Monday, December 8, 2008
Step 3b: Develop a FOREX System
Continuing from the analogy ( FOREX System ) of the previous step we see that in a jigsaw puzzle each piece completes the others to form a greater whole and this is what we are striving for as well. We do not want several indicators that show us the same thing. In the following example I will show you how a Forex system can be put together. In this example I will use EURUSD 30 min bars but you can choose any bar period or currency pair you like. We start out with just price action:
Of course looking at this chart for our Forex System we can easily pin point the optimal places to buy and sell short. Well, anything seems easy in hindsight. Try doing this with streaming data and the task becomes difficult. That is why we need to add indicators in order to supply the mind with reference points. Anyone who has been out on the ocean knows the difficulty of judging distance at open sea, the reason being the lack of reference points. This is exactly why we need to add indicators that enable us to measure our current position. Otherwise you are nothing more than a ship adrift at sea without crew, compass or nautical chart.
By studying the chart of our Forex System you can determine the different rules that would be possible to trade by. The three most common rules are the following:
By experimenting I have found that in general a cross-over is preferable to a direction change. A cross-over filters out small annoying changes, but unfortunately adds lag. If your indicator is very smooth and robust, direction change can be be traded with advantage and sometimes is outright better. It all depends on the robustness and smoothness of the indicator. In our example we will use cross-over and divergence for rule creation.
Divergence in our Forex System is simply a discrepancy between price and an indicator. We can use the following divergence rules:
Settings
TSI: 25 bar Long MA, 13 bar Short MA, 5 bar Signal MA.Keltner Channel: 34 bar Exponential MA, 2.6 ATRs.Trend MA: 100 bar Exponential MABy studying the charts our rules become the following:
Exhaustion Trade
This type works best in an active and trendless market. Doesn't work in a trending or choppy market. Important: Price must have been outside the Keltner Channel just prior to or at time of signal, else it is not valid.
Long Entry
If TSI crosses above Signal Line AND TSI is below 0 AND Close is inside the lower Keltner Channel then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is above 0 AND Close is inside the upper Keltner Channel then Sell Short.
Trend Trade
This type works best when we have a robust trend in action. Works poorly in choppy, trendless market. Important: The Trend MA must be pointing up for Long Entries and vice versa. When I get a Trend Trade Signal I also look for the current TSI high to be lower than the previous TSI signal high for a Short Entry and vice versa for a Long Entry.
Long Entry
If TSI crosses above Signal Line AND TSI is above -20 AND Price goes through Keltner Channel midline and then reverses back up then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is below 20 AND Price goes through Keltner Channel midline and then reverses back down then Sell Short.
Divergence Trade
This type works best in an active and trendless market. It also doesn't work in a choppy market. Important: The best is if price has been outside the Keltner Channel, it then effectively becomes a mix between an Exhaustion Trade and a Divergence Trade. Price doesn't need to be inside the Keltner Channel when the divergence crossover occurs.
Long Entry
If TSI crosses above Signal Line AND TSI is below 0 AND TSI makes a higher Low AND Price makes a lower Low AND Close is inside the lower Keltner Channel then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is above 0 AND TSI makes a lower High AND Price makes a higher High AND Close is inside the upper Keltner Channel then Sell Short. On the following Forex System picture you can see that it works out pretty well:
In a trend like this, you will experience a lot of fake signals:
Fake signals are unavoidable and the only way to handle them is with Trade Management and through experience. By experience you will learn how to distinguish between a trending market and a trendless. Many of the signals above are obvious fake Long signals. Look at raw price velocity at some of the signals and you will realize that is very weak (price pushing up with difficulty) and thus you should avoid such trades. Do not only look at individual parts, but pay attention to the big picture as well.
Be aware that sometimes different platforms have slightly different ways of calculating indicators, so you must check visually and through backtesting (more on that later) the validity of the Forex System described above. I don't know how your trading platform works or how it calculates its indicators.
As far as I know, this system works on all time frames, although you might find yourself changing the parameters to suit your time frame of choice. If you want to trade a currency pair other than EURUSD, then please double check the setting and rules so that is suits that particular currency pair. It wouldn't surprise me if you change them anyway, we are all different with different preferences. Once you have find something that works, stick to it.
When you start trading a new system, there will be some time before you get used to it, before you have learned all the twist and turns of your indicators. It is unlikely you will be able to trade this or any system right off the bat. As I have mentioned before, the brain needs to build new neural pathways, and that takes time and effort. Write down the rules on a piece of paper by hand a few times and make sure you have understood them correctly. In this way is will be properly imprinted in your mind.
Of course looking at this chart for our Forex System we can easily pin point the optimal places to buy and sell short. Well, anything seems easy in hindsight. Try doing this with streaming data and the task becomes difficult. That is why we need to add indicators in order to supply the mind with reference points. Anyone who has been out on the ocean knows the difficulty of judging distance at open sea, the reason being the lack of reference points. This is exactly why we need to add indicators that enable us to measure our current position. Otherwise you are nothing more than a ship adrift at sea without crew, compass or nautical chart.
By studying the chart of our Forex System you can determine the different rules that would be possible to trade by. The three most common rules are the following:
- Cross-over
- Change of direction
- Divergence
By experimenting I have found that in general a cross-over is preferable to a direction change. A cross-over filters out small annoying changes, but unfortunately adds lag. If your indicator is very smooth and robust, direction change can be be traded with advantage and sometimes is outright better. It all depends on the robustness and smoothness of the indicator. In our example we will use cross-over and divergence for rule creation.
Divergence in our Forex System is simply a discrepancy between price and an indicator. We can use the following divergence rules:
- Long: Price makes a lower low, but your indicator makes a higher low.
- Short: Price makes a higher high, but your indicator makes a lower high.
Look at the image below to get an idea how divergence works. Compare the cyan and yellow lines. The indicator in the Forex System (Golden R) is proprietary.
When we are creating a Forex System, we usually start with an idea, probably something we have observed during chart study. In our chart we have added TSI and Keltner Channels and by looking at their behavior we can draw certain conclusions. Going through the Forex System chart you will notice that when price move beyond either the upper or lower Keltner Channel Bands, prices tend to change direction, in other words price has reached a state of exhaustion and turns. Further when TSI is significantly above or below zero, price also tends to reverse. TSI also gives fairly good divergence signals. The Forex System described below works for me and my trading style, it might not be entirely suitable for you. At the very least it will give you some design ideas for your own Forex System, so study it diligently.
Settings
TSI: 25 bar Long MA, 13 bar Short MA, 5 bar Signal MA.Keltner Channel: 34 bar Exponential MA, 2.6 ATRs.Trend MA: 100 bar Exponential MABy studying the charts our rules become the following:
Exhaustion Trade
This type works best in an active and trendless market. Doesn't work in a trending or choppy market. Important: Price must have been outside the Keltner Channel just prior to or at time of signal, else it is not valid.
Long Entry
If TSI crosses above Signal Line AND TSI is below 0 AND Close is inside the lower Keltner Channel then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is above 0 AND Close is inside the upper Keltner Channel then Sell Short.
Trend Trade
This type works best when we have a robust trend in action. Works poorly in choppy, trendless market. Important: The Trend MA must be pointing up for Long Entries and vice versa. When I get a Trend Trade Signal I also look for the current TSI high to be lower than the previous TSI signal high for a Short Entry and vice versa for a Long Entry.
Long Entry
If TSI crosses above Signal Line AND TSI is above -20 AND Price goes through Keltner Channel midline and then reverses back up then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is below 20 AND Price goes through Keltner Channel midline and then reverses back down then Sell Short.
Divergence Trade
This type works best in an active and trendless market. It also doesn't work in a choppy market. Important: The best is if price has been outside the Keltner Channel, it then effectively becomes a mix between an Exhaustion Trade and a Divergence Trade. Price doesn't need to be inside the Keltner Channel when the divergence crossover occurs.
Long Entry
If TSI crosses above Signal Line AND TSI is below 0 AND TSI makes a higher Low AND Price makes a lower Low AND Close is inside the lower Keltner Channel then Buy.
Short Entry
If TSI crosses below Signal Line AND TSI is above 0 AND TSI makes a lower High AND Price makes a higher High AND Close is inside the upper Keltner Channel then Sell Short. On the following Forex System picture you can see that it works out pretty well:
In a trend like this, you will experience a lot of fake signals:Fake signals are unavoidable and the only way to handle them is with Trade Management and through experience. By experience you will learn how to distinguish between a trending market and a trendless. Many of the signals above are obvious fake Long signals. Look at raw price velocity at some of the signals and you will realize that is very weak (price pushing up with difficulty) and thus you should avoid such trades. Do not only look at individual parts, but pay attention to the big picture as well.
Be aware that sometimes different platforms have slightly different ways of calculating indicators, so you must check visually and through backtesting (more on that later) the validity of the Forex System described above. I don't know how your trading platform works or how it calculates its indicators.
As far as I know, this system works on all time frames, although you might find yourself changing the parameters to suit your time frame of choice. If you want to trade a currency pair other than EURUSD, then please double check the setting and rules so that is suits that particular currency pair. It wouldn't surprise me if you change them anyway, we are all different with different preferences. Once you have find something that works, stick to it.
When you are trading, use a little common sense. For example, if you get a Long signal and the entry bar is a wide range (Range = High – Low) down bar, think twice before taking the signal. The least you can do is to wait and see how it develops. If it then starts moving up with a fair amount of momentum, take the trade. Use your mind!!!
When you start trading a new system, there will be some time before you get used to it, before you have learned all the twist and turns of your indicators. It is unlikely you will be able to trade this or any system right off the bat. As I have mentioned before, the brain needs to build new neural pathways, and that takes time and effort. Write down the rules on a piece of paper by hand a few times and make sure you have understood them correctly. In this way is will be properly imprinted in your mind.
My best tip is to have patience (a trader's virtue, remember?) when a signal has been triggered. Wait until you have a confirmation that the trend is going your way. Do not try to anticipate or get in at the top or bottom of a move. The market loves to whipsaw such traders, I know, I have made this mistake many times.
We have now reached the stage where we must put our rules into a Trading Plan together with some other information. A Trading Plan is easy to put together, you simply put down all the relevant information regarding your Trading System on a piece of paper. Do the best you can at the moment– we are not yet ready to cast it in stone. It is not necessary to fill in all at once, do it over a few days so it can mature in your mind. A few new ideas might also pop up during these days. If you have inspiration, and believe you can fill it in all in one sweep, by all means go ahead.
Tip: We are human beings and as such we have emotions. The two emotions that drive traders are fear and greed. Both emotions can be all encompassing and life threatening. Both influences sound judgment negatively and usually makes us sloppy and hesitant. How do we deal with this? The answer is awareness and control. In other words by being consciously aware of your current emotional state you can also control it. When you are experiencing fear or greed, take a step outside yourself, detaching yourself from the emotion, take a good look at yourself and your behavior. Ask yourself what your are feeling and why you are feeling this way. Ask yourself if the actions you are taking makes sense from a professional traders viewpoint. Let your answers soak in for a minute or so, just lingering on the fact without judging. With practice and discipline you will be able to take control of these emotions before they sink your ship. Note: You are not trying to eliminate your emotions, only to understand them and take control over them. Use them to your advantage.
Action Step: Try now on your own to make a simple Forex System. Take an indicator you like. Try different settings and try to figure out how they affect its behavior. Add another indicator which is totally unrelated to the first one (for example add Gann Fan to RSI). Look for incidents that makes good candidates for a profitable trading system. Just practice to see if you could find a combination that could work.
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