Finding the Holy Grail of Forex Trading

03/21/2014 9:00 am EST

Focus: FOREX

Many newbie traders believe that in order to make money in the market, they have to find the perfect trading system, but it doesn’t have to be that way, says Adam Lemon of DailyForex.com.

This is a title that is hard to read or write without smiling. The “holy grail” is the mother of all forex jokes and cynical constructions. Yet it exists, is staring us all in the face, but is widely ignored, because the psychological stresses of working with the grail are paradoxically greater than most people can cope with.

Before the existence of the holy grail can be proven, it has to be defined, as many grail hunters are not really clear about what it is they are looking for.

The Forex Holy Grail Concept
The holy grail is a system or strategy with clear rules that works well enough to ensure effortless trading which is profitable overall. Very often such a system is seemingly found, only for it to fail later, at which point the grail quest must begin again. This is also a larger metaphor for the journey undergone by many retail traders as they struggle to achieve profitability by hopping between different systems and styles.

The major mistakes that less experienced traders make when they build strategies are either to base them on too limited an amount of historical data, or to over-optimize them with too many indicators that make it curve-fitted. This is important to understand, and if you are one of these traders, the sooner that you come to the realization that this is a fruitless and time-wasting path, the better it will be for you. I hope this article will shorten your path to profitability.

The Holy Grail Revealed
The answer is simple. Instead of trying to build the perfect strategy that most profitably fits the historical data, take a step back, relax, and contemplate the big picture of how markets statistically tend to move. After all, as the holy grail is surely a robustly profitable trading strategy that never stops working, logic holds that it has to take advantage of a permanent and persistent “flaw” or phenomenon in the market. So forget about candlesticks and indicators for the time being, and think about speculative markets. What phenomena do they exhibit that might be exploited by the trader? There are two that are common and repetitive:

Mean Reversion – after the price pulls away from a longer-term average price, sooner or later it always returns to the average price, which is another way of saying “what goes up, must come down”.

Fat Tails Within the Returns Distribution Curve – in plain language, markets tend to overreact, rising and falling excessively due to the human sentiments of greed and fear acting upon market participants.

Can either of these phenomena be exploited? Looking at mean reversion first, it is possible but problematic, as stop losses may need to be very wide and profits are by definition limited. I cannot see this as the basis for a holy grail.

The overreaction of markets and their tendency to produce excessive returns on a statistical basis is the holy grail, or rather, provides the basis for a holy grail: a methodology that will make effortless profits over time.

The best way this can be explained is to imagine taking a handful of salt grains and throwing them up in the air. Suppose you were then able to measure the distance of each grain of salt from the throwing point. You would find that most of them would be relatively close to you, with a few outliers that had travelled further away. If you make a graph showing the distribution of the results, the graph would look like a bell curve, which is a typical and “normal” distribution:

chart
Click to Enlarge

The bottom axis shows the distance travelled by each grain of salt. The percentages show how many grains travelled each given distance.

Now suppose that you were constantly buying and selling randomly in the forex market, and you measured and recorded the maximum possible gain of each trade over thousands of trades and thousands of days. If you constructed a version of the above graph with those results and superimposed it upon the earlier graph, the result would look something like this, with the dotted lines representing the market’s returns distributions:

chart
Click to Enlarge

NEXT PAGE: Even the Holy Grail Has Pitfalls

|pagebreak|

So, it can be established that speculative markets such as the forex market produce more excessive returns, both positive and negative, than can be expected from a “normal” returns distributions model. A greater number of excessive price events happen than would normally be produced by simple randomness. In plain language, the market offers more big winners and losers than it really should.

Here is the holy grail: the use of tight stop losses will remove the excessive losing events, and the use of wide take profit targets will allow the “fat tail” of excessively positive returns to be captured. Yes, it can be this simple, although it is not without a few potential pitfalls.

In order to illustrate exactly how the fat tail phenomenon can be exploited, let’s examine some back test data run on gold and the major yen crosses from 2011 to 2013 over a period of three years. These were the most volatile and trending instruments in the forex markets during most of this period. If a very simple trading strategy of entering upon the next bar break of any engulfing bar on the H4 chart in the direction of the engulf was followed, using a stop loss placed just the other side of the engulfing candle, the following results would have been achieved by instrument and reward to risk profit targets:

chart
Click to Enlarge

Notice how a very simple, straightforward strategy that takes no account whatsoever of trend, direction and support and resistance can be made into a positive expectancy of 53 cents gain for every dollar risk, simply by not taking profit until reward has reached 50 times risk!

It would be simple to improve these results by moving stop losses to break even after a certain period of time on every trade. This is because the strongest winners usually will only retest the entry, if at all, relatively quickly.

Even the Holy Grail Has Pitfalls
The holy grail exists, but it has to be handled with caution. You can find the grail by trading the right instruments that move with maximum volatility, i.e. those markets that are most attractive to speculation, and using simple entry strategies to ensure you participate in the market’s excessive movements in the direction of your trade. You do not have to be right or forecast the major moves: you just have to be there, cut your losers short, and let your winners run. The natural tendency of the market to produce fat tails will do your work for you.

There are two major pitfalls that this might lead you to. The first is that you will be better served by a more intelligent exit strategy than simply aiming for a fixed reward to risk multiple. You need to be booking wins above 10 R:R, ideally towards 25 R:R or even beyond, but each trade will be different. Look to exit around those levels but use some intelligence and discretion. Also, being prepared to move stops to break even when the trade is a certain distance or time in profit should help.

The second major pitfall lies in the fact that this type of strategy will always produce very low win rates, where you will lose as much as over 90% of your trades. This will inevitably cause very large losing streaks, which will severely test both your mental strength and your money management strategy. The grail gives gold, but it is hot to touch and burns the unwary! Do you have what it takes to sit through twenty or more losing trades in a row? Do you have a money management strategy that will properly protect you from ruin should you begin with a long losing streak? Will you be diversified and uncorrelated enough in order to keep losing streak risk to a minimum?

One final danger is worth a mention. It is natural to try to filter entries. However, it is very problematic to distinguish entries that are likely to reach a ratio of 25:1. Furthermore, missing just one of these winners will set back your overall expectancy, unless the method used will also filter out at least 25 losing trades at the same time.

These are some questions to ponder and investigate. Spend some time back testing. The holy grail has been placed in your hands!

By Adam Lemon, Contributor, DailyForex.com

Related Articles on FOREX

Keyword Image
The Fabulous Shrinking Renminbi
09/27/2017 1:13 pm EST

As of August 2015, renminbi (RMB) in payments globally accounted for 2.8 percent of the total, the f...