We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site.

Free Trading Guides
EUR/USD
Mixed
GBP/USD
Mixed
USD/JPY
Bullish
Gold
Mixed
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Oil - US Crude
Bullish
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Bitcoin
Bearish
More View more
Real Time News
  • IG Client Sentiment Update: Our data shows the vast majority of traders in Ripple are long at 96.52%, while traders in France 40 are at opposite extremes with 77.95%. See the summary chart below and full details and charts on DailyFX: https://www.dailyfx.com/sentiment https://t.co/lXYqxrSYOx
  • LIVE NOW! Analyst and Editor @MartinSEssex will discuss the most important events and themes that have driven market sentiment and will drive it in the days ahead here - https://www.dailyfx.com/webinars/181540619?CHID=9&QPID=917720&utm_source=Twitter&utm_medium=DFXGeneric&utm_campaign=twr
  • Commodities Update: As of 11:00, these are your best and worst performers based on the London trading schedule: Silver: 0.47% Gold: 0.38% Oil - US Crude: -1.46% View the performance of all markets via https://www.dailyfx.com/forex-rates#commodities https://t.co/ebwfouQlSh
  • Canadian Dollar Weekly Forecast: USD/CAD Reverses Lower, What’s Next? More details in the link below: https://www.dailyfx.com/forex/technical/home/analysis/usd-cad/2020/02/18/Canadian-Dollar-Weekly-Forecast-USDCAD-Reverses-Lower-Whats-Next-MK.html?CHID=9&QPID=917714 https://t.co/EiVBMfDCrE
  • Forex Update: As of 11:00, these are your best and worst performers based on the London trading schedule: 🇬🇧GBP: 0.26% 🇯🇵JPY: 0.15% 🇨🇭CHF: 0.02% 🇨🇦CAD: -0.17% 🇦🇺AUD: -0.41% 🇳🇿NZD: -0.59% View the performance of all markets via https://www.dailyfx.com/forex-rates#currencies https://t.co/FwpqfFNv0d
  • My weekly free webinar on market sentiment is coming up at half past the hour. Do join me if you can. You can sign up here: https://www.dailyfx.com/webinars?ref-author=essex&QPID=917711&CHID=9
  • Indices Update: As of 11:00, these are your best and worst performers based on the London trading schedule: France 40: -0.40% US 500: -0.58% Germany 30: -0.64% Wall Street: -0.66% View the performance of all markets via https://www.dailyfx.com/forex-rates#indices https://t.co/XGUopzAPTp
  • LIVE IN 30 MIN: Analyst and Editor @MartinSEssex will discuss the most important events and themes that have driven market sentiment and will drive it in the days ahead here - https://www.dailyfx.com/webinars/181540619?CHID=9&QPID=917720&utm_source=Twitter&utm_medium=DFXGeneric&utm_campaign=twr
  • LIVE NOW! Currency Strategist @PaulRobinsonFX will keep you updated with the latest movements and trends during the London session for the FX and CFDs Market here - https://www.dailyfx.com/webinars/243785867?CHID=9&QPID=917720&utm_source=Twitter&utm_medium=DFXGeneric&utm_campaign=twr
  • Join @MartinSEssex 's #webinar at 6:30 AM ET/11:30 AM GMT to learn more about trading #sentiment Register here: https://t.co/XUUPRdY06p https://t.co/O3LqxISfjo
Forex Trading Strategy Analysis: Trade with Market Conditions

Forex Trading Strategy Analysis: Trade with Market Conditions

2010-07-19 19:56:00
David Rodriguez, Head of Product
Share:

US Dollar volatility against the Euro and other major currency pairs has made foreign currency trading more popular than ever, but the influx of new traders has often been met with the loss of old as many traders do poorly amidst volatile markets. But why do many traders fail at forex trading? Very often we find that common trading strategies have limitations that few understand. This article attempts to explain why some of the most popular currency trading strategies fail and, more importantly, how to fix them.

improve_your_forex_trading_strategy_part_1_body_Picture_1.png, Forex Trading Strategy Analysis: Trade with Market Conditions

Why does the Average Forex Trading Strategy Lose Money?

Both anecdotally and empirically, we have seen that many forex trading strategies are unable to profit due to 1. poor money management techniques and 2. materially adverse market conditions. The first point is simple enough: good money management means letting your profits run and cutting your losses short. A countless number of trading books advise traders to do exactly that, but we see time and time again that few are able to put such advice into practice.

The second point is less-often quoted but equally important: many trading strategies tend to strongly underperform in specific market environments. If we can recognize a strategy’s limitations in certain circumstances, we can go a long way in protecting capital and preserving profits in unfavorable market conditions. Such dynamics go a long way in explaining why so many traders have lost money through especially volatile forex market environments.

Learning the Strengths and Weaknesses of Different Trading Strategies

Trader 1 – RSI Strategy

Trader 2 – Moving Averages

Basic Indicator

Relative Strength Index (RSI)

Simple Moving Averages (SMA)

Buy Rule

Buy when 14-period RSI crosses above 30

Buy when 50-period SMA crosses above the 100, which trades above the 200

Sell Rule

Sell when 14-period RSI crosses below 70

Sell when the 50-period SMA crosses below the 100, which trades below the 200

We can classify trading strategies into many different groups, but it is useful to go through two examples of materially different styles in recent market conditions. Using our newest offering, FXCM’s Strategy Trader platform, we can code said strategies and use the software’s analytics to learn a great deal about the strategies’ strengths and weaknesses. In the beta version of the Strategy Trader platform, said strategies are labeled as “RSI_LE_SE” and “MovAvg3Line_Cross_LE_SE”.

The above trading strategies are approximations of two distinctly different trading styles, and examining the performance of each reveals many important details. First and foremost, we want to look at relative theoretical performance of these strategies.

Trader 1

Range Trading Strategy

On 60minEURUSD chart

improve_your_forex_trading_strategy_part_1_body_x0000_i1031.png, Forex Trading Strategy Analysis: Trade with Market Conditions

Trader 2

Moving Average Trading Strategy

On 60minEURUSD chart

improve_your_forex_trading_strategy_part_1_body_Picture_3.png, Forex Trading Strategy Analysis: Trade with Market Conditions

Despite the moving average strategy’s impressive outperformance in our 10-year trading period, it remains clear that the range trading strategy was the better option for years at a time. In fact, it seems that moving average strategies lost money more often only make it back in several key instances.

Given such information, we should identify which circumstances we should look to trade using specific styles. Of course, it is virtually impossible to accurately predict which strategy will outperform within a given stretch of time. It subsequently remains critical to use sound money management techniques to protect against the unexpected.

When do we range trade and when do we trade moving averages?

Times of extremely high volatility almost always result in RSI range trading strategy losses, as major breakouts can easily leave currencies in strongly overbought or oversold territory for extended periods of time. Those same breakouts would clearly benefit a momentum-based trading strategy, and the above equity curves emphasize that our moving average trading generated substantial profits through recent price moves.

We need to find a filter that will tell us when to look to trade one type of strategy or look for another. At DailyFX we often make reference to our volatility indices, which use implied volatility levels from forex options markets to gauge overall volatility expectations across key currency pairs. Implied volatility is a key component of forex options prices, and it gives an estimate on how much a given currency will move within a specific amount of time.

improve_your_forex_trading_strategy_part_1_body_Picture_4.png, Forex Trading Strategy Analysis: Trade with Market Conditions

It is subsequently no surprise that our volatility indices correlate strongly to profits and losses from highly-sensitive range trading and momentum strategies. In fact, we see a strong correlation between the Euro/US Dollar 1-month Implied Volatility Index and the performance of both our range trading and momentum strategies.

The strong relationship between performance and our predictive volatility index tells us that we can likely use this volatility measure as a tool to filter our trading strategies. With the benefit of hindsight, we see that the RSI strategy severely underperformed in months where the 1-month Volatility Index reading increased significantly.

According to a simple statistical regression, the RSI strategy never produced a monthly profit whenever the EURUSD 1-Month Implied Volatility level jumped by more than 2 percentage points.

improve_your_forex_trading_strategy_part_1_body_img3.png, Forex Trading Strategy Analysis: Trade with Market Conditions

The link between our Moving Average strategy and volatility is quite similar, and we see that the two tend to move in the same direction.

improve_your_forex_trading_strategy_part_1_body_img4.png, Forex Trading Strategy Analysis: Trade with Market Conditions

Using the same basic statistical analysis, our model suggests that the Moving Average strategy loses every time that EURUSD implied volatility drops significantly. Yet the rule does not work nearly as well as it does for the RSI strategy and serves as a clear reminder that the filter is by no means infallible.

What’s the moral of the story?

We have taken two very common trading strategies and identified the proper market conditions for both. In doing so, we have identified when these trading strategies fail. Though it is unlikely that traders follow these strategies exactly, we can use the same concept on a wide range of similar trading styles. If a strategy depends on strong price breakouts or sustained momentum to turn profits, it would likely underperform during times of exceptionally low price volatility. Range trading strategies, by comparison, would outperform in such environments.

improve_your_forex_trading_strategy_part_1_body_img5.png, Forex Trading Strategy Analysis: Trade with Market Conditions

We encourage you to try FXCM’s Strategy Trader platform for yourself and learn the characteristics of different trading styles—examining when they do well and when they fail. The beta software comes preloaded with a number of benchmark trading strategies that will allow you to gain a better understanding of a great range of systems.

improve_your_forex_trading_strategy_part_1_body_img6.png, Forex Trading Strategy Analysis: Trade with Market Conditions

Look for Part 2 of our newest Money Management and Strategy series using algorithmic trading software on DailyFX.com.

Written by David Rodriguez, Quantitative Strategist for DailyFX.com

To contact the author of this report, write to drodriguez@dailyfx.com.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES

News & Analysis at your fingertips.