How To Decide Which Trading Strategy Is Right

A common trait among beginning and unsuccessful traders is the fickle abandonment of trading strategies that delivered a string of losses. And I am absolutely guilty for as long as I can remember. The underlying motivation is sound.  You want to improve your results and not trade a system that does not work in the long run. So which trading strategy is right?

All Strategies Suck

It’s inherent to all systems to deliver strings of winners and losers. In that sense all strategies suck. That makes finding something that fits your personality both harder and easier. Why? If they all suck it means you have to decide for yourself how to approach the markets. And there lies the crux. If you have the confidence to decide and persist with your decision chances are you will eventually make that approach profitable. Lesson? Make a choice and stick with it. And I don’t mean to religiously stick with the tactical parameters of your approach and now fine-tune them. But stick to your paradigm of choice.

My Choice

So here’s the deal for myself. I am drawn to a trend following approach to the markets, it is my choice. I like it, I am too dumb to interpret fundamental data better than others. It’s an easy traffic-light-type style indication for the market, up down or sideways. Trend following allows me to trade the markets without any knowledge about fundamentals whatsoever. If sound, I will be trading on the side of the insiders and experts who anticipate the trends. And there is strong empirical evidence that trend following works. For details I refer you to Michael Covel’s book Trend Following on Amazon. Get the book and blow your mind with what’s possible.

The Point

So the point is, how do you decide which approach is right for you? The question to ask yourself is very basic.

Say you are looking at trend following. The central question to answer would be: Do trends exist?

Say you want to trade fundamental macro. Ask yourself if macro data determines market prices?

Likewise with any other approach. If you can put a check mark behind that basic question of validity then for god’s sake stick with that approach and make it work for you. Force it to work for you.

Top 2 Reasons Why Trend Trading Is So Hard For Me

Trading and speculation in the financial markets is an appealing endeavor for many people. And so it is for me. But the percentage of people that find success is rather small. 95% of traders reportedly drop out of the game as losers. One of the most popular trading strategies is trend following. Arguably it is also one of the most successful (to learn more about trend following and how some of the richest traders on this planet milk money read Michael Covel’s excellent book Trend Following (Amazon Link)). So why is trend trading so hard?

What Is Trend Following?

Before answering why trading a trend is so difficult we first have to define what it is. So let us break it apart. The term consists of two words, “trend” and “following”. Let’s look at the first one.

Trend

So to be able to follow a trend we have to know what a trend is. It is one of those terms that intuitively makes sense but taking a closer look the devil is in the details. A trend is a sustained movement of prices in one direction, either up or down. Yes, we can all agree. But when does a trend start and when does it end? As with so many things in trading there is no one definite answer. A trend is pretty much anything that you define to be a trend. You can look at highs and lows, you can use the inclination of moving averages, you can use moving average crossovers, you can utilize trendlines or whatever else is out there. None of these tools is going to give you a satisfactory result in all circumstances. Because honestly the market does not care about your definition of a trend. It will always create moves and price action which will fake you out because your definition of a trend has been violated.

Following

The second term is “following”. The meaning of this is that when you apply a trend following strategy you will always be looking to trade in the direction of a trend that has already been established. The basic tenet of trend following is that a market will continue to move in the direction it is already heading. Well, that is not quite correct. As traders we are not actually assuming or making predictions. All we do is find trade setups that give us a favorable reward to risk ratio. (That is the tenet all trading strategies have in common by the way.) So trend followers find favorable setups in the continuation of trends. As a consequence a trend follower will never be the first to enter a trend manifesting in the markets. A trend follower will never buy the bottom or sell the top. In this sense, trend following is a reactionary strategy.

Entries Are Counterintuitive

So trend following means your strategy will never allow you to buy market bottoms or sell market tops. But what does our brain tell us we have to do to make money in the market? Exactly, it wants us to buy at a low price and sell at a high price. And the lower the price of an instrument falls the higher it can rise later the more money we will make with less risk. Right? Wrong, wrong, wrong. In trading it is all about reward to risk. It does not matter whether we buy low and sell high and make 500 pips or whether we buy high and sell a little higher and make only 100 pips only to watch the market rise another 100 or 200. All we have to consider is the reward/risk ratio (and our winning percentage, see my post about why trading strategies work). The trend following trade which takes 100 pips of “the meat in the middle” with a 33 pip stop-loss is superior to the trade grabbing 500 pips with a risk of 250 pips. As simple as that. But this is against what human nature and our brain want us to do!!! You always think you are late. And you will always look stupid if a trade does not work out, because your brain sees that the trend had started way earlier and you were just late with your entry. You would have made money had you entered the trend earlier. So there you go, this is one of the top reasons why trend trading is tough as hell.

Contradictory Data

The other top reason why trend trading is hard is that for any definition of a trend you will have contradictory data. If you are like me at least. Whenever I trade I do my due diligence and analyse markets top down. I look at monthly charts all the way down to 15 minute charts if need be. The nature of charts is that whichever instrument you look at in 99% of the cases you will find contradictory trends depending on which time frame you look at. Here is an example of cable ($GBPUSD):

What is the trend? My (arbitrary) definition of a trend is the 89 period exponential moving average and looking at these charts the answer to the question is “it depends”. We have a monthly downtrend, a weekly transition from down to up, a strong daily uptrend, same for the 4h, the 1h is choppy sideways and the 15 min has fallen strongly to establish a downtrend. So again, you can let this contradictory information paralyze you or you take a stand, follow your rules and look stupid when your trade goes sour. Why look stupid? Let say I trade the uptrend on the 4h for a trend continuation and get stopped out then my brain will see the 15 min and tell my what an idiot I was to enter long. The 15 min trend was clearly down!!!

Oh yeah, you might decide to wait until all timeframes line up in the same direction. This is of course possible, but unless you want to wait for record breaking markets like the $SPX500 or bitcoin each time you trade you will have to make some compromise with the circumstances.

Trading Countertrend

There you have it, those are my top two reasons why trend following is so damn difficult! And at the same time that explains why trading against the trend, buying a falling market or selling a rising market is so appealing. Because in those cases, all timeframes are aligned to give the same signal. What looks oversold on the monthly and weekly will definitely look oversold on the daily, 4h and 1h. That comforts our brain and lures us into counter trend positions that are often the wrong decision. And it animates us to double down when prices falls even further because what was oversold before us then mega-oversold, right? But a weak market is usually weak for very good reasons and no one knows when the decline will stop. It might go to zero and destroy your capital. The only protection that traders have is to know when their idea is wrong and get out of the trade, at the risk of looking stupid when the market turns right back in its original direction.

Even though the rules we define for ourselves are arbitrary they are the only option we have. If you have no rules you will sooner or later have no money because you take the mother of all losses and get margin called.

I hope this is useful. What are your thoughts on trend following and this article? Please let me know in the comments below.

Understand Why A Trading Strategy Works

Whatever The Input To Your Trading Strategy

There is a very simple fundamental truth to any trading strategy out there. Whether you are a discretionary trader, a fundamental trader, a quant, a mechanical technical trader, or maybe you simply trade your gut feel or let your monkey throw darts. Whatever it is, your strategy is somewhere on the following graph.

The Reward-Risk-Ratio vs. Win Percentage Continuum

The Two Parameters For Any Trading Strategy

Two parameters determine the profitability of your strategy: the win percentage in combination with your reward-to-risk ratio (RRR). The win percentage is the average number of profitable trades out of 100. The RRR is the average size of each winner compared to its initial risk. Say you have a very simple strategy where each of your trades has a predetermined entry, stop loss and profit target price. And your potential profit on each trade is exactly the same amount of pips as your potential loss, so your RRR is 1. What follows is, that you will break even as a trader if you win percentage is 50%. The classical coin flip.

So Which Trading Strategies Work?

In the above chart you will be on the dark blue line with a strategy resembling the classical coin flip of 50% winners and 1:1 RRR.  The dark blue line describes all combinations of win percentage and RRR that break even. Any strategy with a combination of win percentage and RRR which puts you below the dark blue line (in the lighter blue area) and you are losing money. So you absolutely must have a tuple of win percentage and RRR that puts you above the blue line, safely in the promised land of profitability. The further you can move away from the blue area the closer you are to the “holy grail” of trading. It’s that simple!

How Order Flow Logic Should Improve My Trading

We all know those dreaded situations. We enter a trade with our best judgement, following the trend etc. etc., we place our stoploss with great care and consideration. And still Mr. Market seemingly knows what we do and think. With uncanny precision price will come to our stop loss, trigger the order and subsequently turn around to fly in the anticipated direction of the trade we had.

So recently I have found the Youtube videos of some people, one of them being Mark Chapman. He does a good job explaining why these “stop hunts” happen and how big institutions need to find pockets of liquidity to fill their massive orders. So what I have been playing with is actually playing those supposed stop clusters as entry signals.

As with any technical strategy you can find lots and lots of examples where this would have worked. Look at this recent uptrend in EURUSD on the 4h chart:

Numerous times we could have prepared for those stop hunt dips and profited by buying with the market makers.

So let’s see how this plays out in real-time trading. In my initial back-test it actually worked out ok on some charts. But also it got me stuck in some positions when the trend turns. I think I can possibly work that out with small position sizing.

Backtest of a swing trading strategy on EURUSD daily chart from 2014 until today

Goal

No matter how hard I study the markets and how well I think I understand the fundamentals, my predictions of what price should do are mostly crap. Maybe I just don’t have the talent.  Also, I am much more drawn to following price action rather than playing the long-term game of “when will everybody else wake up to the over-/undervaluation that I have already figured out before everybody else”! Wait, when I read that I can confidently state that I am not that smart. I will never be that guy. So all thats left for me is technical chart analysis or price action.

Hope

So I have been working hard to put my visual predispositions into something of a valid strategy. And the results give me hope that I have created something of value. I am documenting it here, feel free to backtest yourself, refine, copy, pick my brain. If you have suggestions on how to improve it, I would be happy to hear from you.

Setups

The basic idea I am trying to realize is to swing trade in trend direction. Nothing unique about that. So we roughly four things: a definition of trend, entry signals, stop losses and take profits.

Trend definition

The trend is simply a set of exponential moving averages which all more or less point upwards in an uptrend, all more or less point downwards in a downtrend, or are mashed up in a sideways market. I don’t follow this religiously and sometimes still trade even when the trend is not clearly defined because the dominating signals in my strategy are given by trendlines.

Entry signals

I have a couple of entry signals here explained for long trades in uptrends:

  • 3 Drive: Draw a trendline through two troughs, the third touch of that downward sloping trendline will be the entry signal
  • Trendline Break & Retest: a downward sloping trendline which is drawn through peaks is broken to the upside and subsequently “retested” again from above.
  • Channel completion: A downward sloping channel is drawn through two peaks with the parallel line attached to the trough formed in between those peaks. Enter on a touch of the lower channel boundary.

Stop Losses

The stop loss on each trade is very simply a fixed amount of pips from the entry price. The amount of pips depends on the volatility of the traded instrument and timeframe. A good starting point for stop loss size on daily charts is about 0.8 – 1.2 % of price. So for example on EURUSD which trades at a price of roughly 1.20 the stop loss I use is currently 100 pips.

Take Profits

Profit targets are determined more or less like the entry signals. So mostly the completion of a 3 drive or a channel in trend direction.

Results

So let’s get to it. I have tested this on several pairs and on daily and 4h timeframes with very promising results. Here I will show my backtest for EURUSD on a daily timeframe for the period from 01.01.2014 until 20.09.2017. Here are the stats:

 

Charts

And here comes each individual trade in a sequence of images to understand the results and setups in detail.