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!

Chart check ahead of FOMC

Yellen’s last FOMC

Tonight at 8pm CET the Fed will publish their latest interest rate decision and FOMC statement. It’s going to be Janet Yellen’s last official act as head of the Federal Reserve before she is succeeded by President Trump’s pick as the next Fed chairman, Jerome Powell.

Although some experts have voiced opinions of 3-4 hikes in 2018, the consensus does not see any interest rate hike in tonight’s meeting. Thus, the focus will be on the FOMC statement and its wording. As this is Yellen’s last FOMC she will possibly leave office with a more hawkish stance than shown during her term. This pattern was previously observed with Bernanke as well.

Chart Analysis

So here is a break down of some charts that interest me ahead of the release. Let’s start off with the Dollar Index #DXY.

The USD weakness smashed through all trend supports on timeframes shorter than the monthly chart. The question is when the relief rally will start. The north American economies still seem to be in best shape of all and certainly have been the only ones raising interest rate substantially from GFC levels. For the Fed I don’t see an end to the hiking cycle and with inflation picking up in the states the pressure to raise will not subside.

A possible explanation for recent USD weakness is the expectation that other central banks around the globe soon follow suit and enter a prolonged hiking cycle to fend off accelerating inflation. This would lead to bond yield convergence. And to be clear, a bond yield spread for the 10 year between the US and Germany of more than 2 % is unsustainable in my opinion. Said in other words, the US 10y bonds yield is more than four times higher than that of the German 10y! By my logic interest-seeking capital thus flows into the USD.

EURUSD

This leads us to the #EURUSD chart shown below.

As we can see, EURUSD trades at trendline resistance on the monthly chart. It already stalled at this level and I find it a great setup to initiate an extended relief rally. I see downside targets at 1.2160 and around 1.1915.

Commdolls

The two currencies I also find vulnerable against the USD are the Aussie and the Kiwi. They both delivered an extended rally and are ripe for a setback. In the case of the NZD I even consider selling a projected channel completion at ~0.75.

In AUDUSD the channel completes higher as shown in the daily.

AUDNZD

These observations coincide with the #AUDNZD chart analysis. AUDNZD is in a bullish trend on the weekly and until proven wrong I’m biased bullishly. Although last night’s selloff warned me that anything is possible at any time.

So I am positioned for a relief rally in the dollar and hope tonight delivers some volatility in my favor.

Disclaimer

Please note: I am an amateur retail trader and nothing I write is meant to be investment advice. Always do your own analysis and take responsibility for your own investment decisions.

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.

Weekly Wrap

$AUDUSD, $NZDUSD

The commdolls continue to flush down the toilet. I mean look at the ozzy accelerating through any childish trendline I can draw!

And I continue to get myself into trouble with these pairs. I see the larger pattern potentially making a bearish extension, but of course I can’t help myself and trade some of the support zones on the way down, building a position that’s flashing red. And red is bad! Arrgh! On a positive note, it looks like the channel completed on Friday is holding. On a sucky note, for the trade I took off of that channel that should have brought some release to the bleeding, I mistyped my order size and forgot two zeros. Whatever, I have seen worse! 🙂

$XAGUSD

Anybody watching that silver? It’s been playing dead since days or even weeks, but on Friday finally pushed out of that triangular compression. Wohoo!!! Not yet super bullish IMO, but let’s see if next week brings some follow-through. I wouldn’t mind seeing it above 18.50 soon. Keep tight stops, this fickle biatch can turn on a dime. If it trades back into the triangle my world view changes back to depression. All about that dollar, so watch $EURUSD / $GBPUSD for hints!

$EURUSD, $GBPUSD

Speaking of majors, euro and cable, I mean…WTF? Euro shoots up vertically, I get kicked out of my $EURUSD short, and now? Come on, show that this was real! Ok, here is some context. Reaaaally fu**ing long-term (weekly):

Channel resistance put the pair under pressure around 1.20 but the downside was muted and pretty much called into question by this week’s impulsive rallye. An run up to 1.25 would make sense to complete two waves up. Which is where I will potentially be a seller again. This bias can change if we see weakness on the lower timeframes. Here is my 4h:

This bullish channel that’s currently supporting price might actually offer very nice RRR for bullish continuation trades. But thats very aggressive. I’m not sure I can handle that. On the flip side, no bearish trades as long as this holds!

Cable is a bit more ambiguous. We are locked in an arm wrestle between bulls and bears on the weekly.

It’s kind of like brexit all over again. The decision of up or down is 50:50 but will have yuuuge consequences. And maybe it is about Brexit. Maybe May may not be in control much longer? There are rumors. And my gut says not matter what happens the pound will thrive. It’s been beaten down for years and other nations’ politicians have jealously observed that the UK accomplished what everybody else dreamed of. A depreciating currency. So a snap-back could happen and it could be big. Ok, thats my gut talking and there is a lot of shit in my gut. Don’t bet on this!

$DJIA

One more thing on my mind, look at this 4h chart of the Dow:

Does this look bullish to you? I think it’s going down baby! Down!! Until it doesn’t and Apple reveals iPhoneXXX for 5k dollars which makes everyone project a trillion $ profits per day and buy Apple stock to the moon. And dragging FANG and Tesla along because because. And Nasdaq rises to the moon, which means the dow at least goes to the sky. You get the point. Careful with stocks!

 

Always remember this is not investment advice, I am just writing for entertainment purposes. Do your own analysis!

The “Technical Evidence” For A Bigger Correction

The number of markets that are currently trading at technical targets/resistance is staggering. Usually these targets act as resistance and suggest a bigger correction. I expect stocks to sell off and a little more volatility in the coming weeks.

$Nikkei was one of the first markets to show a reaction after bumping up against resistance.

Next up is the German $DAX, which crumbles rather slowly but has already given back over 400 points from its all-time high. Price action in the $DAX looks very healthy though. Looking with my bullish lense, there is a chance that the $DAX is simply retesting the breakout point from the large channel (solid blue lines).

Moving on to our US American friends. US stocks have gone almost vertical for such a long time that most traders forgot corrections and sell-offs even exist or are too young to have experienced one. $DJIA has been one of the strongest markets and has overshot a couple of major technical levels before this trendline on the weekly chart. $Nasdaq has been the stallion in the stable but it too is trading at a level at which bears commonly come out of hiding. The $S&P500 shows a perfectly clean long-term channel completion. Similarly the $Russel2000 small cap index has completed a long-term channel.

A $GDX Trade With Awesome RRR

RRR-wise, it can’t get much better than this $GDX trade! My estimate is an initial RRR of about 20:1!!! How are the odds that this plays out as planned? I don’t know, as I have never backtested wedge breaks. But it doesn’t really matter that much, be it 50% win ratio or 20% or even 10%, this bet is good! Let the wedge break to the upside and long the shiz out of it. Stops below the recent lows or below the supporting trendline.

* Please don’t take this as investment advice. I’m just presenting my opinion about the market.

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.

 

DAX finally completes ascending channel

The German DAX finally touched the upside of a long-term ascending and immediately gets rejected almost 150 points. Technically this provides an opportunity for a bigger correction, but with all this central bank support of the financial markets you never know. Anyway, I am still cheering for a correction, I have not managed to participate in this rallye enough!