The strategy described in this article uses three technical indicators: MACD, Moving Averages and candlestick patterns, to identify trading set-ups in trending markets.
It was inspired by a similar strategy outlined in the Trade With Precision “Learn a simple 6-step trading strategy” webinar, which can be viewed by visiting the webinar archive at www.tradewithprecision.com, a company which specialises in trader coaching.
I have decided to back-test the strategy to see how profitable it truly has been.
One advantage of the strategy is that it can be used on any time-frame, long or short, and on any liquid asset.
The principle behind the strategy is that trending prices pause occasionally and pull-back, and these ‘dips’ offer optimum entry points for traders wishing to join or add to the prevailing trend.
In this strategy the trader is looking for price to correct back into a zone – called the trading zone – between the 10 and 20 moving averages.
The 50 and 200 MA’s must also be added to the chart and all four MA’s must be in the correct order of the shortest first to the longest last sequentially: this creates the all important ‘fan’.
If this is achieved the third specific requirement is for price action to form a reversal bar or bars, either Japanese candlestick reversals or traditional chart bar reversals.
Finally the third requirement is that MACD is not diverging bearishly with price (in an up-trend) or converging in a down-trend. Assuming these three conditions are met a set-up has qualified and can be traded.
An example of multiple set-ups occurring during a down-trend is shown on the chart of EUR/USD below:
As can be seen in the chart above three MA-Fan set-ups have been highlighted in a down-trend, these all happen to be shooting-star set-ups, which are quite common with the strategy.
Assuming a valid set-up has formed the trader places a buy order a point above the highs of the reversal candle in a bullish set-up and the stop a point below the lows. The target is calculated using the length of the reversal candle extrapolated, giving a 1:1 risk reward.
So how well does the MA-Fan work?
When it was back-tested on a sample of EUR/USD, on a 4-hour time-frame, the strategy worked well.
The key results were as follows:
Of the 35 set-ups only 6 failed to hit their target based on a 1:1 risk/reward, giving a roughly 83% probability success rate.
17 of the 29 winners would have gone twice as far if allowed to run – that’s just under 50% of all trades.
The full results are in table form in the index below.
I have described the basic set-up above but now I will go onto describe the finer points in more detail, for those who wish to trade the strategy properly.
Whilst the best set-ups tend to occur in strongly trending markets such as the one pictured above, the trader does not need to determine whether the asset is trending or not before applying the strategy rules – it is already built in in the need for the MA’s to be out in the right sequence – if they are in the right order it means prices are trending.
Price must respect the trading zone between 10 and 20 MA’s to qualify. As a rule, and using bullish case as an example, price action can move below the 20 but as long as it closes above the 20 the set-up is valid. It would only be invalidated by a close below the 20 MA. Price can close above the 10 and still qualify as long as at least some of it is in the buy-zone, or at the very least touching the 10 MA.
The reversal candle (in the bullish example) need not gain confirmation from a bullish follow-up candle but is enough on its own. If a hammer forms in the trading zone it can be traded without the next bar having to be bullish. If the set-up is a 2-bar reversal or a Harami, however, then it will be composed of two bars anyway – nevertheless these patterns do not need confirmation either.
If MACD hump under the set-up is diverging or converging with the last previous clear hump then the set-up fails to qualify, as it reveals underlying weakness/strength.
It is important to compare the MACD under the set-up with the last clear MACD hump before it. If the MACD is merely lower on the same hump there is no divergence.
The two examples below should clarify this subtle difference:
Set-up A does not qualify because the MACD hump is converging with the last clear hump, which in a down-trend signals potential underlying strength. It does not matter that the market goes on to make new lows and the trade would have been successful, the set-up was not valid:
Example B, however shows a similar set-up but on this occasion the set-up does qualify as although the MACD has been rising it has not formed a convergence if compared with the previous clear hump – it is still part of the same large hump, which starts at the far left of the chart; to check for convergence you would have to scroll back even further and compare this whole hump with the previous one:
|Date||Open||Stop||Max Gain||Long/Short||Candle/reversal||Risk||Reward||Ratio Risk:Reward||Losers||Over 1:2||Over 1:1.5||Total Trades|