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How to Trade Swings with Indicators

How to Trade Swings with Indicators

2014-08-07 19:00:00
James Stanley, Currency Strategist
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Talking Points:

  • Swing trading can be attractive due to the potentially strong risk-reward ratios available.
  • Swings take place in range-bound and trending markets.
  • We show traders how to trade swings in both environments using two different technical indicators.

When someone first begins to learn to trade, they’ll often delve right into technical analysis. After all, if you can read a chart and get trade ideas directly from past price information, there is no need to learn any of the ‘difficult’ stuff. The things like GDP reports, or inflation readings, or central bank announcements: The Macro-Economic events that will often help to shape the way that this world will continue to grow.

This is difficult just because there is so much of it. Many very bright young people will spend their entire lives studying economics and even then, they realize that the field is a very inexact science (case in point, the career paths of both Ben Bernanke and Janet Yellen and the conundrums they face/faced every FOMC meeting).

The shortest distance between two points is a straight line, and for most traders that straight line draws directly from technical analysis.

And right after learning candlesticks, traders will often begin moving into indicators to assist in interpreting that chart information. Trading is difficult enough, but when first encountering a chart most traders just see a bunch of squiggly lines. The indicator can help to make sense of that madness.

The first few indicators learned are often the basics. The moving average is often the first one learned because it is so simple (and we explained the moving average in our most recent article here); and then after that traders will usually move towards slightly more advanced, yet still ‘basic’ indicators.

These traders will learn how the indicator can work, and may even place a few trades based on that indicator. This story almost always ends the same way as these new traders realize that the indicator doesn’t ‘always’ work, so they discard that one and move on to more advanced studies.

This is a very unfortunate mistake.

The fact of the matter is that no tool, whether it’s an advanced indicator or something simple that you learned on your second day in markets – is going to perfectly predict the future. Holy grails don’t exist and regardless of how strong your analytical approach is – any trade you place can end up costing you money.

This accentuates the importance of risk management: The future is uncertain regardless of how great of a trader you become. The difference between a professional and an amateur is that a professional knows what to do when they’re right and when they’re wrong, and an amateur doesn’t. If you want more information on the topic, our Quantitative Strategist Mr. David Rodriguez outlines the importance and relevance of risk management in our DailyFX Traits of Successful Traders research.

Link for Traits of Successful Traders

So, if any trade brings along with it risk, and if the future is uncertain – what does this say about the trader’s pursuit of profit?

This should illustrate that trading is more about probabilities than it is about direct prediction; with the goal being to get the probabilities in the trader’s favor, if even by just a little bit – and this is where technical analysis comes in.

Using technical analysis can allow traders to take a look at what has happened in a market in an effort to get an idea for what may happen in that market. Notice that we didn’t say ‘predict’ or ‘will happen.’ What follows are two ways that indicators can be used to look to initiate positions in the FX market.

The Relative Strength Index(Optimal Usage: Range-bound conditions)

RSI is probably the most discarded indicator on the planet earth. While moving averages are often the first indicator learned, RSI usually follows closely thereafter. And after careful examination, traders will often realize that RSI (like any other indicator) isn’t always right. So they’ll often discard it, and move on to investigate other indicators (which all have the same issue of not being perfectly predictable).

RSI, like any other indicator, has pluses and minuses. RSI can work fantastic in a range as an entry indicator; and traders can use this to trade swings in range-bound market conditions.

Traders can look to use RSI in the default manner, investigating short signals when the indicator crosses down and through ’70,’ under the presumption that the market may be leaving ‘overbought’ status; while investigating long signals with RSI crosses up and over 30 as the market leaves ‘oversold’ status.

As an example, the chart below shows the 4-hour USDJPY market; and I’ve outlined the relevant RSI entry possibilities (red circles indicating short signals, with green indicating long signals). As you can see, not every signal would have worked out perfectly here – but this certainly can put the trader in a position where the probabilities of success can be in their favor.

Trading the Range in USDJPY (4-hour chart) with RSI

How to Trade Swings with Indicators

Created with Marketscope/Trading Station II; prepared by James Stanley

Notice that not every one of these signals would have worked; but that’s okay – that is to be expected. We’re using the past simply to get an idea what may happen; and as you can see in the above graphic, the Relative Strength Indicator can be a fantastic way to get those ideas during a range-bound market.

How to Trade Swings within a Trend Using MACD

As we looked at above, RSI can be a fantastic way to trade swings within a range. But the fact-of-the-matter is that most traders avoid ranges like they were infested with bubonic plague. So I would be remiss in this article if I didn’t touch on the most desired of the three market conditions: The trend.

Many traders love trends, and the reasons are quite logical. If that trend is going to continue, the trader can make a significant amount more than they had to put up to risk upon entering the position. This goes right back to that risk-reward factor that was mentioned as being so important in the Traits of Successful Traders research.

But just as we saw in our Price Action Trends article, traders have the constant conundrum of finding optimal entry points within a trend.

Because it’s not enough to simply go long because the trend is ‘up,’ is it? Nor would we want to blindly sell just because we’ve determined the trend to be ‘down.’

No, we want to do so in the manner that can bring us the greatest probabilities of success: So when buying an up-trend, we want to look to ‘buy low’ and ‘sell high.’ I realize that this may sound overly-logical, and I further realize that what constitutes ‘low’ and ‘high’ are relative measures that many new traders might struggle with; so this is where an indicator can help.

A common question here is ‘which indicator works best?’ There are a plethora of indicators that can work ‘best’ here; it really just depends on the application. Remember – the future is uncertain. An indicator is simply a way to get an idea for what may happen based on what has happened.

To use an indicator to trade swings within a trending environment, we’re going to need some type of a filter to help us determine which direction to trade the trend. A common filter for this cause is the 200-day moving average; as many investment banks and hedge funds around-the-world use this indicator for the same purpose.

If prices are above the 200-day moving average, traders determine the trend to be ‘up,’ in which case they look for opportunities to buy.

After the trend has been determined to be ‘up,’ the trader can then look for a signal to initiate the long position, in anticipation of the trend resuming its previous trajectory. A common ‘trigger’ for this goal is the MACD indicator, and if you’d like to learn more about using MACD as an entry trigger – we discuss that in this article.

In the below image, we’re taking a look at GBPUSD over the past year; in which the pair has seen a brisk up-trend take prices from the 1.5500 vicinity, all the way up towards 1.7000. The 200-day moving average has been applied, and is showing in red on this 4-hour chart below.

MACD has also been applied, using the settings of 21, 55, and 9 periods respectively, and when the MACD crosses up and over the signal line – a long position is considered. Because this is a trending strategy, the short signal from MACD (MACD crossing down and under the signal line) is used only to close the long position. No short positions are initiated here because the trend is classified as being ‘up.’

GBPUSD 4-hour chart (with 200-day Moving Average) Using MACD Trend-Side Entries

How to Trade Swings with Indicators

Created with Marketscope/Trading Station II; prepared by James Stanley

As you can see above, not every signal would have worked out perfectly. But in this year-long trend in GBPUSD, traders had numerous opportunities to jump on the long side when prices were ‘low,’ and then to close the positions out after prices have swung higher.

--- Written by James Stanley

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James is available on Twitter @JStanleyFX

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