| Timing Your Entries in a Forex Trading System |
In this lesson we will specifically talk about the questions related to building entry rules in a system. Trading systems often fail because the trader fails to educate himself in these simple points. What you will learn in this lesson:
- How variability can make or break a system - System builders encounter common entry mistakes that lead to losses - Forward testing and backtesting are vital to determining entries
Article Continues Below. Click on the pairs below for analysis, charts and data
Step one: Define your entry In this lesson, the example we will use is a blend of technical and fundamental information to create an entry possibility. We advocate trading the trend, which is something you will hear a lot from traders in most markets. However, identifying the trend is sometimes tricky. The hardest part of any trend identification process is finding a potential long term move without incurring short term loss. In the process of this, some trend traders suffer whipsaws.
In our example for this lesson, we'll define the trend by looking at the PFX COT report. To learn about the COT report, click here. The report tells us whether the insitutional money of big banks is net long or short a pair.
If institutional traders are net long, we will be looking for long entries. If they are net short, we will be looking for short entries. You can find the COT report for each of the majors in each pair's dashboard by clicking on the flags for the pair you're interested in. Complexity #1: Entry Date New system traders are always asking us to evaluate a system they have produced that seems to be delivering results that are “too good.” Having a trading partner(s) evaluate your system is a great idea, and can save you from making a lot of mistakes.
I bring this up because a common problem I see in systems testing is an early entry. In other words, when backtesting, the trade was executed before it actually would have been entered in real life. This is a very common problem for system testers working by hand as well as backtesting software packages.
In the example below, I am showing a trading signal on the EUR/USD using this entry idea. As you can see the CCI actually crossed above the -100 line with the rally on the 12th (point A.) However, I would not have “known” that until the period closed so my entry would have actually been on 12/13 (point B).
As you can imagine, not accounting for this correctly will get you into a trade before you actually knew it was going to happen and will overstate results. This is the most common problem I have encountered with new system traders and backtesting.
Complexity #2: Entry Price “Slippage Happens.” It can be tempting to assume that you would have executed your trade at the open of the period. However, slippage will often occur. Slippage is that price movement between the time your signal was triggered and physically entering the order. Unless you have perfect execution every time, there will likely be some price movement between the signal and actually entering the order. You can handle this in two ways. First, you could randomize your entry price from the range of prices available during that period. Most backtesting software will allow you to do that.
I recommend that rather than randomizing the entry when you backtest, you add a slippage factor to your entry. Therefore, instead of entering this position at 1.4587, which was the open price on 02/13, I assumed the entry took place at 1.4607, which is 20 pips the wrong direction. I like to use about 20% of the normal daily range for a currency pair as slippage.
Complexity #3: Trading costs In the spot forex, we don’t usually pay commissions, but you do pay a spread. The cost of the spread will vary by pair and I usually add the spread in a particular pair to the “slippage” factor I discussed in Complexity #2. In this case, it will bring my entry to 1.4610.
Although it should not be a factor on the EUR/USD, interest charges may affect your trading costs on some pairs. You should account for this in the same way your included spread and slippage costs. You could also add to your rules that you would not trade against the interest payment. That means you wouldn’t have shorted the USD/JPY during most of this decade.
These items may not seem like much, but they can take the edge away from your profitability. As a general rule, overstating your trading expenses will help you plan for the “unknowns” that will inevitably occur in the live market.
Complexity #4 – Is it executable? There are a lot of good trading ideas out there that work on paper but cannot be deployed in the live market. Sometimes the problems that make a system unexecutable are hard to see. Fortunately this is an easy problem to solve. Trade the entry with a small investment, or paper trade it several times in a dry run to identify problems that you may not have noticed during development.
Now that you have done this work you can start to decide what your positions will look like, and you can develop your exits. This will allow you to establish your win/loss ratio before creating a money management strategy. In the next section we will continue this system’s development by creating exit triggers.
Be sure to watch the video at the top of the page. Next, be sure to read Backtesting Software for Trading Systems.
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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