FOREX trading tutorials - How to Evaluate a Forex Trend Trading Strategy
In this tutorial we will discuss how to evaluate Forex Trend Trading strategies. Before you start trading a forex system, you should have a basic idea of what to expect when trading. Forex trading systems have different characteristics and always two systems may both be profitable, one system may suit one type of person more than another. Many people only look at the winning percentage and the total profit, but there are other factors that are also very important to consider when evaluating a forex trading strategy and deciding which one is best for you to trade.
First, what is a Trend Following Strategies
This is the most well known and popular forex trading strategy. It looks enticingly easy but is deceptively difficult. Traders look at a historical chart and think that it if they had bought at the beginning of the trend and sold at the end of the trend, how much money would have been made. Unfortunately capturing the whole movement of a trend is very difficult if not impossible. It is very difficult to enter the market at the exact time when a trend begins and exit exactly when the trend has exhausted and is about to end. Here are some characteristics of trend following strategies, to decide if it is really a strategy that you would like to use.
- It is said that around 70-80% of the time the forex or any other markets are trendless, either trading in a range or sideways. That means that if you are following a trend following strategy, you will need to be patient to wait for a trend to develop.
- When trends develop, they are often strong, powerful and sustained over a period of a relatively short period of time. This means that if you are following a trend following strategy, you need to make sure that you catch every trend.
- It is difficult to identify the beginning and end of a trend. This means that you will have many false entries as your system seeks to identify a trend, but turns out to be a false signal. Although there are many false signals, making sure that the trend following strategy catches a trend when it eventually develops, will offset the many losses from false entries
- A trend following strategy will have a low win rate. That means that only a small percentage of trades will turn out to be successful. You need to be comfortable and understand that. In a good trend following system, the winning trades however will offset the losses to produce an overall profit.
- Following on from the last point, you need to be prepared that the low win rate means that in most of your forex trades, you will lose money. You may for example lose money in 6 out of 10 trades. That can be very hard for some people to take.
- Forex Trend following strategies can be very profitable over the long term. You must be prepared to wait for the few trends that will make most of the money.
Forex Trading Strategy Evaluation
1. Winning Percentage
This is the first thing that many people look to to evaluate a forex trading strategy. Although you would naturally feel more comfortable with a system that has a high winning percentage, a system with a low winning percentage but a high profit to loss ratio and that has a higher number of trades will be more profitable. Trend following strategies will typically have a low winning percentage, but if you have trading a trend following system, you need to understand that is the nature of trend following, as you have a number of false signals until you catch one of the few true signals that mark the beginning of a profitable trend trade.
2. Profit to Loss Ratio
This is the average profit to average loss ratio. For example if you have 10 profitable trades, with an average profit of $100 per trade and 20 unprofitable trades with an average loss of $50 per trade, your profit to loss ratio is 2:1. Obviously the higher the profit to loss ratio the better. A trend following system should have a high profit to loss ratio, as it will generate a few highly profitable trades and a high number of small losses, making the average profitable trade much higher than the average loss.
3. Number of trades.
This parameter is often overlooked when evaluating a forex trading strategy. The number of trades is the number of opportunities to make money trading. If you are comparing two systems, one with a lower profit to loss ratio and one with a high ratio, but the first one trades more often, you may prefer the first system, because over the same period of time, it will generate a higher profit.
4. Maximum Consecutive Losers
It is important to have an idea of how many losing trades there may be in a row. It is important for two reasons. One is to make sure you have sufficient capital to sustain a number of losses. Of course with a sensible risk management and position sizing strategy this should not be a problem. The more important reason is psychological. It is easy to look over historical results that have 5, 7 or even 10 losing trades before a winning trade appears. But, in reality how would that feel? When would you lose confidence in the system and start to question if the system has busted. Some people are just not suited to strategy that have a low winning percentage and a high number of consecutive losses.
5. Maximum Drawdown
This is the maximum amount that the system has moved from a peak in the equity to the lowest point. It gives you an idea of the minimum capital requirements to trade the system.