systematic-breakouts-and-pullbacks-in-forex-trading-two-strategies-that-work

In this article, we are going to illustrate the results of 2 complementary systems: a channel breakout system and a pullback system. Note the word “complementary”: they work in tandem. One system buys highs and sells lows, while the other buys lows and sells highs.

Illustrating results of fully-functional EAs as we are going to explore further along in this article, serves a very precise purpose: to tilt the odds in your favour. In more ways than one.

Too often, traders fall into a cycle that goes something like this:

  • Study a method for an inordinate amount of time
  • Perfect it and test it
  • Take it live
  • Achieve consistent results for some period of time
  • Look for ways of pushing the limits of the method (using it on multiple time frames, looking for trades instead of waiting for the most evident, etc.)
  • Start getting into a DrawDown
  • Start to doubt the system because “it doesn’t work every time” or “it doesn’t work on every time frame” or some other reason
  • Go back to the drawing board for a new system

It has happened to me. And It probably happened to you too. As a solution, in this article, we will attempt to convey the correct way of looking not only at system trading, but about any method used.

 Two Strategies That Work

Examples of Pullback Trades  in an uptrend

The premise is that each system is meant to capture a particular aspect of market behaviour. No system is a passe partout. Successful system traders know exactly what their edge is, and have programmed that edge into the system, so that:

  • There are no forced trades, only top quality trades
  • The background conditions are most favourable

So read on, and see our proprietary Channel Breakout and Pullback Expert Advisors (programmed by our resident programmer Craig) and understand the principles behind their success. If you focus on this, you will understand with a good degree of accuracy what the future odds of success can be.

Systematic Breakouts and Pullbacks in Forex Trading

Example of Channel Breakout Trade in a downtrend

Breakout vs. Pullback: is there a winner?

We have already covered a variant of breakout trades extensively in a previous article so here we will just summarize the main points that allow a channel breakout system to be successful:

  • Play breakouts from a given range (which is determined by the length of channel).  The length of the range is not as important as you think.
  • Diversification: seek to incorporate multiple asset classes into your portfolio.
  • Position sizing: seek to keep each position small and sized based on volatility, so the portfolio is never overly exposed to one trade.
  • Time horizon: which trends are you seeking to capture? Perhaps combining multiple time-frames can help to smooth the equity curve.
  • Capitalization: evidently, managing a professional diversified trend following strategy requires a decent sized trading account. Fortunately, brokers nowadays are becoming one-stop shops, giving retail traders access to multiple instruments at once.

The point is that playing channel breakouts and looking for continuation is a simple strategy that works, with diversification, steadily over time. Attempting to optimize the results only clouds the essence of the strategy.

But what about Pullbacks? How did we build our systematic Pullback Strategy?  To understand the method, we first need to define a pullback in a systematic way. Stated simply:

A pullback, on any time frame, starts when price moves in the opposite direction of the prevailing trend, and finishes when price starts moving in the direction of the prevailing trend again.

So there are at least 2 variables we need, in order to create this algo. We need a definition of trend. In order to remain consistent with our Breakout Algo, we are going to use the same trend filter:

Uptrend Condition:  50 Day EMA > 100 Day EMA and Price > 100 Day EMA

Downtrend Condition: 50 Day EMA < 100 Day EMA and Price < 100 Day EMA

We also want to target “deep” pullbacks, where price has moved far enough away from the most recent high or low, to become interesting for value hunters. Once again, to remain faithful to our principles of robustness, and building on a classic trend-trade risk management rule detailed in a previous article, our objective is simple:

  • We want to buy pullbacks where classic trend trading rules will most likely throw in the towel.

pullback-2000-2016

The Equity Curve performed by our non-optimized Pullback strategy (programmed by Craig Consulting) on EurUsd

pullback-chart

EurUsd Daily Chart with our trend filter and Pullback trades illustrated

As usual, we do not simply want to marvel at the results a system can obtain on one currency pair and in one single version. We need to check parameter stability and currency pair performance. And that is exactly what we proceeded to do next.

pullback-profit-factor

The Profit Factor chart illustrates the relative performance stability of the Pullback system, across  various permutations and various currency pairs.  Here are the actual statistics of the original method.

pullback-stats

Something that the Breakout system and Pullback system have in common, which may not yet be evident, is that both systems require the market to be in a trend, in order for the system to work. We have already discussed the overriding importance of the market state (trend or range) compared to any entry or exit tactics of a system but it is always worth restating.

The better you become at filtering a trending market state, the better your results will be, whether you trade breakouts, pullbacks or both of them.

Currency Personality Traits

At this point in our venture through systematic strategies, it is time to discuss “currency personality traits”. It is very true that some currency pairs react differently than others. It is the reason why certain strategies work so well on the EurUsd, for example, and not on UsdCad.

So without optimizing strategies, or adding extra filters, a solid approach might very well be to exploit the inherent characteristics some currency pairs seem to have always possessed and still do, to this day. This way, trend systems can be applied to currency pairs that demonstrate strong trends, whereas range systems can be applied to currency pairs that demonstrate more of a range bound behaviour.

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“Turtles Method” (coded by Craig Consulting) permutations and corresponding profit factors, by currency pair

In the chart above we once again highlight the profit factor of a breakout system that attempts to replicate the exact rules of the Turtle Traders.  Once again we find that when applying systematic rules:

  • EurUsd, UsdJpy, Gold, Silver  tend to trend
  • UsdCad, NzdUsd (but also EurGbp, AudNzdend to not trend

Why is this? Is there any explanation for this recurring behaviour?  Of course, many people have asked this question before us, and some analysts at Citigroup attempted to offer an answer many years ago. Here are the main conclusions:

  • Historically, long term trends are displayed in currency pairs which are the exchange rates between disparate economies (UsdJpy, EurUsd, etc)
  • Historically, those currencies which have not trended are the pairs which are the exchange rates between closely linked economies (EurChf, GbpUsd, AudNzd, etc.)

And that is exactly what we see with our models as well – and the behavioural traits continue to this day.

Is it feasible to Trade with EAs?

The preliminary answer to this question is “Yes” it is possible to have EAs to the dirty work for you – if they are programmed well and if you understand how to use them. So for example, whether you use our own Channel Breakout System, Pullback System or Turtle System, or any other system for that matter, here are general practices to help you use them wisely:

  1. Never overleverage – ever! When trading any kind of system, you need to make sure you can withstand twice the historical drawdown of the system, along with any technical glitches that cause hiccups (like internet issues, computer issues, slippage, etc.).
  2. Properly evaluate the system’s results over time. This doesn’t mean just watching equity curves. This means understanding, each and every year, what the system did, where it traded and why it was successful or unsuccessful.
  3. Understand the system’s edge. We have discussed Pullbacks and Breakouts, but there are other edges to be exploited.
  4. Diversify intelligently. It’s no secret that the most successful Trend Following programs are well diversified CTAs that trade soft commodities, hard commodities, currencies, indices, rates futures (all trendy instruments). Some years, there are great trends in some markets and no trends in others. Some years there is excellent volatility (read opportunity) in some markets and there is none in other markets. Within FX, perhaps utilize the “currency personalities” to your favour and stick to the “trendy” pairs when using trend-following strategies.
  5. Do not force trades, and do not be tempted to tweak the system.

Over To You

In this article, we have demonstrated how Systematic Channel Breakouts and Systematic Pullbacks are still, to this day, fully functional strategies that can allow for profitable trading, whilst remaining light on the number of inputs necessary.

We’ve said it before, and we will say it again: less is more, in trading. Understand your edge, filter your currency pairs and rank them according to the background criteria that can bring fourth your edge, and execute with confidence.

And as always, if you get stuck somewhere along the way, get in touch and hopefully, with the experience of our members here at FXRenew, we will be able to guide you towards a more consistent performance.

About the Author

Justin Paolini is a Forex trader and co-owner at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.