You now have mastered the mechanics of your trading platform and have set up a preliminary process for pre-trade, trade, and post-trade. I say preliminary because as you develop your trading method, all setups will need to be modified in accordance with what is specifically needed for it. You have selected one or two brokers and a trading platform to demo. You are ready to begin trading the demo account using a simple indicator battery method. This will get your feet wet and also aid in understanding how trading methods are developed.
Tip: Performance is not an issue here; learning is the focus.
Fundamentals almost certainly drive the long-term trends of currencies, but trading is a short-term affair. Most traders do not even hold a position from one eight-hour session to another. “If U.S. interest rates go up, then the USD will rise” — this is true in some cases, false in others. There are so many other factors determining currency prices that an accurate observation one time may be incorrect the next. Correlations, between them, almost certainly nonlinear, come and go without notice. But even if one knew a statement to be correct, how does that help a trader in the short term? Leverage is the name of the game, and few of us want a $10,000 loss while waiting for a fundamental factor to work.
Ergo, I strongly recommend the new trader develop a simple technical analysis toolbox to get started trading currencies. You may add to the toolbox later or make adjustments. Or perhaps you will find your approach in the Goodman Method of Part 5 — or in any number of other technical trading approaches. Use the techniques of News Trading. as your fundamental analysis adjunct.
At the outset, it is important to keep your tools balanced, and your method simple. Do not select four tools effective in trading markets and only one that works in trending markets. This implies that you know what an indicator, charting technique, or other technical tool really does. Begin your FOREX career by keeping it simple.
Of the three components to trading, trading techniques get the most publicity — perhaps because they are easier to communicate. Traders have hundreds of tools to trade, even though most are variations of a few general types. The composition of toolboxes and trading methods also varies enormously from trader to trader. But almost all successful traders share the same psychological attributes and basic money-management rules.
As you select technical analysis tools, keep in mind:
What does an indicator really measure? Do you really need it in your toolbox, or can you glean the information from a chart? Consider Figure below. This shows prices depicted as a bar chart on the top and a relative strength (RS) indicator (see Technical Analysis) on the bottom. Functionally, relative strength measures the slope of a line (trend); it is a form of the slope-intercept formula you learned in algebra I: y = mx + b. Does the following relative strength indicator add anything that you cannot see on the bar chart? To some extent, it depends on what you want and need.
Tip: To avoid offending RS aficionados, the author must mention that this indicator sometimes helps spot tops and bottoms when a new high (or low) in prices is not matched by a new high (or low) in the RS indicator.
It is quite often possible to eliminate indicators because you can more easily see the same information on a chart. This is the thesis of Charles Goodman’s market environment (ME) charting technique. See Tools for Traders, for more on ME. There is a great deal of overlap in what the dozens of technical indicators measure. You can surely cover the bases with no more than three or four of them.
Tip: When studying a new indicator ask: “Is this good for trading markets or for trending markets?”
This toolbox is only an example of how to select a few basic tools for trading. Survey the field — it is huge — and pick wisely.
A technical analysis toolbox might include:
Begin with the most basic items. Refine them and add — slowly.
Tip: Pick one as a primary method of analysis and use the others as filters to gradually zero in on a trade candidate.
This simple system is an indicator battery that was shown to me by a trader at Peavey & Company in the early 1970s, where I cut my trading teeth on commodity futures. Insofar as futures and currencies are both high-leverage markets, it should be equally at home in either market. The simple system will also give you some idea on how trading methods based on indicators, “an indicator battery,” if you will, are developed. This one is indeed simple! Some of them are very complex and need to be computer programmed to use effectively in the fast-moving FOREX markets.
Tip: Use only one-time frame to trade the simple system for now. It can be applied on any from 5-minutes to 1-day. I recommend 15-minute, 30-minute, or 1-hour to begin.
The simple system is an indicator battery composed of two indicators, a moving average crossover and a momentum index, similar to an oscillator. A battery is a combination of indicators. When the indicators in a battery are combined to automatically generate buy and sell trade signals by a certain set of rules, it is referred to as an expert advisor, or EA.
Tip: An indicator battery or an expert advisor could be used as a primary trading method or as a check on the primary method.
You may wish to review Technical Analysis, which provides details on the workings, strengths, and weaknesses of moving averages and oscillators. All trading platforms offer moving averages, momentum indexes, and prebuilt oscillators. The simple system is built on MetaTrader 4, but other platforms may be used with very little difference.
You will find access to indicators in the navigation window of MT4. Here are some of them broken down as either trading or trending tools.
This is just a sample of those available. But, again, breaking them down to either trading or trending identifies the nature of most of them. If you cannot ascertain the type in advance, try it on a very sharp trending market and a very choppy trading market. The performance will tell you the whole story!
Complex systems involve up to a dozen or more indicators and a rule set that can be followed only with a computer program. As you experiment with the simple system, changing the inputs and adding new indicators and rules, consider the following critique.
Indicator parameters and filters are a type of what is called curve-fitting. Given enough jiggling of parameters, filters, and a few indicators, I can find a set of rules for the system or for the money management scheme that will generate an enormous profit and lose very little over a given data set. The question is will it work in the future as well as it did in the past? The answer is no. Because the filters and ruleset are curve-fitted so tightly to that specific data, a small change in the market environment will quickly change the winning system to a losing system. This is why so many systems look good on paper, but once they go live, disaster strikes.
It is truly best to keep it simple when developing a trading method based on indicators. If it requires too many parameter adjustments and additional filters and rules, it is too delicate and will break hard and probably quickly once it is set to real-time trading. This author has long been skeptical of any trading method based on curve-fitting, even if it is a minor component such as in Ichimoku clouds or Drummond point and line. Why should parameters that worked over a limited data set continue to work over a different data set?
Tip: Always ask two questions: (1) What is this indicator measuring? and (2) What is the buyer-seller tug of war logic to this indicator?
This is all summarized here. I take time to restate it because I have seen too many new traders afflicted with the curve-fitting disease in a search for the free lunch trading system.
The more complex the curve-fitting, the less likely the system will be successful long-term, real-time.
This is because the complex system depends highly on the very specific characteristics of the data set over which it was designed. A small change in those specifics in the future will cause the system to run aground.
It is time to get into that demo account and begin trading with the idea of making profitable trades!
What and how many currency pairs should you begin working with? I definitely recommend staying within the majors. That gives you 21 pairs — or 28 if you included the New Zealand Dollar (NZD) as a major.
Endeavor to catch the action of all three trading sessions — Asian, European, and North American without an unnecessary overlay. A trading suite of EUR/USD, CAD/JPY, and AUD/CHF would have you covered, just as an example. Three will give you a good workout. Four or five would be fine, but more might be too much on your plate at this time.