A couple of years ago, I compared a couple of back tests: both were of trend trading strategies, but one waited for the price to make a 1-day low against the trend, while the other applied positive momentum in the direction of the trend with the entry being triggered only upon a minimum 8-hour high price. The results of the back test showed that while both methods were profitable and robust when applied to the three major currency pairs (EUR/USD, GBP/USD, and USD/JPY), the momentum/breakout method had performed significantly better.
Over the last two years, I’ve got better at measuring edges, so I decided to repeat the experiment, but using some more precise statistical analysis of the relevant edges. I’m also going to use slightly different trading strategies for each of the two categories which we will call “Breakout” and “Pullback”.
Breakout Strategy
The breakout strategy enters a trade upon the close of an H4 candlestick when it is the highest or lowest close of the last 200 candlesticks. The candlestick must close in the top or bottom quarter of its range and its range must be greater than the 15-period Average True Range (ATR). Long trades need to be high/top, shorts low/bottom of what I described, obviously – this is trading with the trend/momentum.
Pullback Strategy
The pullback strategy is the same, but instead of the candlestick needing to be closing at a 200-period high or low, it needs to be making a new 6-candlestick low against the trend (e.g. low for long trades, high for short trades). The trend is defined as the price being either up over the past 3 and 6 months, or down over the same periods, in price.
Back Test Results
To measure the edges, I will be looking at the average close of the next 10 candlesticks after the entry in terms of units of the ATR 15: this is a volatility-adjusted trading strategy.
I measured the two major Forex currency pairs (EUR/USD and USD/JPY) from 2002 until the end of February 2019. Entries were taken only between 8am London time and 5pm New York time, except in the case of the USD/JPY currency pair in which entries could be taken also at Midnight London time. The edge ratio is the maximum profit divided by the maximum loss over the time from entry. For example, if over the first 4 hours the trade went as high as 10 pips into profit and as low as 5 pips into loss, the edge ratio for that period would be 2. A hypothetical spread of 1 pip (but no swap) was applied. The hypothetical results were as follows:
Breakout Strategy | Currency Pair | Edge Ratio 4hr | Edge Ratio 8hr | Edge Ratio 12hr | Edge Ratio 16hr | Edge Ratio 20hr | Edge Ratio 24hr | Edge Ratio 28hr |
EUR/USD | 1.15 | 1.16 | 1.16 | 1.21 | 1.22 | 1.22 | 1.20 | |
USD/JPY | 1.09 | 1.14 | 1.12 | 1.11 | 1.08 | 1.06 | 1.05 |
Pullback Strategy | Currency Pair | Edge Ratio 4hr | Edge Ratio 8hr | Edge Ratio 12hr | Edge Ratio 16hr | Edge Ratio 20hr | Edge Ratio 24hr | Edge Ratio 28hr |
EUR/USD | 0.99 | 1.00 | 1.00 | 0.98 | 0.98 | 0.99 | 0.97 | |
USD/JPY | 0.91 | 0.92 | 0.97 | 1.03 | 1.06 | 1.06 | 1.07 |
It is easy to conclude that trading new highs or lows in the direction of the breakout is significantly more profitable that trading pullbacks. It seems counter-intuitive, when you look at a chart and see all the pullbacks you wished you had used as good entries, but there it is. Of course, these pullbacks represent a single candlestick which has not yet broken, and I am sure the pullback data would be superior if there were a short-term breakout element added as a filter, or some other confirmation – perhaps a second candlestick confirming the turn in direction.
In any case, statistically, the odds have been much better trading breakouts on above-average volatility.