This site is about Trading Strategy Testing. But as both our Strategy Testing Methodology and Software (“Forex Strategy Tester”) are designed for testing Automated Trading Strategies, we discuss here the backgound as well as some our ideas on their implementation.
Why Is Automated Trading Important?
It is widely stated that 95% of Forex Traders lose money. The reasons are also discussed; e.g. quite deep insight into that we found in highly recommended book “How to make a living trading foreign exchange: a guaranteed income for life” (take a look at our review).
Automated Trading has the potential of overcoming the main reason for trading failures – human nature. This is of course, only a pre-requisite. Proper implementation of an Automated Trading Strategy requires a lot of efforts.
Another major benefit of Trading Strategy Automation is that it allows for Automated Strategy Testing as well, which can be done much faster and accurate than manual testing.
Automated Trading Strategies: the simpler the better?
There is an interesting opinion regarding a good Trading Strategy. Namely, a top-notch trader advises that the Strategy should fit on the reverse side of a business card. Otherwise, it won’t work. Controversial, isn’t it?
However, we find evidence in favor of that point of view. For example, quite similar opinion we found in a popular book “Naked Forex: High-Probability Techniques for Trading Without Indicators”
It also goes in line with an observation that during a stable market, there are no major differences between many Trading Strategies. So, if a market goes sideways, then virtually any major oscillator will give similar signals. The same applies to powerful trends.
And, if we agree with that, the logical consequence is that in the case of Automated Trading, strategies should be really simple, as they need to be fully formalized. Otherwise they can’t be translated unambiguously into the Trading Software.
Let’s take a simple example: an Elliot Waves-based Trading Strategy may suggest entering the markets on confirmation of the 2nd wave. Providing formulae clearly defining this confirmation appears to be much more difficult than making this decision just visually.
In our opinion, we can use quite simple strategies that are best suited for certain market conditions, but carefully monitor that these condition are still applicable. And exit the market or switch Strategies as soon as we notice the change in market behavior.
Our test scenario example #2 illustrates this approach. There we run one of the oscillator-based strategies using our Forex Strategy Tester Software. We can see that the point where the Strategy starts persistently losing money, is situated in the middle of the trend move. It is of course unknown at this time, how long the trend will last. So switching to some trending strategy should have been done or at least stopping the current strategy after the market change has been identified.
Automated Trading Strategies and Market “Uncertainty Principle”
The example above brings us to the observation that there is “uncertainty principle” in trading – between the market forecast and quality of the position that we can take based on that forecast. To get the “big picture”, i.e. decide where the market is moving next, we need to use lagging indicators. So, the better we realize the market pattern, the more time it requires and the market price might have already moved in an unfavorable direction.
Interesting way of addressing this problem has been discussed in the book we mentioned above (“Naked Forex: High-Probability Techniques for Trading Without Indicators”). As seen even from the title, the authors suggest not using indicators. The reason for that is that indicators are lagging markets. This way, in authors’ opinion, there are better chances of getting a good price while entering the market.
We are using multiple timeframes of the same indicators to get the trade-off between the forecast time and market entering price. As an example, the decision to enter can be made when market pattern predicted by M15, is confirmed by M10 and M5 (or M1). This indication is lagging markets, of course. However, due to market fluctuations, quite often a good price can still be achieved – thanks to fast order fill, one of the big advantages of Automated Trading.
Unfortunately, Market fluctuations can also trigger stop-loss orders. So even if the algorithm managed to take a good position, it might have to re-enter the market. Each such iteration brings a small loss, so more potential profit is required to justify taking the position. Using lagging “big picture” as a forecast can help manage risks. So, for example, if we are trying to “buy dips” when the “big picture” predicts we are in trend mode, we can place stop-loss orders at a greater distance, assuming that pullbacks should be short-lived.