Next consider random walk scenarios. When we walk from one shop to another we walk directionally with the expectation that we will successfully achieve this simple task. However, we are also aware of fellow pedestrians and will weave our way through other people's random meanderings. The market is no different. Expect moves in either direction for a minor period of time while the market makes its current trend move.
For this project I am using cash market spot prices of the cable (GBPUSD) as then we have a clean database to work from and it's easy to backtest for years where as backtesting futures has its problems. The cash market will not have expiry days that prevent trading nor will we have to consider rollover points and subsequent liquidity traps.
Stops are preset for a zero-sum basis. In other words, any trades you make over say a three-month period will at worse bring you to the same balance figure. Therefore you are no worse off. Consequently if we apply skew, which tightens the stop to below the zero sum value, you know that over time your account will consistently grow.
This one paragraph should be the concept basis for all your trades. Look at your account balance now and then go back through your account statements for three months and you should be wealthier or at the very worst just the same balance.
There is no trade size being quantified for this trade set up as we only want to build a scaleable strategy so assume our success/fail outcomes will be displayed in real-time points and not in any currency value.
So let's begin.
The most liquid time for this market is 0800-2100 GMT so we will only consider the most liquid timeframe for ease of trading. So far using the close price of each 4-hour candle we seek merely the mean reversion of the current and immediately prior candle.
Profit expectation is strictly the mean reversion. Remember we are looking only at the close price differences and seeking 50% of that difference. Profit target level is defined and limited to this level. Never try and exceed this as that is an untested theorem, which incurs additional risk. We are looking at steady income only.
Next we need to look at what the pre-market ranges are. After all we know Asia has been influencing this market before we even wake up so we need a guidance to start from.
Pre-market ranges I utilise are:
- FTSE100: 0400-0800
- EURUSD: 0400-0800
- Cable: 0400-0800
Let's just use the close price of the 4-hour candle of the above range and compare to the prior 4-hour range close price. Remember we are only comparing close price to close price. Nothing else. The usual market event is to move to the mean of these two reference points. However, the drawback is that we do not know when this will occur.
What we do know, however, is typically how long it takes for the market to complete a mean reversion move described above for 50% of the time or 70% or using a basic distribution curve the optimum number of times you can expect a successful outcome.
Yes we are describing our old friend the zero sum again. We need to find the best trade success to ensure we don't erode our account balance over a period of time – say three months – due to a rogue spike in the marketplace.
An equal and exact opposite effect. Photo: iStock
Now we know where we should be looking for trade success and typically what duration of trade we can expect before booking a profit on balance. We also need to consider if any other signal appears subsequently and should we enter a trade for the next signal.
The early pre-market range is invariably small for the potential profits available so we need to see where our chosen market wanders after the opening bell using the following additional 4-hour close price ranges.
- FTSE100 cash market 8-12
- SP500 cash market 8-12/12-16/16-20
- EURUSD 4-8/8-12/12-16/16-20/20-21
- Cable 4-8/8-12/12-16/16-20/20-21
- USDCAD 8-12/12-16/16-20
This also works, for what it's worth, on Dax, USDJPY and AUDUSD – in fact on most liquid marketplaces. You just need to look for the optimum pre-market 4-hour range.
In the case of the FTSE100 at 1200 (noon) when the next 4-hour candle completes we can compare the close price at 0800 and 1200 and enter a contra mean reversion trade with a 86% probability of success within three subsequent trading (4-hour) candles. Three subsequent candles seems very high but the data reflects the maximum period and it is common to see a move complete in four hours.
The drawback of these trades is obvious: we seek ONLY 50% of the two close price values and we are exposed to unknown adverse market moves. Likewise subsequent candles may well give an opposing signal, which you should take as we are trading from a probability model and each 4-hour close price range is an independent trade strategy to take that is NOT conditional on the prior 4-hour candles' movement.
Last week I posted two such trades on the site. Both proved successful. The success rate on one is currently 22 successes and one failure; the other was 87% success. To maintain fiscal control there are a number of trade stop scenarios you can use – my favourite is a monetary stop.
Select a fixed stop that you feel is the maximum loss you would be comfortable with. Also trade small and often. Small trade sizes inflict little pain for drawdown or stops but the frequency of these trades rapidly accrue revenue for you.
Stops are paramount as events like Donald Trump's win or Brexit would seriously damage your account. These two events were obvious trades to avoid likewise the Federal Open Market Committee should be avoided as the market will be illiquid.
Attached are two charts. The first is the euro spot market using an algo function of mine. It made 25 trades and 23 were successful over the last week.
Total gain: 268 pips
Total losses: 74 pips
This is the cable chart for the same period.
It shows pretty much the same outcome except there were three duff trades where the 50% reversion point failed, but two of those trades still went into profit and at worse you closed out at break-even.
Even if I was trading on a spreadbet account using the minimum £1 per point stake size, my account would be in profit in excess of £500 over one week. Perhaps being average is good?
As usual I will post real-time updates and charts. Hopefully if nothing else it makes readers look slightly differently at their charts and then look at hourly charts too for these scenarios.
– Edited by Gayle Bryant