Forex Holy Grail Performance Update

04/18/2014 9:00 am EST

Focus: FOREX

Adam Lemon of DailyForex.com provides an update to his three-part series on following a statistical approach to trading the forex market.

A couple of weeks ago, we published the latest installment in our “Holy Grail” series, showing how a couple of fairly simple strategies performed over recent years.

An “out-of-sample” analysis of the same strategies has now been completed. This analysis looks at the hypothetical performances of the same strategies but over a different time period. It is always important to perform such an out-of-sample analysis when examining trading strategies. Our original statistics were based upon performance from the beginning of 2011 to the end of 2013. The out-of-sample analysis was conducted from the beginning of 2008 to the end of 2010, i.e. the immediately previous period of equal length.

The results were fairly disappointing. The “reversal” strategy was somewhat profitable when traded with profit targets between 3:1 and 10:1. The “trend” strategy was not profitable on any profit target ratio. The numbers were as follows:

“Reversal” Strategy

chart
Courtesy of Marketscope 2.0
Click to Enlarge

“Trend” Strategy

chart
Courtesy of Marketscope 2.0
Click to Enlarge

In spite of the disappointment, it is worth noting that the “reversal” strategy, even without a directional bias, was proven to be potentially profitable during the out-of-sample period.

It is also worth noting that no technical criteria were used to select these currency pairs, at least for the out-of-sample test.

However, a strategy that is prepared to hold positions for long periods of time should be able to do much better than this, for the following reasons:

Overnight Charges
Brokers charge a small fee for every night you keep a trade open (in some cases, they may pay you a small rebate). This is due at least partly to the interest differential between the currencies. Many brokers also charge an additional fee, which tends to mean that you almost always pay something overnight. Something in the region of seven to 10 pips per week is common. This means that if you hold a trade for a 3,000-pip gain, but it takes a year to get there, you could pay something like 520 pips, giving up about one-sixth of your gains. The effect of these charges has not been included in the data presented within this series.

Pair Selection
One of the most commonly overlooked decisions a trader can make is which pairs to trade. Deciding which pairs should be traded at any time is probably the most important part of any long-term trading strategy. Often, traders instinctively diversify, which has some advantages. But during those periods where almost the entire market is ranging, even diversified traders can suffer serious losses.

Directional Bias
A long-term trading strategy should be able to include a directional bias on each of the pairs it is trading. This means adapting to market conditions and deciding to only take either long or short trades, or perhaps both but differentially weighted. This should improve results dramatically as a strong trend would naturally result in the survival of multiple stacked positions that together create exponential profits from any strong trend, provided the bias is correct.

Moving Ahead
Next time, I will outline how a long-term trading strategy can be constructed in a way that works with rather than against the problems we looked at previously. The strategy will:

  • Begin with a methodology for selecting which pairs to trade and which directional bias to take, based upon the weekly time frame.

  • Continue with an entry strategy on lower time frames that is designed to ensure maximum “survivability” of positions, based upon the four-hour time frame.

  • Conclude with a complete exit strategy.

By Adam Lemon, Contributor, DailyForex.com

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