Trading involves numbers. Many calculations need to be made to analyze the price action and gain an understanding of market movements. While economic events usually follow a discernible pattern of cause and effect that may be evident even without the use of technical methods, it is difficult to evaluate the random movements of the price without the tools supplied technical methods. Since it is difficult to define entry/exit points without the use of numbers, numerical tools have been very popular among traders of all backgrounds since the early days of the development of technical analysis. Over the years, the desire to solidify technical strategies into clearly delineated schemes on which trading choices can be based has resulted in a better understanding of what constitutes a successful technical strategy. But while the expectation has become clearer, the nature of trading as an activity where risks are ubiquitous makes the testing of a trading strategy a complicated and difficult task. In this article, we will attempt to discuss some of the basic principles of successful testing and evaluation of a trading strategy. Rather than discuss the various tools used by traders, we will seek to assess the validity of the basic approach to the testing of technical methods.
Constructing a Technical Strategy
First of all, what is a technical strategy? It is a combination of indicators and tools aimed to smooth out the gyrations in price to generate actionable signals for traders. At its basic level, traders use strategies every day as they analyze the markets and enter buy and sell orders in accordance with their analyses. By combining a price indicator such as a line chart or bar chart with an oscillator or a moving average, we already have a simple scheme that will allow the determination of entry/exit points for our trades. As traders become more proficient in technical analysis, the tendency is toward the creation of more complicated schemes that combine a large number of indicators to generate signals.
It is not that difficult to construct a technical strategy. The diverse choices of indicators available ensures that those who seek to combine them for sharper, more precise signals will not need to seek far and wide in achieving that goal. To illustrate this clearly, let’s take a look at two scenarios where we have developed two arbitrary methods that we want to use to trade the markets.
Note – Past performance is not indicative of future results.
The first method involves the use of two moving averages – a 13-period simple moving average and a 50-period simple moving average to generate signals from crossovers, while using the MACD to filter out extreme values where sharp reversals could blur the risk/reward scenario for trading. In this randomly selected example, we notice that our scheme performs well. The entry signal generated by the 13/50 crossover on February 12 signaled an incipient hourly trend that kept going on by remaining above the 13-hour simple moving average until it ran out of energy, coinciding with the extreme value registered on the MACD oscillator. It is clear that our simple method generates promising results on this first example.
Now, let’s examine another method.
This second example uses the same price chart. Here, we use the parabolic SAR combined with a long-term resistance line and Fibonacci extension levels. We observe that the breakout was in line with the signals generated by our simple strategy. As soon as the price moved above the parabolic SAR on the night of February 16, the breakout took the price above the 61.8 Fibonacci extension level and the trend continued moving upward until it reached another higher resistance level.
These cases both show that simple combinations of basic tools can be successful in creating a profitable trading strategy. Naturally, we want to use only one of the two, because applying two strategies to the same chart often results in confusing outcomes without generating clarity on the risk ratio. This is where the evaluation of a technical strategy acquires its critical nature. By testing various strategies, we hope to find the better ones rather than discovering them as the result of a string of losing trades.
This is an excerpt from May 2011 issue of Forex Journal.
