A Simple System
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.
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!
[caption id="attachment_13186" align="aligncenter" width="405"] Indicator ComparisonâTrading and Trending[/caption]
Step 1: The Moving Average CrossoverThe backbone of our simple system is a moving average crossover. For this, we need to apply two different moving averages to our charts. Moving averages are plotted directly over the price bars on a chart.
The moving average may be added to your chart by double-clicking on it in the navigation window, and the parameters palette will appear as in Figure below. Here we are interested in only Inputs and Colors.
[caption id="attachment_13187" align="aligncenter" width="550"] The MetaTrader 4 Moving Averages[/caption]
Under input, you will see periods and methods. A period is the number of time units, or bars, which are used to calculate the moving average. If you use 3, the indicator will sum the last three bar closes and divide by 3 to get the most recent bars' moving average value. When the next bar has formed, the average moves because it drops the oldest value and adds the most current new value.
The methods are the various ways the actual calculation is made. For example, the values in the period may be weighted. In the 3-period example, the oldest bar is multiplied by one, the middle bar by two, and the current bar by three. The sum is then divided by 6. This forward weighting gives more importance to the most current bar(s).
Very sophisticated moving average indicators may have an internal formula or algorithm to automatically alter the period or weighting based on other technical considerations. For example, if a market is in a sharp upward or downward trend, it may forward weight the average to bring it closer to the current bar. If the market is in more of a sideways or trading market, it may backward weight the moving average to keep it a distance away from the current bar andâhopefullyâavoid false signals.
Tip: In MetaTrader 4, the indicator will build only on the active chart unless you place it in a template. You may wish to build a new template and call it Simple System One.
- Click on the Inputs tab and change MA_Period to 5.
- Click on the Colors tab and select the color green.
- Double click again on the Moving Average in the Navigator.
- Click on the Inputs tab and change MA_Period to 21.
- Click on the Colors tab and select the color red.
[caption id="attachment_13188" align="aligncenter" width="550"] Moving Average Crossover[/caption]
You have built a basic moving average crossover. Raw signals are generated by the 5-period moving average crossing the 21-period moving average. You go long when the green crosses the red going up; liquidate or go short when the green crosses the red going down. See Figure below, in which the 5 unit is the hatched line and the 21 unit is the solid line.
[caption id="attachment_13189" align="aligncenter" width="550"] Moving Average Crossover Signals[/caption]
Tip: Set up the moving average on all your watch charts or on a separate Simple System One profile. Take each individually and scroll back in time to see where the crossovers occurred. Note roughly the pips won or lost on each crossover. A little study and doing a few of these on other charts will show the crossover works almost perfectly when a significant trend begins but is a near disaster when prices just move sideways. It captures a big piece of a trend, but generates many false signals in trading markets. Moving averages work well in trending markets, and poorly in trading markets.
Before continuing, you may wish to explore the other moving average parameters on a few more charts. See what happens when you change the periods and methods.
Tip: "You can torture the numbers, but you can't make them speak," said James L. Bickford. No matter how much you manipulate the parameters, a moving average will always do well in trending markets and poorly in trading markets. It is the nature of the beast. Even internally altering the period or method is no escape. You cannot change this tiger's stripes; many new traders have come to grief trying to do so.
So, what are we to do? Perhaps a moving average crossover is too simple?
Is there a means to keep the good trend-following signals of a moving average crossover and eliminate at least some of the bad signals in a trading market? Technical analysis aficionados of indicators typically do this with filters. Mr. Goodman called anything that acted to work a method through a sieve an overlay. Filters may be other indicators, parameter adjustments, or additional rules for taking or rejecting the signals.
Step 2: The Momentum IndexWe know oscillators and momentum work well in trading markets. Perhaps adding one of them to our simple system will tell us when the market is trading, not trending, and assist us in eliminating poor crossover signals?
Click on Momentum in the Navigator window. It is essentially the same thing as an oscillator or a relative strength indexâit measures the slope price movement over a specified number of bars.
For Period, select 13, and for Color, select blue. Press OK. The momentum index will graph on a subpane in the chart window. This will make your chart smaller but you can adjust the relative sizes by grabbing the line in between the two of them.
When an oscillator or momentum index is near the top end of the scale, a market is overbought and due to go down. When it is near the lower end of the scale, a market is oversold and due to go up. When this does work, it is because the slope of a trend often declines before the trend itself reverses.
Repeat the process of exploring different momentum index periods on several charts. It will become clear that this tool works well on trading markets, and not so well in trending markets. But the purpose here is to use it as a filter.
Your momentum and moving average crossover chart should look something like Figure below.
[caption id="attachment_13190" align="aligncenter" width="550"] Oscillator[/caption]
Tip: You may reverse the simple system. Use the oscillator as your primary tool and the moving average crossover as the filter.
Step 3: The Trading RulesWait for the short-term moving average to cross the long-term moving average.
There are only two rules for this simple system:
- Buy if the short term crossed the long term moving up and the oscillator is either near the bottom or in a sharp downtrend.
- Sell if the short term crossed the long term moving down and the oscillator is either near the top or in a sharp uptrend.
The theory behind the simple system is grounded in the idea that we want to go with the trendâbut wait until it has had a bit of a rest before entering. Here, the moving average crossover indicates the trend and the momentum index configuration indicates that the trend has rested.
The momentum index is said to be a filter because it keeps the trader from taking the poor signals but allows the good signals to pass muster. In the simple system, the trader wishes to capture the trends of the moving averages but eliminate the trading market whipsawing.
Tip: The commodities trader who shared this with me way back when also used contrary opinion as a filter. He took buy signals only when the bullish consensus for that commodity was below 30 percent and took sell signals only when the bullish consensus was above 80 percent. For more on this tool, see Tools for Traders.
Step 4: Stop-Loss and Take-Profit RulesFor taking profits and accepting losses with this simple system, you may either:
- Wait for a signal in the opposite direction to close the trade, and if you wish, reverse and enter the opposite direction. This is a method stop-loss, as it is generated internally by the trading method.
- Use a fixed pip or fixed-dollar amount S/L and T/P. In any situation you decide to work with a fix-dollar, make the ratio of the S/L to T/P in favor of the T/P. Some examples: 1.5 to 1.0 (75 pips to 50 pips), 2.0 to 1.0 (100 pips to 50 pips), or 3.0 to 1.0 (150 pips to 50 pips). At this point, actual performance is not an issue, you are just working to learn the mechanics and get a feel for how currency prices behave. There is more on this in The 30-Trade Campaign Program.
Tip: Remember that trends and trading ranges are relative to the price scale you are using. A trend on an hourly chart is probably made up of a number of five-minute mini-trends and trading areas. Use scales for your moving averages and oscillators in harmony with the scale of the price chart you are watching. The trade-off is this: If you use small periods, you will get in earlier on good trades but you will also get in on more bad ones. If you use long periods, you will miss most of the false signals but not capture much of the trends.