A Channel Breakout Trading System for Forex Traders

11/12/2010 12:01 am EST

Focus: FOREX

Using high-volatility channel breakout-style trading systems has historically worked well across major currency pairs, but the forex strategy has shown itself quite vulnerable to shifts in market conditions. Such streakiness makes it a prime candidate for volatility filters, and FX options volatility expectations show promise in determining the opportune time to trade the channel breakout trading strategy.

Channel Breakout Trading System: Strengths and Weaknesses

The channel breakout trading indicator is impressive in its simplicity, and yet has shown promise as a standalone trading strategy. The concept is straightforward: Draw a line at the highest high of the past N number of bars and the lowest low of the same. Such lines provide the channel, and the channel breakout strategy simply seeks to trade breakouts in either direction.

Channel Breakout Indicator on Euro/Dollar Currency Pair

On the chart below, we can see the channel breakout indicator and several hypothetical trades using channel highs and lows as entry points.

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At first glance, we can quickly get a good sense of where this strategy has succeeded and failed in the past. The strategy buys the EUR/USD at the pair’s highest high of the preceding 20 days and sells the lowest low. If price quickly retraces, it will have bought and sold at the worst possible prices, and as such, it does poorly in range-bound markets.

Forex Options Market Volatility Expectations: Predicting Market Conditions

As in other trading systems we will discuss later on MoneyShow.com, we will once again use forex options prices to read market volatility expectations. The following section is a direct copy from the earlier article and readers may skip it if they are already familiar with the concept of implied volatility of FX options:
Volatility expectations are a very important factor in determining the price of an option. An option will become more expensive if traders expect the underlying currency will move substantially through the specified time period. In fact, we can look at an options price and derive the “implied volatility” that tells us exactly how much current options price predicts the currency will move through its expiration. We already use these indices in several DailyFX reports, and it is a natural extension to discuss how they can come in handy for our benchmark RSI strategy.

In our weekly forex strategy outlook, we use a specific derivative of implied volatility levels to determine our strategy biases for individual currency pairs.

Volatility Percentile – The higher the number, the more likely we are to see strong movements in price. This number tells us where current implied volatility levels stand in relation to the past 90 days of trading. We have found that implied volatilities tend to remain very high or very low for extended periods of time. As such, it is helpful to know where the current implied volatility level stands in relation to its medium-term range.

We will extend this idea to develop a trading filter for the volatility-sensitive channel breakout strategy with the following trading rules:

NEXT: Channel Breakout System Rules Explained


Forex Channel Breakout System with Volatility Filter Rules

Entry Rule: Set a stop entry order to buy the currency pair at its highest high of the past 20 bars plus one pip. Set stop entry order to sell the currency pair at the lowest low of the past 20 bars minus one pip.

Exit Rule: Strategy will exit a trade and flip direction when the opposite signal is triggered. It will also close any open trades if the volatility filter crosses the aforementioned threshold.

Filter: Strategy cannot enter trades and must close any open trade if the volatility percentile goes below a specific threshold.

Backtesting Our Channel Breakout System with Volatility Filter

We ran this strategy on the EUR/USD, GBP/USD, USD/JPY, USD/CHF, USD/CAD, AUD/USD, and NZD/USD pairs using their respective volatility values. We assume transaction costs of three pips on the EUR/USD, USD/JPY, and USD/CHF, and four pips on the others. Below are the hypothetical equity curves of said strategy run on four different volatility filter thresholds.

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Though past performance is no guarantee of future returns, the strategy shows promise in trading these select currency pairs. The baseline “unfiltered” channel breakout system does reasonably well for such a simple trading idea.

Looking at the breakdown between different volatility filter thresholds likewise shows some promise. The most aggressive filter—cutting off trading unless the individual volatility figure is below its 90th percentile—seems to do relatively well on a risk-adjusted basis. According to hypothetical estimates, the 90th percentile filter would have cut the strategy’s worst peak-to-trough drawdown from $16,900 to $8,700 in that stretch and resulted in higher final equity.

The equity curve shown for the 75th percentile cutoff shows a slightly higher drawdown than that of the more aggressive 90th percentile cutoff, but the difference in final equity theoretically makes its risk-adjusted returns the best of any of our five equity curves. This filter level seemingly allows the strategy to participate in many of the best stretches of performance while protecting it from slower-moving markets.

Our worst performers are the 50th and 25th percentile cutoff levels. Though the lower of these seems to keep the strategy out of the worst periods of underperformance, the 50th percentile figure keeps the system out at the wrong times, while not doing enough to protect against drawdowns.

Based on our hypothetical results, it seems that fairly aggressive volatility filters do a reasonably good job in protecting against periods of underperformance in the channel breakout strategy.

Applying Our Analysis to Existing Strategies/Trading Styles

Hypothetical backtests show that the channel breakout strategy performs respectably over the past five years of trading, and baseline results improve noticeably if we introduce an implied-volatility-based filter.

Though past performance is never a guarantee of future results, our backtests suggest that the volatility-friendly channel breakout system performs less favorably if our volatility levels are below their 75th percentile of the preceding 90 days.

By David Rodriguez, quantitative strategist, DailyFX.com

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