When people are looking for a new forex trading strategy, what they really want to know is:
- How do I create a strategy that works?
- How do I develop the confidence to trade a strategy I believe in?
The first question almost goes without saying. Without a working strategy, there’s no use in attempting to trade in a consistent and profitable way. The second question, however, is more subtle. My opinion is that if you have a working strategy but don’t have a deeply rooted belief that you can trade this strategy, you will fail.
Confidence in a strategy will make or break your results.
Fortunately, there is an answer to both questions: testing.
Before I ever use a strategy, I will have tested it for weeks. For months. It’s not an extremely difficult process, but it does involve a lot of work. During the years, I’ve tested 100’s of strategies. Most of them failed. Some of them, I could make work. The best ones, I’m trading today. Here are the steps involved to make it happen.
Step 1: Forex Trading Strategy Definition
Creating a new strategy always starts by having a hypothesis. A hunch on something that might work. You’re not sure yet if it does but it’s our job to find out. If you struggle with getting things going, I can recommend the excellent book Trade Your Way To Financial Freedom by Van K. Tharp. It describes everything that should be part of a trading system and also covers many proven approaches to making money in the market.
Still, developing your strategy is no easy task. First, we need to come up with what exactly needs to be defined in order to test it correctly. Unfortunately, a lot of traders think that if you have some entry rules, you have a complete strategy. Far from it.
Entries are not as important as you think.
They are of course part of your strategy, but I’d say they only make up about 15% of what is important in your trading strategy.
Components of a trading strategy
For a moment, think of all the other “variables” that make up a full strategy. Here is a selection of things that I will always include in any trading strategy I create:
- Market selection (on which pairs can I trade this strategy?)
- Market condition (does this strategy work in trending markets only? Or range-bound markets? Maybe only in a bull market? Or only in highly volatile markets?)
- Entry time frame (which time frame to I use to enter a trade?)
- Contextual time frames (which time frame(s) do I use to get market context? – e.g. a higher time frame for overall trend direction or a lower time frame to time entries)
- Chart setup (what chart type do you use, what indicators are part of your default charts, what are the settings of those indicators)
- Position sizing strategy (do I use percentage-based position sizing? Do I increment my position size periodically, once I increased my account by X amount? Do I use fixed lot or contract sizes?)
- Risk and money management (how much do I risk per trade? how much do I risk on all my trades in total? do I have rules for maximum drawdown per day/week/month?)
- Entry rules (what conditions need to be fulfilled in order to enter a trade?)
- Exit rules (do I use a fixed take profit level? Or profit level based on ATR? What’s the risk to reward ratio I’m aiming to get? What will cause you to exit a trade prematurely? Do I use trailing stops? If so, which kind: fixed pip/tick value, volatility-based, percentage-based, etc)
- Managing your trades (do I use set and forget? Can I intervene in a trade and if so, when and how? Do I move my stop loss to break-even in certain cases?)
- Currency correlation rules (can I enter multiple correlated currency pairs at once? Do I hedge positions using inversely correlated pairs? How will I monitor currency correlation?)
- How to deal with news and fundamental releases (do I stop trading before and after? do I only trade around news? do I close positions before certain news events?)
- Do I hold trades over the weekend?
Some of the items in the above list aren’t strictly part of a trading strategy, but rather belong to your trading plan (which should include your trading strategy, amongst other things). I included them anyway in case you haven’t yet thought about these topics before, because you should 🙂
Take the time to go over each of the items and find an answer that aligns with your beliefs about the market. This step alone could easily take you a week, so don’t rush it. With all of it written down, you have a framework to take with you to the next step.
Once we move on to the testing phase, you will automatically discover ways of improving what you have. You’ll see what works and what doesn’t and make adjustments as you go. The definition of your strategy will always be a work in process.
Step 2: Backtesting
Testing leads to failure, and failure leads to understanding.
– Burt Rutan
Based on the set of rules from step 1, backtest the sh*t out of it.
I use many different approaches for this, but will usually start with ForexTester 3. It’s not free, but if you’re serious about forex strategy testing, this is well worth your investment.
You could also write a MetaTrader 4 expert advisor if you’re interested in learning how to do so. Another way to approach this is to use the MetaTrader 4 strategy tester with an EA that allows you to place manual trades as you go along. Here’s an example of such an EA.
Even firing up TradingView, scrolling back and going forward candle by candle works. It’s a bit of work, but no one ever said that finding a working strategy was easy.
The 6 holy backtesting rules
When you’re backtesting, always keep the following things in mind:
1. Follow your strategy rules as closely as possible
I understand that if you have a rule not to trade around news, this is a bit harder to enforce in backtesting. However, things like position sizing and dynamic exit rules should be easy to test. Take the time to do this right, because otherwise, your backtest won’t be representative of your final forex trading strategy.
2. Don’t change your rules mid-test
If you do that, there won’t be any consistency in your test results. You won’t be able to tell what worked and what didn’t. If you feel that your strategy needs changes, note down what you discovered and run a different backtest with the new changes afterwards. You can then compare objectively which approach works best.
3. Test on a representative sample of trades
This obviously depends on the time frame you use and the frequency of your setups (the opportunity factor). Aim for at least 200 trades to get an idea of the performance of your trading strategy. If you’re trading the daily chart, that probably means going back about 5–10 years. Make sure you have enough historical data.
4. Test many different market conditions
Your strategy might have been very profitable in the past 6 months but completely fail in the year before. Different market conditions will give you different volatility, trends or ranges, etc. Not all strategies work in every condition, a part of your strategy might be to be able to detect various market phases and decide whether to trade them or not.
5. Test various currency pairs
Obviously, if you’re strategy is to focus on just one pair, this is not as important. Nevertheless, it can be useful to see how your strategy works in different currency pairs.
6. Avoid curve fitting
When running backtests over and over again, be careful not to test on the same set of historical data over and over again as this will pave the way for an over-optimised and potentially curve-fitted strategy.
Develop your strategy on one part of the data. This is called the in-sample data. Then, test your strategy on a different period (which is called out-of-sample data).
By now, you should start to get an idea if what you came up with is a viable strategy or not. If the backtest isn’t profitable, go back to the drawing board (see step 1).
Note: there’s absolutely no chance that you will be profitable on a live account if your backtest failed. Period.
If your backtest was marginally profitable, still be very careful. The next steps will usually reduce your profitability since there are a couple of benefits to backtesting that you don’t have in forward testing and/or live trading:
- The ability to run through candles fast if there’s no signal. You will have to have patience when actually trading this system forward or live. There’s no fast-forward there.
- Having a better feeling of the “flow” of a market. By going through a lot of candles relatively fast, you start to get a feeling how the market flows. You get in tune with the ups and downs of the trend. This might make it easier to feel what a market is going to do.
- Ignoring emotions and psychological factors. This is an obvious one. This is a testing environment, so you don’t have the same emotions as if there was real money on the line.
If your backtest was profitable, good. How’s the confidence? Do you start to feel like you could actually trade this strategy? You should still be cautious, but we can now move on to the next step. Sweet!
Step 3: Forward Testing
This is sometimes also called paper trading or demo trading. You will now test your strategy on a demo trading account. You’re using live data, without actually using real money.
Forward testing is the perfect time to simulate how you would actually trade your system. It will test your patience. It will test how well you can anticipate the market and how disciplined you are in executing your trading system.
Now would be a good time to start journalling your trades, as the process of logging your trades in a journal will also give you valuable information to move forward.
Be prepared to have less profitable results than what you got in backtesting.
When you don’t have the luxury to quickly run through your candles, you’ll notice that some things are not as easy as it seemed. Maybe that perfect setup happened just as you were asleep? Or maybe you were out for dinner? Maybe you have 5 losers and decided that “for once” you would skip the next setup, only to discover that this was actually the runner?
Even though it’s not real money, it pays to already notice how you’re responding emotionally to your trading execution. You will feel frustrated at times. You will feel like you’re invincible at times.
If you’re not profitable anymore, figure out what went wrong:
- Did market conditions change?
- Did you not execute your trading system as you should?
Be aware of statistical variance and aim to forward test on a sample size that is large enough to let the probabilities of your forex trading strategy play out. Focus on executing your trading strategy as well as you can.
If after a while your strategy is still profitable, you can move on to step 4.
Step 4: Live Trading
Now, this is the real deal. By now, you know your system intimately, you tested your system for a long time, you will have built up the confidence to trade your system without doubts.
Now you will get to know yourself.
Live trading will still feel completely different than your forward tests. When you can lose money, different emotions will start to come into play. If you haven’t done so already, now would be a good time to read Trading in the Zone by Mark Douglas, simply the best book on trading psychology there is.
Again, if after a while you’re not profitable anymore, figure out:
- Did the market conditions change?
- Are trading costs (commissions, spread) a possible reason?
- Did you not entirely follow your trading system?
Start with the smallest possible lot size your broker platform allows.
If you’re profitable, you will want to focus on consistency. Keep executing your trading strategy and slowly build up your position size as you keep on gaining confidence.
In this article, I’ve laid out how I come up with high-probability strategies. It’s a four-step process that can take anything from a few weeks to many months or even years. Many iterations might be necessary, but the following steps are always there:
Step 1: Forex Trading Strategy Definition
Step 2: Backtesting
Step 3: Foward Testing
Step 4: Live Trading
This is how I eventually have the confidence to trade a strategy.
It’s why I know that a trading strategy will work in the long run.
It’s why sharing a trading strategy with other traders is only helpful to a certain extent. You need the process to build up the confidence to trade something you believe in. What that something is, is different for every trader. Following the steps I just outlined, is how you get there.
If you have questions on developing your own forex trading strategy or any other trading related question, don’t hesitate to contact me!