The Unlikely is Not Impossible

And sometimes it's even likely. This is a paradox I often find myself wrestling with as a trader, particularly since I like to think I approach the forex market with a statistical mindset. Why do you think I go on about Bollinger Bands so much? They're one of the more statistical indicators out there, based on a measurement of 2 standard deviations from a specified moving average. But if you trade long enough, you discover that your statistical ideas about market behavior often run headlong into the painful realities of how the market actually behaves.

What set me off on this particular tangent was a recent article in The Economist. (Seems I reference them in every other post. Such is intellectual laziness.) It was commenting on the recent volatility in world financial markets, seen in the meltdown of the Chinese stock market, the serious decline in US markets, and similar turbulence in all the other markets I don't really follow. What really got my attention were these remarks about the statistical likeliness (or rather, unlikeliness) of all this marketplace drama:

"According to Goldman Sachs, the latest jump in the Vix (a measure of stockmarket volatility) took it eight standard deviations from its average. If conventional models are correct, such an event should not have happened in the history of the known universe. Then again, the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard-deviation event. [I wrote about the Amaranth collapse a while back, follow that link to learn more about how they screwed up.] Perhaps modellers do not know the universe as well as they would like to think."

Eight standard deviations. Nine standard deviations. These make the 2 deviations of my Bollinger Bands look painfully inadequate to accurately gauge possible market fluctuations. The key of course is that these types of events are extremely unlikely. Just like the global financial implosion triggered by Russia's loan defaults and the devaluation of the Thai baht back in 1997. Extremely unlikely events, and yet they brought Long-Term Capital Management crashing down. [Wrote about them too. Follow the link for more hedge fund meltdown fun. So, got any assets in hedge funds?]

Extremely unlikely, and yet they happened. In fact, if you look at historiy it seems inevitable that extremely unlikely events like these will happen again. So what does that make them - likely? Depending on your timeframe, yes and no (century: likely, month: unlikely). And they're definitely severe enough to include in whatever rosy model you have for trading and investment success. If you live in an earthquake zone (which I do) you don't expect one every day. But you do prepare yourself for the day when the floor starts moving. So how strong is your trading floor?

Related article:
The Economist: Grey Tuesday - An overdue sell-off flusters exchanges and sobers investors

Bollinger Band Tutorial and Rules

For those who, like me, are fans of John Bollinger's famous bands, I just made an interesting discovery while poking around on Mr. Bollinger's official site. He offers this in-depth tutorial on the history of trading bands, of which Bollinger Bands are one type, and discusses the development of a predecessor of his bands, called Bomar Bands, by Marc Chaikin of Bomar Securities in the 1970s. The tutorial then goes on to explain how he developed his own bands based on the statistical measure of standard deviation, which makes them highly sensitive to extreme deviations in price.

There is also an excellent discussion of multiple counting of different indicators based on the same information, an analytical error many traders are probably familiar with. Multiple counting can lead you to assume that all your indicators are reinforcing each other with additional information, when they're really just reflecting the same, single piece of data.

The tutorial concludes with these 15 rules for setting up and interpreting Bollinger Bands in your charts. They're a must-read for anyone who uses this indicator regularly, especially if you're prone to overinterpreting them - a risk with any indicator, no matter how nifty-looking and well-designed it is.

Overall, the tutorial's a great free resource and well worth adding to your technical analysis bookmarks.

Speaking of Bollinger Bands, the EUR/USD just completed this classic "tag" of the upper band on my 4-hour charts. But as Bollinger himself cautions in his rules, this is not necessarily a sell signal (if only trading were that easy!)

Related links:
BollingerBands.com
Bollinger Band Tutorial

Bollinger Band Trade Filtering

In the spirit of my New Year's resolution to put my trading system on a diet, I've been exploring ways to more aggressively filter out unnecessary trades, boost my trading odds, lower spread costs, and generally fine-tune my system to optimize its performance.

One filtering method I've found that shows a lot of promise involves Bollinger Bands, but not in the way they're usually used. Until now I used Bollingers to identify points where the price was likely to begin a reversal from a (relatively) overbought or oversold position (in forex, all things are relative). But for my current trade filtering project, I'm using them to identify periods of low volatility, when the EUR/USD pair is trading within a narrower range.

The measurement I'm using to determine these periods is the distance between the upper and lower Bollinger Band. When the bands are further apart, the market tends to be in a more volatile, wider-ranging phase. My forex strategy works best in these types of periods (as do most trading systems, I suspect). When the bands are close together, volatility is lower and my system tends to accumulate losses and trading costs.

So what I've done is have my trades switched off when the Bollinger Bands are too close together; the optimal distance between them is something I've determined through a lot of backtesting. What I've found is that my trading odds and performance improve significantly, with fewer big drawdowns and pointless trades when the markets are in the doldrums. Of course, because Bollingers are a lagging indicator, I also miss some big breakouts when the market shifts back from low to high volatility. But I'm willing to live with that - consistent trading performance is far preferable in the long run, and there's nothing that can kills your morale more quickly than waiting out a series of bad trades when the market's drifting in no particular direction. The more of those ugly periods I can avoid, the better!

Related topics:
A Nice Bollinger Band Trade
Put Your Trading System on a Diet
The Quest for a "Kill Switch" Signal

The Trendfollower Trading System

I keep a number of trading systems on file as backups in case the one I'm currently using goes haywire and I need to shift strategies. At some point I may also start trading with one of these backup systems concurrently with my main system to spread out my risks a bit, so I have fewer trades in one basket, so to speak. One of these trading systems I've always thought highly of was devised by Trendfollower, a trader who used to frequent the MoneyTec forums (and maybe still does, haven't checked lately).

You can access a copy of his system for free at ForexBasic.com. It's the first one listed, and you can download it as a Word doc by clicking on the little Word icon.

To briefly summarize how it works, the Trendfollower system looks for a cross of the STARC band below the Bollinger Band for short trades, and the STARC band above the Bollinger Band for long trades. STARC bands are an indicator you don't see enough of, in my opinion, and in fact they're not available on all charting platforms. I know GFT's DealBook software has them, as does Oanda's system; if they're anywhere on MetaTrader I haven't found 'em yet. STARC is an acronym for Stoller Average Range Channels, and you can read more about STARC bands in this Investopedia article.

Here's a picture of a trade specified by this system, which took place over about 2 months (!):



I won't go into all the detail of how the system works, since Trendfollower's explanation tells you everything you need to know. But here are some of the things I like about it:

It uses a multi-day or even multi-week timeframe, which means you don't have to spend hours every day staring at your charts or make trading decisions on a minute by minute basis. As Trendfollower puts it, "The nice thing about trend trading, is that you don't need to be at the computer all day long. 3 looks a day is enough."

It uses a very straightforward entry signal. There's no ambiguity as to whether it's happened or not.

It has very clearly defined exit strategies.

It uses Bollinger Bands, one of my favorite indicators, and STARC bands, which are an interesting indicator in the same genre as Bollingers, since they also form a statistical envelope around the price trend.

Trendfollower says he traded with this system successfully for 3 years, which I consider a pretty good track record.

It gives you the option of trading several different currencies without worrying too much about spread costs, since the trades are large and fairly infrequent. To quote Trendfollower again: "Because of the long term nature of my trades pip spreads are not important to me so I look for new trend breaks amongst 17 odd currency pairs." This means that your "inventory" of potential trades to choose from is quite substantial.

So if you're looking for a trading system that doesn't require constant attention, high spread costs, lots of short-term trades and all the stress that ensues, this might be the one for you. Good luck if you trade with it!

Related Links:
Trendfollower System Download
STARC Band Definition

Related Topics:
A Nice Bollinger Band Trade
Chart-Based Trading Systems
Simplify Your Trading

A Nice Bollinger Band Trade

Since I'm in the midst of a short EUR/USD trade triggered by the upper Bollinger Band, I thought I'd post a snapshot to illustrate the strategy behind this trade. Here's the daily EUR/USD chart from my Metatrader platform. As you can see, a couple days ago, on Sunday, August 6, the price left the upper Bollinger and traded entirely within the band. This pattern, which is very similar to the Doji Star candlestick formation, suggested an imminent reversal downwards. Sure enough, on Monday (below the yellow arrow), the EUR/USD dropped over 60 pips.

Today the downtrend seems to be continuing, after some extreme volatility prompted by the Federal Reserve's rate announcement - that's the huge upward spike you see that nearly hit 1.2900 today. Having weathered that short-lived storm, my trade's showing a profit of 67 pips, plus a few additional pips in interest. Yet another reason Bollinger Bands are one of my favorite chart indicators

Related topics:
Exhaustion signals: Profiting when the market is overbought or oversold
Candlestick Chart Tutorial

Exhaustion Signals - Profiting when the market is overbought or oversold

Some of the most effective signals I've integrated into my trading system are those based on the principle that the market will become exhausted and the price will begin rising or falling back towards its moving average after a strong upward or downward run. These signals go by various names - I prefer "exhaustion," because it's most vivid and immediately familiar, but terms like "overbought" and "oversold" are equally if not more commonly used. "Contrarian" or "correction" also apply, when used in this particular context.

Recent EUR/USD activity offers an excellent case study in a profitable trading opportunity in overbought conditions - as of this writing, I'm up over 100 pips on a short trade that caught the downtrend pictured in the daily chart to the left. After a major uptrend in the EUR/USD last week, the market is now correcting downwards, presenting a great chance to gather pips by going short.

There are a number of advantages I've found with these types of signals:

• They can be focused on a very specific moment during an uptrend or downtrend, and carefully tuned until they trigger trades at the optimal point in the trend. As a result they are more selective and precise than many other types of signals.

• They can be built around readily available chart indicators such as Bollinger Bands, moving averages, CCI signals, candlestick patterns, and highs and lows.

• When properly designed, they perform with a high degree of consistency. They never score 100%, of course, but then I've never come across a signal that does.

Drawbacks of exhaustion signals are that, well, sometimes the market doesn't get exhausted, and continues on its original course upward or downward. This is something you can expect to happen periodically, and it shouldn't be a surprise that it does - every signal has a failing, and this is the big one for exhaustion triggers. The key when designing these signals, as it is for any signal, is backtesting them extensively with historical data to determine their overall effectiveness and profitability over years of market activity. Only then will you have the confidence in them to execute trades consistently over a long enough period to see positive results.

Here are a few examples of exhaustion signals I use to trigger EUR/USD trades:

• If the market has seen a run-up of X pips over the past Y trading days, I sell the EUR/USD short (don't really feel like giving away my X and Y values today).

• If the previous day's closing price was below the upper Bollinger Band calculated over Z periods, and the high price from two days previous was above the upper Bollinger Band, I sell short. (I use a customized Bollinger equation to calculate my bands, and I'll just say it differs significantly from the standard default Bollingers you'll find in most charting software.)

• If the previous trading day's closing price was above the lower Bollinger Band calculated over Z periods, and the closing prices of the two days before that were below the lower Bollinger Band, I go long (buy) the EUR/USD.

Hopefully these will give you some ideas for designing your own signals for profiting from overbought and oversold conditions. If you have any exhaustion trading strategies you'd like to share, please feel free to post them in the comments.

Related topic:
A Nice Bollinger Band Trade