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The trend is your friend!

“The trend is your friend”. This famous phrase is in almost all trading books. But how important is it to trade in the direction of the trend? This is the question I asked myself. Before answering this question, we will discuss some generalities. Whereof is usually composed a trading strategy:

  • An entry that gives us an advantage (edge) compared to a random input. The input can be decomposed into elements such as setup, filters, signal, execution, etc …
  • Exit with loss (stop loss) or profit (take profit).
  • Management of risk (money management) that allows us to maximize profit while minimizing risk.

We’ll start with the entry. According to several authors such as Van Tharp, author of the famous book “Trade Your Way to Financial Freedom”, the input is the least important component of a trading system. Think about it. Before taking a position, the trader is not at risk. He can think long and wide at his entry. Once this entry is executed, the trader is at the thank  of the market and the quality of his exit will decide the profit he will take or at least, how he will minimize the loss. Is it not that the purpose of trading?

I agree that we need an entry that provides a minimum benefit. For this reason that we need a tool to assess the quality of input. This tool will be the MER (Maximum Excursion Ratio). Others call it the e-Ratio. It consists of evaluating the relationship between the advantage offered a position in the market versus the risk to which it exposes you. In more technical terms:

  • MER = MFE/MAE.
    • MER : Maximum Excursion Ratio
    • MFE : Maximum Favorable Excursion which corresponds to the maximum potential benefit that the position offered. It is calculated as the difference between the extreme favorable reached by the market and the price of entry.
    • MAE : Maximum Adverse Excursion which corresponds to the maximum potential loss that the position was offered. It is calculated as the difference between the negative extremum reached by the market and the price of entry.
    • Some normalize the ratio by a factor of volatility (eg ATR) to compare different markets.

 

The concept of MFE and MAE was introduced by John Sweeney author of “Maximum Adverse Excursion: Analyzing Price Fluctuations for Trading Management.” The beauty of this concept and that ratio is obtained (MER) will also be good to assess entries and exits.

 

Figure 1: Maximum Favorable Excursion (MFE) and Maximum Adverse Excursion (MAE) in the case of a purchase.

The post is becoming long and you wonder: What is the relationship with “The trend is your friend”. Patience. I get there …

I’ll start by evaluating a popular entry (the price crosses its moving average) to see how it gives us an advantage in using the MER. I add a filter which consists in taking position only in the direction of the trend of higher time frame and compare MERs. If the filter improves our advantage, that means the trend was really our friend.

 

The test protocol

  • EURUSD. 2008 to 2011 (inclusive). Time frame: H1. Original Amount: $ 10,000. Volume: 1 mini lot.
  • Buy when the last candle crosses, rising, moving average of period N. Close position after N bars.
  • Sale when the last candle crosses, downward, moving average of period N. Close position after N bars.
  • Test for the period N, between 24 and 100 with a step of 2.
  • For tests with filter: Buy only when the price is above the moving average D1 of the same period N. Sale only when the price is below the moving average D1 of the same period N.

 

The results

Figure 2 : MER for a period of the moving average from 24 to 100. EURUSD: 2008-2011

 

Figure 3 : Profit / loss for the period of the moving average ranging from 24 to 100. EURUSD: 2008-2011

H1 only H1+D1 Random
MER 1.03 0.98 1
# trades 14115 12252 20926
$ 7016±1744 37771±1944 -36333±2977
$ / trade 0.5 3.08 -1.74

MER in the table is the average MER in Figure 2 for each test. The number of trades and profit totals are not means. $ / trade is profit per trade in Metatrader called Expected Payoff.

 

Conclusion

The filter has not improved the MER, which was our measuring tool. This suggests to me that the MER, better reflects the quality of the input, which in this case does not offer any particular advantage over a random input. However, the filter significantly improved profit and profit per trade. On 14,115 trades (without filter), the filter was cut 1863 trades responsible for loss of 16.5 $ per trade ((37771-7016) / (14115-12252) = 16.5). That means he has cut overall worst trades.

So the trend is probably our friend, but it certainly is not our enemy.

 

 
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