A couple of months ago, our team developed a very simple indicator to aid us filtering out bad trades from good ones. To our surprise, this indicator that was originally intended to have just a "supporting role" in our strategies, turned out to be way more powerful tool than we thought.
On this post, we will explain what this indicator is, how it is calculated as well as suggest some ways to trade with it.
Simply said, Power Candles (or PC from now on) are very strong price movements when compared to previous candles. They frequently (but not always) appear during release of economic data and opening of London and NY markets. It is a downright simple measure of market volatility.
We created the indicator because we wanted to have an exact measure on how much of an impact the current price movement is bringing to the market. Sure, anybody can spot a big candle being formed, but saying "it's a big candle" is not something that a computer or an EA can understand. Besides, human interpretation is often faulty, and I believe there is always a need to base our decisions on established parameters rather than subjective information.
They are calculated by taking the current candle's range (High - Low) and dividing it by the average range of the candles you want to compare it with. Let's say, for example, that we want to calculate the Power Candle's value for the yesterday's AUDJPY movement on the Daily timeframe (Figure 1).
In this case, we are comparing the current candle with the previous 20. The current candle has a range of 184 pips. The average of the previous 20 is 97, We actually have to take the candle ranges one by one and divide the sum by 20.. no way around that! But we just put the result here so we don't waste too much time on details. Now we have all we need: PC = 184/97 = 1.89. So now we know that yesterday's price movement was 1.89 times higher than the recent average.
In our indicator, we plot these PC values on a histogram below the chart, usually putting a line on key limits, such as 1.00, 2.00 and 3.00, to make the analysis easier (Figure 2).
We can play with this indicator in many ways. Besides the obvious possibility of choosing other number of periods to create the average, we can also filter the range of specific candles that seem more meaningful. For example, we all know that the H1 candle from London's opening will likely have a PC well above 1.00, because that's a time when volatility picks up. But what if we compare it with the previous 20 London opens alone? So we pick the last 20 H1 08:00 GMT candles and make an average specific for that time. Now we know if the opening is going stronger or weaker than usual, such as in this case (Figure 3) where we can see that the range of the candles in the morning are both above 3 times the normal volatility.
Great, but what does this all mean? What really matters is if an indicator has any predictive power or not. We conducted many tests to verify its effectiveness by creating EAs with opening and closing conditions based on the indicator. The results were better than we expected.
One of the tests we made: Long when bullish PC > 2.5 and Short when bearish PC > 2.5. Every position closing after 4 candles. We tested this out on the EURUSD M15 chart, with 15 years of data (2000 - 2014). Results are the following:
It worked quite well! We had a neat profit of 3240 pips for the period, with a profit factor of 1.23 after 2471 trades, which is a large enough sample size to gain confidence that results are not of random nature. But this is not a complete trading strategy of course. It was just a raw product of our initial tests and it already showed a promising performance. Recently were already able to develop some successful EAs based on the Power Candle, where the PF reaches more than 2.00.
To summarize our findings on Power Candles:
So, don't fight the market current.. especially when it's strong!
The Power Candle Indicator is available for Meta Trader 4 on MQL5's website. You can find it by clicking here.
Also, you can find one of the strategies we created based on Power Candle values here.
Later on we intend to make it available an excel spreadsheet for people to be able to calculate PC values for free. They will be mostly for swing trading and backtestings, but at least people will be able to use it with any instrument, including those who are not available on Meta Trader platforms.
We hope you enjoy trading with it as much as we do. And since this will probably be the last post of the year, we wish you all happy holidays!
What is the length of Australia's coastline? 12,500 km, 25,700 km or more? Well, the three answers are correct! It's weird but actually very simple to explain. It just depends on the size of the measuring stick. If you draw straight lines along its coast, each line of the size of 500 km, you will get the first answer. As you start reducing the size of your measuring stick, you'll be able to cover more details, making the length longer and longer. This is called the Coastline Paradox, and you can learn more about it in this awesome video made by Veritasium.
Now, how can this be applied to Forex, and help us to find the optimal average trade length? Well, let's take a look at this recent chart in the EURUSD (Figure 1). Suppose we were actually able to go short at the highest point in the chart (1.1495) and cover our position at the lowest (1.0642). It would have been an awesome trade, where we would have made 853 pips in a month!
We covered the whole downtrend, from the very top to the very bottom. In this situation, we can safely say that we made the most pips we could have ever made for this period, right? Wrong. We could have theoretically made more than this. A lot more.
Let's continue to pretend we are the perfect trader and revisit the trade we made. How could we be able to make more pips in the same period as before? A simple way would be to break our one position into three smaller ones. Suppose we now go short at 1.1495 just as before, but this time we cover our position at 1.0896 (+599 pips). We immediately reverse it into a long trade up to 1.1071 (+175 pips), closing it and reversing it again into a short trade until our previous ending point 1.0642 (+429 pips). Now we made three winning trades, banking a total of 1203 pips; about 40% more than the original trade (Figure 2).
Since we're at it, let's try and break it down to even more trades. If we make 7 perfect trades we make a total of 1661 pips (Figure 3). That means that in a period where the EURUSD's total range was 853 pips, we were able to make almost twice that amount!
Of course this is not the real world. We would never be able to time our trades so perfectly. But these examples are not intended to give you the best entries. They demonstrate that, by the same way that Australia's coast length (or any coast for that matter) increase when we reduce the size of the measuring stick, we increase our maximum profit potential when we reduce the average length of our trades.
I can actually demonstrate this concept with a more real example. One of the strategies our team developed aims to take quick profits, usually in the range of 10-25 pips per trade on the EURUSD. Sometimes, we are able to catch several quick opportunities like this while the market is moving completely sideways. In the period demonstrated below (Figure 4), from the moment we open the first position to the moment we close the last one, the market moved from 1.4210 to 1.4189 (as shown in the red lines). If we would be trading longer term and holding a short position during this period, we would be making only 21 pips. However, by making quicker trades, we were able to open 6 different positions, and amass 92 pips in total, more than 4 times the amount we would get from a single position.
Please understand that average range length and average time length are two closely linked concepts. Most strategies' trade duration are more of an indirect decision, because traders usually aim at profit and stop levels rather than how long they will will have their position open. But when they start taking profit/stopping tighter, the average time length will invariably reduce as well, as markets tend to cover a higher range as time passes.
All this may lead to a hasty conclusion: the quicker our trades, the more we increase our maximum profit potential. And the more profit we can have, the better! But before we start scalping our way to success, we have to understand that there are some factors that may significantly reduce the profitability (if not kill it completely) of extremely quick trades.
The first one is pretty obvious, and I discussed it in the previous blog post: transaction costs. If we are aiming to catch a 50-pip price movement and we pay 1 pip spread per trade (let's not consider commission and rollover in this example), our trading cost will be only 2% of the profit we make. On the other hand, if we aim to close the trade with 5 pips profit, the cost relative to our profit is 10 times stronger!
The impact of transaction costs alone should prevent us from abusing the extremely quick trades strategies. But there is one other factor that may make quick trades even more difficult as well. Many traders and analysts believe that the shorter the time frame, the more "noise" there is in the market. That is, price movement becomes more and more random when we try to analyze them in shorter lenghts. If this is true, the expected returns of quick trades should be proportionally smaller because of this added noise, thus reducing the very same profit potential we were trying to increase in the first place. Personally, I am not sure if it this is a true statement. I read many arguments for and against it, but I've never read a good serious research on this matter, so I'll leave this open for now.
But what is the optimal average trading length, after all? In our experience, we have been more successful developing trading strategies that use the M15 to H1 charts, with an average trade duration ranging from 1 to 8 hours. Less than this and costs start causing too high of an impact in our trades. More than this we limit too much our profit potential. But of course, this is only suitable for the strategies we came up with so far. Each strategy has a different optimal trading length, and there are many factors to take into consideration. Transaction costs of your broker, rollover interest of the pair you're trading, expected return of each single trade and maximum profit potential. All these factors greatly contribute to a trader's overall performance, and they should be always carefully analyzed when building a trading strategy.
Much has been told about how difficult it is to make money trading Forex. I've read many articles which say that 9 out of 10 traders blow up their accounts in the first few months. I don't know if this is true, as I've never seen any good study on this matter. So far it's just a something people say kind of statement.
Equally abundant are the articles explaining WHY these traders lose money so quickly in Forex, and what are the tips for you not to be part of this majority. Those tips are pretty much the same in most of them: some are completely useless, if not harmful for traders (usually the ones that go too much into the rules of technical analysis). Some are good indeed, such as money management techniques, teaching about having patience, asking traders to study the markets...
What I truly believe is that most articles are the same because the authors didn't put time to think into the concepts they are about to write. They just write whatever somebody said before, and it becomes a vicious (and very hard to break) cycle. And it amazes me that in all of those articles, very little is said about one of the most (if not THE most) important factors responsible for wiping all those trading accounts: transaction costs.
Forex, as any other market, is a game of probability and expected return. Every time you are opening a position, you believe that your trade has a positive expected return. The factors that influence the result of your expected return are the probability of winning, the winning amount, the probability of losing and the losing amount. Unfortunately, what many people overlook is that the losing amount will always have a little extra weight, because of transaction costs. And this little extra weight compounded into many transactions becomes a very heavy weight. Keep adding transactions and it becomes almost an unbearable weight! The few traders who survive are the ones who really know what they are doing.
I hear many people who say they trade as scalpers, taking several very quick positions in M1, M5 charts and closing with few pips, either at small profit or small loss. While I see the benefit of strategies that take many positions (I will write about luck, law of large numbers and other related concepts later on), the fact is that transaction costs will just obliterate most of these guys.
Let's think about it: A trader has a strategy in which he will take profit with +3 pips or take a loss at -3 pips not considering the spread. His broker has an average spread + comissions of 1 pip. In this setup, he needs to get 66.7% of his positions right just to break even! And we are talking several of these trading setups every day! And before you say that you have such a trading setup, and that 66.7% 1:1 scalping trades are easy to find, please don't bother, because you are already a billionaire and you don't need to waste time reading this.
Also, before you start cursing the brokerage companies: this is not a post against any brokerage company. Transaction costs are part of the game and there is no way around it. You need a broker to give you liquidity, to provide you with a platform and a safe place to leave your funds, and they have the right to charge for their services. Furthermore, the broker charges are just part of total transaction costs. Any market will naturally have a bid/ask price difference, even when there is no intermediary. Costs are part of trading. Period.
The bottom line: It's probably true that the vast majority of traders will lose all their money trading Forex. But the main reason is that the odds are against the trader. The few traders who do become successful know very well the impact of trading costs. They know that they have to beat the house by creating the best high probability setups possible. There's no way around it: patience, discipline and study are the things that will get you to this goal. But when you do, you will be part of the select few traders who survive and thrive in the market.
Project Monon started in 2014. Our goal is to understand the markets in a analytical way, and develop market products, strategies and etc. based on our findings. We combine computer programming with advanced financial market knowledge to bring us an in-depth analysis on market behavior.
So far we have been concentrating in the Forex market specifically, and that's what we will be talking about in our blog initially.
We hope we are able to share some of our findings with our readers, and help those looking to increase returns in their investments.