In this third and final article of the Top Trading Mistakes series, we’ll look at the importance of strategy selection.
Guessing is not a solid trading strategy.
A large portion of traders entering markets hope to develop a ‘gut instinct’ or ‘feel’ for the market that will allow them to know exactly what they should do at exactly the right time.
Most people will eventually find that this effort to develop a ‘super-natural’ feel for future price action to be a fruitless one. Most of the best traders in the world have a strategy or multiple strategies for trading in markets; and new traders should be no different.
In this article, we’re going to discuss not only the importance of having a strategy, but the importance of using that strategy in the right situations.
‘Holy Grails’ Do Not Exist in Trading
The most common action a trader embarks upon after realizing the necessity of having a trading strategy is trying to find the ‘best’ strategy.
In this stage, it’s normal to see traders stacking seven or eight indicators on top of each other on the chart; looking for ways to ‘build a better wheel.’ The common logic is that if an indicator like RSI can be helpful for entering positions, adding in a Moving Average or Stochastics should make the usage of RSI even more effective. It’s almost as if traders in this stage feel like they can corner price where it has to move in the direction that they want.
Technical indicators can be fantastic additions or elements of a solid trading strategy; but please be careful when it comes to assigning any ‘predictive’ qualities to any of these indicators. In reality, all technical indicators are built off of past price action… and the past is never going to be perfectly predictive of the future, no matter how much we might want it to be.
Rather than over-complicating the strategy, traders should look at the other elements involved in the strategy’s success, such as choosing the right market environment to employ.
The Importance of Using the Right Strategy at the Right Time
As we had done in our previous two Top Trading Mistakes articles, we’re going to incorporate the DailyFX Traits of Successful Traders data to illustrate our points.
The second piece of the series, authored by David Rodriguez and entitled ‘What is the Best Time of Day to Trade Forex,’ DailyFX investigated which trading session had amounted to the greatest profitability for FXCM clients during the observation period.
Within the report was a fascinating observation that speaks to the importance of employing a strategy in a conducive environment.
David took a very simple strategy, using only RSI on the 15 minute EURUSD chart to enter and close positions. When RSI crossed up and over 30, that was a buy; and when RSI crossed down and through 70, the strategy would close the long position and go short which would close at the next RSI move up and over 30 while triggering the next long position (this is called ‘Stop and Reverse logic,’ where the strategy ‘stops’ the current position and reverses with a new position).
This was a very simple strategy using only one indicator on a very short time frame chart, and, as you can probably imagine; the results weren’t pretty:
Simple RSI Strategy didn’t perform too well on EURUSD 15-minute chart
Top-Trading-Mistakes-Part-III_body_Chart_2.png, Top Trading Mistakes, Part III
As you can see from the equity curve above, just letting this RSI strategy run with wreck-less abandon didn’t bring on great results. As a matter of fact, this $10,000 account would have lost everything in less than 10 years, and there were only a couple of periods that actually saw the account grow.
But, as we said earlier – traders should look at the other areas of a strategy that can allow for success, such as the time period with which it’s being employed.
In When is the Best Time of Day to Trade Forex, David took this simple RSI strategy to the next step: He filtered it so that it would only open trades during the Asian-trading session. The rationale behind this is sound: The Asian-trading session will often have a tendency to range (at least more so than European and American sessions), and RSI is a mean-reversion, range-trading type of indicator.
The difference in the strategy is shocking, and once again – the only filter or differentiation is that the strategy is now only allowed to open positions during the Asian trading session.
Simple RSI Strategy set to ONLY trade during the Asian-trading session (in Gold)
Top-Trading-Mistakes-Part-III_body_Object_8.png, Top Trading Mistakes, Part III
With the filter in place to only trade during the Asian-trading session, the strategy performed significantly better. And remember, this is just a simple RSI Stop and Reverse Strategy.
Does this mean that anyone should trade this simple RSI strategy just because it fared well in the observed period when filtered for the Asian-trading session? No. This is simply to illustrate that the entry mechanism is just a small part of the overall strategy’s effectiveness.
What Else Denotes a Strategy’s Effectiveness?
In the first article in this series, we looked at the importance of risk-reward ratios. Bad risk reward ratios (losing way more when wrong than winning when right) was The Number One Mistake Forex Traders Make.
This is a huge part of a strategy’s overall effectiveness because, as we showed in the article, Top Trading Mistake, even a strategy winning 65 or 70% of the time can lose money if it uses poor risk management.
After that, leverage can have an enormous impact on the strategy performance because if too much risk is being taken on with each entry, 5 or 10 bad trades can completely wipe out a trader’s account. We looked at this in Top Trading Mistakes, Part II.
Constructing a strategy based on a desired market condition can help traders build the most effective system with narrow focus and aim for a specific type of environment. So, for instance, if a trader wants to build a strategy to trade trends, they should avoid using that strategy in breakout-scenarios. Or, if a breakout strategy is built to trade in fast and active markets, it shouldn’t look to use wide stops and risk amounts, allowing false breakouts to bleed against their equity for prolonged periods of time.
We discussed market conditions, and elements of strategy creation for each condition in the article, The Life Cycle of Markets: And we showed traders how to build strategies to this effect in the article series, How to Build a Trading Strategy.
Within that article series are 5 points with which traders can look to modify or adjust their trading strategy in an effort to reach maximum effectiveness. After traders have decided which market condition they want the strategy to perform optimally in, they can then decide on optimal time frames for the strategy analysis and execution.
Are you looking to take your trading to the next level? The DailyFX 360° Course offers a full curriculum, along with private, weekly webinars in which we walk traders through dynamic market conditions using the education taught in the course.
Would you like to trade alongside seasoned professionals throughout the trading day? DailyFX On Demand gives you access to DailyFX Analysts during the most active periods of the trading day.
Would you like to enhance your FX Education? DailyFX has recently launched DailyFX University; which is completely free to any and all traders!
We’ve recently begun to record a series of Forex Videos on a variety of topics. We’d greatly appreciate any feedback or input you might be able to offer on these Forex videos:
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. Learn forex trading with a free practice account and trading charts from FXCM.
