Now that we are only a few weeks away from the end of the calendar year and the start of 2018, the time has come to look back over the year. Which trading strategies have performed best in the Forex market so far?
All trading strategies can be broken down into two types: trend trading strategies, and mean reverting strategies. With trend trading strategies, traders define the direction of the longer-term trend and enter trades only in the same direction. Mean reverting strategies define an average price, and traders seek to enter trades back towards the average when the price has become over-extended away from it. As over 80% of the volume of the Forex market is traded in just EUR/USD, GBP/USD, and USD/JPY, I’m going to apply a rough strategy of each type to these three major Forex currency pairs and see which came out ahead. I’ll then dissect the results and see if it tells us anything useful about the way the Forex market is evolving.
Trend Following Strategies
My favorite basis for a trend following strategy, because it is so elegantly simple, is just to check the opening price of each week to see whether the price has been going up or down over both the past three months and six months. If yes, then that’s the trend direction, and each week is just measured as a trade from open to close without any stop loss. If these results are good, then any trend following strategy should also have produced positive results. So, here are the results for 2017 to the end of October:
Winning Trade %
This is a poor result – it would be negative if the costs of all the trades were factored in. In my blog I wrote recently about using linear regression analysis, and I found that using the slope of the line of best fit over the past 20 weeks can work better. What if we try this trend-following method?
Winning Trade %
Using linear regression, we got an even worse result. So overall, we must conclude that trend following strategies have not worked well this year. This isn’t surprising: trend following strategies tend to go through lengthy periods of losses, before profiting excessively during big winning streaks.
So, what about mean-reverting trading strategies?
Mean Reverting Strategies
Mean reverting strategies, as I explained earlier, are the exact opposite of trend following strategies. This suggests that 2017 should have been a good year for this type of trading strategy, so let’s test a couple of good mean-reverting strategies on the same three Forex pairs.
The first strategy is to wait for a weekly candle to make a new high or low – we will try the same period as the last test, 20 weeks. If the candle makes a new high and then closes down, or makes a new low and then closes up, enter at the open of the next week and close at the end of that week. Here are the results:
Winning Trade %
There were less than 10 trades in total using this strategy, but the overall result was slightly negative. This strategy did not work well this year. Let’s look at another typical mean reversion strategy, which uses the Bollinger Bands indicator, set to its standard 20-day, 2 standard deviations bands, on the daily chart. This strategy waits until a daily candle touches one of the outer bands, and then enters once the price breaks past the other end of the candle (i.e. the candle is reversed). The trade is then held until the opposite extreme band of the Bollinger Bands is reached. Unfortunately, this strategy also produced a negative result. There is one final pure mean reverting strategy which has worked well in the past that is worth back testing: whenever a weekly candlestick moves from open to close by more than 2% in value, enter a trade in the opposite direction at the start of the next week, then close it at the end of the week. This strategy only gave a few trades all year, and the result was, again, a small loss.
A ”Time of Day” Trading Strategy
There is no doubt this has been a hard year for Forex traders. It seems that all types of mechanical strategies, whether trend following or mean reverting, would, at best, have failed to make any profit this year. Trying to find a mechanical trading strategy which did perform well, I looked at a “time of day” strategy based upon the position at 9am London time compared to the previous midnight, on just EUR/USD and GBP/USD. This strategy exploits the statistical tendency of the London and New York sessions to follow any clear lead given by the Asian session, which begins at roughly midnight London time. The rule is simple: if the price is at least 25 pips higher at 9am London time than it was at Midnight, go long, or short if at least 25 pips less. The trade is closed at 5pm New York time, and no stop loss is used. There results for 2017 until the end of October were as follows:
Winning Trade %
These are impressive results: not only is there a high winning percentage of trades, but the average result per trade was very good (about 10 pips for EUR/USD, 3.5 pips for GBP/USD). Even when you factor in the spread / commission, it was a nicely profitable strategy. Yet this is the only “brainless” trading strategy I know of which was a winner in 2017. Unfortunately, it was a tough year in the Forex market.
I’ve only looked at the Forex market, even though many Forex brokers also offer trading in major stock indices and commodities. Major stock indices, especially U.S. indices such as the S&P 500 and Dow Jones 30, have been in strongly bullish trends the entire year. If you buy stocks directly, the highest leverage you can get is perhaps 3 to 1, but many brokers offer 20 to 1 on major indices. The S&P 500 Index is up almost 16% year to date, and at leverage of 20 to 1 you could be up 320%, although there is a risk of being wiped out at such leverage in the event of a major market crash slipping a stop loss by more then 5%. Many brokers also charge expensive overnight fees making it costly to hold these positions for many weeks or months.
If you do use trend following strategies based upon price alone, don’t panic. A bad year is not unusual. Some of the best years for trend followers come just after very bad ones. It could be that the Forex market is getting more chaotic and harder to trade, yet there is no rule that you must stick to Forex alone. Stock indices and commodities often provide opportunities when the Forex market is flat.