Designing a Forex Trading Strategy

Common Errors When Designing a Forex Trading Strategy

When wrangling spreadsheets and charts with historical forex price data, it can be surprisingly easy to make the most basic types of errors that, if not caught quickly, can lead to all kinds of mistaken conclusions and costly trades. That’s why I really stress the importance of a good forex trading education. I’ve compiled a short list of the ones I’ve been guilty of at one time or another, which I hope will be helpful to you as you design your own trading methodology.

Error 1: Don’t correlate your dates and times properly.

I once discovered a forex trading signal that seemed too good to be true, predicting market movements with truly amazing accuracy and racking up huge gains on a consistent basis. Well, it turned out it was too good to be true – I’d been using a signal derived from one day’s market activity to predict that same day’s activity, rather than activity the following day. By lining up my dates incorrectly, I ended up with a circular signal that essentially predicted itself. No wonder it was so phenomenally accurate!

That said, misaligning your dates can also lead to some interesting discoveries. For instance, I once did a study to discover how London Stock Exchange (LSE) activity correlated to GBP/USD trading the following day. Only I mistakenly used LSE data from two days previous, not one day. As it turned out, this led to some fairly significant predictions.

So, be open to the possibility of an auspicious accident, but make sure to double-check your dates and times to avoid the nasty accidents, which tend to be far more common.

Error 2: Use the wrong metric of success

This is another of those too-good-to-be-true stories – yet again, I found a signal that looked like it yielded amazing profits. Well, it turned out I was adding up the wrong numbers. Instead of totalling all trades generated by that signal, I’d added up a column of all the positive trades it had triggered. No wonder the totals looked so good. The metric I should have been using was one column over, and recorded all trades indicated by the signal. And it was, surprise surprise, quite a bit lower.

Another way of confusing your metrics is to focus on the percentage of positive trades rather than the total gains a signal generates. While a 70% success rate looks pretty good, it could be outperformed by a signal running at just 50%, or even lower. A signal that generates 100 pip profits half the time and 30 pip losses the other half is a lot better than one generating 30 pip profits 70% of the time and 50 pip losses the other 30%. (Sorry if I’m stating the obvious here…but it’s not always obvious.)

Error 3: Use the wrong periodicity (time span) for your signals

If you’re planning to place day-long trades, you’ll probably have more luck using daily charts and price data than 5-minute charts. And if you’re planning to do short-term scalping, daily data may not be as helpful as a minute-by-minute chart.

Error 4: Use Too Small a Set of Data

When testing out a potential signal, you’ll need a substantial body of market data to determine how it performs over time. A strategy tested on 10 trades over three weeks is likely to be a lot less robust than one tested on 500 trades over three years. The more historical price data you can obtain to put your signals through their paces, the better.

Error 5: Forget to take the spread into account.

pip spreadI’ve discussed this before, but it’s always worth revisiting. You may have a system that makes you 10,000 pips trading the EUR/USD, but if it takes you 5000 trades to do so, you could very well end up making very little, or even losing money because of the spread. One factor to look at when evaluating spread costs is how many of your trades are sequential: if you tend to have blocks of 10 trades that you can roll into one trade, then you have less to worry about than someone with many sporadic trades occurring in isolation.

 

Obviously this is far from a complete list of all the errors you can blunder into when creating a forex¬† trading strategy — so stay tuned for more mistakes as I make them.

 

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