Sharp pullback to 50-day MA in uptrend

Many of the same successful trading patterns that dominate equities trading can be transferred to the forex markets. Moving averages, pullbacks, historical volatility and RSI can be used in both markets to time reversal moves and breakouts.

Let's take a look at a common pullback strategy which can be used in the forex markets to find the right price to buy in. When a market pulls back to a significant moving average, the market becomes oversold and the moving average often acts as a level of support that the price then bounces off of. In effect, the pullback becomes a staging area for the next move.

We will use a 50-day simple moving average, a popular moving average that many traders follow, to help us identify a swing trade. The GBP/JPY has been in a solid uptrend since the beginning of May. From April 27-May 4, the Pound gained steadily over the dollar, breaking highs from a few days before but getting stopped at resistance from highs in February. After testing these highs, the currency initiated a pullback to break support at its 50-day moving average, a move which could be considered by many traders to be a very risky pullback entry opportunity. However, the currency has also reached a point of being extremely oversold. Based upon TradingMarkets' research in the equities market, this condition have many times resulted in strong reversals. We believe that it is possible that the same is true of the forex markets.

A few days later GBP/JPY initiated another smaller pullback to the 50-day MA, and this would have been our optimal entry point after the stock found support at its 50-day MA.

Here is another example of a Forex market pulling back repeatedly to the 50-day moving average. In December '05 the Euro rallied strong against the Swiss Franc, easily rallying through the 50-day moving average resistance. A sharp pullback brought price back through the 50-day MA, getting the Euro to an oversold condition. From there, the Euro started to rally again, this time much more gradually. Then, the Euro tested, broke and then held the 50-day in a small, consolidating pullback. Unlike the example from above, this pullback is a little riskier because price actually broke the moving average during the pullback. However, the Euro was trading above the average during the second pullback, and after two strong moves, one could conclude that this price is trying to go higher.

As we know from buying stocks and futures on pullbacks, many times price will take a rest during an uptrend move, and fall back a couple of points. But because the stock or currency is trading a strong uptrend, this pullback becomes a resting point before the price makes a continuation move in its original trending direction, especially if the pullback occurs next to the moving average. From our observations, the Forex markets appear to behave in a similar fashion.

Try plotting the 50-day moving average on your forex charts and look back in history at how up trending currency pairs have reacted when they pull back to the 50-day moving average. Watch for how trading opportunities unfolded in the past. From there, you can formulate you own entry and exit strategies using this simple setup.

JP Lee
Associate Editor
johnl@tradingmarkets.com