Back in March when I posted the results for one of my simple systems, there was a lot of disbelief. How can such a simple system possibly work? If there’s no logic behind the strategy, then it can’t be profitable. You must’ve curve fitted the data somehow. These are just some of the comments I got when I posted this simple trading strategy.
In this article I will provide an update that shows how the system performed this year. I will also go over the process you should undertake to evaluate trading strategies and the steps needed before including a system in my trading arsenal. But first, a brief recap of the system and the backtested data.
Simple Set and Forget System for EUR/JPY
The rules for this set and forget system are very simple. It’s a weekly breakout strategy. After the markets open on Sunday at 23:00 CET (17:00 EST) we wait for the first 4 Hour candle to close. This happens at 3 AM CET on Monday, or 9 PM EST. If your broker has different 4 Hour settings, just use the hourly chart and draw a breakout box from 23:00 to 03:00.
Place a Buy stop order at the high of the 4 Hour breakout box + 20 pips (+2 pips added for the spread)
Place a Sell stop order at the low of the 4 Hour candle - 20 pips
Here are the rules I used during the backtest. I tried to keep the rules simple and robust to avoid curve-fitting the data. The stoploss is placed at the opposite side of the of the breakout channel. If we are long we exit our trade when price breaks the low of the breakout channel and we simultaneously enter a short trade. But we only take two trades per week maximum, one long, one short. If we’re stopped out of both, we’re done for the week. The take profit is at 4 times our initial risk (more on this below). I kept all trades open until either the stoploss or take profit was hit. I didn't close trades at the end of the week. The chart below shows an example of a winning trade that hit the 4R target.
Backtest for 2013/2014
The table above shows the results for this system during 2013 and 2014. The R above stands for initial Risk. I don't use pips in my backtests because using this measure doesn’t tell us much about the risk side of the trades. Winning 100 pips while risking 100 pips has a completely different risk profile compared to winning 100 pips with a 25 pips stoploss.
As you can see, despite having a very small win percentage of only 22.4%, the system ended up making a profit because of its high risk to reward ratio of 4:1. We only needed to get one win to ‘’neutralize’’ 4 previous losses.
Using R instead of pips allows us to immediately calculate the earning potential of this system. For example, if we risked 0.5 percent on each trade, we would end up with a gain of 7.5 percent. At 1% per trade, this comes out to 15 percent.
Forward Test for 2015
When evaluating a trading strategy, backtesting is only part of the work that needs to be done. Before including a system in my trader’s toolkit, I always forward test it as well.
The main difference between forward testing and backtesting is that backtesting is done on past, in sample data. For example, the EUR/JPY backtest above covered most of 2013 and 2014. Forward testing on the other hand uses out of sample data, this is data that wasn’t covered in the backtest. The usual way this is done is by trading the system for several months on a demo or live account. But if execution isn’t a major factor, you can also shelve the system and come back few months later to perform a backtest of the new data. For us in this article, January 5th 2015 to September 20th 2015 is the new data we will test the system on. There is one important caveat before we proceed.
You Can’t Make Any Changes!
After you’ve established your trading rules for the backtest, you can’t change them when it comes time to do the forward test. If you change any important variable, you’re essentially doing another backtest, now with the newly acquired data.
The picture above shows the forward test for our system during 2015. All the rules are exactly the same. We had a total of 56 trades during this time period. Out of these, only 14 were profitable, a win ratio of 25 percent. But the size of the winners was enough to cover the 42 losers and come out ahead. The 25% win ratio is very close to the percentage during the backtest, 22.4%. The lack of major data discrepancies leads more credence to the forward testing stage.
During 2015 so far, this simple set and forget system produced 14 Rs. This means that if we risked 0.5% on each trade, we would net approximately 7%. For 1% risk, the return goes up to 14 percent.
Systems Are Only Half of the Battle
I’m a believer in using systems as tools, applying strategies fit for the current market environment, not indiscriminately. This summer I posted an article detailing simple trading systems that would do well in range-bound markets. I followed up this article with results on how the systems performed this summer. Here’s why I think this EUR/JPY system may continue to perform well, despite its good showing in 2015.
This System Will Benefit From the Coming Volatility
As a breakout system, this strategy will benefit from the coming volatility. Historically September and October are good months for trending/breakout systems in forex. Furthermore, with China’s economy crashing and Europe slowing down, we’ll hopefully see volatility spike in the EUR/JPY. The Yen is highly sensitive to Chinese data and the recent patch of weak figures in the EU has reopened the debate for more Quantitative easing by the ECB.
Putting Real Money Where My Mouth Is
I didn’t put this strategy together so I can post an article about it. I currently trade this system with my real money. Just to prove this, here are some screenshots from my real Dukascopy trading account. The week started with a false breakout to the upside in EUR/JPY. Total loss on this trade was close to $250 dollars.
The second trade (shown above) was entered at the same time the long was stopped out, at 135.178, as per the system rules. This trade is still open and is currently up by 73.7 pips, or $290 dollars. At one point during the life of this trade I was up by over $750 dollars, when the EUR/JPY fell to a low of 133.15. This is where many traders falter. They take profit too early, or modify the strategy on the fly.
But you got to stick to the system. If I exited at $700 or $750 profit, I wouldn’t be following the rules of the strategy. This would make both the backtest and forward tests worthless and in this case, you end up trading on luck alone. If the swings of the equity make you uneasy, try a smaller trading size. If you’re still not comfortable giving back gains, then this system is probably not for you.
Past performance is not indicative of future results and this system could stop performing at any time.