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Trading Against the Crowd - Automate the Momentum1 Trading Strategy

By , Quantitative Strategist
27 February 2013 12:00 GMT

In our guide to FXCM Speculative Sentiment Index-based trading strategies, we discussed the “why trade against the crowd?” with a specific look to our SSI. This article covers the “how can we trade against the crowd?” with a closer look at the Momentum1 trend trading strategy.The Momentum1 trading system is our purest trend-trading strategy. We need to emphasize that past performance is not indicative of future results, but the system has historically done well in times of long-term currency trends.

Trading Rules for the FXCM Speculative Sentiment Index-Based Momentum1 Strategy

forex_automated_trading_speculative_sentiment_index_body_MirrorTrader.png, Trading Against the Crowd - Automate the Momentum1 Trading Strategy

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Buy Rule: If the Speculative Sentiment Index shows there are more than 1.5 traders short for every one that is long (60% of traders are short), buy one unit.

Sell Rule: If the Speculative Sentiment Index shows there are more than 1.5 traders long for every one that is short (60% of traders are long), sell one unit.

Profit Targets: Momentum1 does not use fixed profit targets. Instead the system takes profits via a trailing stop loss.

Stop Losses: Calculate the Average True Range (ATR) on the past 14 daily bars. Set a trailing stop 1 ATR away from entry price. If short, this means placing a trailing stop above entry price and will move lower if and when the currency moves lower. If long, the system places the trailing stop below price and moves higher if and when the currency pair trades higher.

Reviewing and Understanding the Logic of the Momentum1 System

Entries: If SSI shows there are more than 1.5 traders long for every short, sell. If SSI shows there are more than 1.5 traders short for every long, buy.: This is a trend trading system that looks to take advantage of what we know about forex trading crowd behavior. Put simply: when everyone is buying or selling, it is often advantageous to go in the opposite direction.

Our data shows that the trading crowd is actually successful in most of their trades, but when unsuccessful their losses outweigh their gains. Most traders tend to buy weakness and sell strength, and this approach works well in quiet markets. In times of strong trends, however, our SSI data shows that most are unprofitable. The Momentum1 strategy looks to take advantage of this pattern and go against crowd sentiment extremes.

There is an important distinction in both trading logic and historical performance between this strategy (Momentum1) and our Momentum2 trading system. The first is obvious: Momentum1 looks at the absolute level of crowd buying/selling, while Momentum2 trades the shifts in crowd sentiment.

In practice, this means that Momentum1 tends to enter trades less frequently and more slowly than Momentum2. Yet it is far less likely to change directions rapidly during one-sided market trends. It will tend to stay long or short for more extended periods of time than Momentum2.

Exits: Take the daily Average True Range (ATR) of the currency pair for the past 14 days. If short, place a trailing stop 1 ATR above entry price which moves lower if and when price declines. If long, place stop 1 ATR below entry price which moves higher if and when price advances.

Momentum1 uses no hard profit targets and instead relies on a trailing stop loss to ultimately take profit on its trades. Why?

The system does best during times of strong market trends. In trend trading, it is important to not limit profits when the trade is in your favor. Thus Momentum1 simply trails its stop lower or higher with strong market moves.

This system is based on a strategy that did not use profit targets or stop losses at all, and the ATR-based stop can thus serve as a general guide instead of a hard level. In other words, we believe the system can work best when we manually set profit targets and stop losses based on our own risk parameters.

The mix of hard profit targets in our Breakout2 trading system can serve as an attractive template to managing Momentum1 trades.

Sample Trades from Momentum1 as shown on a EURUSD Daily Chart

forex_automated_trading_speculative_sentiment_index_body_Picture_6.png, Trading Against the Crowd - Automate the Momentum1 Trading Strategy

Strategy Tips and Resources

Not all market conditions suit the Momentum1 trading strategy, and as such there are definitely factors to keep in mind before taking any of its trade ideas. Our research on crowd behavior shows that most do poorly during times of strong market volatility and/or powerful currency trends.

In our Weekly Strategy Outlook report, we cover market conditions with a special focus on volatility and prices in forex options markets. We report the “Trendindicator for individual currency pairs. Momentum1 tends to do better when a currency pair continues to hit fresh highs or lows.As such, we’ll tend to prefer trend trading when that Trend indicator is below 25% or above 75%.

Our research likewise shows that volatility and trends are quite correlated. Thus strongly volatile markets may likewise encourage us to select the Momentum1 strategy. Our Forex Technical Analysis page shows a daily update of our Volatility Percentile figureas well as our Trend indicator:

forex_automated_trading_speculative_sentiment_index_body_Picture_7.png, Trading Against the Crowd - Automate the Momentum1 Trading Strategy

Past performance is not indicative of future results, but our experience shows that using the Volatility Percentile and Trend indicators helps improve performance of the Momentum1 trading system.

Automate our SSI-based trading strategies via Mirror Trader free of charge

forex_automated_trading_speculative_sentiment_index_body_MirrorTrader0.png, Trading Against the Crowd - Automate the Momentum1 Trading Strategy

View Previous Articles on Automating DailyFX and DailyFX PLUS Strategies

View how to automate the Breakout2 Trading System via our previous article and webinar recording.

View how to automate the Momentum2Trading system via our previous article and webinar recording.

Automate the DailyFX Breakouts on Volatility System article, webinar.

Take advantage of forex intraday seasonality via our DailyFX Asia RSI Trading system, view archived webinar.

Why do most forex traders lose? How can we avoid common mistakes?

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

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27 February 2013 12:00 GMT