An exotic technical trend-following strategy in FX.
Many technical strategies do not make a lot of economic sense and are the result of extensive back-testing and data mining. Some are genuine and tend to work while others seem to only work when specific conditions are met. This is what I’m hoping to achieve by presenting one of my favourite trend-following strategies. But first, what is trend-following? It’s a type of trading that is:
- Searching for buying opportunities during a rising market.
- Searching for selling opportunities during a falling market.
The tools necessary for this strategy are:
- A 200-period exponential or simple moving average (optional).
- A short-term Stochastic indicator set at a lookback period of 5.
- A mid-term Stochastic indicator set at a lookback period of 14.
- A Fibonacci expansion tool to measure targets and potentials.
Notice that in the last step, we have mentioned expansion and not retracement. Indeed, the Fibonacci expansion tool is different from the conventional retracement tool in that they help us project the amplitudes. So, naturally, one can use the Fibonacci retracements for determining until what level prices may react and then use the expansion tool to see until where the trend may continue. The common Fibonacci expansion levels used are 61.8%, 100%, and 161.8%. The 200-period EMA is only used to confirm the trend if there are any doubts with the direction as we will only initiate buy orders during up trends and vice versa. Let’s start from scratch.
1 . Trend detection
The first step is to look for a trending series either through a moving average or through visual interpretation. I tend to prefer long-term moving averages such as 100 and 200 so as to be sure of the pre-established trends. During lucky times, the moving averages can provide an extra layer of support/resistance level from where we initiate our trigger. Below is an example on the USDCAD where we can clearly see that the trend is bullish.
As long as we are in a bullish trend, we will only be looking at bullish opportunities. If you want to learn more about moving averages and how to code them in Python, you can check out this article I’ve written here on Medium: How to code different types of moving averages in Python.
2 . Finding the trigger intervals
The next step seeks to find the end of the corrections/consolidations by establishing intervals. How are we going to do that? Simple, by using two Stochastic indicators, we will find the points where both indicators show extreme values. Below is a clear example:
Each two successive extremes form the interval that we will use to initiate our orders, calculate the potential target, and measure the risk (where to put our stop).
Now, we can move on to the next step after having found two successive Stochastic extremes that gave us the bullish signal (Remember: we’re only looking for bullish signals within this bullish trend).
3 . Calculating the potential
This is where the Fibonacci expansion tool comes in. How is the potential calculated? Well, we take the interval, starting from the low of the first candle, project it to the high of the highest candle inside the interval by using the low of the last candle in the interval. Here’s a clear graph to explain the previous statement.
A bullish trend will have the low of the first candle coinciding with the first oversold zone of the Stochastic, the final part of the Expansion tool will also coincide with the low of the last candle occurring with the second oversold zone. The middle part is the highest high inside the whole Fibonacci expansion pattern.
The 61.8% projection can be thought of as the first target. A first target can be where we choose to close out 50% of our position in order to secure some profits.
4 . Calculating the risk
As I am a fan of the simple basic risk management principle that says never to risk more than you expect, I like to use a 2:1 risk-reward ratio. This means that if I expect to gain $2, I would risk losing $1. In the below graph, we have the same trade, with the addition of the stop loss that is half the amplitude from the buy-to-target distance.
Let’s now try out an example on how to find bearish opportunities. We will do everything we did above but with a perspective that we want to follow the downtrend.
- Trend detection and finding the intervals.
- Calculating the potential.
- Measuring the risk and entering into the trade.
The best word to describe this strategy is that it is ‘improvised’. Understandably, a pure technical strategy that combines two or more indicators together in man-made measures and rules does not make much sense. In investing and trading we are all looking for something that not only works, but it also has to make economic sense. In technical analysis, this can pose a problem sometimes. However, the strategy per se does not make much sense as technical analysis can at least be explained by the psychological behaviors and market participants. Nevertheless, live trading this strategy produces good returns for a trend-following system that one can use as a supporting strategy.