Back to basics backtest - quality inside bars (OBSOLETE)

4 May 2012: Please note this post is now obsolete.

Results of my recent backtest on inside bars. 

Trading system:

- Place stops at either end of inside bar to trade breakout

- SL = opposite end of inside bar

Criteria:

- inside bar must be in top or bottom 50% of previous candle

- trade breakout in NEXT candle only

Here is a visual example:

Backtest Results

Six currency pairs were tested on the daily timeframe from 2004 to 2011. 257 trades were compiled. Trades with 1:2 risk:reward seem to be the most practical. 1:3 and 1:4 yielded slightly superior returns, but would require you to hold the trade for much longer.

I didn't include the overnight swap rate as it would be near-impossible to calculate for each trade.

Observations:

- The longest losing streak was six straight losses.
- Inside bars tend to fail breaking out in ranging markets ("stuck in traffic"), flat 21 EMA.
- Seem to perform better at new swing points in "virgin" territory.

25th April 2012 - loss on XAUUSD

This trade on gold didn't work out. A pinbar formed around support so I decided to go long. I saw a potential resistance level shortly above the pinbar so decided to place my entry some distance away. My SL was locked below this resistance level, so if resistance broke, it should turn into support and help repulse price from my SL.

My entry was triggered but price reversed shortly after, taking out my SL. My trade is graphed below.

Damage to my account was minimal.

I spent most of today mechanically backtesting inside bars (with very positive results), and will post my results later tonight or tomorrow after cleaning up my results.

24th April 2012 - loss on AUDNZD

While this trade is technically a loss, I'm learning where to place my take-profit stops (at first support/resistance). A pinbar formed on the AUDNZD overnight at a resistance level and BRN (big round number) of 1.27000. I checked for a second opinion with other traders, and the biggest concern was the close proximity of first support level, around 1.26500. 

Price broke the low of the pinbar before bouncing off support. It's quite amazing how these levels act as decisive points. I placed my SL at the 75% mark of the pinbar, which was taken out later today. I should pay more attention to resistance / support when placing my SL.

Since I'm only trading microlots, damage to my account was negligible. 

Lesson: Respect first support / resistance levels, place SL and TP around here.

In order to instill discipline and learning, I will extend trading in microlots for an additional week (May 4).

Lessons learned

Lessons learned so far. As time goes by, I hope to expand this list.

1. Respect first support / resistance areas. Set possible TP here.
2. Remain faithful to your original order setup (SL and TP), especially if they have been well thought-out. Avoid impulse trading. Exception: release of big news
3. Do not overtrade. Trade quality setups only.
4. Entering at the end of a retracement presents the best opportunity to maximise R:R and probability. 
5. Do your own homework
6. Question EVERYTHING, even if it comes from Dr. Alexander Elder (i.e. the 2% rule)
7. Use context-sensitive, self-adjusting rules rather than hard, arbitrary rules
8. Equity curve growth rate is influenced by profit factor, equity risk % and frequency of trades.

17th April 2012 - nominal win on GBPNZD

A very minor win on the GBPNZD. I went long after seeing two consecutive bullish candles (pinbar and engulfing bar) moving off support and in favour of the trend. Price moved in my favour to within 15 pips of my TP before reversing. I moved my SL to slightly above breakeven, and the SL was hit, resulting in a very minor win. Thankfully it wasn't a loss. 

GBPCAD

An update on the setup that I closed this morning. Looks like price did turn back in my favour once resistance was hit. When I saw this, I felt like laughing. TP#1 would've been hit if I had kept my trade open and stuck to my original SL.

 ^ Before

^ After

On that note, I will be taking tomorrow off.

How to Handle Losses

HOW TO HANDLE LOSSES by Kevin LaCoste

1. Do not live and die with each trade. A single trade is insignificant in the overall scheme of trading.

2. Regard each loss as a single event. If you experience a string of losses, each loss is an independent event. Consecutive losses are nothing more than coincidence. The market is impersonal and not out to prove you wrong.

3. Take a break from trading if you find yourself too emotional, or reduce your position sizes (preferably to minimum) until confidence is regained.

4. After a loss, do something productive or take a walk to gain some perspective.

5. Have faith in your trading system. It is logical and has been backtested extensively.

6. Look forward to your next trade and move on.

7. Remember your long-term goal - financial independence. The pain is worth it. You will look back and admire your resolve.

8. Analyse every loss and salvage lessons. Lessons create future profit.

9. A loss is a stepping stone to future success.

10. Every trader experiences losses. You cannot avoid them.

11. When using a valid trading system, a loss is nothing more than a cost of business.

12. Coping with losses creates mental muscle and discipline. Bear the pain and become a stronger trader and person.

17th April 2012 - loss on GBPCAD

I'm about three months into my trading journal, and I've run into what feels like a horror streak of losses. My last six orders have all ended as losers. This is when traders are psychologically tested, and I can definitely feel it. 

First, I'll briefly discuss my last trade.

GBPCAD

A strong bearish engulfing bar formed off resistance late last week. I decided to trade it. Because of its strong bearish momentum, I decided to split my trade into two shorts, with TP#1 at support level #2 and TP#2 at support level #3. I suppose this seemed quite greedy, but the size of the engulfing bar gave me confidence.

Price did move my way for a bit, but then bounced off support level #1 with a BULLISH engulfing bar. As soon as the bullish candle closed, I closed both orders. I had that gut feeling, hope, that price would return downwards. It was the same feeling I had in one of my recent losses. But I saw no technical signs suggesting a return to a bearish trend. Following the Zurich axiom, if all you have is hope, you should jump. That is precisely what I did. 

Right move? I think so. The bullish engulfing bar is a long signal and can be traded in itself. Remaining short against a bullish engulfing bar seems irrational. Not only would I have to beat newfound bullish momentum, I will also have to try breaking support level #1 again. Probability-wise, I think I made the correct move.

Lesson: Respect first support/resistance areas. Set possible TP here.

Handling losses

I felt quite emotional this morning as I got out of the trade. Somewhat frustrated, especially in the face of consecutive losses. I was acutely aware of the possibility of trading "out of control" and so I've sworn to trade in single micro-lots (smallest size possible) until the end of April. I will still be trading and logging my results, but I won't be making much money (or losing much either!).

Discipline is key.

15th April 2012 - weekend setups

I spent my Saturday night looking at possible market setups for Monday morning. Only one struck me as interesting, being the XAUUSD (gold).

XAUUSD

A two-bar reversal pattern presented itself on Friday's close. It looks as if gold is now moving within a downward-sloping channel. I'm trying to receive feedback from more-experienced traders about this potential setup, but it looks like something I like. The two-bar reversal has formed at both horizontal and channel resistance levels, and favours the overall downward trend.

12th April 2012 - loss on XAUUSD

XAUUSD

This trade went quickly against me. An inside bar formed below resistance, and so I placed a pending short at the IB's low. The short was triggered a few hours ago. Not long after, major economic news came out of the US showing a spike in jobless claims. The market forecasted 355k, but the real figure came out at 380k. This gap is bad news for the US dollar, causing it to weaken.

Emotional analysis

I was really confident about this trade since the IB formed during a retracement to the overall downward trend, the IB was positioned at the extreme end of the previous bar, it was small and provided an attractive R:R (1:1.5 to 1:3) and resistance held. Watching the market swing against me so quickly after my order was triggered was quite infuriating. I was unable to execute my "big news" contingency plan as market movement was frantic and a part of me hoped the market would turn in my favour again.

The best way to react to this loss is to be philosophical and not take it personally. Any news release can just as easily fall in my favour.

12th April 2012 - potential setups forming on AUDCAD and XAUUSD

A few possible setups are forming on the AUDCAD and XAUUSD (gold) daily chart. Both currencies show a retracement approaching a significant resistance level. I'll keep an eye out for reversal signals around this level.

AUDCAD

XAUUSD

4 Minute Drill for Traders

I found this nifty psychological resource on Youtube for traders, the 4-Minute Drill for Traders. Once you've got your trading system defined, the next obstacle is psychology. Check it out!

10th April 2012 - loss on EURJPY

A pin bar formed on the EURJPY overnight at a support level. I placed a pending long which was triggered, then ended in a loss. The pin bar is visually presented below.

Details of the order zoomed in...

I looked at any possible news releases that would explain the downturn but couldn't find anything of real importance. I guess this is one of those statistical trades destined to fail. A factor that could've went against my trade was the strong bearish momentum before the pinbar, where three consecutive bear candles exist. However, the pin bar itself was quite prominent and closed with a bullish tone. I don't really see anything screaming out not to take this trade.

Tightening my SL to the 25% mark of the pinbar helped improve R:R once again.

Improving R:R via moving your stop loss

I stumbled on this idea over the last week and decided to use it with my last AUDUSD trade.

It's conventional for price action traders to place their stop loss at the high or low of the price action signal that they are trading. Sometimes, though, the size of these price action signals can be huge. In other times, momentum can swing against you so strongly that it becomes prudent to leave the market earlier.

As an experiment, I'm deciding to place my stop loss 25% from the high or low of the price action signal. As you can see in the image below, I'm using the fib tool on MetaTrader 4 to determine the 25% mark. 23.6% is close enough. My logic is that if price is within 25% of your stop loss, the likelihood of your SL getting hit is extreme. Why wait when you can leave the market earlier and cut your losses?

Not only that, but tightening your stop loss provides a disproportionate benefit to your risk-reward ratio. Suppose you have a trade with an initial 1:1 R:R. If you tighten your SL by 25%, your R:R is now 0.75:1, or 1:1.33. You've increased your reward by 33% while sacrificing only 25% of your SL. This opens new trading opportunities in tighter markets.

It is a very aggressive form of trading. It is entirely possible for your new, tighter SL to be hit before price returns in your favour. In such a case, a winning trade becomes a loser.

As a quick backtest, I initiated 17 orders on XAGUSD (silver) during 2010 and 2011, focusing on pinbars at levels of support and resistance, with a minimum of 1:1 R:R using the tighter SL. 11 orders were successful. The backtest showed an expected return of 29.4% per order at 1:1 R:R.

4th April 2012 - loss on AUDUSD

AUDUSD

I went long on the AUDUSD last Friday. This trade began well. A pinbar had formed at a support level and proceeded towards my take-profit. As it reached halfway towards my TP yesterday, the RBA released its latest decision on the AUD cash rate and chose to keep it on hold for now.

This was what the market expected and the short-term bull run should have continued. Then the RBA tried to be cute and mentioned that there was a high likelihood of a cash rate decrease next month. That pretty much encouraged traders to discount the AUD today. I guess the RBA is trying to decrease the AUD and trigger some sparks in the Australian economy without having to move the cash rate. Clever, but does nothing for me.

Fundamentals prevailed over technicals, price fell and my stop loss was hit.

I've spoken with other price action traders and the consensus is not to trade during big news.

After mulling over this, I've arrived at the following lessons. During a big news day, if I have a trade open and:

* Price is >50% towards TP, close the trade and take profit. 

Rationale: I'm not far from my TP. If news is in my favour, I won't receive much benefit. Might as well take profit and run.

* Price is <50% towards TP but above breakeven, move my stop loss to breakeven.

Riationale: If news is in my favour, it'll provide the needed momentum to cover the distance to my TP target. If news goes against me, my breakeven SL will ensure I lost nothing.

* Price is <50% towards SL and below entry, move SL up by 25%

Rationale: If news goes against me, I won't lose as much. However, by tightening my SL by only 25%, I can still give my trade some space to breath and a chance for technicals to prevail.

* Price is >50% towards SL, leave trade as is.

Rationale: This is a similar reason as above. There's still enough space for the trade to breath but if the news is bad, I won't lose much. On the otherhand, if the news is good, a trade on the verge of losing will become a winner.