The Third Key to Forex System Development: Damn Good Forex Trading Set-Ups (Part 2)

Education /
11 Jul 2014

This is continuation of our previous post on Forex trading set-ups. You can find part 1 here.


The art of the chart: some damn good technical set-ups

“The 10-day exponential moving average (EMA) is my favourite indicator to determine the major trend. I call this “red light, green light” because it is imperative in trading to remain on the correct side of moving average to give yourself the best probability of success. When you are trading above the 10-day, you have the green light, the market is in positive mode and you should be thinking buy. Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking sell.” – Marty Schwartz

Some of the simplest and best Forex trading set-ups are derived from the art of technical analysis.

Your primary guide should always be price. Ignoring what the price is telling you is the nautical equivalent of ignoring a jagged rocky out-crop because it is not marked on your ship’s chart. Don’t ignore the evidence in front of your eyes.

But there are hundreds of set-ups that you can potentially use, so let’s help you simplify by selecting a few of the most useful.


Know your market type

Those who have been following the Keys to Forex System Development series will have heard me talk about how instrumental it is to understand market types before.

But the reality is market types make some of the best technical set-ups. You can learn in-depth about market types here.


Use a trend filter to befriend the trend

Forex system development is about trial and error. You can make systematic changes step by step, which will improve your results over time.

A trend filter is a set-up that can be used in this manner.

You simply apply a trend following indicator to a chart and never trade against it, like Marty Schwartz with his 10-day EMA. If the price is above the indicator you never go short; if it is below the indicator then you never buy.

Marty Schwartz’s 10-period EMA on a daily chart

You can test the effectiveness of a trend filter by back-testing, either manually by looking on the charts, or if you have the skills by programming a back-test in MT4.

Personally I like manual testing as it can give you insights you can’t glean from a computerised back-test (though the same could be said for the reverse).


Some useful trend filters

10-day Exponential Moving Average. You would never trade against the 10-day EMA. In this case your entry would be on a lower timeframe.
Displaced moving average. Try a 25-period moving average displaced by 5 periods for short-term trends or on a higher timeframe for long-term trends. I came across this indicator through Joe DiNapoli who recommends displaying moving averages to avoid whipsaws experienced by the typically moving average.
Displaced moving average. Try a 200×5 period moving average on your entry timeframe. A variation of the 25×5 above for use on the main timeframe you use for the trade.
MACD – Normal settings of 12/26/9. You can use this on both your entry timeframe and on a higher time frame.
MACD – Settings of 70/200/70. Use this on the main timeframe you use for the trade.

Let’s look at an example of how a trend filter works using the 70/200/70 MACD.

In this example, I am operating a simple support and resistance trading system that sells on resistance in a downtrend and buys on support in an uptrend. The exit is on the opposite support/resistance level. Each winning trade has a 3:1 risk/reward ratio.

By trading with the trend filter there are five wins and three losses but the winners are three times bigger than the losers, returning 12R over 8 trades.

Note this is an idealised example. With any trend filter you can experience periods of whipsaws as markets consolidate before a new trend forms.


Chart patterns, trend lines, and support and resistance levels make excellent set-ups

Maybe you’re an avid chartist, with a comprehensive knowledge of charting that you don’t want to go to waste.

Never fear, your carefully drawn triangles, wedges and Fibonacci levels can serve as perfect Forex Trading set-ups.

The careful distinction here is that when you use a chart pattern as a set-up, it is not your entry. Once you see a likely pattern you then move to a lower timeframe to improve the risk/reward on the trade.

For example, on the GBP/CAD trade we have a resistance level on the weekly chart that has held six times before the breakout finally comes.

After the breakout, rather than rushing to enter the market, you move to a shorter timeframe to improve the risk/reward on the trade.

You can see that not only do you improve the risk/reward on the trade by using the resistance level as a Forex Trading set-up instead of an entry, but also you could have potentially avoided several failed breakouts.


Some damn good news-based set-ups

Some people are attracted to Forex trading for the buzz of it.

You can spot them a mile away.

They have itchy trigger fingers, they trade big because it gives them a rush, and they tend to lose. Forex trading is not the place to get your thrills. That part of your psyche needs to be put aside when you trade.

Needless to say this type of trader is attracted to the thrill of the news announcement. The promise of quick profits is hard for the gambler inside of them to resist.

And this presents opportunity.

Where there is a lack of discipline and emotion in the markets, there is profit potential for the prepared and patient trader.

For you to take advantage of this opportunity, you will need a thorough knowledge of news set-ups. Here are some important ones.

How has price has reacted to this news event in the past?

You can get this information from a service such as Autochartist’s Event Impact Analysis Tool.

What have previous news results have been?

Do they come in as expected or is there a typically a variance? How does the market typically react if numbers come in over or under? You can see past results on this economic calendar.

How important is the event?

Some events move the market more than others. You can find this information on the economic calendar.

How long do the moves typically last?

The reaction to events can be fleeting or can last for months. Try to know how long you can expect the move to last.

What are analysts’ predictions?

You could read your favourite sources of expert commentary about what to expect from the news event. Try for this.

Do you think what the market expects has been priced in?

Harder to gauge, but see if you can glean from market sentiment, analysts’ commentary or chatter if the market is overly long or short and likely to get caught out.

Is there news divergence?

A powerful set-up can occur if the price reacts the opposite to how it should. For example, if there is negative news and the price reacts positively then it could be a good set-up for a buy.

If it is an interest rate announcement, what do the Central Bank minutes say?

Some traders read the Central Bank minutes to get an insight into their directional bias.


When two trades diverge

Trading the news presents you with a very clear choice. Do you enter your trade:

  • Before; or
  • After?

This decision will influence how you use the news as a set-up.

If you are placing your trade prior to the event then it is your prediction of what is actually about to occur that is the set-up.

If you are waiting for the news result to come out, either for a technical move or for the news result to become apparent, then this is actually your set-up.


Some damn good fundamental set-ups

In effect most fundamental information is a set-up, and this is not meant to be a lesson in fundamental analysis.

So here are two very important fundamental set-ups that you could consider before each trade, particularly if you are holding long-term positions.

Interest rates

The interest rate differential between countries is one of the best predicators of currency movements.

Currency trading can be seen to be a form of leveraged fixed interest trading. So if a currency pair has a higher rate, then it can be an attractive long-term buy, and when there is demand there tends to be price increases.

In addition, they have a very real impact on your account balance. If you are buying the currency pair with the lower interest rate you are likely to have the interest charge subtracted from your account each day.

Chris Lori, a popular American trader, takes this set-up very seriously. He recommends trading only the AUD/JPY and only buying AUD so that he is always earning interest on his trades.

You can see an example of interest rates at work on the following chart where you can see the correlation between the spread on German and US bonds, versus the price of the EUR/USD.


Central bank bias

It used to be all about interest rates, but after 2008 central banks across several major developed nations dropped interest rates to close to zero.

Their main tool became quantitative easing, where (essentially) they would inject cash into the economy in exchange for toxic debt. This bias towards easing had a telling impact on the movements of currency pairs. Thus currency traders tune in to the easing or tightening proclivity of central bankers to get an idea of the direction they want to trade.

You can see the impact quantitative easing has on the movement of currency pair on the following chart of the EUR/USD.


Some damn good expert set-ups

Trade ideas dominate Forex websites and for the uninitiated it can be hard to sort the wheat from the chaff.

But if you do find an expert source of information about the Forex pairs you are tracking, it can give you a built-in edge. The experience and connections of those in the industry are not easy for us retail traders to emulate and their trade ideas can prove well worth tracking.

You should not go all in on the “hot tip” of an expert. You should treat an expert’s trade idea like you would any other Forex Trading set-up. They are simply a component to be added into your complete Forex trading system.

Why not follow them in full?

Because you have your own unique objectives, psychology and motivations, which if not considered will lead to trading failure.

What will you do if:

  • They have a drawdown
  • They trade a timeframe that does not suit you, or
  • They don’t give you a place to put a stop?

And they certainly won’t have a position-sizing model that is designed to fit you.

If you don’t treat their ideas as your own in an integrated manner, then over time the incongruences will pile up and you will make mistakes that harm your trading account.

If you want to explore this type of set-up you can check out ForexTell.


Some more damn good set-ups

Set-ups abound. Wherever you can find a Forex Trader you can find a new set-up.

In fact entire books have been written on one or two of these Forex Trading set-ups alone. Here are a few more set-ups that you should know about.

Please note that just because I did not include these above does not mean they are any less useful or important. It all depends on the trader and the edge they are seeking to find.

See what ones suit you and your trading style. Avoid the temptation to overcomplicate. You must have a specific reason for adding a set-up into your plan, and then you should rigorously test it like a scientist tests a hypothesis.

Time of day/session

The time of day and the session you are trading in can have a big influence on the outcome of your trade.


Lookout for indicators that are signalling a change in trend before the price reverses.

Size of the candle

Large candles can signal an important event has happened that will create a change in the trend.

Information about the order flow

Information about where orders and stops are sitting in the markets can be excellent set-ups.

Options barriers

If market participants are looking to either protect their options from execution, or make sure that an option is excuted then their actions could move the market

Sentiment indicators

Sentiment trading is a relatively new innovation in the Forex market. By knowing which way the “herd” is positioned, you can choose to either follow or fade the trend. (You can access this in MT4 NexGen)


Worthy of its own section, correlations between currency pairs can be important leading indicators across multiple timeframes. (Check out correlations in MT4 NexGen)

Upcoming news events

If you assess the events that you have on the horizon for the coming week, you can get a sense of what can move the market and where.

Why a pattern is formed

If a pattern is formed because of a news event or not.


Historically currency pairs may have performed differently based on the time of the year. You can see an example in this chart where for the last 5 years USD/JPY has been strong in March. (Chart courtesy of Kathy Lien)

Environmental or geopolitical events

Geopolitical and environmental events such as 9/11, the Japanese tsunami or Russian troops in the Crimea in 2013 can heavily influence the direction of currency pairs.

Corporate buyers

A large corporate purchasing currency (perhaps due to a merger and acquisition) can be a powerful set-up.


Here’s what to do next

Smart traders know that the search for the perfect combination of set-ups is a chimera.

As you develop your Forex trading system you will be tempted to spend the lion’s share of your time in this area.

But don’t be so easily seduced.

I suggest you choose a:

  • Market type
  • Trend filter

Then choose one other set-up from those listed above (or one of your own that you already like).

And simply move on. Go and work on other aspects of your system, your position sizing or get some real market trading experience with your set-up so you can see if you can trade it mistake-free. You can then come back to focus on your set-ups at a later stage when your trading system is more fully developed.

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