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Here’s a step-by-step look at a trading system that you can incorporate into forex as well as other markets.

The essence of the trading system I discuss here was already proposed by Charles Henry Dow, the founder of the Dow Jones indexes and Dow theory, at the beginning of the 20th century. Dow pointed out three categories of trends: primary, secondary, and minor. The primary trend tells you which way prices are flowing. The secondary is made up of waves that form the flow, and the minor trends look like ripples on the waves. As traders, our task is to define the major trend of the direction of prices and then to find a wave inside it as a good point of entry.

IS IT THAT EASY?

Very often while analyzing the market, we can come across contradictions. Let’s point out two major contradictions:

1. At various time scales, you can observe conflicting trend directions. For example, on a weekly chart the trend may appear to be ascending, whereas on a daily chart the trend may be descending. And when it comes to intraday charts, the direction of the trend is usually vague.

2. Various groups of indicators may show contradictory signals. While a trend indicator may suggest that the trend is ascending, the oscillator may show that traders are outbidding and therefore give sell signals. So which should you believe? Those who just start out trading often get themselves into such traps. They begin to look at charts of different time intervals and apply one indicator after another. It then becomes a complete and unusable mess. As a result, instead of rising, the deposit fades in front of our eyes.

From my point of view, Alexander Elder, in the second half of the 20th century, was the best in presenting the idea of how to avoid these contradictions. He called it the “three screens.” For large time intervals, you define the trend direction by trend indicators. For smaller time intervals, you identify the point of entrance in the direction of the trend indicated by oscillators.

Elder wrote that sometimes at seminars a trader will come up to him and thank him, but then add that he uses the system of three screens in a way not exactly how Elder described it. The trader would explain he corrected indicators or used ones other than what was suggested, added some functions, and made the system a winner.

So the system was along the same lines as the one that Alexander Elder described, but different. The point is that traders can adjust the system to meet their own needs. That’s how I got the idea to write about my own system, the principles of which were borrowed from Elder. Every step here is described scrupulously and gradually. I tested it, day after day, during a long period, before putting it into practice. I hope you can take advantage of the system I’ve described here and adapt it based on your needs and experiences.

EXPLORE AND ENJOY

The upside of being involved with the financial markets is that you have the opportunity to explore and gain some pleasure besides making money. To begin:

Step 1. Time interval: daily (D1) Define the direction of the trend, the areas of the stable development, and the areas of acceleration and deceleration. The indicators that I used:

1. Exponential moving average (21-period), based on the close
2. MACD histogram (12/26/1)
3. Bill Williams’ acceleration/deceleration technical indicator (AC)

The major direction of the trend is specified according to the exponential moving average (EMA). If the price is higher than the moving average and is positively sloping, it means that the trend is ascending. If the price is lower than the EMA and the slope is negative, the trend is descending. But that’s not all!

Books on technical analysis state that you should trade according to the trend. That is true. If you compare price movement on a chart with the flow of a river, you will find a lot in common between them. The direction of the trend, like the river, doesn’t move homogeneously at all times. Looking at a river, first you’ll see the head, or rise of motion. In trading, there are areas where the motion is smooth and slow. And then there are areas where the movement accelerates, turning into a rapid stream. The river also has areas of shoal where the motion fades out. And finally, sooner or later the river ends its flow. When the moving average convergence/divergence (MACD) histogram goes up during an ascending trend and goes down during a descending one, it shows stable areas of trend development.

But how do you spot these areas for acceleration and deceleration? To do that, we’ll add a small touch: the Bill Williams acceleration/deceleration technical indicator (AC). This indicator measures acceleration and deceleration of the current driving force. In his book New Trading Dimensions, Williams compares the application of the indicator with reading the next issue of The Wall Street Journal. Often, AC can warn us about a change in the movement of price before it happens.

So the moving average will show the main trend, the MACD histogram will show the areas of stable development, and the AC histogram will show us the periods of the trend’s acceleration and deceleration.

The most ideal situation for buying a long position will be when you follow these rules:

1. The price is higher than EMA.
2. The direction of the EMA is positively sloping.
3. The MACD histogram is higher than the previous one.
4. AC histogram is green.

When looking to close your long position, you should follow these rules:

1. The price is lower than EMA.
2. The EMA is negatively sloping.
3. The MACD histogram is lower than the previous one.
4. AC histogram is red.

FIGURE 1: 1- PRICE IS HIGHER THAN EMA, 2 – EMA SLOPE GOES UP, 3 – MACD HISTOGRAM GOES UP, 4 – AC HISTOGRAM ALSO GOES UP. In this case you can use the four-hour and the hourly chart. When one of the histograms moves against the trend, you should trade only on the four-hour (H4) chart. When both histograms are moving against the trend — marked by exclamation mark — you should not place the trade.

If you abide by these rules, you can expect to see a point of entry both on the four-hour and hourly chart (Figure 1). But what should you do if the EMA shows an ascending trend and one of the two histograms shows a downward one? At this point it is not yet time to talk about the turn of the trend, but while looking for that point of entry, it is best to look at the four-hour price chart — in other words, start working in a more conservative way. If the trend is ascending and both histograms are going down, you should stop trading and observe how things develop.

The search for a suitable environment and the right trend for trading opportunities is the most important task. For example, if you enter the trade during a strong trend but the trade is not successful, the market will let you leave with little or no loss. But if you were to enter your trade against the major trend, you can’t really justify making that trade and this can lead to a very dangerous situation. To better understand the importance of the trend, imagine you’re going fishing. You are equipped with all the cutting edge technologies. Armed with these tools, in rubber boots you head out to the fountain at the center of the city and cast your line there, hoping to get some fish. But you can’t find anything there except an empty beer can and some coins. There’s no fish in a city fountain!

CASTING THE LINE

Sometimes on the National Geographic cable channel there’s a program about bears hunting for salmon that swim in Canadian and Kamchatka rivers in autumn. At that time of the year there’s so much fish in rivers, all a bear has to do to get food is wave its paw. Similarly, you should be able to single out situations where the trend is so strong that almost any trade you make by following the trend will reward you with good returns.

Step 2. Time interval: hour (H1), fourhour (H4). Once you know the direction and strength of the trend, you are ready to move on to the second step, which is to find the appropriate signal in line with the direction of the trend. I use the threeperiod relative strength index RSI(3) based on the close. Keep in mind that when two histograms move toward the trend, you can use both the hour (H1) and the fourhour (H4) chart. If one of the two histograms moves against the trend, you should look only at the four-hour chart. If both histograms move against the trend, you should stop trading. Once you find the river with a lot of big fish, it’s time to cast the line.

A good signal to open a position will be when the indicator descends or retraces while in an ascending trend — that is, the RSI goes below the 30 level. Or it will go up to the area of outbidding at the descending trend RSI — that is, above the 70 level. If you observe that the indicator is descending below 30 while the trend is ascending, it’s not the time to make a trade. Wait for the close of the current candlestick. Once that happens and you find that the RSI stays in the area of reselling at the ascending trend, or in the area of outbidding at the descending trend, it’s time to move on to the third step.

Step 3. Time interval: H4 (H1 if trend is strong) You need to find the point of entry and define your objective. At this point you start catching the impulse moves that are moving in the same direction as the major trend. Let’s take a look at an example of an ascending trend to determine when to open a position. After the RSI descends below the 30 level, wait for the signal. I have three variations on how to sell a position after opening a trade.

The three variations are:

1. The oscillator goes beyond the oversold area, meaning the indicator is crossing above the 30 level.
2. After the RSI descends below the 30 level, place the pending buy-stop order one point higher than the next candlestick’s high, taking spread into account. If the order doesn’t work on this candlestick, move the order a point higher than the next candlestick. Keep moving the order till the order gets filled.
3. Wait for a divergence/convergence signal with price. The price sets a lower low in comparison to the previous bar while the RSI oscillator moves higher. When this happens, place the pending buy-stop order a point higher than the high of the last candle, taking spread into account. Each trader will have his or her own variation, but a divergence/convergence with price, although rare, is considered to be a very strong signal. Before you make a trade, don’t forget to check the daily chart. While you’re waiting for the entry signal, after all, the situation on the daily chart may change.

FIGURE 2: The figure offers the second variant of the market entrance

FIGURE 3: The figure offers the third variants of the market entrance

PROFIT OBJECTIVE

Your next task is to define your minimum profit objective. After opening your position, wait until the RSI ascends above the 70 level (it may try to head for 80) once the candlestick bar closes. Conversely, after selling short, the RSI may descend below the 30 level (it may try to head for level 20) after the candlestick bar forms. After that, you can either take the profit that is offered by the market or you can leave the trade open, moving the stop-loss to the breakeven area. Later on, to book your profits, you should head for the support/resistance lines or apply a trailing-stop at the moving average. Hold the position till the candlestick closes below the moving average.

This trading system filters out a lot of potential signals that initially appear to be good. In the beginning, you search for the trend suitable to initiate the trade using the daily price chart. You then wait for a good trend on the daily chart, pass to the second step, and cast the line using the hourly chart. But you may not get a bite. You wait for the signal on the hourly chart, and then before opening the position, you check the daily chart and finally the MACD and AC histogram. These may show that the trend is over. So you are sacrificing several opportunities for the sake of stability, but that is a necessary component in trading — besides profit, of course.

WAITING FOR…

To stave off boredom while waiting for the signal, I recommend that you look at different currency pairs. The strong point of this system is that it is universal and can be used for working with any financial instruments. Based on my experience trading foreign currencies, I can say with confidence that you can get a couple of signals a week. This system is suitable for an unhurried trade and doesn’t require staying by the computer all day long. Personally, I look for the point of entry only on the four-hour price chart so I check my monitor every four hours to see if any signal is appearing as the candlestick bar closes. I spend the rest of my time doing other things, like fishing. Those who love to fish will certainly find some commonality:

Step 1: We look for a basin where big fish swim — a strong trend.

Step 2: We cast the line (RSI) and wait for the bite.

Step 3: We hook in time and then haul in the catch — close the deal at the best price!

Alex Sabodin.
Pro Finance Group Inc.