Learn To STOP Curve Fitting!
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Whether you trade stocks, bonds, Forex, commodities, or other financial instruments, or whether you are short-term, intermediate, or long-term trader I am sure you will agree with the next sentence – “Being in sync with the market is vital for success“. It applies for both automated and discretionary investors. In this article, I will share with you how I try to be in sync with the market regarding the exit part of my automated Forex trading systems.
There are four different types of strategy exits – opposite trade signal, stop loss, time exit, profit target, and trailing stop. I’d like to elaborate on the last two options and how they relate to our topic. In my opinion using profit target in trading is counter to the cited above wisdom. That’s why in all my systems I use the trailing stop option instead of the target order.
On the chart above I have marked four days of price action on the eur-usd market during 2015. For four trading sessions, the market has made gains of 670+ pips. It is a huge short-term movement without any visible corrections. It is not an every month move, but when it occurs I’d like to be on the right side of the market for as long as possible.
If I use a profit target of 100 pips I would miss more than 80% of that move. Even if I use 200 pips the missed movement will be 70%. The solution I found out for myself is to use a trailing stop. I plot a trend-following indicator such as Moving Average or Parabolic SAR or any other tool which will work well during trending movements. Then my stop loss order just follows the indicator with regards to the settings and time frame I have chosen. For my long-term strategies I use a very wide trailing stop and for my short-term systems, I use a tight one. With this very simple tool, I am sure that if the market decides to move a lot in a certain direction it is very likely for me to catch a big part of it. How big it is, depends entirely on the chosen settings which are a function of the strategy and the personal preferences of each trader. Aggressive traders use tight stops and conservative traders prefer the wide ones.
It is also possible to use both target and trailing stop in a combined approach. Instead of exiting on your predetermined target, you just can use it as an activation point of a new trailing stop which as I’ve said above could be wide or tight. Once the target is hit, we begin to move our stop loss order when the price continues to move in the desired direction.
If the market advances in our direction widely, we could use the presented above second target option which once hit, we lock in more profits than initially. The thinking process here is that the price has already moved a lot on the upside and thus chances of continuing the bull trend are now much lower. It is very convenient for those who don’t like to have big open profits. It is again a very good combination of both approaches.
Choosing a fixed target for your trading is hard and counterproductive because the market is always changing and a good target of 100 pips today is going to be worthless during a wild volatile market and you potentially could miss very big moves. The same applies to the opposite – using 200 pips target during quiet market conditions is a sure path to never reaching the target and missing profits again.
I like to think that if the market is willing to give me only 50 pips I would gladly take them. If the market is exploding and could give 500 pips or more for just a few trading sessions then again I am willing to be at least ready to grab them. I don’t like to force the market to hit my targets. I need to be very flexible because the market is constantly changing and one approach that has been giving us excellent results in the past few months could not give us good profit anymore.
As a proof of above-written concept, I’d like to present you with an example of a simple Forex trading strategy designed to work on eur-usd currency. It is short-term trend following based on daily bars volatility breakout pattern. I have done four backtests and the only difference in strategy’s inputs is the exit. I have used a trailing stop option and three profit target variations. The backtest has been conducted on 15 years data – from 2001 to 2015. Here are the results:
As you can observe the trailing stop settings make the best gain and lowest MaxDD. The bigger the target the worse the results.
Below are the equity curves of all backtests:
As expected the first one which represents the trailing stop option is the best and most good looking.
I hope that I have contributed to your knowledge about how to be more in sync with current market conditions and be more prepared to grab some big moves which occur from time to time. I wish you a profitable trading!
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