{"title":"Examples of Signals in Forex and Futures Trading","status":2,"publication_date":"2017-10-24T03:51:27","lead":"This fourth story in the series \"Introduction to Trading Systems\" explores examples of simple signals: the MA cross, Pin Bars, Engulfing patterns and Heikin Ashi reversals.","excerpt":"This fourth story in the series on Trading Systems explores examples of simple signals: the MA cross, Pin Bars, Engulfing patterns and Heikin Ashi reversals.","poster":773,"content":"---\r\n#### **Trading Systems Part 4 - Examples of Signals**\r\n\r\nThe [previous story](/stories/45/2017/10/24/trading-systems-part-3-signals/) described the class of triggers we call signals. In this story we will explore some simple examples of signals. Most of these you will be familiar with and they help to clarify the terms we use in the next story on systems.\r\n\r\nAs examples, we will discuss the following types of signals:\r\n\r\n- MA cross\r\n- Pin bars\r\n- Engulfing patterns\r\n- Heikin Ashi reversals.\r\n\r\n\r\n#### Moving Average Cross signals\r\n\r\nAn MA cross signal occurs of course when two MAs cross. One MA has a longer periodicity than the other meaning that it will be slower to react to the latest prices while the MA with the shorter time period will react faster. If the previous trend had been a bear market then prices would generally be below the two MAs with the faster MA closer to the real market prices than the slow MA.\r\n\r\n![MAs above prices in downtrend](/media/uploads/2017/basic_system_trading/EJ-D1-MA-DN-20171013-2.png \"EURJPY MA Downtrend\"):C80\r\n\r\nIn a bull market, the opposite occurs with the slow MA below the faster, and *both* below the actual rising prices. The two charts of EURJPY show different phases of a cycle, with the first above showing a downtrend with the MAs lying above and to the right, and the following chart showing an uptrend with MAs underneath.\r\n\r\n![MAs below prices in uptrend](/media/uploads/2017/basic_system_trading/EJ-D1-MA-UP-20171013-0.png \"EURJPY MA Uptrend\"):C80\r\n\r\nFor the slow MA to be above the faster MA in a bear market but below in a bull market they must have **crossed** over at some point when the trend reversed. This is point A in the charts. This crossover point is frequently used as either a trend starting point or even as an entry signal for actual trading.\r\n![MA Cross on USDJPY](/media/uploads/2017/basic_system_trading/USDJPY-MA-Cross-20171017.png \"MA Cross on USDJPY\"):R40\r\n\r\nWe could use a second set of MAs with even shorter periods, such as MA20 and MA8, as our *signal* while reserving the longer 100 period MA as an indicator of *trend*. While admittedly simple, such a trading system could in fact work, depending on how you tested and implemented it. If there is an advantage to using a more complicated system, you should find that out in the testing.\r\n\r\nThe setup itself is made complicated by the long period of time that evolves while a cross is taking place and the fact that because we are dealing with averages, the low probably does not occur in the same period as the cross. Instead find the lowest price of all the bars leading up to the cross starting from the last downtrend. During the downtrend, prices were higher. At some point they must have flattened out before turning up to create the cross. Sometime in that period a lowest price must have been set. Use that low for the SL. Refer to the accompanying chart of the S&P futures.\r\n\r\n![MA Cross Setup on S&P500](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-MACross-Setup-20171019.png \"MA Cross Setup on S&P500\"):R60\r\n\r\nEven if you witness a cross forming during the period, it may or may not actually appear on the charts depending on the closing price of the bar that day. You can never be sure the cross will complete until the close of trading. The open price should be the open of the very first bar *following* the cross although you're free to enact some intricate open policy that involves a confirmation pattern. That policy emerges later from your testing.\r\n\r\nWith the SL and OP set you can easily calculate the number of contracts to open (CO). The TP would usually be based on some multiple of the risk (OP-SL) and I will discuss that important topic in the story on [testing systems](/stories/48/2017/10/24/trading-systems-part-6-simulations-on-systems/). With the OP, SL, TP and CO we have all the elements required for the setup based on a particular signal.\r\n\r\nTo summarize the MA cross signal:\r\n\r\n- In an uptrend, when the faster MA crosses from below the slower MA to above, open a long position.\r\n- In a downtrend, when the faster MA crosses from above the slower MA to below, open a short position.\r\n\r\nBut MA crosses are just one class of signals out of many. Let's look at a few more.\r\n\r\n\r\n#### Pin Bar Signals\r\n\r\nPin bars belong to a set of simple candlestick patterns, such as doji, hanging man or shooting star. These are sometimes called pin bars when they exhibit certain extra characteristics such as position, shape and size that dominate surrounding bars. There are many other candlestick patterns and we plan to run a future story on some of these and how to use them in a system.\r\n\r\n![Pin bar in an uptrend](/media/uploads/2017/basic_system_trading/OK-PB-20171013.png \"Pin bar in an uptrend\"):R40\r\nA pin bar is a candlestick with a small body at one end and a much longer tail. The key idea is that a particular area has been tested by the long tail and rejected. The market probed down into the support area, triggered the stops and instead of continuing in that direction, bounced right back. The open trades that did not trigger are now considered to belong to *stronger hands*: traders who are less likely to be stopped out next time.\r\n\r\n![Pin bar](/media/uploads/2017/basic_system_trading/Pin_Bar.png \"Pin bar\"):R40\r\nBy shape alone, a pin bar is like a traditional hanging man or shooting star candlestick, although most practitioners only accept a subset of such candles as true pin bars. A *true* pin bar must usually dominate the surrounding pattern and either indicate a resumption of the trend after a retracement or be at the bottom or top of the range in a sideways market. You should strongly avoid accepting every hanging man or shooting star as a pin bar signal. Critically examine the charts to see how often this pattern fails to work as a signal when it is against the trend.\r\n\r\nThe setup is straightforward - the SL should be just beyond the tail of the bar, and the OP could be the open of the next bar. Or you could set a stop-limit order to trigger you into the trade when the market price moves above the top of the pin bar head (for a long trade).\r\n\r\nWith the SL and OP set you can easily calculate the number of contracts to open (CO). As with the MA cross, the TP would usually be based on some multiple of the risk.\r\n\r\nUsing only a pin bar is not a complete system because if the setup is stopped out, it is rarely followed by another pin bar to signal re-entry. However it can be combined with other entry signals such as the engulfing or outside bar pattern to provide a more complete system, and we turn to that now.\r\n\r\n\r\n#### Engulfing pattern signals\r\n\r\nAn engulfing pattern or outside bar is a two bar pattern where the second bar reverses direction and has both a higher high and a lower low than the first. In other words, the second bar encloses or *engulfs* the first.\r\n\r\n![Example outside bar in uptrend](/media/uploads/2017/basic_system_trading/OB-EG-20171014.png \"Example outside bar in uptrend\"):R40\r\n\r\nIf you think about it, this is similar to a pin bar except it plays out over two periods instead of one. On the first day (or period) the market continued its retracement against the trend. On the second day the market opened lower in a bearish sentiment and attempted to go even lower before surrendering to the upward trend in a wave of buying that sent prices higher than the open of the previous day.\r\n\r\n![Outside Bar](/media/uploads/2017/basic_system_trading/Outside_bar.png \"Outside Bar\"):R40\r\nAs with the pin bar, there is the strong sense that the area below has been tested and rejected. But testing and rejecting really only makes sense when the market is probing *against* the real underlying trend. When prices are moving with the trend there are multiple examples of engulfing patterns that never lead to any price reversals.\r\n\r\nThe setup is similar to the case of the pin bar - the SL should be just beyond the tail of the larger outside bar, and the OP could be the open of the next bar or you could set a stop-limit order to trigger you into the trade when the market price moves above the top of the outside bar (for a long trade). The TP and CO are as discussed earlier for the other signals.\r\n\r\nAs with the pin bar, it needs to be combined with several other signals to be a complete system. Together with the pin bar you might be able to catch at least one of the entry points in a trend but whether it's enough to offset losses would depend on what your historical tests will show.\r\n\r\nTo make the engulfing pattern and pin bar more complete, you could also add the Piercing Line pattern (or Dark Cloud Cover) as well as a number of two bar reversals that don't quite qualify as engulfing patterns.\r\n\r\nIn 24 hour forex markets, gaps at the open are not possible unless they happened in the final minutes of trading. For this reason, outside bars are less prevalent than two bar reversals where both bars have a common low but the second has a higher high. You might like to use these in addition to engulfing patterns if you are trading in forex markets.\r\n\r\nCandlestick patterns are a huge field and there is much to explore. Fortunately there are many sites on the web that cover all these patterns.\r\n\r\n#### Heikin Ashi Candlesticks\r\n\r\nHeikin-Ashi (HA) is a different candlestick design that smooths out the shortest term fluctuations in each bar. Because HA bars are a different shape than the standard candlesticks, the technique is not very popular with traders. However there are solutions to most of these problems. HA is presented here as an example of an uncommon technique. Below, side by side are the same two sections of the chart of the S&P futures contract. The chart with the normal candles is to the left and on the right is the same chart using Heikin Ashi candles.\r\n\r\n
\r\n![S&P 500 with Normal candlesticks](/media/uploads/2017/basic_system_trading/SPX-D1-Normal-Section-20171020.png \"S&P 500 with Normal candlesticks\"):L45\r\n![S&P 500 with HA candlesticks](/media/uploads/2017/basic_system_trading/SPX-D1-HA-Section-20171020.png \"S&P 500 with HA candlesticks\"):R45\r\n\r\nAll candlesticks are composed of the Open, Close, High and Low or OHLC. Heikin Ashi (HA) candlesticks are made up of averages of these four key values: haClose, haOpen, haHigh, haLow. Because the averages for the haOpen, haHigh and haLow are further averages of earlier candlesticks, each HA has a 'memory' in much the same way as an exponential MA. Here are the formulae so that you can see how the memory kicks in:\r\n\r\n Where t represents the current period, and t-1 the previous:\r\n haClose = (Open[t] + High[t] + Low[t] + Close[t]) / 4\r\n haOpen = (haOpen[t-1] + haClose[t-1]) / 2;\r\n haHigh = maximum of High[t] and haOpen;\r\n haLow = minimum of Low[t] and haOpen;\r\n\r\nSo the close is just the average of the current periods values but the others are all averages in some way of the earlier period, unless the current high is higher or the current low is lower than the average. It should come as little suprise that the HA reversals track an exponential MA cross of very short duration. ![SPX daily chart](/media/uploads/2017/basic_system_trading/SPX-D1-20171012-EMAvsHA.png \"HA vs EMA4/2\"):R35 The short period, or fast MA, uses EMA(2) with HLCC/4 as the value used in each period (if this is confusing then just use the normal close value).\r\n\r\nWhere they cross is often the same time period where HA changes direction, so we can use the MA cross as a proxy for HA when it's not available. For the long period, or slow MA, use EMA(4). Remember the bars must close before you can know whether the MA crossed in that period or not. It's much easier to visualize these reversals with HA so you would only use MAs if HA is not available in your charting software.\r\n\r\nIn fact, many of these signals are not independent of one another because they are based on the same four market numbers contained in OHLC. There are only just so many ways you can slice and dice four numbers so you will often end up with the same result from otherwise different indicators.\r\n\r\nHere is an example of the EURJPY downtrend chart shown earlier in the section on MA crosses, but this time using Heikin Ashi bars. ![Heikin Ashi chart of EURJPY daily](/media/uploads/2017/basic_system_trading/EJ-D1-MA-DN-HA-20171013.png \"Heikin Ashi chart of EURJPY daily\"):R55 In these charts, HA is displayed in red whenever the haClose