- Trend Strategies can use a 200-period MA filter
- Range Strategies can use the ADX
- All other strategies can use the SSI filter
Inside DailyFX's Forex Fast-Track Webinar Series, our 3rd webinar walks through creating a simple strategy using a strength oscillator, support/resistance levels, a positive risk:reward ratio, and a risk calculator. This lesson normally concludes with a slew of questions from traders trying to find a greater edge by combining together more tools than the ones provided, which is fine. It's great to experiment and test different ideas.
The problem I’ve seen, however, is many traders attempt to use tools without fully knowing what the tools' strengths and weaknesses are; oftentimes grouping similar indicators together or missing out on an important subset of tools that might be worth considering. So today I break down 3 tools known as "filters" that can be used on various types of strategies.
Filtering a Trend Trading Strategy
We’ve all heard the saying, “the trend is your friend” or “trade the path of least resistance.” These phrases are used by traders that want to trade in the same direction as the overall trend. But what if we have a difficult time locating the trend? What do we do if we are uncertain about our direction bias?
An excellent tool to add to a trend-based strategy is the 200-period Simple Moving Average. By averaging the closing price over the last 200 bars, we can see if the current price action is above or below the average.
Learn Forex: The 200-Period Simple Moving Average
(Created using Marketscope 2.0 charting package)
Anytime we see price above the 200-period moving average line, we should look for buying opportunities. Anytime we see price below the moving average line, we should look for selling opportunities. This ensures we are trading in the same direction as the prevailing trend.
We can also take note of the strength of an existing trend by how far price has moved away from the 200-period MA. The further the price is away from the average, the stronger the trend. This can be seen in the chart above. A strong downtrend followed by a more tame uptrend.
Filtering a Range Trading Strategy
With the current drop in Forex volatility, many traders have migrated over to using range-bound strategies. A range strategy attempts to buy low and sell high when price is moving primarily sideways. The only problem is that sometimes market dynamics can change, turning ranging pairs into pairs that may begin trending.
To mitigate range trading during these transition times, we can use a technical indicator called the Average Directional Index or ADX. The ADX is not a direction filter. It is a filter that tells us if a currency pair is currently in a trend our not. The higher the ADX, the stronger the trend is either up or down. The lower the ADX, the more the currency pair has been moving sideways.
The chart below shows a period of time where price was trending and later changed to ranging. The key level for ADX is 25. Whenever the ADX is below 25, we should focus on trading range bound strategies. Any reading above 25 is not as suitable for range trading, and could actually be suitable for trend trading if ADX moves high enough.
Learn Forex: Range Bound when ADX is Under 25
By eliminating our range trades when ADX is above 25, we have a better chance at turning a profit.
Filtering Any Other Strategy
The final filter on my list is the versatile Speculative Sentiment Index, or SSI. The SSI tells us a ratio of buyers and sellers of each major pair. We want to use the SSI by looking for trading opportunities opposite of the retail trading crowd. So when most people are buying, we should mostly be looking to sell, and vice versa.
SSI is updated once a week under DailyFX's Technical Analysis tab and twice daily inside DailyFX Plus. For more information on using the SSI, read My Favorite Trader Tool, How to Use the SSI.
Learn Forex: Chart Displaying Inverse Relationship Between Price and SSI
(Copied from My Favorite Trader Tool, How to Use the SSI)
Fine Tuning With Filters
Hopefully this article has given you ideas on ways to improve your own strategy, whether you are trading trends, ranges, or something entirely different. If you would like to test any of these filters risk-free, download a Free Forex Demo account today with free charts and real-time pricing data.