This system has two exit rules—either a MACD divergence (we prefer to identify them visually, even though we have written code to recognize them) or when prices move against the trend and close on the opposite side of their 89day MA.
This system backtested well; it was profitable but the drawdowns were too high. We rejected it because we could not reduce the risk. If we could have cut the risk, I would not be showing you this system today.
For example
In July 2002 MACD-Histogram showed a divergence, but MACD lines did not diverge.
In September prices did not close below their MA. They did violate the MA in October, and much as we hate to override signals, we were testing the system. All of our other systems said hold. We said the market was closing below the MA not because it was going down, but because it was going flat. We put our stop below the September low—and it ended up holding.
January to March shows a great divergence. Both MACD Lines and MACD- Histogram divergences took longer to develop, which makes them more meaningful.
When the euro closed below its MA we sold it.
At the right edge of the chart, MACD-Lines are tracing a double top. This pattern shows that the market is seriously overbought and warns you to take profits.
“Prices are connected to values with a mile-long rubber band,” one of my clients once said. If we agree that a long-term MA is a reflection of value, we can measure the normal length of that rubber band by calculating the distance from the high of the highest bar to the EMA. On this weekly chart of the euro the “rubber band” could stretch to nine cents—that is how far prices got away from the 26-week EMA in July 2002. In March 2003 prices rose seven cents above value, almost the full length of the rubber band, before snapping back and taking out the previous week’s low. Such sharp snapbacks rarely end before hitting the value zone.
Currencies are among the most trending markets. A well-designed system, while subject to whipsaws in trading ranges, should lock onto the long-term trends in currencies. Fred’s system, which caught a breakout from a base and stayed long for almost a year, riding a major bull move, illustrates this point.
A factor that kills many amateurs in currencies, besides poor money management, is the fact that currencies trade almost 24 hours a day. They can move violently against you while you sleep. If you trade currency futures, you need to set up your account in such a way that a stop from futures is automatically executed in the cash markets if currencies move while futures are closed. A trader who gets into currency futures without this setup is like a man who decides to protect his property by putting up a fence on only one side.
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