In order to succeed at trading a trader must have an edge, and by edge I mean something to tip things in the trader’s favour and give them something better than even odds over the market’s randomness. In this article, I am going to look at what works as a tradable edge in the Forex market and why. Remember if you want to have an edge in forex trading, first of all you need to compare the best forex trading companies out there and then choose the one that suits you the most.
If markets were purely random then no trading system or strategy could ever succeed as there would be nothing to give us odds greater than 50/50 of being right and nothing to give us anything other than a 50/50 chance of gaining more on a winning trade than we would lose on a losing one. A trader simply cannot succeed without something to either tip the frequency of winning in their favour, or something to tip the size of the winning trades in their favour.
If market prices were entirely random then traders would lose as often as they won and their winning trades would (on average) be the same size as their losers. In this scenario traders would slowly lose all of their trading capital as the costs of trading (usually the spread) slowly bleed their accounts dry as they won and lost in equal amounts. Fortunately for traders however, market prices are not random – yes there is a huge amount of randomness in the Foreign Exchange market, especially on short time frames, but market prices are not entirely random in the long-term.
If market prices are not random then the next logical question for traders to ask themselves would be ‘in what way are market prices not random?’ Once a trader understands the answer to this, they can then begin constructing an edge to take advantage of these non-random statistically significant price movements.
If prices are not random, and this non-randomness can be determined by looking at past prices (technical trading), then the price will have to be doing one of only two things: Either a significant price movement will be more likely than not to revert back towards its recent average (reversion to the mean), or a price movement in one direction will be more likely to continue that not (a trend in one direction). If the market’s price after a significant movement is just as likely to revert back towards its mean as it is to continue in the same direction then the market would essentially be moving at random and hence untradeable.
So which is it? Are market prices more likely to revert towards their means (recent average values) or are trends more likely to continue than not? Well the answer to that question depends entirely upon the market which one is trading and in the Foreign Exchange market the answer is that trends, once they are in place, are more likely to continue than not. Of course all market trends end eventually and no matter how strong a trend is and no matter how long it has been in place for it could still end in the next 5 minutes, however once a trend is in place then the price is more likely to continue to move in that direction than it is to reverse and this is about the most we can actually say about it, but it is enough. It is enough to give us a tradable edge over the randomness in the Forex market.
Currencies tend to trend as their values are driven by large, powerful macro economic forces such as government and central bank policies and national trade surpluses and trade deficits which don’t tend to change much on a day to day basis. Once these powerful economic forces start to move the market in a certain direction it will usually continue for quite some time albeit with some temporary price corrections occurring now and again. I should warn the reader now however that these days most markets do not tend to trend particularly well. As a general rule, any market that is driven by short-term speculation and human emotions will revert back towards its mean rather than trend.
In order to demonstrate the effects of mean reversion and the trend on different types of markets I am going to do the following two experiments on ten years of historical data for the EUR/USD currency pair and the S&P 500 index. The first experiment is to demonstrate the effects of mean reversion, the experiment is as follows: If the market closes lower than it did yesterday then go long, and if the market closes higher than it did yesterday then go short. Doing this on the S&P 500 and the EUR/USD on ten years of historical data produces the following results –
Number of Trades: 2,511
Number of Winning Trades: 1,326
Number of Losing Trades: 1,185
Percentage of Winners: 52.81%
Number of Winning Points: 13,463.55
Number of Losing Points: 10,985.80
Win to Loss Ratio: 1.225 to 1
Number of Trades: 3,064
Number of Winning Trades: 1,533
Number of Losing Trades: 1,531
Percentage of Winners: 50.03%
Number of Winning Pips: 89,211.3
Number of Losing Pips: 89,151.0
Win to Loss Ratio: 1.001 to 1
On the S&P 500 index we have slightly more winning trades than losing trades with winners being larger than losers producing a win to loss ration of 1.225 to 1. On the EUR/USD however it has no significant effect whatsoever.
In experiment two I am going to test the effects of the trend on ten years worth of historical data for the S&P 500 stock market index and the EUR/USD currency pair. The experiment involves entering a long position whenever the market closes higher than it has ever closed in the previous 16 weeks, and entering a short position whenever the market closes lower than it has ever closed in the previous 16 weeks. All trades are automatically closed 2 weeks after they were first opened (this is known as a time based exit). The results are as follows –
Number of Trades: 373
Number of Winning Trades: 169
Number of Losing Trades: 204
Percentage of Winners: 45.31%
Number of Winning Points: 5,178.95
Number of Losing Points: 5,243.76
Win to Loss Ratio: 0.988 to 1
Number of Trades: 365
Number of Winning Trades: 218
Number of Losing Trades: 147
Percentage of Winners: 59.73%
Number of Winning Pips: 44,395.8
Number of Losing Pips: 32,790.8
Win to Loss Ratio: 1.354 to 1
If trades were entered randomly and exited with a time based exit then winning trades would be as common as losing trades and winning trades would (on average) be the same size as losing trades. This experiment demonstrates that entering a trade once a trend is in place is not a random entry but that it only provides us with a tradable edge on the EUR/USD currency pair and not on the S&P 500.
The Forex trader’s edge, my conclusion,
I have done many more experiments like these on currencies, stock market indices, commodities, and many other markets. These experiments consistently show that an edge exists in following the trend in the Foreign Exchange market but that this edge does not exist on some other markets. I have never found any real solid evidence of any edge other than the trend working on currency pairs when back-testing trading systems and strategies on historical data. But now that we have an edge we can use it to create a rock solid Forex trading strategy that actually works.