System 5: Market Corrections Vs. Market Extremes Entries - Favourable Price Exits Vs. Time-Based Exits
The Trading System,
This system presents the reader with two entry options, buying on dips and selling on highs Vs buying a new high and selling even higher or selling on a new low and buying back even lower. And two exit options, exiting on a favourable price Vs a time-based exit. Which options are best depends on the market the system is intended for use on. As with all the systems on this website, they're here for the reader to modify and make their own – this system however will probably require more 'tailoring' than the previous four.
Entries, Exits and Position Sizing,
If you've read any of the trading books by the numerous Forex 'gurus' out there you'll know doubt have come across the following advice, these golden rules for success in the markets. Usually, it goes something like this -
1. Trade with the trend don't fight it. Buy during an uptrend; sell during a downtrend.
2. Let your profits run, cut your losses quickly.
3. Add to a winning position; never add to a losing position.
This, on the face of it at least, is sound advice. But I don't believe it goes into nearly enough detail to actually be all that useful. For example, during an uptrend, when exactly should we buy? Is it best to get in immediately after a new high is made? Or should we wait for a short-term reversal to buy into, even if that means we risk missing a really big move? Should we be looking to buy high and sell even higher, or should we be waiting for a pull back. Likewise, during a downtrend, should we selling on a new low so that we can (hopefully) buy it back even lower? Or is it best to wait for a better price before entering and sell into a mini rally?
And how do we best go about letting our profits run and cutting our losses? Should we use a 'trailing stop' or a moving average crossover and give back some of our profits as these lagging indicators take their time to signal that the trend has reversed? Or should we just get out after a certain number of days (a time-based exit)? Or maybe we should be looking for a compromise between those two extremes and exit on a lack of 'follow through', i.e. exit if the market fails to make a new high or new low for x number of days, as I used in my first ever technical/mechanical trading system Strange Currencies. Or perhaps this advice to let our profits run and cut our losses quickly isn't that important after all and it's best to just seek to maximise our chances of avoiding a losing trade by taking an ideal exit opportunity when we have it, such as, say, exiting from a long trade after a new 3-day high and exiting a short trade after a new 3-day low?
And what about the advice of adding to our winning positions and never adding to our losing positions? It makes sense never to double up on a trade that is a loser as if the market continues to go against you and you continue to double up you'd lose your entire trading account; but what about adding to a winning position? When exactly should we add to a winning position and 'pyramid'? Should we add to the position once the position is x number of pips in profit? Or should we only add to a position after the market makes new high or low which has taken all our previous positions into profit, but will eventually end up ensuring that the last position(s) taken using this strategy will be losers? When?
Market Corrections Vs Market Extremes – The Test,
I am going to try and answer a few of these questions by testing three different systems on three different markets, the major currencies (EURUSD, GBPUSD, USDJPY and USDCHF), the commodity currencies (USDCAD, AUDUSD and USDNOK) and the SP500 stock market index. The systems, all end-of-day mechanical systems, are as follows –
System I: Entering on extremes with a time-based exit,
Every time the market makes a new 3 month (60 trading days) high or low closing price I will enter in the direction of the breakout and hold the position for 3 weeks (15 trading days). Or, in pseudo code –
- IF Today's_Close > Close 60_Trading_Days_Ago THEN Go Long With a 15-day Time-Based Exit.
OR -
- IF Today's_Close < Close 60_Trading_Days_Ago THEN Go Short With a 15-day Time-Based Exit.
An Example Of How System I Might Work In A Strongly Trending Market
System II: Entering on a correction and exiting with a favourable price,
To keep our comparisons as meaningful as possible System II uses the same time frame that System I used for a breakout as trend 'filter'. When the market closes higher than it closed 3 months (60 trading days) ago the trend is said to be up and when the market closes lower than it closed 3 months (60 trading days) ago the trend is said to be down. However, with this system we will go long during an uptrend when the market closes lower than it has closed in the previous 3 trading days and hold onto that position until the market closes higher than it has closed in the last 3 trading days. And during a downtrend we will go short when the market closes higher than it has closed in the last three trading days and hold that position until the market closes lower than it has closed in the last three trading days. Or, in pseudo code –
- IF Today's_Close > Close 60_Trading_Days_Ago AND Today's_Close < Close_1_Day_Ago AND Today's_Close < Close_2_Days_Ago AND Today's_Close < Close_3_Days_Ago THEN Go Long and stay long until Today's_Close > Close_1_Day_Ago AND Today's_Close > Close_2_Days_Ago AND Today's_Close > Close_3_Days_Ago
OR -
- IF Today's_Close < Close 60_Trading_Days_Ago AND Today's_Close > Close_1_Day_Ago AND Today's_Close > Close_2_Days_Ago AND Today's_Close > Close_3_Days_Ago THEN Go Short and stay short until Today's_Close < Close_1_Day_Ago AND Today's_Close < Close_2_Days_Ago AND Today's_Close < Close_3_Days_Ago
An Example Of How System II Might Work In A Strongly Trending Market
System III: Entering on a correction and exiting with a time-based exit,
As with the 2nd system, System III compares the current closing price with the closing price 3 months (60 trading days) ago as a trend filter. When the market closes higher than it closed 3 months ago the trend is said to be up, and when the market closes lower than it closed 3 months ago the trend is said to be down. We will use the same entry criteria as the second system used, going long during an uptrend when the market closes lower than it closed in any of the three preceding trading days and enter short in a downtrend when the market closes higher than it closed in any of the three preceding trading days. Our exit is exactly the same as our exit in the first system; all trades will be closed exactly 15 trading days (around 3 weeks) after they were first opened. Or, in pseudo code –
- IF Today's_Close > Close 60_Trading_Days_Ago AND Today's_Close < Close_1_Day_Ago AND Today's_Close < Close_2_Days_Ago AND Today's_Close < Close_3_Days_Ago THEN Go Long With a 15-day Time-Based Exit.
OR -
- IF Today's_Close < Close 60_Trading_Days_Ago AND Today's_Close > Close_1_Day_Ago AND Today's_Close > Close_2_Days_Ago AND Today's_Close > Close_3_Days_Ago THEN Go Short With a 15-day Time-Based Exit.
An Example Of How System III Might Work In A Strongly Trending Market
The Results,
System I: Entering on extremes with a time-based exit, the results -
The Major Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| EURUSD |
153 |
116 |
38,485.3 |
26,142.0 |
1.47 to 1 |
| GBPUSD |
148 |
119 |
62,583.4 |
35,837.3 |
1.75 to 1 |
| USDCHF |
129 |
126 |
29,208.5 |
29,617.5 |
0.99 to 1 |
| USDJPY |
106 |
139 |
20,052.5 |
31,077.9 |
0.65 to 1 |
The Commodity Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| AUDUSD |
157 |
139 |
30,363.4 |
27,328.8 |
1.11 to 1 |
| USDCAD |
160 |
124 |
45,914.4 |
25,630.6 |
1.79 to 1 |
| USDNOK |
137 |
118 |
199,165.8 |
170,809.5 |
1.17 to 1 |
Stock Indices,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| SP500 Stock Index |
159 |
139 |
4,125.2 |
4,555.68 |
0.91 to 1 |
System II: Entering on a correction and exiting with a favourable price, the results -
The Major Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| EURUSD |
57 |
49 |
6,359.0 |
4,260.0 |
1.49 to 1 |
| GBPUSD |
189 |
110 |
18,637.3 |
20,500.0 |
0.91 to 1 |
| USDCHF |
201 |
97 |
13,333.4 |
15,456.0 |
0.86 to 1 |
| USDJPY |
252 |
116 |
14,822.5 |
12,832.6 |
1.15 to 1 |
The Commodity Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| AUDUSD |
231 |
97 |
13,211.8 |
10,144.5 |
1.30 to 1 |
| USDCAD |
200 |
74 |
13,426.4 |
9,918.0 |
1.35 to 1 |
| USDNOK |
201 |
111 |
93,471.6 |
104,661.8 |
0.89 to 1 |
Stock Indices,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| SP500 Stock Index |
241 |
78 |
2,688.95 |
1,319.39 |
2.04 to 1 |
System III: Entering on a correction and exiting with a time-based exit, the results -
The Major Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| EURUSD |
462 |
449 |
116,696.5 |
101,164.0 |
1.15 to 1 |
| GBPUSD |
426 |
443 |
133,132.5 |
143,564.1 |
0.93 to 1 |
| USDCHF |
327 |
420 |
72,964.1 |
115,680.8 |
0.63 to 1 |
| USDJPY |
336 |
399 |
67,684.7 |
80,441.9 |
0.84 to 1 |
The Commodity Pairs,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| AUDUSD |
487 |
396 |
97,190.7 |
68,330.5 |
1.42 to 1 |
| USDCAD |
370 |
326 |
86,930.0 |
63,543.3 |
1.37 to 1 |
| USDNOK |
337 |
380 |
539,541.3 |
581,315.8 |
0.93 to 1 |
Stock Indices,
| Market |
Number Of Wins |
Number Of Losses |
Number Of Pips Won |
Number Of Pips Lost |
Win To Loss Ratio |
| SP500 Stock Index |
535 |
316 |
16,163.39 |
10,152.02 |
1.59 to 1 |
My Conclusions,
System I Vs. Systems II and III,
Entering in the direction of the longer-term trend on a correction worked very well on the SP500 stock market index, but it didn't work particularly well on either the major currency pairs or the commodity currencies. Unlike with stock indices, mechanical trading systems designed for markets like the Forex market (which trends very well and experiences large and frequent breakouts) work best when they enter on a new price extreme rather than when they wait for a correction as waiting for a correction runs the risk of missing a really big move. None of these systems however performed particularly well on the Forex market, probably due to the fact that 60 days is not a long enough time period for a breakout, technical trading systems like Strange Currencies I and Strange Currencies II work better as they use breakout times of around 80 – 120 days.
System II Vs. System III,
The only difference between System II and System III was the exit strategy. System II used a 'favourable' price (a 3-day high or low close in the direction of our trade) as an exit signal while System III used a simple time-based exit. System II's superior performance is therefore down to it's exit strategy.
In Brief -
- For the Forex market and market's like it that trend well and experience frequent and powerful breakouts it it's best to enter on a breakout rather than waiting for a correction; for stock indices and markets like them it's best to enter on a price correction.
- A favourable price exit generally provides an edge.
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