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How do we Use Money Management for Moving Average Forex Strategies?

How do we Use Money Management for Moving Average Forex Strategies?

2010-07-26 20:17:00
David Rodriguez, Head of Product
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What can we learn about Moving Average trading strategies?

Good money management comes down to one all-too-popular trading aphorism: let your profits run and cut your losses short. Almost every popular trading guide says this, but all too few give the reader good examples of what constitutes proper money management. Of course, part of the difficulty comes from the fact that there is no definite answer or definitive guide on what to do. Our job is to establish analysis techniques that allow us to determine what to do in specific situations.

For the purposes of this article, we will revisit one of the basic strategies discussed in our earlier introduction: the Moving Average Crossover Trading Strategy. Using FXCM’s Strategy Trader platform, we are able to put a strategy on our charts and analyze the results using high-powered analytical tools. In the beta version of the program, our Moving Average Crossover strategy is labeled as MovAvg3Line_Cross_LE_SE.

Moving AveragesCrossover Strategy

How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_x0000_i1030.png, How do we Use Money Management for Moving Average Forex Strategies?

Basic Indicator

Simple Moving Averages (SMA)

Buy Rule

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

Sell Rule

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

Our basic Moving Average Crossover Trading Strategy has fared well with the Euro/US Dollar through the last several years of trading, as extraordinary volatility benefits the trend-trading strategy. Indeed, moving average strategies exploit major shifts in price action and latch on to trends in their early stages. Yet the strategy is not without its flaws, and the equity curve above emphasizes that it spent many years trading sideways before making its big break. Thus the trick is to devise money management techniques that protect us through times of especially low volatility but do not hold us back when markets break out.

Before we do so, it is helpful to think of what the strategy attempts to accomplish: catch major trends as they first begin. We use three moving average lengths to give us different information about price momentum. If the fast moving average moves below the medium and slower lines, we know that overall price momentum has shifted to the downside. Yet such signals operate with a clear lag, and they imply that price has fallen fairly significantly through previous price action.

How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_CP-10-07-26-02.png, How do we Use Money Management for Moving Average Forex Strategies?

How do we protect against this?

A study of the strategy’s long-term performance highlights its key weakness, and our job is to fine-tune money management to protect against its prolonged periods of underperformance. Our immediate temptation may be to simply place a tight stop loss on our Moving Average system and let gains run. Yet we would need to know what constitutes a tight stop loss for our strategy and how to use it in actual trading.

Setting Stops for our Moving Average Crossover Strategy

The single most important factor in determining where to set our stops is how far adrift a trade usually goes before becoming profitable. Clearly we want to set our protective stop loss at a level such that it will protect us but not interfere with successful trades. As such, we’ll look for the “Maximum Adverse Excursion” of profitable trades and set stops accordingly. The chart below shows exactly how much in losses we incur and whether the trade is, in the end, profitable.

How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_CP-10-07-26-03.png, How do we Use Money Management for Moving Average Forex Strategies?

Our chart once again gives us important insight into the effectiveness of our strategy. For instance, we see that the majority of highly profitable trades have very little adverse excursion; profitable trades are most often correct from the outset. We likewise note that our biggest losing trade was far smaller than biggest gain.

Our chart tells us that any trades with an adverse move of over $150 (in this case, 150 pips) have never turned a meaningful profit. We could potentially limit all trades to a maximum 150-point protective stop-loss, but we likewise note that this may not be the optimal strategy. A very good number of the trades that draw down over 150 pips subsequently retrace and register smaller losses.

Setting Limits for our Moving Average Crossover Strategy

Given that moving average crossovers operate with a substantial lag, it is likewise important to watch for instances in which we can improve returns by setting hard profit target levels. Our analysis for take-profits will essentially be the same as our protective stop levels except in reverse.

How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_CP-10-07-26-04.png, How do we Use Money Management for Moving Average Forex Strategies?

The Moving Average Crossover strategy clearly has big winners, but we likewise see that it has been unable to capture its largest potential profits on a handful of key trades due to its inherent lag. Though we can never reasonably expect to capture profits at the perfect moment, we likewise do not want to throw away several clearly successful trades. Our maximum profit captured was approximately 1750 pips, and a take-profit above this level would have generated a pickup in net-profits.

The next step is to combine our analysis into solid money management. For the purposes of this article, we have the benefit of using the FXCM Strategy Trader software to code our strategies and run powerful analytic tests on our systems. Yet there is no reason we couldn’t do this manually with discretionary trading systems—it would just obviously take more time.

In exploring different stop loss and limit order levels, we are not necessarily looking for the perfect number. Optimizations can be very deceiving because they tell you what worked well in the pastand not necessarily in the future. Given such dangers, we are looking to simply gain a better understanding of the strategy’s relative strengths and weaknesses.

Finalizing our Money Management for the Moving Average Crossover Strategy

The charts below show us the effects of different levels of stop-loss and take-profit levels for our Moving Average Crossover strategy. For the purposes of the Stop Loss test, we assume that the system does not have a set Take-Profit level and vice versa.

How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_Chart_1.png, How do we Use Money Management for Moving Average Forex Strategies?How_do_we_Use_Money_Management_for_Moving_Average_Forex_Strategies_body_Chart_2.png, How do we Use Money Management for Moving Average Forex Strategies?

We discover several interesting facts about this strategy when we look at the optimization results. Though we suspected that placing a relatively tight (150-pip) stop loss would improve results, the strategy would have theoretically turned the highest net-profit with a very wide stop loss. In fact, the highest net-profit was achieved with a stop loss of approximately 400 pips—very difficult to withstand unless trading with very low leverage.

On the flipside, we indeed see that a take-profit of 1750 pips would have resulted in the highest net profit over the course of the past 7 or so years. In other words, our fixed take-profit would be larger than our stop loss by more than 4 to 1. It is critical to stress that past performance is NOT in any way a guarantee of future results, and we urge a great deal of caution against taking optimized parameters as actual guidelines. Yet we gain a great understanding for what may work on this trend-following moving average crossover strategy with aggressive fixed risk-to-reward parameters.

Does an optimized parameter of a 1750-pip profit target suggest that we would make 1750 pips per trade? The answer is a resolute “no”. Such a trade occurred four times in a seven-year period, and our positions were far more frequently taken out by the reverse signal. In other words, our long positions were closed not by a fixed profit target but by the opposite sell signal.

If forced to place a fixed profit target and stop loss on our trades, however, the reward to risk profile would be close to a 4 to 1 in order to maximize performance. That is quite the impressive conclusion indeed and underlines the general reward-to-risk profile of the moving average crossover strategy.

What’s the Moral of the story?

Our money management exploration techniques have given us a clear idea of what to expect from the Moving Average Crossover strategy. Our analysis has lent clear support to the trading cliché: let your profits run and cut your losses short. Obviously it is a good deal more work to perform this analysis on anything that is not easily automated, but it is all the same important to keep close tabs on your particular trading style.

If you swing trade and attempt to capture large shifts in trends, do your trades follow a similar profile? If you think there is an appropriate protective stop loss level for your strategy, it is relatively easy to monitor your charts or demo trade your idea to confirm that it will work. Paying much closer attention to your trading system will teach you everything there is to know about your strategy—highlighting strengths and, perhaps more importantly, weaknesses.

Join the FXCM Strategy Traderbeta test group and try your hand at analytics on the Moving Average Crossover strategy and others. See this FXCM webinar for a how-to guide on the new platform.

Written by David Rodríguez, Quantitative Strategist for DailyFX.com

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

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