Two Indicators, One Profitable FX Trade

10/29/2015 9:00 am EST

Focus: FOREX

The staff at ForexAbode.com explains how to use two popular technical indicators to trade different types of trends in the currency markets.

In this article, we will see how the Average Directional Index (ADX) and moving averages (MAs) may indicate that we can take a trading position and then use the Relative Strength Index (RSI) and MACD crossover to indicate the entry/exit point.

See related: ADX: The Pure Technician’s Indicator

In forex trading, the volatility in general is quite high and the trends can change very dynamically. Uptrend to sideways move to downtrend to uptrend may take place even during one life cycle of a trade. (Of course, we are not talking about trades where we enter and close within hours.)

Combining selected technical indicators comes in handy in such dynamically changing markets.
It is always better to combine the chosen technical indicators for the trading decisions. While we talk about combining, we are not talking about selecting similar indicators to cross check on each other.

Before we take our trading decisions, we need to analyze the trend situation:

  • Is it a strong trend?
  • Is the trend becoming stronger or weaker?
  • Is the market running sideways without a clear trend?
  • It has been a trend, but a reversal may be on the way
  • A break out from the sideways movement is probable

Trend identification is one of the important starting points before taking a position.

How to identify the trend:

  • ADX above 25 and rising
  • Exponential moving average (EMA - for uptrend): The prices closing above moving average (say five to 20 periods for short-term trading and 20 to 60 periods for medium-term trades).

So the price action is above the moving average line, and we have a rising moving average line. This shows an uptrend. ADX being the same if price action was below the MA line, and if the moving average line was dropping, then it would have indicated a downtrend.

Now once we identify the trend situation, we need to decide on the entry and possible exit. Apart from entry, we also need to think about stop-loss levels and targets for taking profit.

See related: How to Place an Objective Stop Loss

As far as entry point is concerned, we can use various crossover methods like a crossover of MACD with the MACD signal line or shorter-period simple moving average (SMA) or EMA crossover with longer period of the corresponding moving average line.

Let’s bring in RSI here. RSI indicates overbought (hence, probable selling levels) and oversold (hence, probable buying levels) conditions. But will overbought and oversold indications work when the trend is very strong? The answer would be “no,” but if we apply RSI with the knowledge of the trend as mentioned above, then we may be able to take better decisions.

So let’s see how to combine technical indicators. We are talking about combining the indicators which we have mentioned above, i.e., ADX, moving averages, and RSI.

Lets consider the following scenarios:

  1. Strong trend
  2. Trend becoming stronger
  3. Trend becoming weaker

NEXT: Finding Opportunities in All 3 Trending Environments

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Strong Trend

ADX is above 30 and rising further. Price action is continuously over 20-period EMA and the EMA line is rising.

The above indicates a strong uptrend. We can’t wait for oversold and overbought signals from oscillators such as RSI in strong trends, as the price can be in the overbought area for long in strong uptrends, and vice versa. So how to go about entering the market in such situations?

  1. Entry: Buy when RSI goes to the range of 68/71
  2. Exit: Exit the buy position, i.e. take profit when ADX stops rising and/or RSI drops below 50 and/or price action closes below the 20-day EMA. The take-profit targets mentioned are indicative as the exit depends on market situation/volatility and the decisions need to be dynamic. In strong trends, it is advisable to use trailing stop losses and rising take-profit levels.
  3. Stop loss: As mentioned above, it is better to use trailing stop losses. Stop loss levels even with trailing levels would depend upon the volatility. If the price movement is quite volatile, then the stop-loss margins would be wide. We may decide to put a stop loss a few pips below the previous candle’s low.

We can also use SAR (stop and reverse) indicator to indicate the stop-loss levels. As mentioned, if the market is very volatile, then the stop-loss margin has to be more, otherwise, even if upward movement continues, the narrow stop-loss margin may close the position with a loss.

Trend Getting Stronger

Considering an uptrend, ADX is above 25 and rising. Price is closing over 20-period EMA and EMA line is rising. This gives an indication that it is an uptrend and the trend may become stronger.

  1. Entry: Buy when RSI goes below 50 mark.
  2. Exit: Exit or take profit when ADX stops rising and/or RSI goes below 40/42 and/or price action closes below the 14-day EMA. The take-profit targets mentioned are indicative, as the exit also depends on various factors and market situation/volatility, and the decisions need to be dynamic.
  3. Stop-loss orders: Use trailing stop losses. Stop losses would depend upon the volatility. If the price action is very volatile, then the stop-loss would be wide. It could be a few pips below the previous candle’s low.

As mentioned, if the market is very volatile, then the stop-loss margin should not be very close to the entry level, otherwise, even if upward movement continues, the narrow stop-loss margin can close the position with a loss if price takes some corrective action.

Stop loss could be a few pips below the previous candle’s low. As mentioned in the above example, we can use SAR to indicate the stop-loss levels.

Trend Getting Weaker

Considering an uptrend, ADX is above 25 but not rising. The 20-period EMA is getting flatter.

  1. Entry: Buy when RSI goes below 50.
  2. Exit: Exit or take profit when price closes below 14-period EMA. The take-profit targets mentioned are indicative, as the exit also depends on various factors/market situation and volatility and the decisions need to be dynamic.
  3. Stop-loss orders: Use trailing stop losses. Stop losses would depend upon the volatility. If the price movement is quite volatile, then the stop-loss would be wide. It could be a few pips below the previous candle’s low.

In the above examples, we have considered an uptrend. During a downtrend, we can take short positions when the EMA line is dropping down and price action remains below EMA, which is opposite to the uptrend.

ADX readings should remain same as in the above example because the ADX reading only indicates the strength of the trend, not the direction. We can also take short positions when RSI moves over 50 mark.

By the Staff at ForexAbode.com

You may also check other forex technical analysis indicators at ForexAbode.com.

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