• Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess


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    • Abstract: Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick DyessBASIC TECHNIQUESTime Frame Within Time FrameTrading Currencies UsingMultiple Time Frames

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Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
BASIC TECHNIQUES
Time Frame Within Time Frame
Trading Currencies Using
Multiple Time Frames
When trading currencies, it’s best to get the big picture first and much time in tight trading ranges and tend to develop strong
then use a shorter time frame to select entries and exits. trends. More than 80% of forex volume is speculative in
nature, so as a result, the market frequently overshoots and
by Kathy Lien and Patrick Dyess then corrects itself. A technically trained trader can easily
identify new trends and breakouts, providing multiple oppor-
ith $1.5 trillion in daily turnover, the foreign tunities to enter and exit positions. In addition, aside from
exchange market is the largest market in the trend trading, certain currencies may undergo extended peri-
W world. Previously, access to this market was
restricted to hedge funds, large commodity
trading advisors (CTAs), and institutional
investors due to regulation, capital require-
ments, and technology. The big players have always wanted
ods of range trading. Traders can find ample opportunity to
play the ends of ranges.
In order to trade successfully on an intraday basis, it is
important to be selective. You’ve heard of the trading cliché
“The trend is your friend,” haven’t you? Clichés become
access to the market because unlike the equity markets, clichés for good reason — more often than not, they’re true.
where liquidity is dispersed across many different stocks, the This one is the tenet for trading, and its importance should not
$1.5 trillion in liquidity is concentrated in four major cur- be understated. Trading with the trend while employing
rency pairs, so they are very liquid. This means that traders trailing stops allows the opportunity to capture big moves in
can get in and out easily, executing more than $100 million any market.
without causing a significant shift in the markets. The goal of multiple time frame analysis is to get traders to
think about the big picture first. This can be likened to taking
TRADING THE TRENDS a road trip from Los Angeles to New York. Certainly, there
Technical analysis is the most common trading strategy used will be left turns and right turns along the way, but it is
by professional forex traders because currencies rarely spend important to know that overall, you are heading east. In much
GBP/USD daily chart
eSIGNAL
FIGURE 1: FIRST STEP: THE DAILY CHART. Since May 2001, the British pound has been in an upward trend, which means that the most effective way
to trade this market is to follow the trend.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
GBP/USD hourly chart
50% Fibonacci — 1.8314
FIGURE 2: NEXT STEP: THE HOURLY CHART. Focusing on the selloff (see Figure 1) between February 2004 and May 2004, you can see where an
ideal entry point would be. In this example, Fibonacci retracements were used but you may use any method you prefer.
the same way, in trading, looking for opportunities to buy in USING MULTIPLE TIME FRAMES
an uptrend or sell in a downtrend tends to be much more The best example of multiple time frame analysis is to use
successful than trying to pick tops and bottoms. daily charts to identify the overall trend and then to use hourly
charts to determine specific entry levels.
EUR/USD daily chart
Former support
turned resistance
20-day SMA
FIGURE 3: APPLYING MULTIPLE TIME FRAMES. Here you see the daily chart of the EURUSD with a 20-day SMA and support turned resistance level.
As you can see, the trend has turned negative.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
EUR/USD hourly chart
Former support
turned resistance
20-day SMA
10-day SMA
FIGURE 4: MOVING ON TO THE HOURLY CHART. The EURUSD is trading below the 10- and 20-period SMA, confirming the downward trend seen
in the daily chart. This means that you should look for opportunities to sell.
Let’s take a look at the daily chart of the British pound moving average (SMA). On a near-term basis, the trend has
against the US dollar (GBPUSD) in Figure 1. As you can see, turned negative.
the British pound has been trending higher since May 2001. Then look at the hourly charts (Figure 4); you’ll see that the
Traders looking to pick tops would have been faced with at pair is also trending below the 10- and 20-period SMA, which
least three years of unprofitable and difficult trading, particu- confirms that you should look for opportunities to sell.
larly when the GBPUSD was making 10-year highs in January Therefore, as a daytrader, you turn to the 15-minute charts
2004. This area would have certainly attracted traders looking (Figure 5) to identify entry levels. The circled areas indicate
to pick a top and fade† the trend. The GBPUSD has rallied up to when the short positions were initiated based upon a break of
10% beyond its 10-year high since January, which means that a short-term intraday range.
those traders would have incurred significant losses.
The more effective trading strategy would have been to USEFUL TOOLS
follow the trend. This would have involved looking for The best way to stay with the trend is to apply a moving
opportunities to go long the GBPUSD on dips. In Figure 2, you average to your price chart and determine the trend. A dual
see an hourly chart of GBPUSD, with Fibonacci retracements moving average crossover is a popular combination with
of the February 2004–May 2004 selloff. Rather than looking intraday traders. Using the crossover, you can trade with the
for opportunities to sell, by using the 50% Fibonacci trend by trading long when shorter moving averages move
retracement level as the key support zone between May 30 above the slower ones or short when the converse occurs.
and June 6, you can look for opportunities to go long around Combining this technique with a technical study such as
the support zone at 1.8300–1.8325. the moving average convergence/divergence (MACD) is one
Multiple time frame analysis can also be employed on a intuitive way to trade with the trend. While the MACD
shorter-term basis. Take a look at an example using 15- calculation is complex (see sidebar, “The MACD spread-
minute charts and hourly charts of the euro against the US sheet” ) and beyond the scope of this discussion, interpreting
dollar (EURUSD) as the indication of the broader trend. the MACD is not nearly as complicated. When you apply the
Although 15-minute and hourly charts are sufficient, we’d MACD, you will see two lines oscillating above and below the
still recommend that you use the daily charts for further zero line. In addition to these two lines you will see a
confirmation, although focusing on a shorter time frame.
Similar to our example of the LA–NY road trip, first you
must take a look at the daily charts for guidance on the near- The best way to stay with the trend is
term trend for the EURUSD. As you can see on the daily chart to apply a moving average to your
(Figure 3), the pair has broken a key former support-turned- price chart and determine the trend.
resistance level and begun moving below the 20-day simple
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
THE MACD SPREADSHEET
This spreadsheet calculates the MACD fast line and the
signal line. Column A is the date; column B is the closing
price of the security. Column C calculates the 12-day
EMA. The EMA is calculated as:
EMAn = αPn + (1 – α) * EMAn-1
where P is the price, α is the smoothing constant, 2/
(n+1), in which n is the length of the period used for the
moving average. In cell C13, enter the formula:
(0.154 * B13) + (0.845 * (SUM(B2:B13)/12))
The number (2/(n+1))=0.154 is the smoothing factor. In
this specific cell, the simple moving average is used
instead of the EMA, whereas in the subsequent cells in
column C, the EMA is used.
In cell C14, enter the formula and copy it down through
to the bottom of the data series in column C:
(0.154*B14) + (0.845*C13)
SIDEBAR FIGURE 1: SPREADSHEET. Here’s a spreadsheet to calculate the
Column D calculates the 26-day EMA. In D27, enter the MACD.
formula
EMA of the fast line. It is calculated by using a smoothing
(0.074 * B27) + (0.926 * (SUM(B2:B27)/26)) factor that was determined by using the formula mentioned
previously.
Here, the smoothing constant is (2/(n +1)) = 0.074. In cell F35, enter
In cell D28, enter the following formula and copy it into the
cells in the same column through to the bottom of the data (0.2 * E35) + (0.8 * (SUM(E27:E35)/9)).
series:
Enter the following formula in cell F36 and copy it down
(0.074 * B28) + (0.926 * D27) through to the bottom of your data series:
Column E calculates the difference between the 12-day (0.2 * E36) + (0.8 * F35)
EMA and the 26-day EMA (column C minus column D). The
results in this column should be plotted as the MACD fast The results in column F should be plotted along with the fast
line. line.
Column F calculates the signal line, which is the nine-day —Jayanthi Gopalakrishnan, Editor
histogram of the two lines. The histogram essentially charts hour chart with the same indicators.
the difference between the lines as an oscillator so you can see When the (four-hour) chart indicates an uptrend (price
the variance between the two lines more clearly. above the moving average and the MACD fast line tracing
When the fast line (the jagged line) moves above the slow above the slow line), you can move to the shorter time frame
line (the smoother of the two) and the price of the instrument (two-hour) chart to look for the identical indication. When
has moved above the seven- or 50-period moving average, both time frames indicate a trend, there is arguable support
the long trend is established. At this point it is safe to trade for a long trade. At this point, often you have one long signal
with the trend and establish a long position. In Figure 6, the on the longer chart and the short time frame chart moves into
long trend is established in the circled area, where the fast line a sell. In this instance, you remain inactive while watching the
crosses above the slow line and the pair trades above the screen closely for the sell signal. If, however, the shorter chart
seven- and 50-period moving averages. also indicates the same signal, you should initiate your
Employing multiple time frame analysis makes a MACD position.
play particularly successful. The time frame of the confirma- Once the trade is open, if the two-hour chart shows a sell
tion chart should be approximately two times the time frame indication, you wait to exit the position unless your stop has
of the chart that you are using to determine your entry point. been hit. If the four-hour chart shows a sell, close your
Thus, if you use a seven-period moving average on the two- positions and check to see if there is continuity between the
hour chart, the confirmation chart would have to be a four- two charts on the sell indication.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
EUR/USD 15-minute chart
FIGURE 5: IDENTIFYING YOUR ENTRY POINTS? Moving on to the 15-minute chart, you can now place your entries. Here the short positions are based
on breakdowns from a trading range.
NOW FOR THE BEST PART “double up” (caution: doubling up increases risk and expo-
If the two-hour chart calls for a sell but the four-hour chart sure). This process is referred to as laddering or pyramiding
does not and the two-hour version comes back into a buy, it a trend. When the four-hour chart indicates a sell, you exit the
may be an opportune point to add to your long position or trade. You can use the same screen method on the short side.
USD/CHF four-hourly chart
Pair moves above
7- and 50-period SMAs
Fast line crosses
above slower line
FIGURE 6: COMBINING OTHER TOOLS. On this four-hour chart of the USDCHF, you see that the currency pair has broken above the seven- and 50-
period SMA and started an upward trend. The MACD also confirms this upward trend, making it a safe bet to open a long position.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 22:11 (60-65): Trading Currencies Using Multiple Time Frames by Kathy Lien and Patrick Dyess
When the fast line (the jagged line) moves above the slow line Kathy Lien is a seasoned forex analyst and trader with experi-
(the smoother of the two), you have indication of underlying ence in the interbank market (using both technical and funda-
strength amid the buyers that often is not apparent in the price mental analysis). She has been a contributor to CBS
action. When the histogram moves above zero, it is indicating MarketWatch, Active Trader, Futures, Trader’s Source, and
buyer strength. If the histogram moves below zero, it indicates SFO Magazine. Patrick Dyess writes a daily forex technical
seller strength. This information is valuable when trading with column that is published on www.dailyfx.com. They can be
the trend. Combine this with the dual moving average crossover, reached at [email protected] For more of their research,
and you have a systematic approach to trading. please visit www.dailyfx.com or http://biz.yahoo.com/fxcm/.
The strategy of multiple time frame analysis is sound for
a couple of reasons. First, this strategy will help you develop SUGGESTED READING
consistency so you become more systematic with your Gopalakrishnan, Jayanthi [1999]. “Trading The MACD,”
results and fine-tune your money management. Second, this Technical Analysis of STOCKS & COMMODITIES, Volume
strategy can expose you to the market during an extended 17: October.
trend, offering the opportunity to reap large returns. †See Traders’ Glossary for definition S&C
Copyright (c) Technical Analysis Inc.


Use: 0.2347