Saturday, September 20, 2014

Filtering of trend following set ups

For a change, I thought in this post I would focus on a different market. Ever since I started trading it has almost exclusively related to trading equities, however opportunities can and do arise on other markets or instruments. This can add diversification to your own trading and is certainly something I am considering going forward.

Below are a couple of charts from different periods of the USD/JPY forex pair. In these charts, you should clearly be able to see the trending or non-trending phases.

You will also see that, on plenty of occasions, a new long or short signal quickly failed. This is typical of trend following using price channels and breakouts as a method of entering and exiting your trades. You should not necessarily rely on price simply breaking out to new highs or new lows.  It makes sense to look at adding some filters to your trade selection. These may include one or more of the following:
  • Looking for contractions in volatility prior to possible breakouts (as identified by an indicator such as the Volatility Factor indicator shown on these charts);
  • Some long-term moving average trend filter (to ensure you are only trading in the direction of a much longer-term trend)
  • Basic visual characteristics (I look for either a prolonged consolidation or what I refer to as the 'staircase' as visual clues)
There are plenty of others you may want to consider.

Using the filters mentioned above would have kept you out of almost all the failed breakout signals, allowing you to profit from the subsequent big move.

One other point about including volatility in your trade selection. Ideally you want volatility to drop prior to entry, and then an expansion of volatility in the direction of the breakout. These types of set ups can allow you to use tighter initial stops, which may help you achieve larger R multiples of profit. The more volatile a market is, then your initial stop and position size should reflect that.

Quite often, I discount some setups simply because of that metric. I will tend to go for setups where there is potential for a bigger R multiple win, and looking at volatility helps me achieve that.

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