How to Distinguish Good and Bad Trading Strategies
If you plan on being successful as a Forex trader, you need to be able to distinguish between good and bad trading strategies. While the most obvious way to measure success is to look at the profits and losses columns for any given strategy, there are other things to consider when choosing a trading strategy.
Trading strategies should be personal
Trading strategies should be personal, and for very good reason. This is because the markets are very volatile and very emotional at times. A lot of traders implement risky trading strategies, and that might not be the best option for you. For this reason alone, if you’re thinking of copying someone else’s trading strategy, you should look past the nuts and bolts of the strategy and consider the risk management aspect as well, to determine if it’s right for you.
Be brutally honest: If you are not comfortable hanging onto a trade in the strategy or placing the trades according to any rules that are part of that strategy, it doesn’t matter whether this strategy has a longer-term profitability expectancy or not – it will be difficult for you to follow the rules and you will not achieve optimal results.
Expectancy is a word that you should use quite often, especially when determining whether a trading strategy is good or bad. A trader will understand that the system that they trade has a good chance of making the money over the longer-term based upon this figure. Expectancy is figured by taking a calculation to the results to figure out the typical profit for each trade place. If it is negative, the strategy is a loser. If it’s positive, then that strategy is a winner. The calculation combines how many trades are typically one with the average loss on losers and the average gain on winners being the formula.
The mathematical formula to calculate expectancy is:
(Win % x Average Win Size) – (Loss % x Average Loss Size)
This gives you an idea of how much you can expect to make per trade. It doesn’t matter whether you make money most the time or very infrequently, it comes down to what the overall math works out to. For example, there are traders out there who will make money 15% of the time, but those wins are so much bigger than their losses that the system proves to be profitable. The question of course is whether you can hang onto a strategy like that? Most people can’t, so clearly you need to give that some thought.
Does a strategy depend on a specific set of variables?
Some strategies depend on a specific set of variables or inputs. For example, there is a strategy out there known as the “London daybreak strategy”, that focuses on what London does when British and European traders come on board. This is because the largest amount of liquidity during the day is during the European session, so it makes sense that perhaps the big money is moving the market in a particular direction. Obviously, if you are working or sleeping during that time, that strategy won’t work. It doesn’t matter whether the strategy works or not in this case – what matters is that it won’t work for you. Fortunately, there are enough strategies out there that can work within your confines, so all you have to do is find one with variables that match yours.
One of the things you should keep in mind is that markets change. Sometimes it’s that sentiment wavers, sometimes it is the overall trend that changes (some would argue that these are the same thing). Many long-term traders are very hesitant to change a strategy that’s used on a daily basis, but realistically speaking, sometimes the situation demands that you do so. This is why you should always be looking for potential changes in performance of any trading strategy. A truly good strategy will adjust to new market conditions, while a bad strategy might continue to run when it’s not appropriate.
For example, markets may suddenly become quiet for several days in a row, and you need to understand how to trade this. Obviously, a longer-term trend following strategy is not going to function as well in this scenario. Because of this, most traders will need to have a couple of different systems, but you should recognize that it’s important to use the right system in the right scenario. What I mean by this is that something that uses that the stochastic oscillator typically won’t function well in a trend but does quite well in consolidation. Obviously, something that it’s expecting the Bollinger bands to offer trading opportunities will tend to do much better in some type of trend or at least overall volatility. By knowing the scenarios that the system tends to focus on, then you can trade the appropriate system at the appropriate time, and don’t get hung up on the results by themselves as some systems simply are not meant to be traded in certain scenarios. Simply put, even the best strategies don’t work at all times, so it’s a good idea to keep a few solid ones in mind to trade when the market changes.
I believe that systems are like tools. In other words, you should be able to apply the correct tool for the correct job. I also believe that there is no “magic bullet”, so you should be cautious about thinking along those lines. There is a well-known axiom in the business that you can give two traders a winning strategy and expect completely different results. That’s the most important thing to keep in mind. Any trading strategy can be good or bad, depending on how and when it is implemented.