What Statistics Are Important in Forex?

Tuesday, December 27, 2011
When you are testing a Forex system or method, you are testing it to see if it can provide consistent, repeatable profits. The only way for you to see this objectively is through statistical evidence. There is a tendency for new traders to assume that there is one all important statistic which they should work on, but this isn’t a realistic way of going about developing a system that works. Many people think that if they create a Forex system with a high win percentage, for example, they will be profitable. But what if your losses are all huge and your wins are tiny? You might still have a losing system.

The best approach is to cultivate a number of Forex statistics which provide you with important information about your trading. Well-gathered statistical evidence will not only demonstrate to you whether a system is profitable, but give you information which you can use to improve that system. Here are some important statistics to focus on during your Forex backtests and demo tests.

  • Win/loss ratio (or win percentage). Obviously you want to get a high percentage of wins and a low percentage of losses. This is one of the most important things you can aim for, but as mentioned already, it isn’t everything.
  • Size of wins and losses. You want larger wins and smaller losses if possible.
  • Net pips. How many pips have you made, total, over the course of the Forex test?
  • Number of breakeven Forex trades. How many trades did you break even on? The reason this is important to calculate is because you will usually lose a little money on breakeven trades since you must still pay the spread for the trade. You will need to add up the costs of your breakeven trades and subtract that cost from your net profit. It can be significant if you have a lot of breakeven trades.
  • Worst losing streak. How many losses in a row did you incur during your worst losing streak?
  • Average number of winning trades per day/week/month/year. If you’re eventually going to trade for a living you need to get some feel for how much money your system might actually make you in a given real life time period.
  • Number of winning/losing trades for various types of Forex trades. If your method involves multiple entry methods, tally up data on every single one of them. You may also want to take notes on context. You may discover a price pattern or indicator which works great in one context works poorly in another. You can then make the adjustment to your next test.
  • SOL Quotient. This term comes from well known Forex trader Rob Booker. Your SOL Quotient = your net profit/maximum loss. The resulting number is how many of your worst losing trades you’d be able to withstand in a row before blowing your net profit. Naturally you want this to be a large number.

You can profit with any one of these statistics being poor — if the others make up for it. There is no one golden statistic which determines statistics — but taken together these statistics can help you to succeed at Forex. If you are using MetaTrader platform to backtest or demo test your trading strategy, you can then use a report analysis tool to get all these important statistics.

If you want to share your opinion on the importance of various FX trading statistics, please use the commentary form below to post it.

What Is Moving Average?

Monday, December 12, 2011
One type of indicator which you'll see time and again as you are learning about Forex is the moving average (MA). Moving averages are lagging indicators—this means they don't predict price direction, but rather are calculated from past prices. There are four popularly used types of moving averages: Simple, Exponential, Weighted, and Smoothed. You will rarely see Weighted moving averages used in Forex, but we'll go over them anyway. Most traders prefer to stick with Simple and Exponential moving averages. The default is to calculate moving averages using closing prices, but you can also choose to calculate using High, Low, Open, Median, Typical, and Weighted prices. You'll be able to choose how to calculate your moving averages in your charting platform, unless you wish to calculate them manually.

Let's start with simple moving averages (SMA). A simple moving average is calculated by adding up the most recent N number of prices and then dividing that sum by N. What is "N"? It's called a period of moving average and you can set it in your charting software. It can take any positive integer value from 1 to infinity. It indicates how many days (or hours, or weeks, or any other chosen periods of time) you’ll be adding up. The general formula for calculating the simple moving average for a given moment of time is:

SMA = (P0 + P1 + ... + PN-1) / N

For example, you chose 5 as the number of days (period), and the Close prices for those are (from oldest to most recent): 1.3345, 1.3348, 1.3350, 1.3374 and 1.3325. Then the simple moving average can be calculated as:

SMA = (1.3325 + 1.3374 + 1.3350 + 1.3348 + 1.3345) / 5 = 1.33484

With an exponential moving average (EMA), the calculation is more or less the same, but the difference is that exponentially less weight is given to the older data. This is done to reduce lag. Here's a general formula to calculate the EMA:

EMA = EMAprev + alpha * (price - EMAprev)

Which means that the EMA for today is calculated based on the EMA value yesterday, today's price and the special multiplier α, which can be anything from 0 to 1 (the higher it is, the sharper is the exponential decline of the weight of the older data). In Forex, α for exponential moving averages is usually calculated as 2 / (N + 1), where N is the period of the MA.

For example, we have the same data and period as in the above example for SMA. Let's calculate α:

α = 2 / (5 + 1) = ~0.33

The EMA of the first day is considered equal to the price of that day:

EMA1 = 1.3345

EMA2 = 1.3345 + 0.33 × (1.3348 - 1.3345) = 1.3346

EMA3 = 1.3346 + 0.33 × (1.3350 - 1.3346) = 1.33473

EMA4 = 1.33473 + 0.33 × (1.3374 - 1.33473) = 1.33561

EMA5 = 1.33561 + 0.33 × (1.3325 - 1.33561) = 1.33458

As you see, it's quite different from the result obtained using the simple moving average calculation.

A weighted moving average (WMA) is similar, except that in the case of an EMA, the weight given to each older point of data decreases exponentially. In the case of a weighted moving average, the weight decreases incrementally. In general case the WMA is calculated as follows:

WMA = (n * P0 - (n - 1) * P1 + ... + PN-1) / (n + (n - 1) + ... + 1)

If, for example, we choose the same data and period as in the examples above, we'll get the following result for the weighted moving average:

WMA = (5 × 1.3325 + 4 × 1.3374 + 3 × 1.3350 + 2 × 1.3348 + 1 × 1.3345) / (5 + 4 + 3 + 2 + 1) = 1.33475

Once again, the result is somewhat different from both SMA and EMA.

A smoothed moving average (SMMA) is like a mix of a simple moving average and an exponential moving average. In general, it's calculated the same way as the EMA except that the multiplier α = 1 / N:

SMMA = SMMAprev + alpha * (price - SMMAprev)

Consider the same example with the same 5 pieces of data. Let's calculate the multiplier:

α = 1 / 5 = 0.2

The SMMA of the first day is taken as the price of that day:

SMMA1 = 1.3345

SMMA2 = 1.3345 + 0.2 × (1.3348 - 1.3345) = 1.33456

SMMA3 = 1.33456 + 0.2 × (1.3350 - 1.33456) = 1.33465

SMMA4 = 1.33465 + 0.2 × (1.3374 - 1.33465) = 1.3352

SMMA5 = 1.3352 + 0.2 × (1.3325 - 1.3352) = 1.33466

Although it's different from all of three previous variants of the MA, as you see, it's closer to the result obtained with the EMA calculation.

The nice thing about charting software is that you don't have to learn all these formulas; your charting platform will do your calculations for you. All you have to do is choose the periods you want to calculate the moving averages across and let the software display them for you. Here is a MetaTrader chart of the daily GBP/USD showing all four types of moving averages applied to the close for a period of 14:

4 Moving Averages: Simple, Exponential, Weighted, Smoothed

Simple Moving Average: Red
Exponential Moving Average: Blue
Weighted Moving Average: Green
Smoothed Moving Average: Orange

As you can see in the chart, exponential and weighted moving averages are faster than simple moving averages, and smoothed moving averages are the slowest of all. The longer the period of any moving average, the greater the lag will be.

What can you do with moving averages? Most people who trade moving averages use them either to provide context for other systems or on their own in crossover systems. Moving averages tend to act as support and resistance levels; a lot of people like to place a slower moving average and a faster moving average on their chart, and then wait for the faster moving average to cross under or over the slower one. This can indicate an opportunity to sell or buy respectively. But one should also remember that moving average is not some magic trading tool and it will often fail.

If you have any questions or want to share some useful info regarding various types of moving averages, please feel free to reply using the commentary link below.

What Is Confluence in Forex?

Sunday, November 6, 2011
In Forex, especially while studying technical analysis, you may hear the term "confluence" used in conjunction with trade setups. What is confluence and why should you care about it as a Forex trader?

Confluence refers to any circumstance where you see multiple trade signals lining up on your charts and telling you to take a trade. Usually these are technical indicators, though sometimes they may be price patterns. It all depends on what you use to plan your trades. A lot of traders fill their charts with dozens of indicators for this reason. They want to find confluence—but oftentimes the result is conflicting signals. This can cause a lapse of confidence and a great deal of confusion. Some traders add more and more signals the less confident they get, and continue to make the problem worse for themselves.

Most Forex traders who succeed do so with a minimal number of indicators on their charts. Two or three is a good number of indicators to aim for. Some traders use just one, and some use none at all—though it’s harder to find a good trade context if you don’t have any at all.

Here is a good example of using confluence to place a great Forex trade. Say you trade using price patterns formed by the candlesticks on your chart, and you see a pattern which signals a "buy" trade. While the price pattern itself might be all you need to be right 80% of the time, perhaps you’ve discovered that confirming the pattern with some confluence can help you to be right 90% of the time. Maybe you’ve tested and discovered that Fibonacci retracement levels can help you find a good context. If your price pattern which signals "buy" lines up with a Fibonacci retracement level which is acting as support, then that is a great example of an "A" trade confirmed by confluence (the price action and the Fibonacci level). Note how this is not a cluttered Forex system. Aside from the Fibonacci levels, there are no indicators drawn on the charts at all. All you’re looking at here are price patterns. You only overlay the indicator when you want to check the context surrounding a price pattern. If you notice that the retracement level matches up with a pivot point you’ve been keeping an eye on, that’s another form of confluence.

This is only one example of using confluence in Forex. There are many different ways to use confluence. Systems are as varied as personalities. Test different combinations of signals to determine the best Forex indicators for you to use. Experiment and see what gives you the best statistical results over a large number of trades using historical data. Maybe you’ll find that using confluence of moving average crossovers combined with Fibonacci levels gives you great results. Maybe you’ll discover that Bollinger bands used in conjunction with support and resistance tests well. One thing which is important to note is that when you experiment with confluence, you need to choose indicators which are independent of each other—not calculated using each other. Otherwise you will stack up time lag, which will decrease accuracy.

Confluence is beneficial because it does more than show you a good setup in isolation—it shows you a good setup in context of the market. This is essential in Forex to avoid fake outs, unexpected reversals and trading against the trend. In a way, most Forex systems are built on the idea of confluence. If you haven’t found a system you like, this is how you can start building one from scratch. A good system will show you what’s going on right now, and how it fits into the bigger picture—and how you can profit from that knowledge.

Avoiding Slippage in Forex

Friday, October 14, 2011
«My Forex broker cheated me. I put in an order at one price and it got filled at another, and now I’m in a losing trade. That’s why I’m losing.»

How often have you heard that story, or been tempted to tell it yourself? One of the many risks of trading Forex is something called slippage. No, it’s not your broker cheating you (well, that’s up for debate, but seriously, don’t make excuses for your lost trades). It’s something you need to be aware of and compensate for during your trades.

What is slippage in Forex? Slippage is when you place an order at a quoted price, and your order gets filled at a different (worse) price than the one you were quoted. Slippage can be minor enough not to impact your trade outcome at all, or it can be major enough to stop you out the moment you’ve entered the trade! You can lose a lot of money through slippage, so it’s something to be wary of and to avoid if at all possible.

Why is there slippage in Forex? Slippage tends to result during times of great volatility, and also in response to fundamental events like reports being filed, etc. Slippage almost always happens when the market opens each weekend on Sunday nights! If you stay in a trade over a weekend, be very wary. Sunday nights are unpredictable—in general this is not a good day to trade.

If you do place a Forex trade which you’re going to hold over the weekend, or set up for a trade on the weekend which might get triggered when the market opens again, compensate for that potential slippage. Place entries a little farther out than you usually would (testing will help you choose a good amount of buffer to leave). You may also want to move your stops out a little farther than usual too if you are already in a trade.

Do some Forex brokers deliberately make money through slippage? Probably, but slippage is a fact of life, even with good Forex brokers. It’s best to learn to deal with it than to complain and blame someone else for your failure. There are bad brokers out there though, so if you’re concerned you might have one, look up their ratings and find out about other traders’ experiences.

On a related note, you can set up most broker platforms to show you the spread. This should help you to understand spread and slippage better and thus make better trading decisions. Spread widens and shrinks in different market conditions—during volatile ones it tends to widen (which is how slippage usually occurs). By setting your charts to show this spread, you’ll be able to visually see the days of the week and the times at which the spreads widen the most. Then you can compensate in the future by following the previous suggestions to avoid slippage in Forex outright or work around it.

What to Include in a Forex Backtest Spreadsheet

Thursday, September 29, 2011
One critical step on your Forex journey is going to be backtesting. Once you find a system or method which you like, you are going to need to run through historical data and see how your method would have performed on real trades over the past few weeks, months or years (depending on the timeframe you’re planning to trade). It is recommended you do at least a couple hundred of backtest trades for any given system to establish a really good idea of how the Forex system will perform in those market conditions. Market conditions do change, so a backtest still doesn’t give you all the information you need, but it can sure give you a good lead in to your demo testing. If you record a lot of important information you can also learn specific things that work and don’t work and how you can refine your system to statistically improve your profits.

On a Forex backtest spreadsheet you will want about six columns. The first will state whether each trade was a buy or a sell. The second column should list the date, and the third column the reason for the trade. The fourth and fifth columns should be the entry and exit prices respectively. The last column will be the sum of pips you gained or lost from each trade. The column where you list the reason you entered the trade can be a good place to take specific notes along with the triggers which caused you to enter. Those notes will come in handy later, so be detailed, especially on trades you lose. Later you can look back and find patterns which will help you to refine and eliminate losses.

Write your Forex trading rules at the top of your spreadsheet. They will help you focus and also remind you of what your rules were on this backtest when you look back on it later. If you make changes as you go to your system, note those changes and the historical dates on which you implemented them.

Some statistics to calculate from your data, which will be useful to you, include net pips from your entire Forex backtest, along with the values of your average win and average loss. You’ll want to tally how many wins and losses you have, and what your win percentage and win to loss ratio is. Remember that the spread will cost you some profit on every trade, and breakeven trades are technically at a very small loss as a result. You can calculate an adjusted net which takes these losses into account. Take note of your biggest losing streak, and how many losses in a row you endured. Also find out your average net winning trades per month, week, day, or whatever is an appropriate unit of time for you to overview your trading. Another good quotient to add up is your net profit divided by your maximum loss. This will tell you how many of your largest losses you could endure before blowing all your profits.

Forex backtesting can be pretty overwhelming at first, but eventually you’ll get used to it and get into a rhythm. And it can be incredibly rewarding—it can make the difference between whether you blow your account in real life or become a profitable trader.

Tips for Trading Forex at Night

Thursday, September 22, 2011
For a lot of us (especially in the US), the best times to trade Forex fall at the worst times of day—either during work hours or while we’re asleep at night. Fortunately for those who trade the dailies in the US, the start of the new candle tends to happen in the afternoon, but that often means that trades will span overnight on this and other timeframes. What do you do if your trading schedule is this inconvenient? Suggestions online usually range from “quit your job” to “move to Europe.” This is hardly feasible for most of us. Most of us are going to be faced with examining an option which is more viable but still challenging: trading Forex at night.

For many people, trading overnight is just a given since position traders who trade longer term charts like weeklies are going to be in trades for many days on end. These timeframes move slowly though and are easier to keep an eye on during the daytime than other trades on faster timeframes. What if you trade the dailies or hourly charts? You could be stuck making critical trading decisions in the dead of night.

Unfortunately many FX traders arrive at the solution, “I’ll just not sleep.” This is the road to disaster though. You cannot function without sleep. You need sleep to be healthy and also to keep your mind sharp and fresh. Trading on a sleep deficit is like trading inebriated. It’s just a really bad idea; it’ll destroy your health and your finances. So you have to sleep. How do you balance sleep with currency trading at night?

The trick is to set up alerts in such a manner that you can maximize your rest, minimize the complexity of your decision-making process, and maximize your returns. You want to only have your alerts wake you up at critical junctures, and you want those junctures to be clear cut. Making difficult, complex decisions in the dead of night will rob you of sleep and also harm your judgment, resulting in losses. The alerts should wake you up in order to make simple, straightforward decisions.

One technique you can use to trade during the night is to set alerts at pivot zones. Different techniques will be appropriate for different Forex systems, but if for example you exit trades partially based on support and resistance, then you will want to identify important pivot areas and set alerts in those areas. Choose a sound to signal when a trade is moving toward profit and another sound to signal when it is moving away. That way if you hear the “good” sound in your sleep you can roll over and go back to sleep (or get up and trail your stop). If you hear the “bad” sound you can get up and choose whether to exit. By letting the sound itself give you information, you can optimize your sleep. Also make sure to have the alert beep at you more than once so you don’t miss it in your sleep the first time.

Trading the foreign exchange market at night is one of the most challenging real life integrations you can do, but with some tweaking you should be able to make it work for you. You don’t have to move to another country or quit your job to trade during the day if you can learn how to trade at night and get adequate sleep!

Trading in Real Life: Why You Need to Demo Test

Tuesday, September 13, 2011

Have you backtested a fantastic system over hundreds or even thousands of trades, and achieved a high win percentage and otherwise excellent statistics? If so, you may be tempted to go live. Some traders struggle to bring themselves to actually take their Forex systems live, but for others it is impatience and not trepidation which is the enemy. If you are thinking of taking this great system which you’ve backtested live without demo testing, think again. Backtesting and trading in real life are completely different, and you may have quite a bit of work ahead of you to achieve the same kind of results in real time as you did backtesting.

The first thing a lot of us discover while demo testing is that we completely forgot that in real life we do stuff like work, eat, and sleep. Something which worked fine in backtesting may be impossible to fit into our real life schedules, or take some very serious workarounds. You may need to learn to trade using a cell phone if you are at work during trading hours for example. Or what if your Forex trades tend to fall in the dead of night? You’ll need to trade in your sleep, and that means setting a lot of price alerts. Those alerts will have to wake you up at useful times though, and even figuring that out can be like designing an entirely new system. The wrong system of alerts can cause you to lose the same trades you’d have won while demo testing!

Another difference you’ll discover quickly is the role which time plays in your trading psychology. When you move the Forex charts forward a candle at a time and make trading decisions in a few seconds or minutes while backtesting, you don’t have a lot of time to second guess yourself. The same trades though, spread out over a time period of hours, days, or even weeks, can cause a lot of traders to experience a wide range of conflicting emotions. Many times we ask ourselves “What decision would I have made backtesting?” only to discover that we don’t know anymore! It takes a lot of practice to find out how timing is impacting your trading. You may find you need to trade on a different timeframe, or just get a grip on your emotions.

While all this may again sound simple in theory, most traders discover Forex demo testing presents a lot of unexpected situations which need resolution before they can go live. We highly recommend that you demo test until you are profitable for at least 2-4 consecutive months before you go live with your system. There is no reason for you to lose a dime in this business unnecessarily since you can demo test for as long as it takes for you to master your trading, completely free! Your drawdown live should reflect your backtesting figures, but it won’t unless you invest some time and effort demo testing and finding out how to integrate trading into your real life first.

Good Forex Trades Need Great Context

Monday, August 29, 2011

On your path to becoming a profitable trader, you will test many different methods for entering and exiting trades. At some point you may find a method which works pretty well for you and which you feel comfortable using. You may take a lot of great trades using this method, only to find that one day your method just stops working. What happened? Did your system break? Will you have to start all over?

Sometimes the answer to questions like this is simpler than you might expect. A lot of traders pay attention to entry triggers like moving average crossovers, price action patterns, and other indicators lining up on their charts, but don’t pay as much attention to what the market is doing on a given day. The market does slowly transform, and like any other living system it will evolve with time. Some things about Forex will never likely change, but others are sure to do so. The “mood” of the market can change considerably as the years go by, and a system which worked great in one context may fail in another—or simply need an adjustment to keep working.

If you are in a situation like this and your system has abruptly “failed,” you may want to ask yourself if this is what has happened to you. Has the economic climate changed substantially since you were last profitable? If so, then perhaps the context around your trades has stopped being quite as optimal as it once was. You may have been placing trades in an excellent context before without even knowing it or attempting it by complete coincidence. And now that the context isn’t as great, your trades aren’t working out.

Here are some questions to consider. Ask yourself, “Am I trading against the trend?” This can often work against you. “Am I trading in a choppy market?” Choppiness kills a lot of traders. If there are a lot of fake outs, sometimes you need to take a break and wait for the market to even out a bit before you come back in. “But I’ll have to wait forever,” you might say. If this is the case, then look at more currency pairs. If you only trade a couple of pairs, and great setups are coming half as often in the current market climate, then think about looking at twice as many pairs each day. This phase of the market, like all others, will pass. It doesn’t mean your system is broken, it just means that right now it’s a little harder to make it work than usual. All traders face this sometimes. Once in a while you may indeed find you need to go back to the drawing board, but more often than not it’s a waste of time to start all over. If what you have makes sense and it works often enough, than you probably should just adapt to the market conditions and stick with what you’ve got.

Develop a technique to find the best setups in the best locations. Great Forex traders point out that finding excellent setups is like using a rifle, not a shotgun. They’re right—good trades don’t take good setups, they take great setups.