In theory, trend trading is easy. All you need to do is keep on buying when you see the price rising higher and keep on selling when you see it breaking lower. In practice, however, it is far more difficult to do this successfully. The greatest fear for trend traders is getting into a trend too late, that is, at the point of exhaustion. Yet despite these difficulties, trend trading is probably one of the most popular styles of trading because when a trend develops, whether on a short-term or long-term basis, it can last for hours, days and even months.
Here we'll cover a strategy that will help you get in on a trend at the right time with clear entry and exit levels. This strategy is called the moving average MACD combo.
The MACD combo strategy involves using two sets of moving averages (MA) for the setup:
- 50 simple moving average (SMA) - the signal line that triggers the trades
- 100 SMA - gives a clear trend signal
The actual time period of the SMA depends on the chart that you use, but this strategy works best on hourly and daily charts. The main premise of the strategy is to buy or sell only when the price crosses the moving averages in the direction of the trend.
Rules for a Long Trade
- Wait for the currency to trade above both the 50 SMA and 100 SMA.
- Once the price has broken above the closest SMA by 10 pips or more, enter long if MACD has crossed to positive within the last five bars, otherwise wait for the next MACD signal.
- Set the initial stop at a five-bar low from the entry.
- Exit half of the position at two times risk; move the stop to breakeven.
- Exit the second half when the price breaks below the 50 SMA by 10 pips.
Rules for a Short Trade
Wait for the currency to trade below both the 50 SMA and 100 SMA.
- Once the price has broken below the closest SMA by 10 pips or more, enter short if MACD has crossed to negative within the last five bars; otherwise, wait for the next MACD signal.
- Set the initial stop at a five-bar high from entry.
- Exit half of the position at two times risk; move the stop to breakeven.
- Exit the remaining position when the price breaks back above the 50 SMA by 10 pips. Do not take the trade if the price is simply trading between the 50 SMA and 100 SMA.
Our first example is for the EUR/USD on an hourly chart. The trade sets up on March 13, 2006, when the price crosses above both the 50-hour SMA and 100-hour SMA. However, we do not enter immediately because MACD crossed to the upside more than five bars ago, and we prefer to wait for the second MACD upside cross to get in. The reason we adhere to this rule is because we do not want to buy when the momentum has already been to the upside for a while and may therefore exhaust itself.
The second trigger occurs a few hours later at 1.1945. We enter the position and place our initial stop at the five-bar low from entry, which is 1.1917. Our first target is two times our risk of 28 pips (1.1945-1.1917), or 56 pips, putting our target at 1.2001. The target gets hit at 11am EST the next day. We then move our stop to breakeven and look to exit the second half of the position when the price trades below the 50-hour SMA by 10 pips. This occurs on March 20, 2006 at 10am EST, at which time the second half of the position is closed at 1.2165 for a total trade profit of 138 pips.
Positive and Negative Oscillations
Why can't we just trade the MACD cross from positive to negative? You can see by looking at the EUR/USD below that multiple positive and negative oscillations occurred between March 13 and March 15, 2006. However, most of the downside and even some of the upside signals, if taken, would have been stopped out before making any meaningful profits.
Why can't we just trade the moving average cross without the MACD? Take a look at the chart below. If we took the moving average crossover signal to the downside when the MACD was positive, the trade would have turned into a loser.
The next example, shown below, is for USD/JPY on a daily time frame. The trade sets up on September 16, 2005, when the price crosses above both the 50-day and 100-day SMA. We take the signal immediately because the MACD has crossed within five bars, giving us an entry level of approximately 110.95. We place our initial stop at the five-bar low of 108.98 and our first target at two times risk, which comes to 114.89. The price is hit three weeks later on October 13, 2005, at which time we move our stop to breakeven and look to exit the second half of the position when the price trades below the 50-day SMA by 10 pips. This occurs on December 14, 2005, at 117.43, resulting in a total trade profit of 521 pips.
One thing to keep in mind when using daily charts: although the profits can be larger, the risk is also higher. Our stop was close to 200 pips away from our entry. Of course, our profit was 521 pips, which turned out to be more than two times our risk. Furthermore, traders using the daily charts to identify setups need to be far more patient with their trades because the position can remain open for months.
On the short side, we take a look at the AUD/USD on hourly charts back on March 16, 2006. The currency pair first range trades between the 50- and 100-hour SMA. We wait for the price to break below both the 50- and 100-hour moving averages and check to see whether MACD has been negative with the past five bars. We see that it was, so we go short when the price moves 10 pips lower than the closest SMA, which in this case is the 100-hour SMA. Our entry price is 0.7349. We place our initial stop at the highest high of the last five bars or 0.7376. This places our initial risk at 27 pips. Our first target is two times the risk, which comes to 0.7295. The target gets triggered seven hours later, at which time we move our stop on the second half to breakeven and look to exit it when the price trades above the 50-hour SMA by 10 pips. This occurs on March 22, 2006, when the price reaches 0.7193, earning us a total of 105 pips on the trade. This is definitely an attractive return given the fact that we only risked 27 pips on the trade.
From a daily perspective, we take a look at another short example in EUR/JPY shown in the chart below. As you can see, the daily examples date farther back because once a clear trend has formed, it can last for a long time. If it didn't, the currency would instead move into a range-bound scenario where the prices would simply fluctuate between the two moving averages.
On April 25, 2005, we saw EUR/JPY break below the 50-day and 100-day SMA. We check to see that the MACD is also negative, confirming that momentum has moved to the downside. We enter into a short position at 10 pips below the closest moving average (100-day SMA) or 137.76. The initial stop is placed at the highest high of the past five bars, which is 140.47. This means that we are risking 271 pips. Our first target is two times risk (542 pips) or 132.34. The first target is hit a little more than a month later on June 2, 2005. At this time, we move our stop on the remaining half to breakeven and look to exit it when the price trades above the 50-day SMA by 10 pips. The moving average is breached to the top side on June 30, 2005, and we exit at 134.21. We exit the rest of the position at that time for a total trade profit of 448 pips.
When the Strategy Fails
This strategy is far from foolproof. As with many trend-trading strategies, it works best on currencies or time frames that trend well. Therefore, it is difficult to implement this strategy on currencies that are typically range bound, like EUR/GBP.
The chart below shows an example of the strategy's failure. The price breaks below the 50- and 100-hour SMA in EUR/GBP on March 7, 2006, by 10 pips. The MACD is negative at the time, so we go short 10 pips below the moving average at 0.6840. The stop is placed at the highest high of the past five bars, which is 0.6860. This makes our risk 20 pips, which means that our first take-profit level is two times the risk, or 0.6800.
EUR/GBP continues to sell off, but not strongly enough to reach our take-profit level. The low in the move before the currency pair eventually reverses back above the 50-hour SMA is 0.6839. The reversal eventually extends to our stop of 0.6860 and we end up losing 20 pips on the trade.
The moving average MACD combo strategy can help you get in on a trend at the most profitable time. However, traders implementing this strategy should make sure they do so only on currency pairs that typically trend. This strategy works particularly well on the majors. Traders should also check the strength of the breakdown below the moving average at the point of entry. In the failed trade shown above, had we looked at the average directional index (ADX) at that time, we would have seen that the ADX was very low, indicating that the breakdown probably did not generate enough momentum to continue the move.