What’s Your FOREX Edge? Four Steps to Developing Your Trading Edge
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The goal of this post is to break down into four critical steps necessary to create your trading edge. During this post, I’ll give you some tips from my own experience of over twenty years trading on how to research, test, and trade your edge.
I have experience of trading not just forex but also stocks and options as futures and cryptocurrencies. For a period I day traded futures, and among my long term investments, I have a portfolio of residential rental properties.
The point is, it doesn’t matter what market you trade, or even whether you define yourself as a long-term investor or short-term scalper, you must have an edge. You should be able to explain what your edge is before putting any of your capital at risk.
As forex traders, we define our edge as something we have seen in the market. This event has repeated frequently enough for us to think we can develop a trading strategy around it.
Our edge becomes the advantage we have over other traders.
So our trading edge will define what forex pairs to trade and how to trade them. How to trade them will include the entry, exit rules, rules that are triggered when volatility increases or decreases, rules that might trigger when something else unrelated to the instrument you’re trading occurs.
Ideally, we want to develop a strategy that can be executed trade after trade without hesitation. Did we lose money on the previous five trades? It doesn’t matter; we execute again when the next signal fires.
From these rules, we have a positive expectation that if this edge is traded consistently over the long term, it will lead to profits.
In plain English, that means that we are sure that if we place our order every time we see this event, more often than not, we will have a profitable strategy.
This article is an educational guest post, it was written by Tim Thomas from Tim Thomas Co, How to Trade and Invest for Wealth and Financial Freedom
So, in building our forex trading edge, let’s look at the first step:
Step 1 What’s Our Idea?
We have an idea or hunch, something we’ve seen, a hypothesis that we want to prove.
Some real-world examples of hunches:
- The EURGBP cross tends to trend. If it increases or decreases by at least 1% in one day, in the two days that follow, price continues by a further 2% in the direction of the travel.
- When the S&P500 increases or decreases in value, the USDJPY will typically move in the opposite direction.
- In the week that follows Black Friday, the USDJPY typically increases in value by at least 3%.
- 11 am to 11.30 am GMT typically sees New York traders come online. If the EURUSD and GBPUSD crosses have been trending strongly that morning, the US traders will either validate or invalidate that trend. Therefore, if the trend is still structurally strong, i.e. there are no reversal signs on the price chart, we should be able to join the trend.
Ideas can come through sitting in front of a screen for hours on end, watching price ebb and flow, and seeing patterns emerge. Or an idea can come whilst reading a book on investing or on a Sunday morning, reading The Economist, wondering how strong US economic data might affect Japanese pension funds decisions to hold more USD and less Yen. It could be anything.
You are a trader; you have the right to think freely and independently, so don’t restrict yourself but always think critically and objectively. I can trash 20 hunches before finding an idea that I believe warrants further investigation.
Step 2 Define Our Rules
So far, our initial idea is the basis for what might become our edge. What is missing are the rules for entering and exiting the market.
Let’s work with the first example, the EURGBP pair – we need to develop this idea a little. We must start to define our rules.
The signal will be the daily closing price of EURGBP. Has it closed by more than 1% on the previous day’s closing price?
The close can be positive or negative, so up or down.
If this has happened, the next step will be to define when we enter so for the sake of argument, we decide to enter on at the open on the next trading day.
Now, with the forex markering trading 24 hours a day, 5 days a week, we will need to be clear when the start and end times are.
Typically we will define the open as 10 pm UK time on Sunday and close at 10 pm UK time on the following Friday.
So we can take our close as being 9.59 pm, and our open is 10 pm, Sunday through to Friday. Within this, the 24 hours can be divided into sessions, the first being Sydney, followed by Tokyo, London follows then New York which precedes Sydney.
Each session sees different levels of volatility. In my own experience, the highest activity occurs when New York comes online, which will overlap with London. This overlap happens around 11 am UK time.
So now we have our signal, we have our entry rule and our exit rule will be to exit the position either if we are stopped or if the price reaches our target of 2%.
We can add other exit rules such as what to do if volatility changes but for now, let’s keep it simple with the entry rule and the two exit rules we have.
The next stage is to test our idea with those rules on historical data.
Step 3 Test Your Idea (Backtesting)
Backtesting starts with gathering as much data as possible.
We cannot assess the relative merits of an edge by looking at the results of just one past trade.
When researching, we must look at a large sample size of data, the larger the sample size, the better.
With more data, we can test more, and more testing brings greater confidence that our idea is either valid or invalid. In scientific terms, the larger the sample, the more robust will be our results.
So if we are day trading forex, that means accessing plenty of intraday data, there are providers on the market, Quandl is a such a platform but remember when you’re working with real-time data, you’re likely to pay a premium.
One of the advantages of trading on closing price data is that the data costs are significantly cheaper.
When a trader considers only Open, High, Low, Close and Volume using daily bars, his research can buy 20 or 30 years of data without breaking limited budgets.
So we have our data, now we need a trading simulator platform to test our ideas. There are a few on the market, I have experience of TradingBlox, which is good, but there are others available, all vary in cost and functionality.
The alternative is to turn your rules into logic statements through code and have a program analyze the data based on the parameters you set.
While there will be a learning curve in this process, the good news is that Python is entirely free to use and there are vast amounts of free modules that can make the process of analysis more straightforward and quicker.
If we don’t have time or desire to code, we can hire a programmer from Upwork and give them our requirements. They’ll do the work for us in a fraction of the time that it might take us.
Whether we code ourselves or pay someone to do it for us, the process requires us to think through and explain clearly the signal and rules. We must transfer the strategy that might be in our heads into computer logic.
This process enables us to move away from emotionally driven decisions – the code decides for us.
Keep in mind, trading by algorithm makes up the majority of trading volume during the day, and it will continue to grow. While algorithms do not mean our emotions will disappear. However, they become easier to manage, and as traders, in my opinion, we should do whatever it takes to succeed. If this means delegating trading decisions to code, then we should be at least open to it.
Having done the testing and the results look promising, we can begin to say our trading edge has a positive expectation that over enough trades, our strategy is profitable.
Without this positive expectation, why would we place orders in the market? We would not be trading; we would be gambling, entering orders for the thrill.
Step 4 Forward testing
The results from our backtesting our encouraging so we move into the testing on live data. This stage is called the forward testing stage and is where we apply our strategy and its rules to new live data.
Once again, we can use our trading simulator for this, or with some tweaking to our code the programme can analyze the live data as it arrives.
We are still not putting any money at risk – this is paper trading which will produce hypothetical results that should be close to our backtesting results.
When our simulator or code generates a signal, an entry price is generated along with the time/date we might have achieved had we been trading with real money.
In real life, slippage will impact our results, so the indicated price is just that – an approximate price. When our hypothetical position is stopped or because we’ve reached our price target, we are given an indication of the fill price.
For example, instead of testing our strategy on only the EURUSD pair, we should aim to test several pairs such as the EURUSD, USDJPY, GBPUSD, AUDUSD, USDCHF, USDCAD etc. The results of the strategy will be the average performance of each market.
Few trading platforms allow back or forward testing on a basket of markets, that’s why a trading simulator or our code can help.
Building a strategy around a single market can lead to over-optimization – tweaking our rules to match the historical data to produce the best results.
The more optimizing we do, the less robust our results become – once we apply them on real data with money, it is likely our live results will not match what we anticipated.
The simulator implements our strategy and its rules on all markets we are testing. The performance of the strategy is given as an average based on the individual markets included in our test.
The results will validate or not validate our original idea if we have enough confidence, we can start trading with real money.
FOREX Edge Final Thoughts
Developing an idea for edge is only one aspect of profitable trading. There are a lot of moving parts in any system; clicking a mouse to execute trades is a tiny part of it. The best way to think about this is to regard yourself and your behaviors as a system. This system has a strategy which has been backtested and forward tested and has a positive expectation that it is profitable.
Strategy development of an edge requires a lot of patience and effort, and for long periods it can feel you are not getting anything for your work.
Stick at it though.
You can have a great strategy, but unless it complements the system that is running it (you), there will always be conflict. You will not be able to execute the orders when your rules are met. Without consistency, the strategy will be useless, and the strategy will not deliver on the profits it indicated it might do.
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About the author:
My name is Tim Thomas, Born in Guildford and now living near Southampton, UK with my family. I started my career in the financial markets and have traded and invested in stocks, options, FOREX, futures, crypto, and real estate. My website is dedicated to trading and investing and is written to help you reach your wealth and financial freedom goals.
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