Trading System

One of the best tools for gauging the volatility of the markets is the one developed by John Bollinger in the early 1980’s and named simply, Bollinger Bands. This tool has the ability to contract when the market is slow and quiet and expand when the market moves like a rocket. In a previous article regarding the Bollinger Bands, we told you not to trade in the zone where you see the Bands contracting more than usual because a strong move is next. Well, the strategy that we are presenting today tries to identify the direction of the strong move that follows. And it does so by using the Moving Average Convergence Divergence indicator, commonly known as MACD. Volatility can be good for the trader, but it also implies more risk, because if price goes in the opposite direction of our trade, the Stop Loss will be quickly hit so we must use good money management rules when we are trading a volatility strategy like this one.

After plotting Bollinger Bands and MACD on our charts, both with default settings, we must wait for a contraction on the bands. Remember, the distance between the Bands changes almost all the time, but we need to see them contracting more than usual, until they form a very thin channel, containing price This contraction is commonly known as the Bollinger squeeze. After a Bollinger squeeze, we know for sure that price will move strong in one direction or the other. Then we must let the MACD give us an indication of where price will go. Here is a picture of what we are looking for:

As for the Take Profit, that will not be predefined before we enter the trade, but when the trade moves in our favor by the same amount of pips as our original Stop Loss, we will move it to break even and set a Trailing Stop Loss of the same amount of pips. Here is an example: if for our trade we use a Stop Loss of 20 pips, when price moves in our favor by 20 pips, we will move the Stop Loss in the same place where our entry was (now we cannot lose anything on this trade) and set a Trailing Stop Loss of 20 pips. Using this technique, we will be in the trade for as long as price continues to move in our direction without retracing for 20 pips. If it retraces 20 pips, The Trailing Stop will close it automatically. Remember, our Trailing Stop stays 20 pips behind price as long as price moves in the desired direction, locking in profit.

This is a more advanced strategy than the ones we presented until now, with more conditions for a valid entry, but having more rules filters out bad entries, giving us fewer but more reliable signals. Ok, down to business: the MARS strategy uses two MovingAverages, a RSI and Stochastic. For the two Moving Averages, we will use the Exponential method, with periods of 5 and 10. The RSI will remain at the default value of 14 (you will have to manually add the 50 level on it) and for Stochastic we are going to use 15, 3, 3 settings. The chart should look like this after you placed all the indicators on it:

Now for the entry rules: for a Sell trade, we must wait for the 5 EMA (blue one on our chart) to cross the 10 EMA (the red one) from above, and going downwards (bearish cross). The RSI must be under the 50 level and pointing down; the 50 level of the RSI is often used for trend confirmation: once it is crossed, a trend is considered to be in place. However, this is not a trend definition, but it helps in our strategy. Finally, the Stochastic must be pointing down but not in oversold condition. If the Stochastic shows oversold, we shouldn’t enter a trade because a reversal could be coming. Remember that Stochastic is a leading indicator, which informs us about a possible change in the direction of price by going below the 20 level (oversold condition) or above the 80 level (overbought condition). Just like the other strategies, this one also requires us to wait for the close of the candle corresponding to the cross of the two EMAs. For a Buy trade, all the rules must be reversed. A valid Sell signal should look like this:

A good strategy/system should also focus on the exit point, whether is at a profit, or at a loss. The MARS strategy requires us to place the Stop Loss at a logical point, above the previous peak for a Sell trade and below the previous low for a Buy trade, at a safe enough distance, giving the trade some room to breathe. Even if our Stop Loss is not hit, but the RSI crosses the 50 level in the opposite direction, we will also exit the trade. The same is valid for a trade that is in profit: we exit it if the RSI crosses the 50 level in the opposite direction. So the RSI acts in this case as a manual Stop Loss and a manual Take Profit level. Here is an example:

In the picture above we have a short trade example so when the RSI crosses the 50 level in the opposite direction (i.e., going up) we exit the trade in profit. In our example, the RSI crossed up, signaling an exit, but immediately crossed back down making us realize that was a too early exit, but it’s always better to protect your profits and exit early than waiting to see if RSI goes back down. Besides, we can enter again if all the conditions are met when the RSI goes again below the 50 level.

It is believed that Japanese candlestick charts were developed by Munehisa Homna, a rice trader from Japan, during the 18thcentury. However, Steve Nison, who introduced them to the Western trading world, thinks that most likely Homna did not use candlestick charts and that they were later developed, during the late 1800s. Whether Homna used or not candlestick charts is of little importance to this strategy, because we are going to focus on a single candlestick – the Pin bar. This is an important and powerful reversal candlestick and if it appears at an important level of Support or Resistance, it can be traded with pretty much confidence. The Pin bar is a candle with a small body and a long wick; the best Pin bar is considered to be a candle where the wick is 2/3 of the whole candle, but other candles are accepted as Pin bars. Here is a picture of a Bearish Pin bar and a Bullish Pin bar:

The Pin bars shown in the picture above have a long wick (much longer than the body) and a small body, with price closing near the highest point of the candle (for the Bullish Pin bar) or near the lowest point of the candle (for a Bearish Pin bar). Now we will focus a little on the psychology behind the development of a Bullish Pin bar: assuming that we are talking about Daily candles, in the first part of the day, the sellers are in control of the market and are able to take price lower, but this strength fades away towards the later parts of the day and the buyers regain control of the market and start to push prices higher and eventually, even manage to close the day higher than it’s opening, resulting in a Pin bar on the Daily chart. This is indicative of the fact that sellers, even though they were strong in the first part of the day, lost the battle and now the buyers are clearly in control. Price will fluctuate during the day and we cannot divide the day in two distinct periods. It doesn’t matter when the buyers took back control of the market (that can even happen in the last hour of the day – although it is not usual). The opposite applies for a Bearish Pin bar.

Like we said, the Pin bar is a strong sign of reversal and we can trade it if several conditions are met. Remember, we are not just trading any Pin bar. When a proper Pin bar is formed we must carefully determine the importance of the level where it was formed. First we must draw Support and Resistance levels and then, if we see a Pin bar forming at one of our previously drawn levels, we must determine if it’s formed in the direction of the trend or counter-trend. Here is a picture to exemplify better:

Although not all of the Pin bars shown in the picture above are perfect, they clearly show rejection from a level of Resistance (or support turned resistance), mark the end of the retracement and are indicative of the continuation of the main trend. This kind of Pin Bar can be traded once the next candle opens, placing a Stop Loss a few pips above the highest point of the Pin for a short trade and a few pips below the lowest point of the Pin for a long trade. Take Profit order must be placed at the next Support or Resistance level. Here is the picture for Stop Loss placement: