How to Overcome Trading Mistakes - Part 3

04/10/2014 9:00 am EST

Focus: FOREX

James Stanley

Trading Instructor, DailyFX Education

In this third and final article of the trading mistakes series, James Stanley of DailyFX.com takes a look at the importance of strategy selection.

In our first article in the series, we looked at the value of risk management to traders. In our second piece, we took on the topic of leverage. Now, we'll examine strategy selection.

Guessing is not a solid trading strategy. A large portion of traders entering markets hope to develop a "gut instinct" or "feel" for the market that will allow them to know exactly what they should do at exactly the right time.

Most people will eventually find that this effort to develop a "super-natural" feel for future price action to be a fruitless one. Most of the best traders in the world have a strategy or multiple strategies for trading in markets; and new traders should be no different.

In this article, we’re going to discuss not only the importance of having a strategy, but the importance of using that strategy in the right situations.

‘Holy Grails’ Do Not Exist in Trading
The most common action a trader embarks upon after realizing the necessity of having a trading strategy is trying to find the "best" strategy.

In this stage, it’s normal to see traders stacking seven or eight indicators on top of each other on the chart; looking for ways to "build a better wheel." The common logic is that if an indicator like RSI can be helpful for entering positions, adding in a moving average or stochastics should make the usage of RSI even more effective. It’s almost as if traders in this stage feel like they can corner price where it has to move in the direction that they want.

Technical indicators can be fantastic additions or elements of a solid trading strategy; but please be careful when it comes to assigning any "predictive" qualities to any of these indicators. In reality, all technical indicators are built off of past price action…and the past is never going to be perfectly predictive of the future, no matter how much we might want it to be.

Rather than over-complicating the strategy, traders should look at the other elements involved in the strategy’s success, such as choosing the right market environment to employ.

The Importance of Using the Right Strategy at the Right Time
As we had done in our previous two articles, we’re going to incorporate the DailyFX traits of successful traders data to illustrate our points.

DailyFX's David Rodriguez investigated which trading session had amounted to the greatest profitability for FXCM clients during the observation period. Within the report was a fascinating observation that speaks to the importance of employing a strategy in a conducive environment.

David took a very simple strategy, using only RSI on the 15 minute EUR/USD chart to enter and close positions. When RSI crossed up and over 30, that was a buy; and when RSI crossed down and through 70, the strategy would close the long position and go short which would close at the next RSI move up and over 30 while triggering the next long position (this is called "Stop and Reverse logic," where the strategy "stops" the current position and reverses with a new position).

This was a very simple strategy using only one indicator on a very short time frame chart, and, as you can probably imagine; the results weren’t pretty:

Simple RSI Strategy didn’t perform too well on EUR/USD 15-minute chart

chart
Click to Enlarge

NEXT PAGE: What Else Denotes a Strategy’s Effectiveness?

|pagebreak|

As you can see from the equity curve above, just letting this RSI strategy run with reckless abandon didn’t bring on great results. As a matter of fact, this $10,000 account would have lost everything in less than 10 years, and there were only a couple of periods that actually saw the account grow.

But, as we said earlier—traders should look at the other areas of a strategy that can allow for success, such as the time period with which it’s being employed.

David took this simple RSI strategy to the next step: He filtered it so that it would only open trades during the Asian-trading session. The rationale behind this is sound: The Asian-trading session will often have a tendency to range (at least more so than European and American sessions), and RSI is a mean-reversion, range-trading type of indicator.

The difference in the strategy is shocking, and once again—the only filter or differentiation is that the strategy is now only allowed to open positions during the Asian trading session.

Simple RSI strategy set to ONLY trade during the Asian-trading session (in gold)

chart
Click to Enlarge

With the filter in place to only trade during the Asian-trading session, the strategy performed significantly better. And remember, this is just a simple RSI stop and reverse strategy.

Does this mean that anyone should trade this simple RSI strategy just because it fared well in the observed period when filtered for the Asian-trading session? No. This is simply to illustrate that the entry mechanism is just a small part of the overall strategy’s effectiveness.

What Else Denotes a Strategy’s Effectiveness?
In the first article in this series, we looked at the importance of risk-reward ratios. Bad risk reward ratios (losing way more when wrong than winning when right) was the number one mistake forex traders make.

This is a huge part of a strategy’s overall effectiveness because, as we showed in the article, even a strategy winning 65 or 70% of the time can lose money if it uses poor risk management.

After that, leverage can have an enormous impact on the strategy performance because if too much risk is being taken on with each entry, five or 10 bad trades can completely wipe out a trader’s account.

Constructing a strategy based on a desired market condition can help traders build the most effective system with narrow focus and aim for a specific type of environment. So, for instance, if a trader wants to build a strategy to trade trends, they should avoid using that strategy in breakout scenarios. Or, if a breakout strategy is built to trade in fast and active markets, it shouldn’t look to use wide stops and risk amounts, allowing false breakouts to bleed against their equity for prolonged periods of time.

After traders have decided which market condition they want the strategy to perform optimally in, they can then decide on optimal time frames for the strategy analysis and execution.

By James Stanley, Trading Instructor, DailyFX.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...