- Markets have an average daily trading range, which can be defined as 'normal'
- We know how far FX pairs oscillate in any one day, we can approximate new trends
- With liquid pairs like GBPUSD, EURUSD, USDCAD, 45 pips appeared regularly
- If stop is hit at 46 pips, we also know a new trend direction is taking place
- The back-tested trading strategy outlined here produces surprising results
- Mainstream indices, especially futures markets, have similar quirks of 'normality'
It's helpful to perceive when there's a change of direction... Photo: iStock
Each and every day we measure '"normality" in multiple ways. We walk at a measured pace and our strides are mundane, one foot ahead of the other. In other words, we all know what "normal" means to us. We know from experience that our strides shorten when walking uphill, but that effect is within what we perceive as ''normal''.
Markets are no different. They all have an average trading range each and every day. We can easily utilise an average true range, or ATR, setting to determine over a predefined period of our choice what would be regarded as average or normal for our chosen market. In earlier articles, I have mentioned trading standard deviations, which essentially is seeking to trade within the normal market range/patterns. But what can be done when the market's moves exceed our perception of normal?
First let's ask "what happens if we miss a move?" Can we assess what our chances of success would be in chasing a missed move? For clarification there is a 73.8% chance that your trade would be successful, as is fully described via this link
All simplistic so far. But we also know where to place our stops; we carefully assess our chosen markets and determine where the optimum stop placement should be to give our opening trade room to move and subsequently generate a profit. Again, I have provided some eight months of trade strategies and updates for you to peruse in the history files on this site. So let's look at the ''optimum stop''. If you place a stop at a point where you know your trade is wrong and has failed, then ask yourself if would you then turn your trade around and open a contra trade. Bear in mind that, if your stop has been hit, clearly the market has moved against you.
It is impossible to answer the above question definitively as some trades may have very tight or very wide stops, and the contra move may well be a short-lived impulse. Remember, however, that we know what "normal" is for the market. We know how far we can expect forex pairs to oscillate in any one day, so we know by approximation how far outside the norm a move must be before the market heads into a new trend.
We know from experience what "normal" is. Photo: iStock
Sticking with the value ''optimum'', when we back-test currency strategies for efficacy and maximum drawdowns, success rates etc, we see something interesting. Using only liquid pairings, such as GBPUSD
, and even the yen, when trying to maximise success and ensure profitability greater than the current risk-free rate of return for the year and above the index growth rate, we saw 45 pips regularly appear.
In other words, the natural harmonic number or vibration of the general marketplace is 45 pips. So, when we open a trade strategy, we know a stop of 45 pips is the optimum point before we can expect the market to turn in the opposite direction. If our stop was hit then at 46 pips, we also know a new trend direction is occurring.
All straightforward enough, but can we improve on this? A potentially successful trade strategy can be ruined by seeing your stop hit before turning the trade. What we really need is the optimum point for a trade entry without having to endure a loss in the first place.
If you recall, I mentioned normality for a marketplace. What if we measured 45 pips from the end-of-day closing price how successful would a trade be if we simply set an order to go long/short 46 pips away from the close price, and would the trade prove successful?
The results are surprising. But first let's see what occurs if these orders were filled:
- More than 90% of these trades exceeded 12 pips minimum profit.
- 18% exceeded 100 pips profit
- Average profit, however, was 29 pips
- Optimum stop: Yes, you've guessed it, at 45 pips
So an average scenario of 90% success and 10% loss equates to nine good trades to one duff trade.
- So nine successful trades with the average gain = 9 x 29 pips = 261 pips profit
- Thus one loss of 45 pips
- Net gain = 261 - 45 = 216 pips
But what if we use the weakest data and assume our successful trades only made 12 pips each time?
- Nine successful trades x 12 pips = 108 pips profit
- One unsuccessful trade = 45 pips loss
- Net gain = 63 pips
On Monday, September 12, Cable would have earned 20 pips. On Monday, September 13, at the time of writing, it would have earned 35 pips.
I will post live updates and an overview after the article appears.
What is interesting is that not only forex markets have an optimum, but mainstream indices, especially the futures markets, have similar quirks of ''normality''.
Who knows, but perhaps we should consider presetting orders for the minimum move as our ''norm'?
With liquid pairs like GBPUSD, this strategy generated nine
successful trades to one duff. Image: iStock
— Edited by John Acher