Moving Average and MACD combo strategy works really well in a trending market condition and has a good risk management. Find out more about the strategy below..
Trend trading is a strategy where following the direction of market momentum. The concept is quite simple; trend traders would buy currency during an uptrend or sell it during a downtrend. The practice, however, can be much more complicated than that. Joining a trend too late will possibly result in a loss since the trend has already exhausted itself. With Moving Averages and MACD combo strategy, you can learn how to ideally enter and close a trade during a trend.
This combo strategy involves the following indicators:
- 50 SMA
- 100 SMA
- MACD (default setup)
The 50 SMA is used as a signal line that triggers the trades, while the 100 SMA gives clarity to the trend. The SMA can be hourly or daily, depending on the charts. Meanwhile, the MACD confirms that the momentum is in motion. The main idea is to buy or sell when the price crosses the SMA in the trend direction as confirmed by the MACD.
How the Combination Works
The Moving Average lines can identify trend direction, but it sometimes gives false signals. That's why the MACD is added as confirmators. You can see from the chart below that there is a bearish crossing between the SMA lines. However, the MACD signals a bullish movement as the bars step up from negative to positive area.
Rules for Long Position
First, take a look at the 50 SMA, 100 SMA, and MACD on the charts. See if the following conditions occur:
- The price moves above 50 SMA and 100 SMA and it trades above the closest SMA by 10 pips or more.
- The MACD is positive within the last five bars. If not, you have to wait for the next signal.
If the aforementioned conditions are met, apply these steps to enter a long position:
- Set the initial stop loss at the lowest low in the last five bars from the entry.
- Close half the position when the price moves up two times the risk and move the stop loss to breakeven.
- Close the rest of the position when the price moves below the 50 SMA by 10 pips.
Let's take a look at the first example as shown on the USD/JPY on a daily chart. The trade opened on September 16, 2005, when the currency pair traded above both the 50-day and 100-day SMA. Since the MACD crossed to positive within five bars, we could immediately enter a long position at 10 pips above the 50-day SMA (the closest SMA), which was 110.95. Step by step, the following shows how the strategy worked:
- The initial stop loss was set at 108.98: the lowest low of the last five bars from the entry. The risk, thus, was 197 pips (110.95 – 108.98).
- The first target was set at 114.89, which was twice the risk (110.95 + 394 pips). The half position was eventually closed on October 13 when the target was hit. On this occasion, we moved the stop loss to breakeven.
- The second half was closed at 117.43 on December 14 as the price traded below the 50-day SMA by 10 pips, generating a total profit of 521 pips (197 pips + ½ (117.43 – 114.89)).
The example below showed a high risk of 197 pips, although in the end the profit is more than twice the risk. Daily charts typically offer bigger profits but present higher risks at the same time. The key is to remain patient when you enter trades on daily charts. The position can remain open for months, as demonstrated by this example where the trade was closed after almost 3 months.
The next example is from the EUR/USD hourly chart. On March 13, 2006, the price moved above both 50-hour and 100-hour SMA. However, the MACD had crossed to positive more than five bars ago, so wait until the MACD turned in the positive values again. We waited because the uptrend may exhaust itself as the momentum had moved to the upside for a while.
The second MACD signal came a few hours later with an entry price of 1.1945. Here was what happened next:
- The initial stop loss was set at the lowest low in the last five bars from the entry, which was at 1.197. This put the risk at 28 pips (1.1945 – 1.197).
- The first target was set at two times the risk, which was 1.2001 (1.1945 + 56 pips). The half position was then closed on March 14 at 11 a.m. when the target was hit, and the stop loss was moved to breakeven.
- The second half was closed at 1.2165 on March 20 at 10 a.m. as the price moved below the 50-hour SMA by 10 pips. The total profit was 138 pips (56 pips + ½ (1.2165-1.2001)).
Rules for Short Position
Look at the moving average indicators on the charts and check the following conditions:
- The price moves below both the 50 SMA and 100 SMA and it trades below the closest SMA by 10 pips or more.
- The MACD is negative within the last five bars, if not you have to wait for the next signal.
Next, follow these steps to enter a short position:
- Set the initial stop loss at the highest high in the last five bars from the entry.
- Close half the position at two times risk and move the stop loss to breakeven.
- Close the rest of the position when the price moves above the 50 SMA by 10 pips. Make sure that it's not between the 50 SMA and the 100 SMA.
The first example is from a daily chart for the EUR/JPY pair. The chart showed a clear downtrend that had occurred for months. This scenario was the opposite of a range-bound market where the price moved up and down between the two SMAs. On April 25, 2005, the pair traded below the 50-day and 100-day SMA, and the MACD was negative. We opened a short position at 137.36, which was 10 pips below the closest SMA (100-day SMA).
- The initial stop loss was set at 140.47, which was the five-bar high from the entry. This gave a high risk of 271 pips (140.47 – 137.76).
- The first target was 542 pips (two times the risk) from the entry, which was 132.34 (137.76 – 542 pips). Half of the position was closed around 5 weeks later on June 2, when the target was hit. We then moved the stop loss to breakeven.
- The price moved above the 50-day SMA by 10 pips on June 30 at 134.21 for a total profit of 448 pips (542 pips + ½ (132.34 – 134.21)).
On March 16, 2006, the AUD/USD was traded between the 50-hour and 100-hour SMA on an hourly chart. The price then moved below both the 50-hour and 100-hour SMA. Since the MACD also had negative values within the last five bars, we could enter a short position when the price was lower by 10 pips than the closest SMA, which was the 100-hour SMA. Therefore, the entry price was 0.7349. Then, apply the strategy as follows:
- The initial stop loss was set at the five-bar high from the entry, which was 0.7376, putting the risk at 27 pips (0.7376 – 0.7349).
- The first target is set at two times the risk, which was 0.7295 (0.7349 – 54 pips). The target was then reached seven hours later. We closed half of the position and moved the stop loss to breakeven.
- The second half of the position was closed at 0.7193 on March 22 as the price moved above the 50-hour SMA by 10 pips. The trade yielded a sizable profit of 105 pips (54 pips + ½ (0.7295 – 0.7193)) against a low risk of 27 pips.
No Strategy Is Perfect
Moving Average and MACD combo strategy works more effectively on trending conditions, so it is not quite effective in range-bound markets. Let's take an example from the hourly chart below. EUR/GBP is typically a range-bound pair, thus it is difficult for this strategy to work on this currency pair.
On March 7, 2006, the price moved below the 50-hour and 100-hour SMA. The MACD was also negative, so we entered a short position at 10 pips below the closest SMA, which was 0.6840. The stop loss was set at the five-bar high, which was 0.6860. This was a risk of 20 pips, meaning the first target was 0.6800 (0.6840 - 40 pips). The target, however, was never hit as the EUR/GBP sell-off was short-lived. In fact, the low only reached 0.6839 before the price crossed above the 50-hour SMA. The market eventually reverted back to the upside and hit the stop loss level, generating a 20 pips loss.
The Moving Average and MACD combo strategy can help you trade on trends to maximize your profits. But you have to be aware of its conditions. This strategy should be implemented on pairs that trend well, preferably the major ones. You also need to check the extent of the market trend. The ADX (Average Directional Index) can indicate whether the momentum is strong enough for the trend to continue. Indeed, in the example of losing trade above, the ADX is very low.