What makes a trading strategy or auto trade (EA) system get failed?
We often see that after constructing a great strategy, which shows pretty good results in short time period of backtesting, gets devastated in a longer time period. A common scenario for most the traders who design an auto trading system for backtesting a trading strategy. Mostly the Expert Advisor (EA).
But have you ever thought what was causing your trading robot the trouble? The short answer is worst or the bad market condition or black swan event.
What is a Bad Market Condition or an Unstable Market Condition?
Lack of liquidity? High volatility? Basically all of these. Following are the top symptoms of bad market conditions. So in the time of designing an Auto trade system or testing any of your manual trading strategies, keep those points in mind.
1. Market Range, No Man’s land:
Some trader will say range market is good for a trading breakout or trading reversal from range top & range bottom. That might work for sometimes. But if you are looking for range breakout then yes you do need the trend to accomplish that.
2. Market Choppiness:
Market Choppiness or unclear market movement cannot even help you to trade from range top or bottom. Cause it’s more like a chaos. Some random movement exactly like a Richter Scale. Majority of the trading system get failed inside these zones. At least 50% or more time market stays in this zone.
One common way to spot market choppiness is large upswing & downswing altogether. Generally during market news release, such candlestick pattern forms. An ideal circumstance for the failure of your favorite trading system. Unless you are trading with a straddle strategy for a news release.
3. Stop Hunters with Large Spreads:
A nightmare for all traders. During news release or any major market event, spread gets increased for some brokers, which causes traders to lose money. Because their stop loss gets hit.
So choose a well-reputed broker who does not practice stop hunting.
At the left is the Tickmill spread for forex major pairs. You can see its pretty low spread of EURUSD around 0.2 spread during European open trading session. You can start trading with Tickmill only with $25 deposit for ECN pro accounts & also can earn a daily rebate from IntraQuotes.
Then What Makes Things Work?
The trend is your friend!
Truly trend is your friend. Majority of the trading strategy works best in a trendy market environment. No matter you are a scalper, swing trader or even position trader, the trendy market will always give you profit if you are in a correct boat.
Sometimes I have seen, even if are not in a correct boat, you can switch your position & still make money after recovering your losses.
Example, if you sold EURUSD around 1.0885 but it hit your stop loss then you can change your trade position & BUY EURUSD around 1.1001 & keep buying then you will make money, even after having one loss. If you keep buying until 1.2034. Then you will almost make 100+ pips. If your previous loss was 50 pips, still you will make 50 pips profit after your loss. This is the benefit of the trendy market price structure.
Market stays trendy only during 30% of the time. So that is your window of opportunity.
How Can You Filter Your Strategy to Avoid Catastrophe?
There is some technical analysis, which can help us to avoid such unfriendly market conditions. Yes, it is not accurate to 100%. But it can be around 90%.
1. ADX (Average Directional Movement Index):
With this indicator, you can filter your trading strategy, ADX index below 30 indicate slow or ranged market. ADX above 70 indicates strong movement, indicating volatility. My call would be somewhere around 50 -70 could be a reasonable place to look for entries.
Another indicator which similarly indicates market movement in percentage Momentum ranges from 0% to above 100%. Momentum indicator can help us to filter high volatile insane market movements. If momentum is above 100% that indicates a spike in price movement. But remember momentum is a lagging indicator, it means it will show the signal after the incidence. So you can actually avoid the after effect of such events using momentum indicator.
In the picture above, we have used SFX Multi Pair Trend Dashboard Indicator to scan for momentum breakout among 15 currency pairs.
3. ATR (Average True Range):
Another good indicator to avoid any black swan market event. Imagine if the market had a crash & keep falling at the speed of 100 pips per minute, then ATR is the shield which can protect. Before back testing your strategy on a particular trading instrument, stocks, shares, currency pair, learn about its general range. Remember ATR can be different for a different time period.
For example, if your target market is GBPUSD minute chart, then check ATR of GBPUSD for one year time period (Targeted Backtesting period). If the ATR is 3 pips per minute then make sure you add that 3 pips ATR filter on your system. At 100 pips per minute, movement ATR will not be staying around 3 pips rather be around 50-60 pips. So that will be your alarm zone.
4. Moving Average (MA) Difference:
We all know about moving average & moving average crossovers. But moving average distance with price or another moving average can also help us to determine how trendy the market is. See the picture below, when the distance between two moving averages increases, that indicates strength in trend. In the picture illustration, we have used 100 EMA (Exponential Moving Average) & 200 SMA (Simple Moving Average).
5. ZigZag Indicator:
ZigZag Indicator is another good indicator to guide traders eye with better visuals. With Zigzag indicator, you can view which area to avoid for trading & at which area you should place your BUY or SELL orders.
There can be more other different indicators to use for a filter, for example, volume in case of stock trading, Open Interest etc. If programmatically possible then we can also add a filter to the news event.
So next time, when you create a new strategy, use these filters to avoid bad market conditions. Be creative & logical. Also, keep one thing in mind, we can not always be 100% accurate, there is no holy grail, so in search of it, do not make your system too complex. Simple things always work better. Having 2-3 filters in your trading strategy are good to go.