Trading

Forex Trading: When does Luck Matter?

Forex Trading: When Luck Matters

I hate to use a gambling analogy when discussing FOREX trading. But it is just so appropriate.

Most experienced FOREX traders would be offended if you compared them to a gambler, as well they should be.

There is a distinct and extremely important difference between a responsible FOREX trader and the typical gambler. The difference is expectancy. In this case positive expectancy.

Positive expectancy means the “game” you are playing, if played long enough, will yield positive results.

Negative expectancy is just the opposite. If a “game” with negative expectancy is played long enough, the outcome will be negative.

Casinos are built on games of negative expectancy (from the gambler’s point of view, not the casino owner’s). Most gamblers know this but hope to get lucky.

No FOREX trader in her right mind would play a game, or follow a trading strategy, with a negative expectancy.

This is the fundamental difference between the responsible FOREX trader and the average casino gambler.

Actually, the casino owner and the FOREX trader have much in common. They each find a handful of games with a small positive expectancy.  And then they play each game whenever possible.

The casino owner (or FOREX trader) knows that the outcome of single game (or trade) is unknown. However, the outcome of many games (or trades) will eventually meet its expectancy. In this case a positive expectancy.

The job of the casino owner is infinitely easier than that of the FOREX trader. In a casino, the odds are fixed, the number and quantity of variables are known.

In the FOREX market, the variables are constantly changing. And the reasons for the changes are not always clear. (I’d like to say that changes in the Market are at times senseless, but who am I to question the market? The market price is always correct.)

The only responsible way to trade the FOREX market is to exercise a trading strategy with a proven positive expectancy.

One of the best ways to implement a trading strategy and verify its profitability (or positive expectancy) is by using a mechanical trading system, like an Expert Advisor.  Also, an easy way to consistently execute a trading strategy is to run an Expert Advisor.

So, if a trader has a strategy with a positive expectancy and a platform to consistently execute the strategy, when does luck matter?

To the well funded trader: never.

To the under-capitalized trader: in the beginning.

Remember this  fact: the outcome of any one trade is unknown.

Actually, the outcome of a string of trades is somewhat unknown. For this reason, the starting-capital-challenged trader must pay close attention to the statistics of their trading system.  Especially the amount of the maximum loss and the number of consecutive losses. These statistics are used to determine the system’s maximum draw down.

The value of the system’s maximum draw down dictates the minimum starting account balance. To begin trading FOREX without knowing your maximum draw down, or to knowingly under fund your account based on the draw down, is well, trying to get lucky.

Trading

Is Trading FOREX a 50-50 Proposition?

Is Trading FOREX a 50-50 Proposition?

You’ve heard it before:

“Trading FOREX is easy. The market either goes up or down – you just have to be right more than half the time and you make money.”

Ah – if only it was that easy.

So is it true? Is trading FOREX a simple 50-50 proposition?

“I mean, if I have an Expert Advisor that performs just horribly, can I just change all the buy orders to sell orders, all the sell orders to buy orders, and have a terrific system?”
Let’s use a simple MetaTrader Expert Advisor to find the answer to these questions.

The 50-50 Expert Advisor enters a trade each time the 8-period Exponential Moving Average (EMA) crosses through the 13-period EMA. The Expert Advisor has two inputs, OrderFlag and Xbars.

The input value OrderFlag instructs the  50-50 Expert Advisor  to swap the order type between Buy and Sell. The input value Xbars is optional and can be used to exit a trade after any number of periods (or bars).

The market condition that causes an order to be created is consistent: when the 8-period EMA crosses through the 13-period EMA.

The following table summarizes the possible combinations and the resulting order type.

Input:OrderFlag   Market:8 crosses up through 13 Market:8 crosses down through 13 Output:OrderType
0 TRUE FALSE BUY
1 TRUE FALSE SELL
0 FALSE TRUE SELL
1 FALSE TRUE BUY

This handy Expert Advisor will allow us to test some theories regarding the 50-50 proposition.

Test #1 is a benchmark test.

  • It will buy each time the 8-period EMA crosses up through the 13-period EMA.

  • It will sell each time 8-period EMA crosses down through the 13-period EMA.

The stoploss is set at 50 points, the takeprofit is set at 75 points.

The following table summarizes the test input and the test results for Test #1.

 

                                                       iExpertAdvisor TestTable

 

                                                            Test Information
ExpertAdvisor Name

50-50 ExpertAdvisor

ExpertAdvisor Version

1.0

Test Number

1

Test Period

11/2003 – 8/2005

Currency Pair

GBP/USD

Chart Period

1 hour

 

 

                             Test Input

 

                       Test Results

Spread/Commission

5

Total Trades

305

StopLoss

50

Winning Trades

146

TakeProfit

75

Losing Trades

 

                     ExpertAdvisor Input

Winning Percentage

 

OrderFlag

0

 

 

Xbars

0

Total Net Profit

– $9,130

For Test #2, we will change the input value OrderType from 0 to 1. This will cause each trade’s order type to be reversed.

The Buys become Sells, and the Sells become Buys.

The following table summarizes the test input and the test results for Test #2.

                                                       iExpertAdvisor TestTable
                                                            Test Information
ExpertAdvisor Name
 50-50 ExpertAdvisor
ExpertAdvisor Version 1.0
Test Number 2
Test Period 11/2003 – 8/2005
Currency Pair GBP/USD
Chart Period 1 hour
   
                             Test Input

                       Test Results
Spread/Commission 5 Total Trades 304
StopLoss 50 Winning Trades 133
TakeProfit 75 Losing Trades  

                     ExpertAdvisor Input

 Winning Percentage  
OrderFlag 1    
Xbars 0 Total Net Profit – $28,210

Not what you would expect if trading FOREX is 50-50?

If trading FOREX is a simple 50-50 proposition, you would expect the following two conditions to be true:

  • The number of Test #1 wins would equal the number of Test #2 losses.
  • The number of Test #1 losses would equal the number of Test #2 wins.

Well, the spread is set to 5 points. Perhaps the spread is obscuring the test results.  Let’s rerun tests #1 and #2, with the spread set to 0. These are tests #3 and #4.

The following table summarizes the test input and the test results for Test #3.

                                                        iExpertAdvisor TestTable
                                                              Test Information  
ExpertAdvisor Name
 50-50 ExpertAdvisor
ExpertAdvisor Version 1.0
Test Number 3
Test Period 11/2003 – 8/2005
Currency Pair GBP/USD
Chart Period 1 hour
   
                                                    Test Input

                    Test Results
Spread/Commission 0 Total Trades 74
StopLoss 50 Winning Trades 202
TakeProfit 75 Losing Trades  

                      ExpertAdvisor Input

 Winning Percentage  
OrderFlag 0    
Xbars 0 Total Net Profit – $4,370

Now let’s reverse each order type (by setting OrderFlag=1) and retest.

The following table summarizes the test input and the test results for Test #4.

                                                        iExpertAdvisor TestTable
                                                            Test Information
ExpertAdvisor Name
 50-50 ExpertAdvisor
ExpertAdvisor Version 1.0
Test Number 4
Test Period 11/2003 – 8/2005
Currency Pair GBP/USD
Chart Period 1 hour
   
                             Test Input

                       Test Results
Spread/Commission 0 Total Trades 218
StopLoss 50 Winning Trades 79
TakeProfit 75 Losing Trades  

                     ExpertAdvisor Input

 Winning Percentage  
OrderFlag 1    
Xbars 0 Total Net Profit – $6,430

Again, not what you would expect if FOREX is a 50-50 proposition.

Each trade entry has definitely been swapped, so perhaps the discrepancy is caused by the trade exit.

Maybe the lack of symmetry between the trade’s stoploss and takeprofit is the problem.

Let’s set the stoploss equal to the takeprofit at 125. These are tests #5 and #6.

The following table summarizes the test input and the test results for Test #5.

                                                        iExpertAdvisor TestTable
                                                            Test Information
ExpertAdvisor Name
 50-50 ExpertAdvisor
ExpertAdvisor Version 1.0
Test Number 5
Test Period 11/2003 – 8/2005
Currency Pair GBP/USD
Chart Period 1 hour
   
                             Test Input

                       Test Results
Spread/Commission 0 Total Trades 118
StopLoss 125 Winning Trades 50
TakeProfit 125 Losing Trades  

                     ExpertAdvisor Input

 Winning Percentage  
OrderFlag 0    
Xbars 0 Total Net Profit – $23,500

Now let’s reverse each order type (by setting OrderFlag=1) and retest.

The following table summarizes the test input and the test results for Test #6.

                                                        iExpertAdvisor TestTable
                                                            Test Information
ExpertAdvisor Name
 50-50 ExpertAdvisor
ExpertAdvisor Version 1.0
Test Number 6
Test Period 11/2003 – 8/2005
Currency Pair GBP/USD
Chart Period 1 hour
   
                             Test Input

                       Test Results
Spread/Commission 0 Total Trades 118
StopLoss 125 Winning Trades 68
TakeProfit 125 Losing Trades  

                     ExpertAdvisor Input

 Winning Percentage  
OrderFlag 1    
Xbars 0 Total Net Profit + $23,500 *

That’s more like it! The symmetry is easy to see in the test results.

  • Test #5 number of losses is equal to Test #6 number of wins.
  • Test #5 number of wins is equal to Test #6 number of losses.

If the time-based exit is used (by setting Xbars), and the commission is zero, the test results are symmetrical as well (Try it).

We conclude, trading FOREX is a 50-50 proposition, if the following two conditions are true.

  1. The cost of trading is free: no commission, no spread, no swap fees.
  2. The trade is symmetrical. Two examples are: the stoploss is equal to the takeprofit; or the exit is time-based.

Since condition #1 is never true, we can say confidently that trading FOREX is NOT a 50-50 proposition. (And even if the cost of trading was free, it’s unlikely a system’s entry and exit would always be equivalent.)

(Another advantage of backtesting an Expert Advisor is that you can quickly see the effect of trading costs on your system’s profitability.*)

It’s valuable to understand the true nature of the FOREX market. In future posts we’ll address other assumptions commonly made about the FOREX market.

*In case you are wondering, Test #6 is not a profitable system. When the spread is set to 5 points, the net profit is -$25,600.

 

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