The trend is your friend. We’ve all heard it.
In hindsight – it almost seems too easy. Buy before a prolonged uptrend and just ride price on the way up. The trend can seem so clean when looking back in time – that we can’t imagine ever questioning the strength behind the bullishness that propels price even further.
In actuality – catching these moves is much more difficult than at first glance. By the time price has started to run up, we wonder if the train had already left the station; if it’s too late to put our money on the line in an expectation of that huge initial move continuing. If price had, by chance, pulled back – we question whether or not the original move was fake and beginning to be retraced upon. These are quandaries that speculators have faced for years. This is exactly how the Breakout trade was borne.
Traders would observe that as the market was making new highs, or new lows – price could continue to trade in that direction. The art of trading a breakout is just that – identifying the high and low points with which the trader wanted to look for price to run in that direction.
There are numerous ways of denoting a ‘new high,’ or a ‘new low.’ One could wait until only annual highs or lows (on a rolling 12 month period) were made, in search of the ‘cleanest,’ moves that a currency pair makes. However, that could be a tedious task as annual highs and lows aren’t made very often and trading breakouts in this style would leave the trader with only a few valid entries every year.
However, many traders have looked for and found ways of trading this style while still receiving enough ‘entries,’ to stay interested in the strategy. One of the more popular methods for doing so entails the use of Price Channels.
Price Channels will show the trader the highest high, and the lowest low – for the last X periods; with X being a variable input by the user for the number of candles or bars to look back.
For example – a Price Channel with an input of 20 on the EUR/USD hourly chart will show us the highest high that was attained, and the lowest low that was reached during the last 20 hours.
As you can see – as new lows are made – the lower price channel will accordingly move lower indicating that the lowest low for the last 20 periods is being made.
Traders adopted this indicator so that as a new high was made – they would go long; and as new lows were made – go short. This is a basic price channel strategy utilizing each breach above and below the 20 period price channels. Positions are closed when a counter-signal is generated (example – long position is closed when price hits lower price channel and the strategy goes short).
As you can see below – upon adding the Price Channels strategy to the chart – Long positions are opened on a breach of the upper price channel – short positions being opened on a hit of the lower price channel.
The difficult part of the strategy is when the market is range bound: Long positions that get opened at resistance or Short positions that get opened at support are stopped out as price fails to make new highs or lows.
Running this basic Price Channel Strategy on an hourly chart of the AUD/USD, we see what would have amounted to extremely variable performance.
In the equity curve below, we are looking at a hypothetical account with a starting balance of $5,000 and an estimation of the performance that this strategy would have offered in the past. As you can see – at the end of the testing period – the strategy was positive (By approximately $390 or 7.8% of the initial starting balance). But throughout the testing period – performance was extremely variable.
You can see multiple points throughout the testing period (hourly data from 8/13/2009 to current period) in which the strategy would have been in a losing overall position.
Many traders attempt to mitigate the damage that can be presented to the strategy in range-bound markets by only trading breakouts in markets that are exhibiting a longer-term ‘trend.’
Once again, there are numerous mannerisms that we can use to define trend but for the sake of testing the strategy – let’s look at one of the more basic: The 2 Moving Average crossover. When employing the 2 Moving Average Crossover as a Trend-Filter, the Fast Moving Average being above the Slow Moving Average would entail bullishness. In these conditions, we would only be taking the long entries on a breach of the upper price channel. Conversely – we would only be taking short positions when the Fast Moving Average is below the Slow Moving Average, and price penetrates the lower price channel.
Adding the trend-filter helped the historical performance of our breakout strategy. By using an input of 20 periods for the Fast Moving Average; and an input of 100 periods for the Slow Moving Average – we can see that the strategy traded with what appears to be a little more consistency.
While the strategy earned only a moderate amount more with the trend filter (net gain on the back-test with Trend Filter is now at $470.10 or 9.4% on initial capital), you’ll notice that the draw-down periods seem less violent and erratic on the new equity curve.
But what if we wanted to take it a step further?
Many traders like to limit the amount at risk on positions that they open. This is very standard with Breakout trading – as false Breakouts (times which price penetrates resistance, but comes right back down) can be abundant. By adding a stop – the trader can potentially mitigate the damage of the ‘false’ Breakouts; while at the same time – allowing the positions that trade profitably to continue to run.
By adding stops and limits, the trader can now calculate their risk on a per-position basis – ensuring that the risk of taking on new positions is going to be adequately compensated by the amount they could potentially gain.
Using a standard 1:2 Risk to Reward ratio (as is advocated as a minimum for this Trading Style in The DailyFX+ Trading Course), we notice the improvement to the historical performance of the Breakouts strategy. The strategy is now utilizing a 25 pip stop, and a 50 pip profit target on each position that is opened.
The strategy now gave us a higher overall performance, producing a back-tested net profit over 100% higher than our breakout strategy using a trend filter, and nearly 200% more than using simple price channels. And perhaps even more attractive, the strategy now back-tests with the consistency of what many traders are looking for.
This strategy has been completely automated for the Strategy Trader platform, and is available completely free-of-charge to anyone interested. This is one of the many strategies found in the “Free Trading Strategies,” found within the forums of DailyFX dedicated specifically for the Strategy Trader platform. You are more than welcome to download, test, and trade with this strategy as well as many others. Please follow the links below for more information:
DailyFX Trading Strategies:
http://www.dailyfx.com/technical_analysis/forex_trading_strategies/
Breakouts Strategy:
Free Trading Strategies:
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