This article has been written as a follow up to the Cable 10/2 Momentum Trading System for the GBP/USD currency pair. The idea behind momentum trading systems that trade
using price action is that when enough momentum has been built up and the market is making a significant movement in one direction then it takes a lot to stop it, and there is therefore more chance of the price continuing to move in that direction than there is of a reversal.
Of course, a reversal will eventually happen at some point in the future as no market can continue to move in the same direction forever; but trading is about probabilities not certainties, and all we need to build a technical trading system using the price movement as a signal is for the price moment to be big enough that the chance of it continuing is, statistically speaking, big enough to be tradeable. When the chance of something happening is statistically large enough to be tradeable we have an edge. Without an edge, no trading system can be successful.
But merely having a statistical edge isn't enough to make a complete trading system, to be truly useful as a component of a mechanical trading system the edge must appear frequently enough to make trading the system worthwhile. Consistently applying an edge will make you money, but the more chances there are to apply the edge the quicker you will make it. And systems that trade frequently also have the advantage that they tend to produce smoother equity curves than those that trade relatively infrequently.
The simplest way (that I can think of) to demonstrate the edge given by momentum on a daily candlestick chart, this is the time-frame that I like to trade, is to measure the number of pips the price closes above or below yesterday's high or low; and when an end of day signal is given in the form of the price closing x number of pips above the previous day's high or x number of pips below the previous day's low to enter at the day's close and hold the position until the close of the following day. The currency pair that momentum trading seems to work best on is the GBP/USD, so it's this currency pair that I will test for the purposes of this article.
I will measure the effects of GBP/USD closing x number of pips above previous day's high or closing x number of pips below the previous day's low on data from the beginning of 2006 to the end of 2010. The results were as follows -
Number Of Pips Above Or Below Previous Day's High Or Low
Number Of Trading Days
Number Of Trades
Number Of Winning Trades
Number Of Losing Trades
Number Of Pips Won
Number Of Pips Lost
Percentages Of Days With a Trade
Percentage Of Winning Trades
Pips Won To Pips Lost Ratio
10
1225
547
280
267
27,116.7
22,274.3
44.65%
51.19%
1.22 to 1
20
1225
485
247
238
24,889.0
19,867.0
39.59%
50.93%
1.25 to 1
30
1225
425
208
217
22,104.4
17,142.1
34.69%
51.06%
1.29 to 1
40
1225
374
195
179
19,921.8
14,921.2
30.53%
52.14%
1.33 to 1
The two important columns in the results table are the 'percentages of days with a trade' and the 'pips won to pips lost ratio', the pips won to lost ratio tells indicates how great an edge the system actually has and the percentage of days with a trade tells us how often we get to apply this edge.
