Forex Trading System Development An Interactive Qualifying Project submitted to the Faculty of WORCESTER POLYTECHNIC INSTITUTE in partial fulfilment of the requirements for the Degree of Bachelor of Science by Michael Poon Austin Alibozek Michael Guarino Date: 1 June 2014 Report Submitted to: Professor Hossein Hakim Professor Michael Radzicki i Abstract The focus of this report is to demonstrate the process of building a trading system to be used in the foreign exchange market. The report will introduce an overview of the currency market and different trading techniques and concepts used in the construction of a trading system. The process of building a forex trading strategy, from initial formation to optimization, is laid out based on existing research. The results and analysis of the group’s own experience building and testing a forex strategy is included to exhibit the method presented in the report. i Table of Contents Abstract ............................................................................................................................................ i Table of Figures ............................................................................................................................. iv 1 Introduction ............................................................................................................................. 1 1.1 Project Description ........................................................................................................... 2 2 Background .............................................................................................................................. 3 2.1 Trading Markets ............................................................................................................... 3 2.1.1 Stocks ........................................................................................................................ 3 2.1.2 Commodities ............................................................................................................. 5 2.1.3 Forex ......................................................................................................................... 6 1. Forex ................................................................................................................................ 6 2.2 Overview of Forex ........................................................................................................... 8 2.2.1 History of Forex ........................................................................................................ 8 2.2.2 Currency Pairs ........................................................................................................... 9 2.2.3 Market Structure ..................................................................................................... 11 2.2.4 Trading Sessions ..................................................................................................... 12 2.2.5 Leverage .................................................................................................................. 13 2.3 Analysis Techniques ...................................................................................................... 14 2.3.1 Fundamental Analysis ............................................................................................. 14 2.3.2 Market Sentiment .................................................................................................... 19 2.3.3 Technical Analysis .................................................................................................. 22 2.4 The Trading System ....................................................................................................... 36 2.4.1 Selecting a Currency Pair ........................................................................................ 37 2.4.2 Market Analysis ...................................................................................................... 37 2.4.3 Trading Style ........................................................................................................... 38 2.4.4 Risk Management and Position Sizing ................................................................... 39 3 Methodology .......................................................................................................................... 40 3.1.1 Establishing an Understanding of the market ......................................................... 40 3.1.2 Learning Trading Mechanics .................................................................................. 41 3.1.3 Research of Technical and Fundamental Analysis ................................................. 41 3.1.4 Testing and Evaluating Trading Strategies ............................................................. 42 ii 4 Process ................................................................................................................................... 44 4.1 Strategy I Process ........................................................................................................... 44 4.2 Strategy II Process .......................................................................................................... 54 4.3 Strategy III Process ........................................................................................................ 61 5 Results ................................................................................................................................... 69 5.1 Gain an Understanding of Forex .................................................................................... 69 5.2 Define Trading Personality ............................................................................................ 69 5.3 Select Useful Indicators ................................................................................................. 70 5.4 Define Entry and Exit Rules........................................................................................... 70 5.5 Manage Risk ................................................................................................................... 71 5.6 Trade the System ............................................................................................................ 71 Appendices .................................................................................................................................... 72 Appendix A. Exchange Rate Theories and Models .................................................................. 72 Purchasing Power Parity ........................................................................................................ 72 Interest Rate Theories ............................................................................................................ 73 Monetary Theory ................................................................................................................... 73 Appendix B. Weekly Reports.................................................................................................... 75 Weekly Report - 2/6/14 ......................................................................................................... 75 Weekly Report – 2/27/14 ....................................................................................................... 85 Appendix C. Trading Logs ........................................................................................................ 93 Strategy I Trading Log .......................................................................................................... 93 Strategy II Trading Log ............................................................................................................. 95 Strategy III Trading Log ........................................................................................................... 98 Appendix D. EasyLanguage Code .......................................................................................... 100 EL Strategy I – Strategy ...................................................................................................... 100 EL Strategy II – Strategy ......................................................................................................... 102 EL Strategy III - Indicator ....................................................................................................... 102 6 References ........................................................................................................................... 106 iii Table of Figures Figure 1 – Diagram of Forex Market Structure ............................................................................ 12 Figure 2 – Example of Simple Moving Average Indicator........................................................... 26 Figure 3 – Example of Moving Average Divergence Convergence Indicator ............................. 28 Figure 4 – Example of Bollinger Bands Indicator ........................................................................ 30 Figure 5 – Example of Relative Strength Index Indicator ........................................................... 33 Figure 6 – Example of Stochastic Indicator .................................................................................. 35 Figure 7 – Strategy I 2-Line SMA Strategy Chart ........................................................................ 47 Figure 8 – Strategy I: MACD Momentum Strategy Daily Chart .................................................. 49 Figure 9 – Strategy I: MACD Momentum Strategy 4-hour Chart