Algorithmic and Mechanical Forex Strategies | OneStepRemoved

Forex Volatility Trading Playbook

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The forex marketplace supports a diverse community of successful independent traders who have developed winning strategies that work during changing market conditions. Trend-following strategies are popular among newbies, but veteran traders truly earn their keep during times of volatility.

This article gathers and summarizes some longtime traders’ forex volatility trading strategies that can win even when markets are volatile. In fact, the strategies in the volatility trading playbook work best during times when the gains from trend-following systems lag far behind.

Forex volatility trading

By definition, volatility means that prices rise and fall quickly, and do not show clear direction or trend. Successful volatility-focused trading systems usually feature these characteristics:

• Based on volatility or breakouts from channels or ranges

• Trades are short-term

• Trading systems are very choosy with trades, and are usually out of the market

• Win a high percentage of trades

• Earn only a small-to-modest profit per trade

• Take advantage of small moves instead of big moves

Well-designed mechanical trading systems can anticipate and take advantage of changes in volatility, then exit the trades without giving back the open profits.

Parabolic stop-and-reverse trading strategy

Some forex traders harness the power of volatility by trading parabolic time-price systems. First introduced by the legendary trader J. Welles Wilder, Jr., the parabolic stop-and-reverse trading strategies capitalize on price reversals.

Parabolic indicators help determine the direction of a currency pair’s price movement as well as indicating when the trend is likely to change and a price reversal is imminent.

These indicators work well for determining both entry and exit points in volatile currency markets, since prices tend to stay within parabolic curves during trends. When prices move wildly, parabolic indicators can help show the direction or change in trend.

market volatility

Successful parabolic stop-and-reverse strategies are also time-focused: The mechanical trading system weighs the potential gains against the amount of time the position must be held in order to have the best chance of achieving those gains.

If using a “pure” parabolic trading system, the forex trader would always be in a given market, either long or short. For example, when the parabolic indicator generates a buy signal, the trade is entered. Then, when the trend begins to reverse, the “long” position is closed and a new “short” is opened at the same time.

Still, order to reduce the number of quick shake-outs from volatility whipsaws, most parabolic traders filter their trading signals by using a trading volume screen as well as a variety of other indicators.

Parabolic trading rules

The basic parabolic trading rules are simple – For long signals, the mechanical trading system buys when the currency pair’s price reaches a parabolic point above the current market price, and the trading volume is higher than the five-bar simple moving average trading volume.

In order for a trading signal to be confirmed for this parabolic trading strategy, both parameters must be true during the same time-bar. Here are the general parabolic setup, entry and exit rules used by several successful forex traders:

• Calculate the parabolic points

• Calculate the 5-bar simple moving average (5 SMA) of trading volume

• For long entries, the system buys when the price reaches a parabolic point higher than the current market price, as long as the volume is higher than the 5-bar moving average

• For short entries, the system sells short when a price touches the low parabolic point below current market prices, as long as the trading volume is greater than the 5-bar moving average

• To exit from a long trade, the system liquidates the position when the parabolic points decline

• To exit from a short trade, the system covers the position when the parabolic points rise

• To set the trailing stop for a long position, the system uses the parabolic points below the current market price

• To set a trailing stop for a short trade, the system uses parabolic points above current market price

• Savvy traders often set profit targets like this, for example: 70 pips for GBP/USD or 60 pips for EUR/USD when trading a 4-hour time frame; or, 200 pips for EUR/USD or 250 pips for GBP/USD when trading a daily time frame

Volatility channel breakout strategy

Many successful forex traders use channel-breakout strategies fueled by volatility. Here are the basic indicators and trading rules for a simple channel-breakout strategy that works for especially-volatile currency pairs on time frames of 15 minutes or higher:

• 30 ATR (the Average True Range over 30 time periods) with 5 EMA (the Exponential Moving Average over 5 periods)

• 15 ATR with 5 EMA

• 30 EMA (Exponential Moving Average over 30 periods) High

• 30 EMA Low

• For long entries, the system buys when the price closes above the upper EMA band and the 30 ATR is greater than the 5 EMA

• For short entries, the system sells short when the price closes below the lower EMA band and the 30 ATR is greater than the 5 EMA

• The trading system sets the stop-loss on the lower EMA band for long positions, and on the upper EMA band for short positions

• With fine-tuning, the strategy may achieve fairly aggressive profit targets

Volatility double channel breakout strategy

Other forex traders who specialize in harvesting gains from especially-volatile currency prices use a similar, yet “double” channel breakout strategy. Below are the basic trading indicators and rules for a double channel-breakout strategy that works well for volatile currency pairs:

• 11 Relative Strength Index (RSI) at levels 35 and 65

• 20 EMA High

• 20 EMA Low

• 5 EMA High

• 5 EMA Low

• The mechanical trading system buys when the 5 EMA High is greater than the 20 EMA High and the 11 RSI is greater than 65

• The system sells short when the 5 EMA High is less than the 20 EMA High and the 11 RSI is less than 35

• If the initial setup bar’s trading range is more than double the value of the previous bar, the trading system declines the trade

• The trading system sets the stop-loss at the lower band of the 5 EMA for long trades, and at the upper band of the 5 EMA for short positions

• Aggressive profit targets can be set

Forex trading strategy for extreme volatility

Forex traders who thrive on volatility, there are many profitable trading opportunities. Below is a simple forex volatility trading strategy.

When a long candle appears during a trading session, that is, when an intraday time-bar has a greater range than the previous time-bar, it may be the setup for a trade. Long candles are a sign that volatility has increased, and that a change in trend may be imminent.

Often, after a big candle a new trend may develop, or the previous trend may become stronger. And, the trend will usually be moving in the same direction as the price movement of the time-bar when the long candle happened.

When a long candle occurs, if that candle breaks the high or low of the trading session then the price will probably continue to move in the same direction.

Trading rules for extreme volatility strategy

• A candle or intraday time-bar which is much bigger than any previous candles during the session, but has not yet reached 100 pips in total range

• That same long candle is also now setting a new intraday high

• For long entries, the trading system buys at 1 pip over the high of the previous candle’s price

• For short entries, the system sells short at 1 pip under the low of the previous candle’s price

• For longs, the stop-loss is set at 1 pip below the low of the entry candle

• For shorts, the stop-loss is set 1 pip above the high of the entry candle

• Profit targets are set according to nearby support and resistance levels

• It’s important to note that any entry order should be placed only after the time-bar containing the long candle is completed, and the trader should use at least one other indicator to confirm the signal before entering a trade

ATR channel breakout strategy

Some forex traders who specialize in volatility-focused strategies rely on indicators which use Average True Range (ATR).

The trading system determines the midpoint of the ATR channel by calculating the Exponential Moving Average (EMA) of the time-bars’ closing prices, using a number of time-periods as defined by the “close average periods” parameter. When volatility pushes the currency price out of this channel, the breakouts are easy to trade.

This volatility trading strategy is similar to a Bollinger band breakout strategy, except that it relies on ATR instead of standard deviation as a measure of volatility to define the width of the bands or channels. The trading rules for this type of volatility strategy are simple.

• ATR for 20 time-bars

• EMA of the closing prices of each time-bar

• For long entries, when the last price of a time-bar crosses over the mid-band of the ATR channel the trading system buys on the open of the next time-bar

• For short entries, when the last price of a time period crosses the mid-band of the ATR channel the system sells short on the open of the next time-bar

• Stop-loss orders are set 2 pips below or above the first band of the ATR channel

• The trading system sets profit targets according to nearby support-resistance levels

ATR channel breakout strategy using fractals

Forex traders also use fractal indicators with volatility trading. Below is a simple strategy relying on ATR channels to signal breakouts, and using fractals to determine optimal entry and exit points.

• 130 ATR

• 9 EMA

• When ATR is greater than the 130-period average and the EMA is greater than the 9-period average, trading signals can be confirmed

• When ATR is less than 130 and/or EMA is less than the 9-period average, no trade

• Fractal indicators to show the likely breakout range

• Entry orders are set 1 pip above or below the breakout range

• Enter long when ATR is greater than 130 and greater than the 9 EMA, and fractals confirm the upward breakout

• Enter short when the ATR is greater than 130 and greater than the 9 EMA, and fractal indicators confirm the downward breakout

• Stop-loss orders are set to be triggered if/when the currency pair’s price touches the opposite side of the range

• The trading system closes the position automatically when the volatility decreases, for example, if the ATR goes below 14 EMA

• Set profit targets at a ratio of about 1:3 according to the stop-loss levels; so, for example, if the stop-losses are 30 pips, then the profit target is set at 40 pips

Volatility meters

Forex traders sometimes use “volatility meters” such as the Volameter indicator for intraday trading signals. These volatility indicators spotlight overbought and oversold zones. The trading rules vary depending upon the indicator. Below are the basic setup and rules that some traders use with the Volameter, a popular volatility meter.

• Overbought/oversold indicator

• Volameter

• Pivot-point indicators

Trading rules

• A long trade is signaled when the value of the overbought/oversold zone indicator touches or breaks through a level of -8

• Enter the long trade when the overbought/oversold indicator reaches a level of -4 by placing an order to buy-on-open at the next time-bar

• A short trade is signaled when the overbought/oversold indicator reaches a level of 8

• Enter the short trade when the overbought/oversold indicator touches or breaks through the level of 4 by placing an order to sell-on-open at the next time-bar

• Set stop-loss orders to be triggered at 1 pip above or below the price indicated when the overbought/oversold indicator reaches a level of -8 or 8, depending on whether the trade is long or short

• Set profit targets according to nearby support/resistance levels and pivot points

Volatility creates plenty of forex trading opportunities

There are plenty of good volatility trading strategies in the forex playbook. Traders should welcome volatility because of the profitable opportunities available during trading sessions which feature big price ranges. With appropriate risk management, volatility is a forex trader’s best friend.

Is volatility a friend or enemy of your current trading system?

The Frankfort Intraday Forex Breakout Strategy

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The fast paced nature of intraday Forex trading lends itself to simple strategies that don’t go overboard on indicators. When traded on the right markets at the right times, a simple price-based breakout strategy can return very impressive profits. Earlier this week, Forex Factory user PIP Combine published a simple breakout strategy that follows that line of thinking.

In his Forex experience, PIP Combine has noticed that the 6 am (London) / 1 am (New York) candle tends to play a significant role in terms of intraday support and resistance. From that observation, he believes that a breakout above the high or below the low of that candle has a strong probability of resulting in a profitable trade. While this strategy is a long way from tradable as it is now, it could provide us with an interesting case study as PIP Combine develops it over time.

forex breakout strategy

Forex Factory user PIP Combine has started to develop a simple price-based Forex breakout strategy.

Possible Breakout Results

In his post, he explains that he has been watching this phenomenon for the past year while entertaining different options to develop a strategy around it. He has observed that there are three possible outcomes once a market breaks above or below the 6 am (London) candle.

The first outcome is that the price continues in the direction of the breakout. PIP Combine suggests that when these breakouts hold, a trader can generally capture a good percentage of the market’s average true range (ATR).

The second possibility is that the price reverses and retests the breakout, but holds the breakout and continues higher. This creates a slightly more complicated trade as the timing of the trade becomes a factor.

The third possibility is for the price to reverse back into the range of the significant candle, perhaps even breaking out in the opposite direction. This would obviously indicate a losing trade.

The Frankfort Breakout Strategy

The Frankfort Breakout Strategy is designed to trade one-hour charts on the following instruments: GU, GJ, GA, GCHF, GCAD, GN, EU, EJ, EG, AU, NU, UCHF, UJ. Trade entries are signalled by a breakout of at least 5 pips above the high or below the low of the 6 am (London) candle. 

The strategy trades a position size of 0.25% its account. Initial stops are set at either 50 pips or a 5 pip breakout of the significant candle in the opposite direction, whichever is smaller. The profit target is 50% of the instrument’s 30-day ATR.

Further Development

This strategy is still in the very early stages of its development. For that reason, PIP Combine does not have any backtesting data to confirm that there is actually an edge here. While he doesn’t have any backtesting data, he has set up a small account to test the strategy live and is updating his Forex Factory thread with his results.

PIP Combine also suggests that there are already a number of possible improvements that could be made. He lists a number of variables that could be optimized, including the stop-loss and take-profit values, position sizing, days to limit the trade to, and the number of confirmation pips above or below the range of the 6 am (London) candle.

Another area for further development will be determining what to do about trades that fall into the second possible outcome. PIP Combine says that his goal is to close out the trade before the US market opens, but he will have to determine how to handle trades that are not clear winners or losers at that point.

First Strike Trading System

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The First Strike Trading System is an interesting combination of a breakout system and a time-based system. It uses a version of a breakout system to determine entries and then uses a time deadline and an initial stop to determine the exit. By establishing Friday’s close as the time deadline, this system never carries a trade into the weekend.

While I am not convinced that the overall system is tradable, its entry method is extremely interesting. The initial backtesting results that I found also indicate that there could be some value with this system.

First strike trading system

About The System

The First Strike Trading System was originally published in 2007 by Joel Rensink. The basis for the system is the opening price of the week on Monday morning. The system notes this price and then places a Buy Stop order 50 points above it and a Sell Short Stop 50 points below it. That way, if the price moves 50 points in either direction during the week, that breakout will initiate a position.

Once a trade has been established, the system sets a Stop Loss 60 points above or below the entry price. It also exits all positions at the close every Friday. These exit rules make this a short term trading system that has some measure of downside protection.

Trading Rules

Go Long When:

  • Price breaks 50 points above Monday’s opening price.

Go Short When:

  • Price breaks 50 points below Monday’s opening price.

Exit Long When: 

  • Initial Stop is Hit, or
  • Friday’s Closing Deadline

Exit Short When:

  • Initial Stop is Hit, or
  • Friday’s Closing Deadline

Backtesting Results

Jeff from System Trader Success backtested this system on Euro Currency Futures from May of 2001 through December of 2010. During that time, the system was able to generate positive returns. There were a total of 421 trades, and 33% of those were winners. The system posted a profit factor of 1.19 and an annual return of just over 10%.

Jeff then took his backtesting a step further and added a trend filter. This would limit the system to only making trades in the same direction as the long term trend, which he defined using the 220 unit SMA. This reduced the total number of trades to 344 and increased the number of winners to 36%. It also raised the profit factor to 1.27 and the annual return by 0.18%. While the trend filter didn’t dramatically affect the results, it clearly was able to remove some of the unproductive trades.

System Analysis

What we have here is a very unique take on a breakout system. By adding the trend filter, Jeff was able to improve the system even further. The First Strike Trading System doesn’t quite have the win rate or profit ratio of the 89/13 Breakout System, but it should have lower drawdowns because it makes such short term trades. Of course, these short term trades will also rack up commission costs.

Improving The System

The First Strike Trading System was designed to trade forex markets. However, if we used percentage breakouts instead of the 50 point breakouts to identify entry points, we could take the system and trade it on a wide assortment of financial markets. This would give us a more robust, diversified approach.

If we were able to trade this system across a wide range of markets, perhaps we could increase the significance of the breakout required to generate an entry signal. This could possibly lead to a higher success rate.

Another idea to improve this system would be to put a deadline on entries. As the system is currently constructed, it is possible to enter a position on a Thursday or even Friday only to be forced out at Friday’s close. This would likely result in a good deal of slippage and commission costs.

I would also be curious to see how much the returns would be affected using a different exit criteria. I’m not convinced that forcing the system to exit on Friday’s closing price makes sense. I would like to find out how a system with the same entry rules would perform using either a trailing stop or a breakout for an exit signal.

As you can see, while the initial backtesting results for this system aren’t as good as some of the other systems we’ve looked at, there are a number of interesting ideas that might improve the First Strike Trading System.

89/13 Day Breakout System From Trend Following

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Richard Dennis once said that even if he published his trading rules in the newspaper, people wouldn’t follow them. With that idea in mind, let’s take a look at a trading system that actually has been published and widely distributed.

About The System

One of the most distributed trading systems of all time can be found in the appendices of Michael Covel’s Trend Following. It is provided as a real world example of how a trend following system works. There is even some programming language included.

The system is designed to establish a position on an 89 day price breakout and exit that position on a 13 day price breakdown. It also uses a position sizing algorithm that factors in the dollar value that is to be risked on each trade but also makes sure that each trade risks less than 2% of the account. Backtesting was done across 15 commodity and currency markets over a ten year period.

The backtesting results show us that this simple system returned an average of better than 21% annually, while only profiting on 42.53% of its trades. The average winning trade was a little more than twice the average losing trade, and the maximum drawdown was 23.05%. The system has a Sharpe Ratio of 1.02, which is good, but not great.

Strategy Analysis

Like most of the systems I have looked at in this series, this would be a good starting point if you were developing a system from scratch. The system clearly has an edge, but when you factor in commissions and slippage that edge will shrink. There is also the constant threat of a Black Swan event destroying your entire portfolio.

The strong points of this system are that it is built to trade multiple markets, has a position sizing algorithm, and that is can be profitable while winning on less than half of its trades. The biggest negative of this system is that we only have 10 years of backtesting data. It would be interesting to see how the system fared from 2001 through 2012.

Position Sizing Algorithm

The most interesting aspect of this system is its position sizing algorithm. It is designed to make sure that each position is less than 2% of the portfolio, but also adjusts those positions based on the dollar value of the risk they are exposed to. The system does this by calculating the position size in two separate ways and then using the more conservative result.

The first approach simply calculates 2% of the total equity and then divides that number by the dollar value of the entry minus the stop, which is the amount being risked. This approach is just using the entry and stop to calculate how big the position can be to account for 2% of the total equity if it is unsuccessful and the stop is triggered.

The second approach takes 2% of the total equity and divides it by the dollar value of twice the average true range. This approach takes volatility into consideration, thus adding an extra layer of risk protection.

Price Breakouts

Trading breakout strategies can often seem far more complex than they actually are. Breakout systems are actually incredibly simple, however as traders, we tend to overcomplicate things. A Breakout of Breakdown is simply a new high or low for a given time period.

For example, this system uses an 89 day price breakout as an entry point. This means that the system would go long when a market hits an 89 day high, meaning the market is at its highest level for the past 89 days. In the opposite situation, where a market hits an 89 day low, the system would establish a short position.

When a position is taken, the system sets a stop at the 13 day high or low depending on the direction. If the position is long, the stop would be placed at the 13 day low. This stop value is then recalculated by the trading software every day.

Breakout Example

On this chart of the SPY, the red lines represent the 89 day highs and lows. The blue lines represent the 13 day highs and lows. These lines make it easier to visualize the breakouts that the system is looking for.

89-13 Breakout

An SPY chart showing the 89-13 breakout system

The system would have generated a buy signal when it broke through to a new 89 day high at the beginning of 2013. Having the benefit of hindsight, this was an ideal time to establish a long position. When the long position was established, a stop would have been set at the 13 day low, which is the solid blue line. That stop would have been triggered at the end of February.

There would have been another buy signal at the beginning of March. That position would have run until it was stopped out in April. Then another long position would have been taken in early May.

This system would have captured a significant portion of this markets uptrend over the first few months of 2013. This is similar to the results we have seen from other trend following systems that we have looked at. While each of these systems goes about it in a slightly different way, they are all attempting to capture significant portions of long term trends.