By Kathy Lien, Chief Strategist of DailyFX.com*
Posted: July 11, 2008

One of the most popular ways to trade currencies is to try to pick tops and bottoms. Although many FX experts, including me, stress the effectiveness of trend trading in the currency market, fading a trend tempts many people into what often becomes a frustrating endeavor.

A perfect example is the EUR / USD, which first looked as though it could top out at 1.45 but then moved on to hit a high just shy of 1.60. Countless numbers of FX traders have tried to fade this move, but a quick glance at the charts shows that, even though some profit was made fading the 2-year uptrend, far more money was made by traders who simply stayed with the trend.

However, for those traders who prefer to pick tops and bottoms anyway, I do have a strategy I use to take advantage of short-term turns within the overall trend because, admittedly, not all of us have the patience to stay in a trade for a week, let alone 2 years. This strategy uses a combination of Bollinger Bands and an Exponential Moving Average. I call this strategy "Targeting the 20".

In this strategy, we use the 1st standard deviation Bollinger Band (SD BB) and the 20-day Exponential Moving Average (EMA). My decision to use the 1st standard deviation band rather than the more commonly used 2nd is based on testing that says, "If an uptrend is strong, a currency pair should not break the 1st standard deviation moving average by more than 50 pips on an intraday basis."

If the currency pair does break the 1st standard deviation, there is a very high probability that it will test the 20-day EMA. This strategy only works on a risk / reward basis if the distance between the Bollinger Band and the EMA is greater than 100 pips.

The reason I use the EMA instead of the SMA is because it gives greater weight to recent price action, which, for my trading purposes, is more accurate.

General guidelines or rules for the “Targeting the 20” trading strategy:

Long Trade

1. Look for a currency pair that has been trading below the 1st SD, which means that it is in a downtrend.
2. Wait for price to break the 1st SD BB by 50 pips. (Make sure that the difference between the BB and EMA is greater than 100 pips.)
3. Go long the currency with the day’s low as the stop.
4. Close half of the position when the currency hits the 20 EMA; move the stop on the remaining position to the break-even point.
5. Close the second half of the position when the currency hits the upper Bollinger Band.

Here is an example of how the strategy would have worked with the EUR / USD:

On February 12, 2008, the EUR / USD comes out of a short downtrend and breaks the 1st SD BB by 50 pips:

We go long the EUR/USD at 1.4593.
The stop is the low of the day at 1.4496.

The EUR / USD continues its move higher and touches the 20 EMA at 1.4643, and we exit half of the position at that price level. The stop on the remainder of the position is then moved to the break-even point, or 1.4593.*

1Moving the stop to the break-even point makes this trade profitable even if the EUR / USD reverses course and fails at the 20 EMA, which can happen often.

The EUR / USD continues to move higher and hits the 1st SD upper Bollinger Band at 1.4800; at which time, we exit the trade for an average profit of 128 pips.

The rules for a short trade are the opposite.

Short Trade

1. Look for a currency pair that has been trading above the 1st SD BB, which means that it is in an uptrend. 2. Wait for price to break the 1st SD BB by 50 pips. (Make sure that the difference between the BB and EMA is greater than 100 pips.) 3. Short the currency with the day’s high as the stop. 4. Close half of the position when the currency hits the 20 EMA; move the stop on the remaining position to the break-even point. 5. Close the second half of the position when the currency hits the lower Bollinger Band.

Here is another example of the EUR / USD:

On March 20, 2008, the EUR / USD comes out of a 1-month uptrend and breaks the 1st SD BB by 50 pips:

We go short the EUR / USD at 1.5536.
The stop is the high of the day at 1.5647.

The EUR / USD continues to sell off and touches the 20 EMA at 1.5360; at which time, we exit half of the position. The stop on the remainder of the position is then moved to the break-even point, or 1.5536.*

2The EUR / USD fails to continue lower and, instead, reverses sharply, hitting our break-even stop of 1.5536. Even though we make no pips on the second lot, the trade is still net profitable with 176 pips on the first half of the position for an average of 88 pips.

The key behind the success of this strategy is to wait for a turn to happen instead of actually trying to pick one. Another important success factor is being nimble with your profits while at the same time recognizing the fact that the move could very well be just a retracement or recovery within an overall trend.

*Reprinted (and modified) with permission from Kathy Lien of DailyFX.com