Monday, August 4, 2014

Introduction to a Market-neutral Strategy for Forex Markets


“For traders and investors, finding low risk ideas is one of the most important tasks no matter what asset class you trade.” - Gabriel Grammatidis

The world of speculation is replete with strategies that are aimed at making profits. The strategies can be ones that follow the lines of the least resistance or ones that make use of mean reversion; there are many ways to skin the cat. No matter what methods we use, we’re either following the dominant biases or going against them.

Let’s face it, the reason why we invest our money in the markets is to make profits. We’d also prefer to enjoy permanent success in the markets. The sure way to achieve this is to go for small and consistent profits that become great over time, and to employ safe risk control measures that make sure that our portfolios remain intact in spite of the vagaries of the markets.

For more than a century, trading legends have made use of market-neutral strategies. A market-neutral strategy is a non-directional trading approach that enables us to harness profits from the unpredictability of the markets. An overextended bullish market can still remain more overextended: and vice versa for an overextended bearish market. Whether the market goes up or down or sideways, we end up making average gain that is much bigger than average loss.

This kind of trading approach is very popular among expert traders – it’s one of their most closely-guarded secrets. Non-directional trading approaches can be used in any types of financial markets; they can be used in Forex markets. For example, one method is to go short on both the EURUSD and the USDCHF a few hours after the open of the markets, especially when it’s observed that they’re in a trending mode. This is one effective way of making money from the negative correlation of the two pairs. Using an RRR of 1:3 enables traders to gain about two times the loss that is sustained from one trade.

A habitually choppy trading instrument would tend to remain choppy in spite of being punctuated by sustained trending moves. In the face of a sustained trending move, there would normally be occasional pullbacks. Given this, optimal stops ensure that normal market fluctuations wouldn’t stop us out quickly, nor would we experience a huge negativity on a position because of a protracted loss trade. In order to run our profits for a considerable amount of time, fairly wide stops must be put in consideration so as to make room for normal market fluctuations.

Trading Like a Market Wizard
The trading methodology that’s discussed here is the one that makes use of positively correlated pairs in Forex. It is completely NFA-compliant, and thus, it can be used by all traders the world over. The risk is low and limited. With this non-directional strategy, we consider instruments that are in positive correlation only, not the ones in negative correlation like the EURUSD versus the USDCHF. There are many examples of positively correlated instruments in Forex, but we want to watch for opportunities on those which are somewhat popular. The highly correlated pairs we’d like to use are:

Gold and Silver

Let’s consider AUDUSD and NZDUSD. Both are positively correlated, i.e. when one goes up, the other goes up, and the other way round. When one moves sideways, the other also moves sideway. Meanwhile, a good non-directional trading signal occurs when one of the highly correlated pairs goes north significantly and the other one goes south significantly. How do we know this? We put the RSI period 14, levels 70 and 30 on the 4-hour chart. When one of the two normally correlated pairs has recently gone above the level 70 (or 30) and the other one has recently gone below the level 30 (or 70), we open new orders.

We want to bet on the transitory negative correlation of a normally highly-correlated pair. We short the instrument that goes north and purchase the one that goes south.  In time, the two instruments would become positively correlated again, and that’s how we make our profits.
The only issue with this strategy is that its trading signals in Forex markets (especially on popular pairs and exotic crosses) are few and far between.

Both trades make money in 60% of cases. About 70% of cases, one trade makes less loss than profit in the other trade. Please take note that when a stop for a trading method is wide, this would make sense only if the method has a hit rate of at least 60%. A wide stop with a very low hit rate won’t improve any statistics. Combining medium-term and long-term speculative outlook enables us to close trades that quickly meet our target and at the same time, create more leeway for those that take longer time to meet our target.

Trade, Money and Risk Management
Once new orders are opened, trading becomes managerial and discretionary.  We risk only 1.5% per trade, setting our stop at 150 pips. The take profit is usually 300 pips. A breakeven stop is triggered when a trade has at least 70 pips in profits. A trailing stop of about 100 pips is triggered when the trade has at least 170-pip profit. When two open trades of a correlated pair have profits that are up to 200 pips in total, the two trades are smoothed. When the difference between a negative trade and a positive trade is at least, 200 pips in profits, the two trades are smoothed.

The duration for a positive trade is about one month. A negative trade may reverse or it would be left alone until it hits the stop (but the stop wouldn’t be widened under any circumstances). In most cases, we look for trading opportunities every Monday. We look at 4-hour charts for this purpose.

Conclusion: In addition to the JPY Pairs Pullback Trading Signals and Premium Signals on selected pairs/crosses, this Non-directional Trading Signals would be sent to our readers as soon as they’re pinpointed. This article is important in that it reveals the rationale behind the signals that would be generated with the trading approach, plus the stop, the breakeven stop, the trailing stop, risk per trade, exit possibility and trading duration. These facts won’t be repeated in coming signals – only signals would be sent. 

This article is ended by the quote below:

“If I get into a protracted drawdown, I reduce trading size until it stabilizes, or my positions start working again.” – Larry Tentarelli

Learn from the Generals of the Markets: Market Generals

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