Trend following – trading with the trend – is the easiest and simplest way for traders to make money in financial markets. Trend following usually works less well in the Forex market, but if you stick to the three major currency pairs and follow multi-month trends, you should have made money over recent years, provided you used even a half-decent trading strategy to trade with the trend. The real problem is knowing whether your specific strategy is good or, even better, close to optimal. It is correct to follow principles such as keep your losers small and let your winners run, certainly. Yet beyond that, how can you know whether you are doing the right thing?
Back testing strategies to see how they would have performed against good-quality historical data is a must and will tell you something important if your test includes hundreds or even thousands of hypothetical trades, stretching over a lengthy period. This should ensure it captures a range of different market conditions, so your results are more realistic and reflect how the strategy is likely to perform in the future. Yet how do you know if the strategy is good enough?
A possible solution is to use a generic measurement of trend over the back-test period, which indicates how strong and smooth the trend was, and compare that to strategy results. If your strategy performs well when the generic trend is strong and badly when it is weak, it is more likely to be a robust trend-following strategy. If the opposite is the case but the results are still positive, then your system might have just “got lucky” over the test period – which could be disastrous in live trading going forward.
In one of my next posts soon, I will examine some metrics that can be used to create a trend-following benchmark for measuring trend-following trading strategies.