until a long bull/bear candlestick appears after them.

Long-legged doji

Long upper and lower shadows, open and close prices are virtually the same.

These candlesticks also represent intensive action between bulls and bears, and no one was being able to take control over prices.

Dragonfly and Gravestone doji´s are Long-legged doji´s.

Dragonfly doji

Long lower shadow with open and closing prices near the top of the range. Bears took control first, but then bulls were attracted by cheaper prices then taking control of prices.

This candlestick is more bullish than bearish since the bears were not able to drive prices lower because bulls took control over prices, pushing them up.

Gravestone doji

Long upper shadow with open and closing prices near the bottom of the range. Bulls took control of prices at the beginning, but then bears resurfaced gaining control taking the price near the low (and open) of the range.

This candlestick is slightly more bearish than bullish since bulls tried to take control over prices driving them higher first, but then the bears took control over them driving them back down.