Hoping for Whipsaws

Strange as it sounds, my current trading system has me looking forward to days with extreme price swings, or whipsaws, which I used to anticipate with dread. The key to this change in perspective was shifting my strategy from primarily trend-based trading to a system that looks for profits in ranging behavior as well. The result is that a whipsaw no longer looks like one of the nastiest patterns on the chart, but instead is a potential opportunity to grab some easy pips as the market swings within a semi-predictable range.

One essential part of my whipsaw-friendly strategy is a take-profit target of just 33% of the previous day's trading range in whatever direction I place the trade. Using a fairly modest limit order like this dramatically increases the chances that a wildly ranging day will also be a profitable one. By combining this take-profit strategy with a significantly wider stop-loss, my trades also allow for swings in the wrong direction that reverse and come back around to hit the take-profit a lot more often than they're taken out by the stop-loss.

Whether this strategy will work over the long-term is still an unanswered question (just like it is for any trading system) but results in both backtesting and live trading so far look good. I'll provide a periodic update on how the system's working (or not working) after it's logged some more live trades. Now bring on the whipsaws!

Risk/Reward Ain't Always What It Seems

It's very easy to get caught in the illusion that a tight stop-loss and a generous take-profit/limit order are going to earn you profits in that ratio. You know, setting your stop at 20 pips, your take-profit at 50 pips, and waiting for those consistent profits to start rolling in. This is a newbie error I made plenty of times before learning my lesson. What I've found since then is that a very generous stop-loss and a conservative take-profit strategy is often more consistently profitable.

A case in point: I'm currently running a GBP/USD trading system that features timed exits of around a week, take-profit at 100 pips, and stop-losses set at 300 pips. Yes, 300 pips. Sounds a bit weird, I know, but the key here is that those stop-losses almost never get hit. What's far more likely is that the price will advance 100 pips in that week, or the trade will time out if it doesn't (and sometimes with a profit). In fact, I could probably run the system without a stop-loss at all and the results would be similar, thanks to those timed exits - I'll have to backtest that notion soon, though the idea of trading without any stop-losses makes me nervous.

In general I've found that stop-losses work best for me in extreme emergencies, when the market is acting wilder than usual and hence could lose me more than usual. So for my trading style it makes sense to set them at the outer limits of the likely trading range, rather than squarely in the middle of the range where they're likely to get hit by a whipsaw or retracement.

Figuring out where to set your stop-losses

Though it may seem like one of the more mundane topics in forex trading, where you set your stops is a crucial factor in how you balance risk and reward in your trades. While it may be tempting to set your stops close to your entry price, with the goal of tightly limiting your potential losses, you inevitably leave yourself open to the market's whipsaws and retracements by doing so, and can end up racking up a lot more losses than you would otherwise.

Placing your stops a substantial distance above or below the current price leaves more room for back-and-forth ranging, but can leave you with painful bite out of your account when the market decides to swing in the wrong direction in a big way.

It's also worth considering that some people don't trade with any stops at all (though I'm not one of them, and I'm not recommending you do it). As one trader's forum signature light-heartedly put it, "Look ma, no stops!" How can anyone have the guts to just let their trades swing freely in the sometimes violent winds of the market, with no "ejection seat" to bail them out when things get really ugly? Well, if you've watched the market for a long time, and have done your homework by examining and analyzing historical price data, you'll begin to see how someone might become more comfortable with the idea. As I've said before and will undoubtedly say again, the data is your friend. For instance, when I did the initial backtesting of my trading system with historical EUR/USD data, I had absolutely no stop-losses built into the calculations. Hundreds and hundreds of theoretical trades were performed without a safety net, and the result was still very profitable. In fact, trading without stops proved to be more profitable than trading with them in most cases.

However, there are occasions when a stop-loss will prove essential in bailing you out of a dangerous market. For instance, after a catastropic event, the market may swing equally catastophically in ways you'll want no part of. This is when you'll be glad to have your stops in place.

For the record, I'm currently running pretty sizable stops on all my long and short EUR/USD trades. To figure out where to set them, I used the same backtesting system I used for designing my daily trading entries and exits, and just ran the data with stops set at various levels. For long trades, I found a stop-less set 118 pips below the entry price worked best. For short trades, a stop set 128 points above the entry price was optimal. In both cases, the stops added around 10% to my trading profits. (Keep in mind these stops worked best in the limited data set I was using - a different data set will probably produce somewhat different results.)

Finally, the timeframes you're trading in will be a key factor in where you place your stops. My stops were designed using daily EUR/USD price data for trades that last a minimum of 24 hours. So if you're planning to exit your trades within a shorter or longer timeframe, you'll need to use a different set of test data and adjust your calculations accordingly.