4 Reasons Why Forex Trading Systems Fail - Part 2

06/13/2014 9:00 am EST

Focus: FOREX

Forex traders are always in search of an edge, that winning trading system, but coming up with a consistently profitable one is not easy, notes the staff at FXTM, and what looks good in theory doesn’t always work well in a live market environment.

Many trading systems look good on paper and cunning system developers and fraudsters often use this fact to promote a forex EA or trading system product that actually has no chance in the real world. Some of these products will come with slick marketing materials that offer the potential to substantially increase your income from trading.

It’s fair to say that the majority of these products are scams; although there are a few legitimate systems among the crowd. In order to realize why these trading systems don’t work it’s important to note how a profitable system should be designed in the first place.

Market Inefficiencies Have Disappeared
For any trading system to be effective, forex or otherwise, that system relies on taking advantage of an inefficiency in the market that allows a profit to be made. Since forex markets are highly competitive, such inefficiencies are extremely small and the margin of error very tight. These inefficiencies get even smaller on short time horizons since the commissions of trading play a bigger part.

To come up with a working system then is to find an inefficiency in the markets, a pattern that can be traded for a profit time and time again. The problem is that when other traders latch on to the same inefficiency (or pattern) they will quickly erode the profitability of the pattern by trading it. Because the inefficiencies are so small it will not be long before the opportunity disappears completely and the system will likely not work again.

Careful system design requires exploring different parameters, different patterns, and opportunities over different market conditions. It is actually very easy to come up with a system that produces good, steady profits and this is what many system developers and promoters are able to do. The problem is that often they will completely forget to include one of the most important elements of system design.

Commissions are set by the broker and are the cost for placing and exiting a trade and as such need to be included in system back-tests in order to produce reliable results—results that have a chance of being replicated in real markets. It’s also important to take care of slippage and to set commissions generously so that the system has some margin of safety.

For example, the cost of trading EUR/USD is not zero, it is usually around 2-3 pips. So this cost should be incorporated into the system tests, otherwise they are completely worthless. If you have a system that is profitable but has an average profit of 2 pips per trade, such as a scalping system, then including the commission would easily wipe out the profitable expectancy of the system.

By the Staff at FXTM