Step 1.
Create a weekly chart [bar or candle] of a currency pair. On this chart overlay a 21 EMA [(H + L)/2], and a 5 SMA [(H + L)/2]. Note that the 21 period is an exponential moving average and the 5 period is a simple moving average.
Now, look at the difference between the two. As a market rises over time on the weekly chart, the 5 will rise faster relative to the 21. As the market goes down, the 5 will lose faster relative to the 21. The difference, in pips between the two, measures relative momentum of the market in real time. Each week, as long as the number of pips keeps rising [SMA 5 – EMA 21] from the previous week, the market continues in a bull run. Once a bull run loses pips [SMA 5 – EMA 21] from the previous week, it signals a medium-term top in the market. Conversely, once a bear run loses pips [EMA 21 – SMA 5] from the previous week, it signals a medium-term bottom in the market.
This now gives us [with only one week lag] a positive probabilistic model in determining which side [long or short] to initiate trades in a defined time period. We are identifying market momentum.
Step 2.
Create a 4 hour chart [bar or candle] of the same currency pair. On this chart overlay a 55 SMA [(H + L)/2], and an 8 SMA [Close only].
Now, look at the difference between the two on your 4 hour chart. Since we are using different types of MA’s and a shorter time period with a relatively longer period, the two will cross many times. We call these MOMENTUM tunnels.
So, we now take a look at the weekly chart again and determine that we are in a bull run. We then take a look at the 4 hour chart. We now know that we are looking to long the market, and that short positions will not be taken because they have been predetermined to be low probability events for large profits.
We now are looking for the 8 SMA to move lower through the 55 SMA. When it does, we carefully watch and notice when the SLOPE of the 8 SMA changes from negative to positive. It will do this when the 8 SMA stops losing value in one 4 hour bar and gains in the next. This is the 4 hour bar to initiate new long positions with 3 units [remember: units are whatever trading size you can handle. When you trade bigger, just adjust the size of the unit, not the number of units]. Stops can be placed using technicals [support/res/trendline] of the most recent 4 hour bars.
Assuming the market starts to go up, we stay long until 1) at some point in time the 8 SMA changes slope from positive to negative, at which point we exit the entire 3 unit trade, 2) the market moves up, there is no slope change, and goes to the 144 or 233 fib number from the 55 SMA line, where 1 unit is taken off, 3) the market moves up to the next fib number [233 or 377], again with no slope change, and the 2nd unit is booked.
Let’s now assume that the weekly chart determines we are in a bear run. We will now be looking to initiate new short positions only.
We are looking for the 8 SMA to move higher through the 55 SMA. When it does, we carefully watch and notice when the SLOPE of the 8 SMA changes from positive to negative. It will do this when the 8 SMA stops gaining value in one 4 hour bar and loses in the next. This is the 4 hour bar to initiate new short positions with 3 units. Again, stop placement depends on technicals of the most recent 4 hour bars.
Assuming the market starts to go down, we stay short until 1) at some point in time the 8 SMA changes slope from negative to positive, at which point we exit the entire 3 unit trade, 2) the market moves down, there is no slope change, and goes to the 144 or 233 fib number from the 55 SMA line, where 1 unit is taken off, 3) the market moves down to the next fib number [233 or 377], again with no slope change, and the 2nd unit is booked.
There will be times when the slopes will change and the 8 SMA will not be above/below the 55 SMA line. In these circumstances we use only 1 ½ units to initiate a trade with the same rules above.
We are implementing this new 4 hour method with only 2 filters. The first is on the weekly chart. If the difference between the 21 EMA and the 5 EMA is > 500 pips, then the pip difference from the prior week must change by more than 10 pips, or just go lower over 2 consecutive weeks, to signal a trend change.
The second filter is on the 4 hour chart. If the 8 SMA and the 55 SMA and the market price are all within 50 pips or so of each other, we go to technicals [breakout] to continue the trade. We do this because, at this juncture, you are more likely to get the 8 SMA jumping up and down 2 or 3 pips every few bars, thus generating a false trade signal. It doesn’t happen very often, but when it does, using this filter can save us money, and the market isn’t really moving anywhere anyway. Therefore, a breakout of the techs makes sense to initiate a trade, if it’s in the direction you are supposed to be trading.
If you now go ahead and make the charts and take a cursory look at the weekly, you should be amazed. The weekly criteria hits every single turn in the market within a couple of weeks. The fact of the matter is that the weekly difference of the MA’s TRENDS. It doesn’t change gaining/losing unless the trend changes.
The 4 hour chart is equally powerful. A more careful look at the 4 hour will show large 4 hour bar spikes that often change the slope of the 8 SMA. The reason we chose the 8 SMA with close only, is so that we can better estimate in the next 4 hour bar period the price needed to change the slope before the period is over. Many times this will give us a huge profit advantage over waiting until the period is over.
ANALYSIS
The following spreadsheet gives a rough idea of what kind of profitability you are looking at using the 4 Hour Momentum Tunnel Method. It is very important to realize what assumptions we used in calculating these numbers. The criteria was as follows:
1) 1) Any trade that looked like less than 100 pips profit we totally ignored,
2) 2) When taking profits we ignored fib numbers from the market price and instead used the 8 SMA line if it hit a fib number. We did this because it was much easier to calculate and took far less time than analyzing each bar on every chart with every pair. Note though, that this REDUCES profitability tremendously over time. The market is much more likely to hit fib numbers than the 8 SMA.
3) 3) Any trade that looked like a scratch or a loss, we treated as a loss, and
4) 4) After we summed up all the periods we DOUBLED the losses,
5) 5) We used 3 units on most trades, except 1 ½ units on trades where the 8 SMA changed slope and did not cross the 55 SMA. This trading signal is somewhat less powerful than the original, so we reduced size accordingly.
RISK MODELS
I could write a book on risk models, and it could easily be 500 pages and sell for $100. There are as many models, along with their variations, as there are wannabe traders in the world. Instead of going through conservative and aggressive scenarios, I decided just to write about the model we will initially employ. I am not suggesting you use it: I am simply presenting it for your information. You must come up with your own risk model.
Unit value: 1 unit = 500,000 base currency vs. $US
Trade Size: 3 units per currency pair, except 1 ½ units when 4 hour chart filter kicks in.
Filters: Only the 2 mentioned earlier in the file
Stops: Will be based on technicals off of 4 hour charts.
Pairs traded: Initially only GBP/USD.
Options: Yes, will write [sell put or call] premium opposite trend off of weekly chart with 1unit, with trend change triggering covering of positions. We will sell out-of-the-money option [depending on signal, sell calls for bear signal – sell puts for bull signal] premium with expiration of 6 – 8 weeks, and look to cover 2 – 3 weeks from expiration at approximately a third of selling price.
Other: May not take off entire position at slight change in slope of 8 SMA on the 4 hour chart. Most likely scenario is to take partial profit, with stop based on technicals for remaining position.
WHERE DO WE GO FROM HERE?
I hope most of you reading this file can see how adaptable and flexible this method can be to your trading style. Even if you choose to trade shorter timeframes, this method can keep you on the right side of the market. It should confirm other types of analysis as well. When I sit back and think, I can see a host of scenarios some people will envision and implement. By all means, make the necessary changes to fit your trading style. This is not a one size fits all trading method. All anyone should care about is making money, and we think this will definitely help you in that objective.
For newbies to forex, or more conservative traders, you can scale back and cherry-pick the best trades. Simply use the model as your guide, and take the guesswork and emotion out of trading. You will always be buying dips in a bull run, and selling rallies in a bear run, to initiate new positions. You are letting the market tell you when it has had its little contra-trend rally/break. That, in essence, is what a MOMENTUM tunnel is all about. It creates a visual space for you to see these contra-trend opportunities as they are being created. When they turn, you can pounce on the trade, and now it’s time to continue the medium-term trend. You’re not going to hit every one perfect, but you will definitely get your share if you stay patient and wait for the optimum time. Even if you screw up the entry, the trend will probably make the trade a profitable one.
I hope you can see why trading MOMENTUM tunnels [4 hour] are better than trading PRICE tunnels [1 hour]. You will have less losing trades, and there is no chop around the MOMENTUM tunnel. If the market continues to go against the trend, within a very short period of time you will only have 2, possibly 3 losing trades before the weekly trend would change. This is a very acceptable tradeoff for the new information being given to you by the market: i.e. a weekly trend change. At least for us, this means closing old option positions [at just the right time], and creating new ones [at just the right time].
Remember the old trading proverb: price = information. That’s exactly what’s happening when you get a trend change from the weekly charts. Of course, remember that there is a lag of 1 week from knowing when the high or low reading comes, because you won’t know until Friday’s close if last week’s reading was the high/low or not.
Let me just add, that MOMENTUM tunnels should work particularly well with other financial markets. Stock indices, oil, and interest rates should trade very profitably with the new method. Some of the currency crosses [eur/jpy, eur/gbp, eur/chf, eur/cad], in theory, should also work well. Vegas Jr. is going to look at these particular crosses in a few weeks to check them out, so I’ll withhold my opinions on them until he is finished.
Finally, let me reiterate what I said in the first file [the 1 hour method]. We seek nothing from anyone in regards this method. You are free to use as much or as little of this as pleases you. If you want to call it your own that’s OK with us. The entire Vegas team only wants to see you make money trading forex, and anything we can do towards that goal makes our effort worthwhile. Please feel free to contact us anytime with your questions and/or comments via e-mail. We will answer as quickly as life allows. Our e-mail address for those who may not have it is as follows:
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