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"url": "https://www.pagoolabs.com/stories/api/40/?format=api",
"id": 40,
"title": "How Much Should you Risk on a Futures or Forex Trade?",
"slug": "the-basic-setup-part-3-risky-trades",
"status": 2,
"publication_date": "2017-10-24T03:29:31Z",
"lead": "How do we calculate the risk on each forex or futures trade? You will learn about risk management and how position size helps contain your risk.",
"excerpt": "Learn how to calculate the risk on each forex or futures trade. Explains risk management and position size.",
"poster": "SeanManefield",
"content": "---\r\n\r\n#### **How risky is a trade - Basic Setups Part 3**\r\n\r\nIn [earlier stories](/stories/38/2017/10/24/basic-trade-setup-part-1-introduction/) in this series on \"The Basic Setup\", I presented an example gold trade along with the open, stop loss and target prices for a potential bullish setup. In this third part of the series, we discuss the risk we face should the gold price trigger our stop and cause us to exit the position for a loss. We will use this risk calculation to determine the number of contracts we will open in Gold.\r\n\r\nThis is what we have so far for our important **setup variables**:![Setup Variables](/media/uploads/2017/a_basic_trade_setup/20171008-Gold-setup4.png \"Setup Variables\"):R40\r\n\r\nKey variables | Price\r\n-------------------------------------------------------| ----------------------------------------\r\n<span style=\"color: #009;\">**Target price**</span> | <span style=\"color: #009;\">**1295.00**</span>\r\n<span style=\"color: #090;\">**Open price**</span> | <span style=\"color: #090;\">**1260.75**</span>\r\n<span style=\"color: #900;\">**Stop loss**</span> | <span style=\"color: #900;\">**1251.40**</span>\r\n\r\n\r\nWith this information we are almost ready to calculate the number of contracts to open. The math is fairly easy although it may seem unfamiliar at first. If you trade only a few markets (or **`instruments`**) you will soon be doing the calculations in your head. You can even write out a little table of risk amounts and contract sizes and keep it close at hand when examining a new setup.\r\n\r\n**Step one** is to determine how much money you have available to trade risky currencies and futures. Most of the extra risk compared to trading equities comes from the leverage that is available to you via your **`margin account`** with your broker. I will show you how to limit that risk, but these markets will always be subject to unexpected and sometimes extraordinary price movements. You need to protect yourself.\r\n\r\nSegregate the funds you have available for trading. You cannot reasonably expect to cover your living expenses until you are a successful trader and that may be months or years away. Keep your day job, keep your real estate separate and preferably maintain a bond and equity portfolio with another broker. On top of that you should allocate enough spare cash for emergencies over the next year at least. Whatever is left over, you might choose to allocate to your futures and **`forex`** trading.\r\n\r\nIf you are in any doubt, consult a licensed professional. They deal with issues like this all the time. Nobody online can know all the factors you face in assessing your risk profile: your age, your health, your sources of income, your need for emergency funds, etc.\r\n\r\nSo now you have an amount you can allocate to trading. It needs to be at least $10,000 to get started and preferably much more because you will only be risking a tiny amount of those funds on each trade. Since the probability of losing any one trade is greater than 50%, you cannot risk most of your funds on one trade or you will be wiped out very early in the game.\r\n\r\nIf all you can spare is $10K after following all these safety rules, you may find the forex market flexible enough for your needs. Even one mini S&P contract in the futures market requires US$4,500 margin just to get started. The forex market is less regulated and allows a smaller margin and a wider range of contract sizes. Carefully assess the risk first before committing funds because a higher margin protects both the brokerage and you.\r\n\r\nIf USD is not your currency, just substitute your own adjusted numbers below. The calculations are independent of the actual account currency you use until you get to market quotes and your available risk funds. Similarly if you are trading in USD, you will need to make adjustments when trading foreign markets where markets contracts are quoted in Japanese Yen or Euros. For example in forex trading, profits and losses may accrue in units of the **`quote currency`**. I will go into this in greater depth in a later story on forex trading.\r\n\r\n**Step two** is to determine how much to risk per trade or your **`position size`**. We calculated above the amount you can allocate to trading. There are many ways of approaching position sizing but the following lists common amounts to risk per trade given the trader's situation:\r\n\r\n- **Zero** - for an absolute beginner - please start a demo account and test everything first!\r\n- **1%** - after you have mastered the demo, and hopefully grappled with your own personality quirks\r\n- **2%** - after you have successfully survived several market shocks and have acted rationally and not emotionally to developments in the market\r\n- **5%** - only for experts with many years successful trading experience and a trading system that has proven itself through good markets and bad.\r\n\r\nIn general, proficient traders will risk no more than 2% of their **`available risk capital`** on each trade. That allows 50 losing trades in a row before you are wiped out (as long as you stick to 2% of the original sum and not 2% of what is left over - we can discuss that later).\r\n\r\nBut is it possible to lose 50 times in a row?\r\n\r\nWhile unlikely, it's not impossible and could happen purely by chance alone, just like throwing 50 heads in a row. Mostly such a low probability outcome would only occur if you trade against the trend, or panic, or trade low probability situations. A more likely outcome is to win more often than you lose but to not win enough to cover losses. Only a systems approach with proper money management could work to prevent that happening but that's the subject of the [next series](/stories/43/2017/10/24/trading-systems-part-1-introduction/).\r\n\r\nIf you find yourself losing more than 10 times in a row, stop what you are doing and investigate why. What trading rules are you breaking or what is really happening in the market? Perhaps the trend has reversed and you are stuck in the earlier way of thinking? Time for a sobre reassessment.\r\n\r\nThe difficulty is that you do not know the probability of a trade's success. You may see from a chart that some trades appear more probable than others, but you cannot see *how* probable. You cannot say for example, a certain trade is 50% likely to succeed. We can test historical patterns but the future is free to follow its own path. **`Black swans`** happen regularly enough that we should approach every trade with caution and humility.\r\n\r\nThere is no rule of nature that requires future prices to follow the same path as in the past. You must set up rules for your preferred strategy and stick to those rules. Following a system while those around you are losing their heads will help you score more wins than losses.\r\n\r\nWe can make our calculations easier here by assuming a trading portfolio of **$100,000** and using a trade risk of **2%**. That allows us up to $2000 to risk on one trade. Just divide by 10 if you have allocated $10,000 or multiply by 10 for each $1 million.\r\n\r\nIf we knew the risk on each contract, we could calculate how many contracts to open by dividing our total risk on the whole trade, $2000 in this example, by that risk per contract. It's like having $10 when apples cost $2 each and asking how many apples can we buy. That will be the subject of [Part 4](/stories/41/2017/10/24/the-basic-setup-part-4-risky-contracts/) coming up next.\r\n\r\n---\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[USD]: United States Dollar\r\n*[AUD]: Australian Dollar\r\n*[Yen]: The Japanese currency\r\n*[Euro]: The European currency\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[signal]: a price pattern in the market triggering the opening of a position\r\n*[instrument]: a particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: a particular traded forex or futures contract such as gold or USDJPY",
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"title": "Trading Education"
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"url": "https://www.pagoolabs.com/stories/api/41/?format=api",
"id": 41,
"title": "How Many Contracts to Open in a Futures or Forex Trade",
"slug": "the-basic-setup-part-4-risky-contracts",
"status": 2,
"publication_date": "2017-10-24T03:31:45Z",
"lead": "How do we calculate the risk per contract and how does that lead to position sizing?",
"excerpt": "Learn how to trade Futures and Forex markets. Calculate how much to risk per contract and learn about position sizing.",
"poster": "SeanManefield",
"content": "---\r\n\r\n#### **How much to risk on each contract - Basic setups Part 4**\r\n\r\n\r\nLet's return to our [earlier trade](/stories/40/2017/10/24/the-basic-setup-part-3-risky-trades/) where we are now ready to allocate $2000 toward a long gold trade. How many contracts can we buy for $2000? To calculate this we need to determine the amount we risk losing per contract, and then divide that into our $2000. The amount we risk per contract is the amount we would lose by opening one contract at OP and getting stopped out at SL.\r\n\r\n\r\n##### A simple stock market example: MSFT\r\n\r\nIn order to see more clearly the direction these calculations are going, let's consider a typical example you might be more familiar with from the world of stocks. The usual contract size for stocks is 100, so at today's price of around $76 per share for Microsoft (MSFT), a full lot of 100 shares would cost $7,600.\r\n\r\nIf we only had $10,000 to invest in this trade then we could only buy one 'contract' of 100 shares. Two contracts would cost more than $10K (I am ignoring **`odd lots`** for this example). The only difference in futures and forex markets is that the contract size varies between different instruments. Also, to keep things simple I ignore **`margin`** rules here.\r\n\r\n Example of a simple trade in the stock market: MSFT\r\n OP = 76 (Open Price)\r\n CS = 100 (Contract Size)\r\n Cost of 1 'contract' = OP x CS\r\n = 76 x 100\r\n = $7,600\r\n Amount to invest = $10,000\r\n Number of 'contracts' = Funds / contract cost\r\n = 10,000 / 7,600\r\n = 1.3\r\n Contracts rounded down = 1 (Ignore odd lots)\r\n\r\n\r\nEvery financial contract traded on an exchange will specify the contract size. You must be familiar with the contract sizes of the instruments you trade. The following table lists just a few of the contract sizes for common instruments:<a id=\"common-contract-sizes\"></a>\r\n\r\nInstrument code | Description | Contract Size\r\n-----------------|:-------------------:|---------------\r\nGC | Gold | 100 ounces\r\nQO | Gold mini | 50 ounces\r\nMGC | Gold micro | 10 ounces\r\nSI | Silver | 5,000 ounces\r\nHG | Copper | 25,000 pounds\r\nCL | Crude oil | 1,000 barrels\r\nHO | Heating Oil | 42,000 US gallons\r\nSP | S&P 500 | $250 x S&P500 index\r\nES | S&P mini | $50 x S&P500 index\r\nEURUSD | Euro FX | 100,000 euros priced in USD\r\nUSDJPY | Yen FX | 100,000 USD priced in Yen\r\nAUDUSD | AUD FX | 100,000 AUD priced in USD\r\nZW | Wheat | 5,000 bushels\r\nPB | Pork Bellies | 40,000 pounds\r\nZT | 2 yr Treasury Note | 2,000\r\n\r\nAs you can see from this small selection of futures and forex instruments, there are wide variations in contract sizes.\r\n\r\nNote that the forex contracts listed above are traded in the very liquid 24 hour interbank market. There are similar contracts with different symbols and sizes traded on the [CME](https://institute.cmegroup.com/markets/fx). For example the Australian dollar futures contract is traded on the CME under the base symbol AD.\r\n\r\nWhat is important from the table above for our example trade in gold is that one contract of gold specifies 100 ounces with one ounce costing about 1260.75 at the open. So the price quote from an exchange that you see reported in the media is for one unit, but you will need to calculate the value or risk of a whole contract. For example, when the gold price moves up or down $1, an open contract has changed in value by $100 ($1 x 100 ounces).\r\n\r\n<a id=\"Dollar-risk-of-one-contract\"></a>\r\n#### **Dollar risk of one contract**\r\n\r\nTo calculate the dollar risk of one contract, simply subtract the SL from the OP and multiply that answer by the contract size, because that's how many units we will need for one contract. If you are shorting, the SL will be higher than the OP and you will need to subtract the OP from the SL. In other words, calculate the absolute difference between the open and stop loss prices. For our example above:\r\n\r\n Risk per Gold Contract for the Sample Trade\r\n OP = 1260.75 Open Price\r\n SL = 1251.40 Stop Loss\r\n CS = 100 Contract Size\r\n CR = (OP - SL) x CS Contract Risk (absolute value)\r\n = (1260.75 - 1251.40) x 100\r\n CR = $935\r\n\r\n\r\nEarlier we calculated the amount we could invest in the trade without risking more than 2% of our available risk capital. Given $100K to invest, we have $2,000 available for this trade. Finally we can readily calculate the number of contracts to buy:\r\n\r\n Number of contracts = ($ at risk) / (risk per contract)\r\n = 2000 / 935\r\n = 2 contracts\r\n Cost of position = $1870 from: 2 contracts x $935\r\n\r\nWe cannot buy a partial contract so we need to round the final result down to a whole number. Rounding up will cost more than the $2K we are prepared to risk. It is important to stay close to the $2,000 and two contracts only risks $1870. That's not bad but if we lose this trade and the next one rounded down to only 1 contract then it becomes that much harder to regain a profitable position: we need to consistently win more than double the amount we lose. Consider buying more mini contracts, where available, if they help you stay closer to the $2,000 risk limit.\r\n\r\nWhile the numbers above apply to trading gold, the calculations are almost identical for most futures and forex instruments. You will need to insert the proper contract size and adjust for the quote currency if it is not your local currency. For example, the USDJPY contract opens a position in 100,000 USD and is priced in Yen. I will discuss these differences in a separate story on forex trading.\r\n\r\nWe now have all the elements in place to make the trade: the open, stop loss, target price and the number of contracts. All of these elements ensure the trade never risks more than 2% of our risk funds. To place the trade you will need to be familiar with the software your broker provides. Trading software from MetaTrader, which is widely used, accepts all the key variables in one panel.\r\n\r\nSoftware from Interactive Brokers on the other hand provides greater flexibility for those who want it, breaking the trade up into the three constituent orders:\r\n\r\n- a limit or market order for x number of contracts, representing the main trade\r\n- a stop order at your SL, bracketed as a ONO (One Cancels the Other) with:\r\n- a limit order at your TP.\r\n\r\nIf either the limit or the stop gets triggered, the order executes and immediately cancels the other pending close order. With this method, you can have trailing stops, partial enters, partial exits, and almost any other combination you prefer. For example, you can have the stop trigger but only to then place the close order with a limit attached to help you get a better price. Of course, it may then fail to protect you if the limit is outside the market. The software your broker provides is a major tool and you must become familiar with how to enter and exit trades smoothly and proficiently before you risk any of your capital in a live trade. Practice in a demo account until you are 100% comfortable.\r\n\r\nIn the [final story](/stories/42/2017/10/24/the-basic-setup-part-5-manage-that-trade/) in this series, I discuss some important considerations about margin calculation. I will also make a few points about managing the above gold trade.\r\n\r\n---\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[USD]: United States Dollar\r\n*[AUD]: Australian Dollar\r\n*[Yen]: The Japanese currency\r\n*[Euro]: The European currency\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[signal]: a price pattern in the market triggering the opening of a position\r\n*[instrument]: a particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: a particular traded forex or futures contract such as gold or USDJPY",
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"url": "https://www.pagoolabs.com/stories/api/48/?format=api",
"id": 48,
"title": "Getting the Right Target Price in a Forex or Futures System Using Simulations",
"slug": "trading-systems-part-6-simulations-on-systems",
"status": 2,
"publication_date": "2017-10-24T03:56:39Z",
"lead": "This sixth and final story in the series \"Introduction to Trading Systems\" tests systems to show how to develop an optimal risk/reward multiplier. This RR is used to calculate the target price in each setup.",
"excerpt": "This sixth story in the series on Trading Systems tests systems to show how to develop an optimal risk/reward multiplier. This RR is used to calculate the target price in each setup.",
"poster": "SeanManefield",
"content": "---\r\n#### **Trading Systems Part 6 - Basic Manual Simulations in Forex and Futures**\r\n\r\nWe are going to apply the techniques discussed in the previous story to show how to simulate a particular market. What we are looking for is an optimal risk/reward multiplier, RR. In the real world, however, we more often find complications.\r\n\r\nI will be writing other stories on this topic because this is a major focus of our web site: **Pagoo** or *Playing A Game Of Odds*.\r\n\r\nHowever to begin, let's take an example where an optimal multiplier may not exist because we all want to remain sceptics about this whole approach. What do we do when our method does *not* work out easily?\r\n\r\nThe **first step** is to find a chart you want to trade where a trend reversal has recently taken place. This means you can enter early enough to profit from the remaining trend. As noted earlier, you may have a notion of why that trend reversal is occurring. As a result you may have reason to believe the new trend is tradable. By 'tradable' I simply mean that the target price of the first signal is achievable.\r\n\r\nFor our purposes, let's take the S&P 500 where the market has been in a longer term uptrend from 2009 but suffered through a period of correction from 2014 through 2016. As you can see from the chart below, at **point A** a trend reversal takes place, made evident by the faster 100 period moving average, MA(100), crossing above the MA(200). You are free to choose whichever relevant MA periods you prefer, or just use price action cycles, or use a regression line or whatever makes you confident the trend has changed. Crossing MAs is just an example I use here. Mistakes are allowed and you will see the outcome of those when you do your testing.\r\n\r\n![Uptrend in SPX futures](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-20171012.png \"Uptrend in SPX futures\"):C90!\r\n\r\nWe can readily see the S&P is in a solid uptrend but we did not know that at point A. In fact, all we knew was that the S&P had been uptrending for many years and had recently gone through a correction. For all we knew, the correction might have become deeper. Once the MAs crossed, we acted *as if* the uptrend had resumed. That's all we needed to know.\r\n\r\n\r\n#### Pin bar example\r\n\r\nFor our first example of a system, let's use the pin bar signal. It's a popular candlestick pattern and many traders already make use of it.\r\n\r\nThe **second step** is to mark every hanging man candlestick on the chart. A hanging man candlestick pattern has a small head and a long lower tail. A bullish pin bar is just a hanging man with a prominent size and location to distinguish it, but that will be clearer as we work along. Each hanging man has been marked with a green arrow. Now let's filter out the candlesticks that do not meet our basic criteria for a pin bar:\r\n\r\n- Ignore hanging men outside the range of the MA cross: marked as red **'OR'**\r\n- Ignore hanging men which have **n**o **r**etrace with at least two previous red bars: **'NR'**\r\n- Mark the spikes which seem too extreme: **'S'**\r\n\r\n![Pin bars on S&P500 futures](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-PBs-20171012.png \"Pin bars on S&P500 futures\"):C90\r\n\r\nThat leaves five candidates that qualify as signals. The spike is disqualified partly because it is not preceded by several down bars and partly because the target price may be so far above today's market that achieving that TP seems improbable - and probability is the name of the game. Pin bar #3 barely qualifies, but it does have two prior down days but is not as prominent as we would like. Pin bar #5 does not strictly qualify but is 'rejecting' the area below the MA(100), which gives it a measure of confluence.\r\n\r\nAlso note that if we lose the second trade we will be out of the market until we reenter for the third trade. During that period there was a big rally in our direction. There's an earlier engulfing pattern in the first week of December 2016 that we could add, but then we need to examine *all* engulfing patterns as entry candidates otherwise we would be selecting patterns based on hindsight. I will just keep this simple for now, but this is the sense in which I mean a pin bar signal is not *complete*.\r\n\r\nThe **third step** is iterative: starting at an RR multiplier of one, consider each trade in turn in the order it would occur in a live trade scenario. We will mechanically simulate what would transpire given our setup and the calculated TP. We will hold that position, opening no others, until it is either stopped out for a loss or triggers our TP for a win.\r\n\r\nTo show the mechanics, I indicate the risk of each trade in the table below, where the risk comes from the OP of the following time period less the SL given by the bottom of the pin bar. I always move the SL a few points beyond the bottom of the pin bar so that my stops would survive a challenge at the same price as the pin bar low. I will count any final open position as a loss because I want to be as sceptical as possible in the simulation and I have no other way to handle it until it's closed or the trend ends.\r\n\r\nThe starting conditions for this table are:\r\n\r\n- A maximum risk of 2%, assumed to be $100,000 here\r\n- A Risk Reward ratio of 1:1, or **RR=1**, so that the TP is 1 x Contract Risk\r\n- We are trading the ES mini S&P500 contract with a contract size or CS=50\r\n- The columns are just the setup parameters except for the final two result columns.\r\n\r\n Trade# | OP | SL | Risk | CR | TP (1) | CO | Result | Win/Loss\r\n----------|-----------|-----------|--------|--------|-----------|------|----------|-----------\r\n 1 | 2078.60 | 2049.70 | 28.90 | 1445 | 2107.50 | 1 | Win | +1445\r\n 2 | 2133.30 | 2112.70 | 20.60 | 1030 | 2153.90 | 2 | Win | +2060\r\n 3 | 2281.80 | 2266.50 | 15.30 | 765 | 2297.10 | 2 | Win | +1530\r\n 4 | 2343.80 | 2320.80 | 23.00 | 1150 | 2366.80 | 1 | Win | +1150\r\n 5 | 2430.20 | 2416.20 | 14.00 | 700 | 2444.20 | 2 | Win | +1400\r\n\r\n Total wins 5/5 $7585\r\n\r\nWe went over the risk limit by 3% on trade #2. A small amount is acceptable but in general avoid extra risk of more than 5%. Also note that we were able to open all trades because each trade reached its limit before the next signal was reached. It's unusual to get five wins in a row but that is a consequence of the strong trend and the fact that we only required an RR of one. A low RR means the market was more likely to reach the TP.\r\n\r\nThe **fourth step** is to repeat the simulation, raising the value of RR by a small step. Let's run the simulation again, this time with an **RR=2**.\r\n\r\n Trade# | OP | SL | Risk | CR | TP (2) | CO | Result | Win/Loss\r\n----------|-----------|-----------|--------|--------|-----------|------|----------|-----------\r\n 1 | 2078.60 | 2049.70 | 28.90 | 1445 | 2136.40 | 1 | Loss | -1445\r\n 2 | 2133.30 | 2112.70 | 20.60 | 1030 | 2174.50 | 2 | Win | +4120\r\n 3 | 2281.80 | 2266.50 | 15.30 | 765 | 2312.40 | 2 | Win | +3360\r\n 4 | 2343.80 | 2320.80 | 23.00 | 1150 | 2389.80 | 1 | Win | +2300\r\n 5 | 2430.20 | 2416.20 | 14.00 | 700 | 2430.20 | 2 | Win | +2800\r\n\r\n Total wins 4/5 $11,135\r\n\r\nEven though we were stopped out of one trade, we received double on the remaining four so our wins exceeded the results of the first simulation. We can conclude for this market under these counditions that holding out for an RR of two times risk is more profitable.\r\n\r\nLet's run the simulation again, this time with an **RR=3**.\r\n\r\nTrade# | OP | SL | Risk | CR | TP (3) | CO | Result | Win/Loss\r\n--------|-----------|-----------|--------|--------|-----------|------|----------|-----------\r\n 1 | 2078.60 | 2049.70 | 28.90 | 1445 | 2165.30 | 1 | Loss | -1445\r\n 2 | 2133.30 | 2112.70 | 20.60 | 1030 | 2195.10 | 2 | Loss | -2060\r\n 3 | 2281.80 | 2266.50 | 15.30 | 765 | 2327.70 | 2 | Win | +4590\r\n 4 | 2343.80 | 2320.80 | 23.00 | 1150 | 2412.80 | 1 | Win | +3450\r\n 5 | 2430.20 | 2416.20 | 14.00 | 700 | 2472.20 | 2 | Win | +4200\r\n\r\n Total wins 3/5 $8,735\r\n\r\n**Step five** is to compare our results. When we raise our TP to three times our risk, the total profit falls compared to the case with two times risk.\r\n\r\nBecause our wins fell compared to the previous round, we would normally turn to target that area 1 < RR < 3 and iterate in smaller steps to focus in on an optimal value of RR. This final **Step six** would result in an optimal RR.\r\n\r\nHowever, in this case, it's worth looking further since this market has been in a long term uptrend. In fact, the S&P 500 climbed over 25% in this same period and it seems that a win of only $11K out of $100K in funds is too low, even if we only risked 2%. Others who are 100% invested in the S&P stocks have made about 25%, but only if they close now. In contrast, we are fully cashed up. Still, 25% is better than 11% so let's see what is going on here.\r\n\r\nFirst, note that in the previous simulation with TP set to two times risk, we won four times receiving twice our risk for each. So in total we made roughly eight times our maximum risk (4 wins x 2 x $2K), except for slippage cause by rounding down. So let's try to see if taking a trade with an **RR=8** will win:\r\n\r\nTrade# | OP | SL | Risk | CR | TP (8) | CO | Result | Win/Loss\r\n--------|-----------|-----------|--------|--------|-----------|------|----------|-----------\r\n 1 | 2078.60 | 2049.70 | 28.90 | 1445 | 2309.80 | 1 | Loss | -1445\r\n 2 | 2133.30 | 2112.70 | 20.60 | 1030 | 2298.10 | 2 | Loss | -2060\r\n 3 | 2281.80 | 2266.50 | 15.30 | 765 | 2404.20 | 2 | Win | +12,240\r\n 4 | 2343.80 | 2320.80 | 23.00 | 1150 | 2527.80 | 1 | skipped | 0%\r\n 5 | 2430.20 | 2416.20 | 14.00 | 700 | 2542.20 | 2 | Win | +11,200\r\n\r\n Total wins 2/5 $19,935\r\n\r\nTrade #4 was skipped because we still had trade #3 open and one of our rules is not to go over 2% risk. Not only did one trade win at RR=8 but we managed to win two trades.\r\n\r\nAlmost $20,000 is a substantial profit for a $100,000 portfolio that never risked more than 2% per trade, although by trade #3 we were down potentially 6%. The system I have used above is one of the simplest. It uses a crossing MA to detect trend reversal and just one type of candlestick, the pin bar, as a trade signal. There's clearly huge potential for improvement.\r\n\r\nThe gains took place over 16 months and the trend is not yet finished. As it finishes you can expect to surrender some of that profit as what appear to be retracements turn out to become trend reversals that trigger stops.\r\n\r\nAt some point it will become clearer that the uptrend is over and either a period of consolidation or a downtrend ensues. At that stage you can stop opening positions on signals. Until then the system does need to book profits to pay for the coming losses, or you could stop now until the next uptrend starts. Whatever you do, you must be consistent so that you can evaluate your performance and make necessary adjustments for the next trend you trade.\r\n\r\nIf we look at the chart, something we can only do in hindsight, we can see a number of pin bars have not yet had their lows retested and the chart is currently trading at all time highs. That means that *any* RR multiple would work, as long as we closed our position now to lock in those profits. But how do we approach this problem before the trading takes place?\r\n\r\nIf we knew the path of prices from the outset with clairvoyence, but determined to only enter trades based on pin bar signals, pin bar #3 would be best because it has furthest to run without being stopped. Yet it is also possibly the weakest shaped pin bar on the chart: small, does not protude from surrounding bars, is in a tiny retrace, is far above the moving averages, and so on. A reasonable pin bar trader would reject it. A position opened on pin bar #3 and held until the last day of trading would yield almost 18x risk, or $27,390 here because of rounded down contract sizes ($765 x 2 contracts x 18). So the optimum RR for this leg of the bull market in the S&P would lie somewhere between RR=8 and RR=18.\r\n\r\nBut you cannot know about this single pin bar in advance. When you see RR numbers going over five, stop and examine the situation further. Your entire simulation cannot depend on one outlier.\r\n\r\nThis chart is typical of the S&P 500. It represents stocks that have risen consistently for a century. The growing companies that comprise the S&P together with general price inflation, cause the index to be in a solid uptrend. There is no guarantee this will last but with all time highs being posted daily, it's unlikely to end anytime soon.\r\n\r\nThe current rapid rise we are witnessing is at the high end of its previous performance, comparable to the post Soviet Union bull market of the 1990s. This suggests that expecting an eightfold increase or more for a pin bar could be unrealistic for other periods. You need to go back further and run the same simulation in earlier time periods. This is the time to break out your programming talents, for those that have them. Even a spreadsheet would make short work of this data and the worksheets or programs could be reused on other markets and time periods.\r\n\r\nIf you don't have the time or inclination to program a simulation, print out the charts and user a ruler to find where stops are triggered. Do rough calculations for the trade risk and TP levels and avoid laboring over decimal places unless necessary for the market in question. The advantage is you will have a permanent record for your files.\r\n\r\n#### Summary\r\n\r\nTo begin our exploration of systems, I have picked an easy chart, although it is absolutely current and has some tricky quirks. Most charts will not be so easy because very few markets at the present time trend so strongly without pause. When inflation picks up, commodity prices should resume their uptrend.\r\n\r\nWhen we turn to other markets that don't trend so strongly, we will see that there is often an optimum RR somewhere in the range one to five. It's up to you to find that optimum so that you can calculate the TP for the setup tool.\r\n\r\nIn the first series on \"The Basic Setup\" I showed you how to bring together all the key components of a trade setup except the target price, TP. We have now come full circle, calculating an optimal risk/reward multiplier, RR, and therefore a TP that completes all the elements you need in the basic setup. Now with the basic setup in place you should be able to apply it to your preferred signal method and estimate an RR as input into a system of trades.\r\n\r\nPerhaps what you discover by measuring the results of your system under different RR values will lead you to calibrate the approach you have been using up until now, or even to change to a different signal method. That's all part of learning and trading.\r\n\r\nNone of these methods or ratios are permanent fundamental constants of the universe in the way that mathematical pi is. In fact you can expect RR and some of the signal filters to change over time and between markets.\r\n\r\nHowever if you apply your time and energy to investigating the trend and measuring the performance of your system rather than constantly second guessing every trade and whether you should take profits or move to break even, I believe you will be far better psychologically equipped to make profits in futures and forex. Micro managing trades will cause you to make so many mistakes you will lose confidence in your ability to trade anything. Aside from excess leverage, there is probably no greater impediment to trading than poor psychology and implementing a system will help you see that.\r\n\r\nIn our future stories I will apply the methods detailed above to calculating the optimal RR for other markets. I will continue to pick tricky examples, such as ambiguous trends or markets consolidating, because that's where I believe there is the most to learn.\r\n\r\n<br>\r\n<br>\r\n<br>\r\n#### Disclaimers\r\n\r\nAlthough the PagooLABS site is educational and does not advocate any position in a futures or forex contract, it is important to present the following disclaimers as additional information. Trading these markets can be risky and you must be aware of the following:\r\n\r\n**U.S. Government Required Disclaimer**\r\nCommodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.\r\n\r\n** CFTC RULE 4.41 **\r\n\"These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.\"\r\n\r\n<br>\r\n<br>\r\n<br>\r\n\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n*[pi]: ratio of a circle's circumference to its diameter\r\n*[HA]: Heikin Ashi\r\n*[MA]: Moving Average over a specified period - 100 periods for eg\r\n*[EMA]: Exponential Moving Average - has a long 'memory'\r\n*[OHLC]: Open, High, Low, Close: the 4 key values for any bar on a chart\r\n*[bull]: An uptrending or rising market\r\n*[bear]: A downtrending or falling market\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[MR]: Maximum Risk\r\n*[USD]: United States Dollar\r\n*[AUD]: Australian Dollar\r\n*[Yen]: The Japanese currency\r\n*[Euro]: The European currency\r\n*[EURJPY]: The Euro - Yen cross currency: buying Euros priced in Yen\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[signal]: a price pattern in the market triggering the opening of a position\r\n*[setup]: An instance of a signal ready for trading with values for the number of contracts and the Open, Stop and Target prices\r\n*[instrument]: A particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: Particular traded forex or futures contracts such as gold or USDJPY\r\n*[underlined text]: Congratulations! You have successfully hovered over text\r\n*[indicator]: A calculated line, such as a Moving Average drawn on a chart, that is separate from the OHLC prices but often calculated from them\r\n*[indicators]: Calculated lines, such as Moving Averages drawn on a chart, that are separate from the OHLC prices but often calculated from them\r\n*[H4]: Chart of the four hour timeframe\r\n*[M5]: Chart of the five minute timeframe\r\n*[H1]: Chart of the one hour timeframe",
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"forums": [
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"url": "https://www.pagoolabs.com/forums/api/trading-education/?format=api",
"title": "Trading Education"
}
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"replies": 6
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{
"url": "https://www.pagoolabs.com/stories/api/46/?format=api",
"id": 46,
"title": "Examples of Signals in Forex and Futures Trading",
"slug": "trading-systems-part-4-examples-of-signals",
"status": 2,
"publication_date": "2017-10-24T03:51:27Z",
"lead": "This fourth story in the series \"Introduction to Trading Systems\" explores examples of simple signals: the MA cross, Pin Bars, Engulfing patterns and Heikin Ashi reversals.",
"excerpt": "This fourth story in the series on Trading Systems explores examples of simple signals: the MA cross, Pin Bars, Engulfing patterns and Heikin Ashi reversals.",
"poster": "SeanManefield",
"content": "---\r\n#### **Trading Systems Part 4 - Examples of Signals**\r\n\r\nThe [previous story](/stories/45/2017/10/24/trading-systems-part-3-signals/) described the class of triggers we call signals. In this story we will explore some simple examples of signals. Most of these you will be familiar with and they help to clarify the terms we use in the next story on systems.\r\n\r\nAs examples, we will discuss the following types of signals:\r\n\r\n- MA cross\r\n- Pin bars\r\n- Engulfing patterns\r\n- Heikin Ashi reversals.\r\n\r\n<a id=\"Moving-Average-Cross-signals\"></a>\r\n#### Moving Average Cross signals\r\n\r\nAn MA cross signal occurs of course when two MAs cross. One MA has a longer periodicity than the other meaning that it will be slower to react to the latest prices while the MA with the shorter time period will react faster. If the previous trend had been a bear market then prices would generally be below the two MAs with the faster MA closer to the real market prices than the slow MA.\r\n\r\n![MAs above prices in downtrend](/media/uploads/2017/basic_system_trading/EJ-D1-MA-DN-20171013-2.png \"EURJPY MA Downtrend\"):C80\r\n\r\nIn a bull market, the opposite occurs with the slow MA below the faster, and *both* below the actual rising prices. The two charts of EURJPY show different phases of a cycle, with the first above showing a downtrend with the MAs lying above and to the right, and the following chart showing an uptrend with MAs underneath.\r\n\r\n![MAs below prices in uptrend](/media/uploads/2017/basic_system_trading/EJ-D1-MA-UP-20171013-0.png \"EURJPY MA Uptrend\"):C80\r\n\r\nFor the slow MA to be above the faster MA in a bear market but below in a bull market they must have **crossed** over at some point when the trend reversed. This is point A in the charts. This crossover point is frequently used as either a trend starting point or even as an entry signal for actual trading.\r\n![MA Cross on USDJPY](/media/uploads/2017/basic_system_trading/USDJPY-MA-Cross-20171017.png \"MA Cross on USDJPY\"):R40\r\n\r\nWe could use a second set of MAs with even shorter periods, such as MA20 and MA8, as our *signal* while reserving the longer 100 period MA as an indicator of *trend*. While admittedly simple, such a trading system could in fact work, depending on how you tested and implemented it. If there is an advantage to using a more complicated system, you should find that out in the testing.\r\n\r\nThe setup itself is made complicated by the long period of time that evolves while a cross is taking place and the fact that because we are dealing with averages, the low probably does not occur in the same period as the cross. Instead find the lowest price of all the bars leading up to the cross starting from the last downtrend. During the downtrend, prices were higher. At some point they must have flattened out before turning up to create the cross. Sometime in that period a lowest price must have been set. Use that low for the SL. Refer to the accompanying chart of the S&P futures.\r\n\r\n![MA Cross Setup on S&P500](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-MACross-Setup-20171019.png \"MA Cross Setup on S&P500\"):R60\r\n\r\nEven if you witness a cross forming during the period, it may or may not actually appear on the charts depending on the closing price of the bar that day. You can never be sure the cross will complete until the close of trading. The open price should be the open of the very first bar *following* the cross although you're free to enact some intricate open policy that involves a confirmation pattern. That policy emerges later from your testing.\r\n\r\nWith the SL and OP set you can easily calculate the number of contracts to open (CO). The TP would usually be based on some multiple of the risk (OP-SL) and I will discuss that important topic in the story on [testing systems](/stories/48/2017/10/24/trading-systems-part-6-simulations-on-systems/). With the OP, SL, TP and CO we have all the elements required for the setup based on a particular signal.\r\n\r\nTo summarize the MA cross signal:\r\n\r\n- In an uptrend, when the faster MA crosses from below the slower MA to above, open a long position.\r\n- In a downtrend, when the faster MA crosses from above the slower MA to below, open a short position.\r\n\r\nBut MA crosses are just one class of signals out of many. Let's look at a few more.<a id=\"Pin-Bar-Signals\"></a>\r\n\r\n\r\n#### Pin Bar Signals\r\n\r\nPin bars belong to a set of simple candlestick patterns, such as doji, hanging man or shooting star. These are sometimes called pin bars when they exhibit certain extra characteristics such as position, shape and size that dominate surrounding bars. There are many other candlestick patterns and we plan to run a future story on some of these and how to use them in a system.\r\n\r\n![Pin bar in an uptrend](/media/uploads/2017/basic_system_trading/OK-PB-20171013.png \"Pin bar in an uptrend\"):R40\r\nA pin bar is a candlestick with a small body at one end and a much longer tail. The key idea is that a particular area has been tested by the long tail and rejected. The market probed down into the support area, triggered the stops and instead of continuing in that direction, bounced right back. The open trades that did not trigger are now considered to belong to *stronger hands*: traders who are less likely to be stopped out next time.\r\n\r\n![Pin bar](/media/uploads/2017/basic_system_trading/Pin_Bar.png \"Pin bar\"):R40\r\nBy shape alone, a pin bar is like a traditional hanging man or shooting star candlestick, although most practitioners only accept a subset of such candles as true pin bars. A *true* pin bar must usually dominate the surrounding pattern and either indicate a resumption of the trend after a retracement or be at the bottom or top of the range in a sideways market. You should strongly avoid accepting every hanging man or shooting star as a pin bar signal. Critically examine the charts to see how often this pattern fails to work as a signal when it is against the trend.\r\n\r\nThe setup is straightforward - the SL should be just beyond the tail of the bar, and the OP could be the open of the next bar. Or you could set a stop-limit order to trigger you into the trade when the market price moves above the top of the pin bar head (for a long trade).\r\n\r\nWith the SL and OP set you can easily calculate the number of contracts to open (CO). As with the MA cross, the TP would usually be based on some multiple of the risk.\r\n\r\nUsing only a pin bar is not a complete system because if the setup is stopped out, it is rarely followed by another pin bar to signal re-entry. However it can be combined with other entry signals such as the engulfing or outside bar pattern to provide a more complete system, and we turn to that now.<a id=\"Engulfing-pattern-signals\"></a>\r\n\r\n\r\n#### Engulfing pattern signals\r\n\r\nAn engulfing pattern or outside bar is a two bar pattern where the second bar reverses direction and has both a higher high and a lower low than the first. In other words, the second bar encloses or *engulfs* the first.\r\n\r\n![Example outside bar in uptrend](/media/uploads/2017/basic_system_trading/OB-EG-20171014.png \"Example outside bar in uptrend\"):R40\r\n\r\nIf you think about it, this is similar to a pin bar except it plays out over two periods instead of one. On the first day (or period) the market continued its retracement against the trend. On the second day the market opened lower in a bearish sentiment and attempted to go even lower before surrendering to the upward trend in a wave of buying that sent prices higher than the open of the previous day.\r\n\r\n![Outside Bar](/media/uploads/2017/basic_system_trading/Outside_bar.png \"Outside Bar\"):R40\r\nAs with the pin bar, there is the strong sense that the area below has been tested and rejected. But testing and rejecting really only makes sense when the market is probing *against* the real underlying trend. When prices are moving with the trend there are multiple examples of engulfing patterns that never lead to any price reversals.\r\n\r\nThe setup is similar to the case of the pin bar - the SL should be just beyond the tail of the larger outside bar, and the OP could be the open of the next bar or you could set a stop-limit order to trigger you into the trade when the market price moves above the top of the outside bar (for a long trade). The TP and CO are as discussed earlier for the other signals.\r\n\r\nAs with the pin bar, it needs to be combined with several other signals to be a complete system. Together with the pin bar you might be able to catch at least one of the entry points in a trend but whether it's enough to offset losses would depend on what your historical tests will show.\r\n\r\nTo make the engulfing pattern and pin bar more complete, you could also add the Piercing Line pattern (or Dark Cloud Cover) as well as a number of two bar reversals that don't quite qualify as engulfing patterns.\r\n\r\nIn 24 hour forex markets, gaps at the open are not possible unless they happened in the final minutes of trading. For this reason, outside bars are less prevalent than two bar reversals where both bars have a common low but the second has a higher high. You might like to use these in addition to engulfing patterns if you are trading in forex markets.\r\n\r\nCandlestick patterns are a huge field and there is much to explore. Fortunately there are many sites on the web that cover all these patterns.<a id=\"Heikin-Ashi-Candlesticks\"></a>\r\n\r\n#### Heikin Ashi Candlesticks\r\n\r\nHeikin-Ashi (HA) is a different candlestick design that smooths out the shortest term fluctuations in each bar. Because HA bars are a different shape than the standard candlesticks, the technique is not very popular with traders. However there are solutions to most of these problems. HA is presented here as an example of an uncommon technique. Below, side by side are the same two sections of the chart of the S&P futures contract. The chart with the normal candles is to the left and on the right is the same chart using Heikin Ashi candles.\r\n\r\n<div class=\"clear-floating-cols-above\"></div>\r\n![S&P 500 with Normal candlesticks](/media/uploads/2017/basic_system_trading/SPX-D1-Normal-Section-20171020.png \"S&P 500 with Normal candlesticks\"):L45\r\n![S&P 500 with HA candlesticks](/media/uploads/2017/basic_system_trading/SPX-D1-HA-Section-20171020.png \"S&P 500 with HA candlesticks\"):R45\r\n<div class=\"clear-floating-cols-above\"></div>\r\nAll candlesticks are composed of the Open, Close, High and Low or OHLC. Heikin Ashi (HA) candlesticks are made up of averages of these four key values: haClose, haOpen, haHigh, haLow. Because the averages for the haOpen, haHigh and haLow are further averages of earlier candlesticks, each HA has a 'memory' in much the same way as an exponential MA. Here are the formulae so that you can see how the memory kicks in:\r\n\r\n Where t represents the current period, and t-1 the previous:\r\n haClose = (Open[t] + High[t] + Low[t] + Close[t]) / 4\r\n haOpen = (haOpen[t-1] + haClose[t-1]) / 2;\r\n haHigh = maximum of High[t] and haOpen;\r\n haLow = minimum of Low[t] and haOpen;\r\n\r\nSo the close is just the average of the current periods values but the others are all averages in some way of the earlier period, unless the current high is higher or the current low is lower than the average. It should come as little suprise that the HA reversals track an exponential MA cross of very short duration. ![SPX daily chart](/media/uploads/2017/basic_system_trading/SPX-D1-20171012-EMAvsHA.png \"HA vs EMA4/2\"):R35 The short period, or fast MA, uses EMA(2) with HLCC/4 as the value used in each period (if this is confusing then just use the normal close value).\r\n\r\nWhere they cross is often the same time period where HA changes direction, so we can use the MA cross as a proxy for HA when it's not available. For the long period, or slow MA, use EMA(4). Remember the bars must close before you can know whether the MA crossed in that period or not. It's much easier to visualize these reversals with HA so you would only use MAs if HA is not available in your charting software.\r\n\r\nIn fact, many of these signals are not independent of one another because they are based on the same four market numbers contained in OHLC. There are only just so many ways you can slice and dice four numbers so you will often end up with the same result from otherwise different indicators.\r\n\r\nHere is an example of the EURJPY downtrend chart shown earlier in the section on MA crosses, but this time using Heikin Ashi bars. ![Heikin Ashi chart of EURJPY daily](/media/uploads/2017/basic_system_trading/EJ-D1-MA-DN-HA-20171013.png \"Heikin Ashi chart of EURJPY daily\"):R55 In these charts, HA is displayed in red whenever the haClose<haOpen, and in green otherwise. A great advantage over normal candlesticks is HA highlights the runs in one particular direction, smoothing out the minor fluctuations that distract you from the bigger picture.\r\n\r\nTo be sure, HA candlesticks cannot replace the normal charts, but they are a great addition when you flick quickly between both. If your software allows multiple open charts, and most do, just set up the normal chart in one window and the Heikin Ashi chart for the same instrument in another.<a id=\"HA-signals\"></a>\r\n\r\n\r\n#### HA signals\r\n\r\nOne signal that is readily apparent is to open whenever a bar changes from red to green if the trend is up. You must not already have an open position and you will need to **wait until the first green bar is complete** at the end of the period. Because the bar has changed color, there must have been a low set during the change, either on the new green bar or one of the immediately preceding red bars. Just below that is where you place your stop loss.\r\n\r\nThe setup then is similar to the case of the MA cross. With the SL determined, the OP should be the open of the first bar *after* the green reversal bar (red in a downtrend). The TP and CO are as discussed earlier for the other signals. See [The Basic Setup](/stories/38/2017/10/24/basic-trade-setup-part-1-introduction/) if you are unclear on any aspect of the setup tool.\r\n\r\n![Heikin Ashi chart of S&P500](/media/uploads/2017/basic_system_trading/SPX-D1-HA-rev-20171012-2.png \"Heikin Ashi chart of S&P500\"):C90\r\n\r\nAbove, in the Heikin Ashi chart of the S&P500 continuous futures contract, most of the HA reversals have been marked with a green check if they have not yet been stopped out, or a red cross if subsequent prices triggered the SL.\r\n\r\nEven in an uptrend it's possible to see that about half the reversals were successful and the other half failed. That's because the unsuccessful signals occur in areas of consolidation and involved much whipsawing causing many minor reversals. The successful signals on the other hand resulted in resumption of the trend and continued for some time before the next HA reversal down.\r\n\r\nIf you open a signal that eventually fails you will open the next signal, which should come after the series of bars that stopped out your trade. If that fails you will open the next, and so on. Eventually, unless the trend has changed, you will be in a position that has the lowest SL of all those earlier failed trades.\r\n\r\nYou can see this on the chart above in the troublesome area after point A. The first setup fails, triggered by the concerns over the UK Brexit vote. When the market resumes in the direction of the trend, a new HA signal is triggered, this time with a lower SL than the first setup. None of the bad HA setups that follow should impact the open position because its stop never gets triggered and one of the rules is to not open a second position.\r\n\r\nHowever if for some reason you did not enter on the first signal, the next occurs about six days later. It eventually fails, stopped out by the US 2016 election result. Before then however there are multiple signals to enter, all of which fail for the same reason, but none of which affect you because you already have an open position. The point is that many of the failed signals on a chart are irrelevant, you will be in the first one until that fails, if it does. If it wins it will of course need a TP to compensate for the losses.\r\n\r\nThe HA signal is complete in the sense that the trend cannot resume without you. It is not possible for the market to trade higher after a period of retracement without first signaling an HA reversal.\r\n\r\nWhat could go wrong is that the reversal bar could be very large and untradable, like the spike we talked about above for pin bars. In that case you will have to wait for a more reasonable sized correction. Large spikes usually, but not always, provide these later opportunities. In the meantime however, you could miss out on a substantial rally in line with the trend.\r\n\r\nAside from the huge reversal spikes, the only part of the trend that is not covered are the bars after the TP has been hit and before the next HA signal. If the next signal is higher than the TP, which can happen, then the trader will miss out on a portion of the trend.\r\n\r\nThe disadvantage of the HA is that it displays candlestick bars that are slightly different to the real bars - it is after all an averaging system. To correct this, use your software to show both charts, the normal one and the HA, side by side. Or better still, place one chart on top of the other and then flick between them so that you can see the signals and the original chart. In this series, whenever I can, I will try to place them side by side with the HA on the right. Also, the normal chart has the EMA4 (green) and EMA2 (gold) moving averages so that you can compare the signals with the HA chart.\r\n\r\nThis section has not done justice to Heikin Ashi which has its own set of candlestick patterns differing from the traditional ones. Candlestick tails (shadows) or their absence take on new meaning. If you are interested, there are many books and sites on the web that discuss this technique further.\r\n\r\n#### Custom Signals\r\n\r\nThese examples above illustrate how to create a setup around any custom signal. All that is required is a clear, unambiguous trigger to open a position starting at a particular time period with some condition specifying the open price. To open the position you use the setup tools from our earlier series on \"The Basic Setup\". Looking around the area the signal occurs, you should be able to identify the most appropriate SL level. The setup tools describe the number of contracts and your own simulation described in a later story determine the TP.\r\n\r\n#### Summary\r\n\r\nHere we discussed what qualifies as a signal and showed several different signals based on MAs, candlestick patterns and Heikin Ashi charts.\r\n\r\nNote, these are all simple signaling systems: there is nothing complex about a pin bar or crossing moving average. Taken by themselves they could lose more than they would win. However when combined into a system they become powerful trading tools.\r\n\r\nIn other stories and posts I may use different signals just to show how widely the system method can be applied. While it does not depend on any one signal strategy, every system needs at least one signal strategy in order to trigger opening a long or short position.\r\n\r\nThe problem with signals is that sometimes they fail and the setup is stopped out. By itself, all we can say is the signal was successful or unsuccessful. However if losses are accumulating in the account then you are faced with the very real prospect of being wiped out. We need the bigger picture to see if all the positions we have opened as a result of signals are winning or likely to win.\r\n\r\nNow we turn to [building our first system](/stories/47/2017/10/24/trading-systems-part-5-systems/). With all the building blocks in place - trend, setup and signal - it is just a matter of assembling them in the right order into a system.\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n\r\n*[HA]: Heikin Ashi\r\n*[EMA]: Exponential Moving Average - has a long 'memory'\r\n*[OHLC]: Open, High, Low, Close: the 4 key values for any bar on a chart\r\n*[bull]: An uptrending or rising market\r\n*[bear]: A downtrending or falling market\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[MR]: Maximum Risk\r\n*[USD]: United States Dollar\r\n*[AUD]: Australian Dollar\r\n*[Yen]: The Japanese currency\r\n*[Euro]: The European currency\r\n*[EURJPY]: The Euro - Yen cross currency: buying Euros priced in Yen\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[instrument]: A particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: Particular traded forex or futures contracts such as gold or USDJPY\r\n*[indicator]: A calculated line, such as a Moving Average drawn on a chart, that is separate from the OHLC prices but often calculated from them\r\n*[indicators]: Calculated lines, such as Moving Averages drawn on a chart, that are separate from the OHLC prices but often calculated from them\r\n*[H4]: Chart of the four hour timeframe\r\n*[M5]: Chart of the five minute timeframe\r\n*[H1]: Chart of the one hour timeframe",
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"url": "https://www.pagoolabs.com/stories/api/57/?format=api",
"id": 57,
"title": "Examples of how to Manage Risk in a Forex Trade Using AUD.JPY and AUD.USD",
"slug": "examples-of-how-to-manage-risk-in-a-forex-trade",
"status": 2,
"publication_date": "2017-11-27T23:56:40Z",
"lead": "How to manage a forex trade so that the risk and the risk-reward of the trade is set in advance, using the examples of AUD.JPY and AUD.USD.",
"excerpt": "Managing a Forex trade using the examples of AUD.JPY and AUD.USD that set the risk and the risk-reward of the trade in advance.",
"poster": "SeanManefield",
"content": "---\r\nOur [previous story](/stories/51/2017/11/27/trading-audjpy-in-a-heikin-ashi-forex-system/) on risk in forex markets went over the definitions of the <small><strong>base.quote</strong></small> currency ticker format and how the quote defines the currency the contract is valued in. In this story I will go through a couple of specific examples to show how to correctly value any forex contract and have it priced in the same currency you use for your accounts.\r\n\r\nTo begin, imagine you are a United States Dollar (USD) account holder and you want to value a contract to sell <small><strong>AUD.JPY</strong></small>. I am extending the work we went through in an earlier story on the [dollar risk of one futures contract](/stories/41/2017/10/24/the-basic-setup-part-4-risky-contracts/#Dollar-risk-of-one-contract) by adding the currency conversion rate and converting the quoted currency back to the account currency.\r\n\r\nWe will use the trade data indicated in the following H4 chart of the AUDJPY:\r\n![AUDJPY H4](/media/uploads/2017/Forex_Setups/2017-11-27_AUDJPY_H4_HA_zoom1.jpg \"AUDJPY 4H\"):C90\r\n\r\nHere is the trade from the highlighted setup, with the actual open price and stop loss:\r\n\r\n<a id=\"basic-setup-for-audjpy\">\r\n#### **Example 1. The Basic Setup for AUD.JPY**\r\n\r\n Risk per AUD.JPY Contract for a Sample Trade\r\n OP = 87.605 Open Price in Yen\r\n SL = 88.115 Stop Loss in Yen\r\n CS = 100,000 Contract Size\r\n CR = |OP - SL| x CS ¥Contract Risk (absolute value)\r\n = |87.605 - 88.115| x 100K\r\n ¥CR = ¥51,000 Risk in Yen\r\n $CR = ¥51,000 x JPY.USD Risk in USD\r\n\r\nThis last statement says that the risk in dollar terms is equal to the risk in yen multiplied by the cost of each yen. Because there is normally no traded <small><strong>JPY.USD</strong></small>, we have to *synthesize* it from:\r\n\r\n JPY.USD = 1 / USD.JPY\r\n\r\nThis simply says if the market for <small><strong>USD.JPY</strong></small> is currently trading at 100 then 1000 Yen is worth exactly $10 when valued in US$:\r\n\r\n $value = ¥1,000 x (1 / 100) Where 100 is the USD.JPY rate.\r\n = $10 In USD\r\n\r\nThese calculations are good enough here, but programmers will have to adjust the equations further by swapping the bid/ask rates:\r\n\r\n JPY.USD(bid) = 1 / USD.JPY(ask)\r\n JPY.USD(ask) = 1 / USD.JPY(bid)\r\n\r\nand applying each one correctly depending on whether the adjustment is for a buy (use the ask) or a sell (use the bid). That's a little too much detail for a non-programming article like this so let's just abstract away from the bid/ask for now to stay focused on the general idea.\r\n\r\nAt the time of the trade above from 2017-11-03 00:00 (written in [24 hour time](/stories/50/2017/11/09/where-does-the-day-begin-in-24-hour-trading/), the <small><strong>USD.JPY</strong></small> mid close price was 113.95. Using this to value the contract in US$, gives us:\r\n\r\n JPY.USD = 1 / 113.95\r\n = 0.0088\r\n $CR = ¥CR x JPY.USD Risk in USD\r\n = ¥51,000 x 0.0088\r\n = US$448.80 Risk per contract in US$\r\n\r\nWhat if your account is based in a currency other than US$? In this example so far we have used the inverse of <small><strong>USD.JPY</strong></small> to convert the Yen profits and losses to US$. If you are in another currency, say <small><strong>XYZ</strong></small>, you have two choices. The simple method is to find a direct currency pair from Yen to your currency, such as <small><strong>EUR.JPY</strong></small>, and replace the <small><strong>JPY.USD</strong></small> in the formula above with 1/<small><strong>EUR.JPY</strong></small>. In general you are looking for either <small><strong>XYZ.JPY</strong></small> or <small><strong>JPY.XYZ</strong></small>. In the case of the latter, there is no need to invert it beforehand.\r\n\r\nThe second method, useful when no direct cross exists between Yen and your account currency XYZ, is to add an extra step above after calculating the US$ contract risk. This step converts the US$ amount into your local currency. Every currency in the world should have a forex pair linking its currency to the USD, either <small><strong>XYZ.USD</strong></small> or <small><strong>USD.XYZ</strong></small>. If it is the former than invert it to arrive at the rate that converts US$ values into your account currency: <small><strong>USD.XYZ</strong></small>.\r\n\r\n ¥CR = ¥51,000 Risk in Yen\r\n $CR = ¥51,000 x JPY.USD Risk in USD\r\n CR = $CR x USD.XYZ New: Risk in your XYZ currency\r\n\r\nYou now have the value of one contract in the same currency as your account. Just continue on below, but substitute your currency symbol for the $ sign.\r\n\r\nWe now have enough information to calculate the number of contracts to open.\r\n\r\nAn [earlier story](/stories/40/2017/10/24/the-basic-setup-part-3-risky-trades/) showed how to calculate the amount we could invest in a trade without risking more than 2% of our available risk capital. Assuming $100K to invest, we therefore have $2,000 available for this trade. Now finally we can calculate the number of contracts to buy:\r\n\r\n Number of contracts = ($Funds at risk) / ($risk per contract)\r\n = 2000 / 448.80\r\n = 4 contracts\r\n Cost of position = $1795.20 from: 4 contracts x $448.80\r\n\r\n\r\n<a id=\"basic-setup-for-audusd\">\r\n#### **Example 2. The Basic Setup for AUD.USD**\r\n\r\nIn this example, because <small><strong>AUD.USD</strong></small> is priced in US$, US account holders can view the entire setup as a normal US$ futures contract with a contract size of 100K. But non-US traders will need to convert the US$ contract risk back to their own account currency. Here we consider the case of a trader with Yen accounts, but you could just as easily substitute Euros or any other account currency.\r\n\r\n Risk per AUDUSD Contract for a Sample Trade\r\n OP = 0.76910 Open Price in US$\r\n SL = 0.77310 Stop Loss in US$\r\n CS = 100,000 Contract Size\r\n $CR = |OP - SL| x CS $Contract Risk (absolute value)\r\n = |0.76910 - 0.77310| x 100K\r\n $CR = US$400 Risk in USD\r\n ¥CR = US$400 x USD.JPY Risk in Yen\r\n = US$400 x 113.95\r\n = ¥45,580\r\n\r\nThe second last statement says that the risk in yen terms is equal to the risk in US$ multiplied by the cost of each US$ valued in yen. So in this case we have US$400 and each US$ costs ¥113.95.\r\n\r\nNow assume the Japanese trader has ¥10,000,000 worth of risk funds in a Yen account to invest, of which only 1% or ¥100,000 can be invested in any one trade.\r\n\r\n Calculate the Number of Contracts From Funds Held In Yen:\r\n Number of contracts = ¥Funds at risk / ¥risk per contract\r\n = ¥100,000 / ¥45,580\r\n = 2 contracts\r\n Cost of position = ¥91,160 from 2 contracts x ¥45,580\r\n\r\n\r\n#### **The Account Currency Conversion is Only Needed to Calculate Position Size **\r\n\r\nTo determine whether the trade hits the target or is stopped out, we only need the contract risk which is provided by the SL and open price. The RR multiplier provides a simple way of getting a TP. So we do not need to mess with quote or account currencies. However whenever we need to calculate the number of contracts in order to open a trade, we need to go through the calculations above.\r\n\r\nAnother way of doing this is to calculate the value of one pip per contract in the forex rate you are opening. Then multiply that by the number of pips at risk and calculate the number of contracts to be opened. It's the same formula, just executed in a slightly different order.\r\n\r\nIt is very important to know what you are doing if you want to limit your risk, hence the calculations above. However, you can save yourself a lot of hassle by using one of the many free online calculators. Just search on \"forex calculator\" when you need one. Here are two to get you started:\r\n\r\n**Forex Calculators:**\r\n\r\n- [IC Markets](https://www.icmarkets.com/advanced-trading-tools/forex-calculators/)\r\n- [OANDA](https://www.oanda.com/forex-trading/analysis/profit-calculator/)\r\n\r\n#### **Conclusion**\r\n\r\nI have explained the general format of a currency pair, <small><strong>Base.Quote</strong></small>, and how to assess it as units of the base priced in the quote currency. We walked through how to convert the risk from the quote currency into your local account currency. Finally we were able to calculate the number of contracts to open while at the same time limiting our risk to a small percentage of our risk funds.\r\n\r\nWith this background in forex contracts we are now ready to consider how we might go about building a simple forex system. That will be the subject of our next story. Stay tuned.\r\n\r\n\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.",
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"url": "https://www.pagoolabs.com/stories/api/49/?format=api",
"id": 49,
"title": "Building an Oil Futures Trading System Using Heikin Ashi Candlesticks",
"slug": "oil-futures-using-heikin-ashi",
"status": 2,
"publication_date": "2017-11-06T06:18:03Z",
"lead": "I show how to convert the Heikin Ashi reversal method into a simple trading system to profit in the oil futures market.",
"excerpt": "Teaches how to convert the Heikin Ashi reversal method into a simple trading system to profit in the oil futures market.",
"poster": "SeanManefield",
"content": "---\r\n\r\nOil has been consolidating since 2016 in the $40-$55 range after having fallen steeply from the $147 a barrel high set in 2008. At the end of last week it had just peeked above the previous consolidation high posted in early December 2016. On the longer timeframe *Bigger Picture* weekly chart below, oil is still in a downtrend, as indicated by the falling moving averages.\r\n\r\n![Weekly WTI Oil Chart](/media/uploads/2017/20171106_Oil/2017-11-06_Oil-W1.jpg \"Weekly WTI Oil Chart\"):C100!\r\n\r\nBased on the recent breakout above the trading range, either the downtrend is ending or a bigger upward correction is underway. We don't know which at this stage. And we do not have to know because we will not be trading against the weekly trend until any uptrend, if it exists, reveals itself in the market.\r\n\r\nOn the fundamental side, we have a steadily improving world economy, stronger than expected numbers coming out of the USA and a renewal of tensions with Iran. It's interesting to note that Iranian tensions were also flying high during the last peak in 2008. Of greater concern, some unexpected turmoil is emerging from [Saudi Arabia](https://news.yahoo.com/round-saudi-princes-businessmen-widens-travel-curbs-imposed-083251967--finance.html), a key oil producer. It's early days yet but it appears that any Saudi policy that might have existed of depressing oil prices to drive USA frackers out of business, has come to an end.\r\n\r\nEach of these developments is oil positive, but should we trade *against* the longer term falling prices?\r\n\r\nThe answer is to never trade against the trend. Instead I will pull back to a shorter timeframe that concentrates more chart space around these recent developments. I am going to drop down two standard timeframes from the weekly to explore the effects of applying [our simple system method](/stories/43/2017/10/24/trading-systems-part-1-introduction/) to the four hour (H4) chart. In this shorter timeframe, shown below, oil is showing a distinct uptrend, in line with recent fundamentals. We should be cautious here because the longer term chart is still considered a downtrend until at least the $63 high from May 2015 is taken out and the MAs trend up or cross.\r\n\r\nTo demonstrate this sample system in the oil market, I will be using the [Heikin Ashi reversal technique](/stories/46/2017/10/24/trading-systems-part-4-examples-of-signals/#HA-signals) (HA). However, as in our earlier stories, I am not wedded to any one signaling technique. Feel free to use MACD, crossing moving averages or your own favorite indicator if you wish. You can follow along with our discussion here as you apply your custom signals to the same charts. Everything presented here is done as simply as possible for learning purposes only. I encourage you to go out and apply these general techniques to developing your *own* system.\r\n\r\n\r\n#### <a id=\"The-H4-Oil-Chart\"></a>**The H4 Oil Chart **\r\n\r\nIn the earlier series on Systems I used a moving average cross of the MA(100) and MA(200) to mark the start of a trend. There are better trend methods but I will stick to the MA cross here both because I have [already explained how they work](/stories/43/2017/10/24/trading-systems-part-1-introduction#Moving-Averages) and because crosses are easy to demonstrate. Once a trend has started we will open a position whenever our [signal](/stories/45/2017/10/24/trading-systems-part-3-signals/) fires, as long as our system's [conditions or filters](/stories/45/2017/10/24/trading-systems-part-3-signals/#Rules-and-Filters) are met.\r\n\r\nTo signal our entry into a trade I will use the [Heikin Ashi reversal technique](/stories/46/2017/10/24/trading-systems-part-4-examples-of-signals#HA-signals) which we discussed in the earlier series. The HA method is an easy signal to show on a chart because of the changing color of the candles.\r\n\r\nThe HA bars are really just averages of today's and earlier prices so they smooth over the little period to period wiggles in the standard bars. As a result, they differ from the more standard candlesticks so, to help you become familiar with them, I present two charts below. The first has standard candlesticks and the second, which is marked up with setups, has the HA bars.\r\n\r\n![H4 WTI Oil Chart](/media/uploads/2017/20171106_Oil/2017-11-06_Oil1.jpg \"H4 WTI Oil Chart\"):C100!\r\n\r\n![H4 WTI Oil HA Chart](/media/uploads/2017/20171106_Oil/2017-11-06_Oil-HA1.jpg \"H4 WTI Oil HA Chart\"):C100!\r\n\r\nThe **signals emitted** when a HA bar changes color are marked on the above H4 Oil chart. I have filtered out HA reversals that did not come after a countertrend retracement of at least two bars. Also excluded are reversals where the retracement did not move back against the prevailing trend. We are only interested in HA signals where we can say the market appears to have *rejected* lower prices, so inside bars don't count. These signals are marked 1 to 7 on this first set of charts, shown above. They are further annotated with an **x** if the setup fails, a **✓** if it wins or a **?** if it's unclear for whatever reason.\r\n\r\nThe rules for calculating how much of your funds to allocate and the number of contracts to open were discussed in the series on [The Basic Setup](/stories/38/2017/10/24/basic-trade-setup-part-1-introduction/) and if you haven't yet read that series, now is a good time to have at least a quick look. The math is presented in tabular form [here](/stories/42/2017/10/24/the-basic-setup-part-5-manage-that-trade/#Profit-in-the-Sample-Gold-Trade) if you need a reference.\r\n\r\nI will keep this presentation simple by assuming we are allocating **1%** risk capital to this trade and expecting a risk-reward multiplier of four (**RR=4**). So any loss would be -1% and a win +4%. Scale up accordingly if you are an experienced trader risking 2%.\r\n\r\nWe will start mechanically trading our system at the time period where the [faster MA(100) crosses](/stories/43/2017/10/24/trading-systems-part-1-introduction#Moving-Averages) above the slower MA(200), or point A in the charts above.\r\n\r\nThe first thing to note is there was a string of losses until the end of the period shown on the chart. However, the beauty of the systems approach is about to reveal itself, so don't give up just yet!\r\n\r\nAlthough the first trade does not look like a confident setup, a system will require you to open it anyway. That's because you are following a mechanical program that you designed in the earlier [systems and simulation step](/stories/47/2017/10/24/trading-systems-part-5-systems/). In this case here, we have decided the trend is up after point A, the MA cross, and we are taking every signal (HA reversal) that follows the rules we have set ourselves.\r\n\r\nIn your case you may have different criteria for establishing the beginning of a trend and a different signaling method, such as MACD. In addition you will have [filters that ignore certain poor setups](/stories/45/2017/10/24/trading-systems-part-3-signals/#Rules-and-Filters). In our case, our filters will be:\r\n\r\n- the retrace must include at least 2 bars of the opposite color\r\n- the retrace must involve the market *falling* and not simply a sequence of inside bars\r\n- we must not expose ourselves to more than 1% risk in the trade, so once fully invested, we open no new positions until it's closed.\r\n\r\n#### <a id=\"Setup1\"></a>Setup #1\r\n\r\nUnfortunately for us, the setup #1 in the chart above meets those criteria so, weak or not, we open it. The consequence though is that until that first position is stopped out in the price fall down to setup #7, we conveniently miss the other failed setups. That is, we are already fully invested from setup #1 and we don't want to take on more than 1% risk in this trade. What looks like a string of losses becomes just one loss.\r\n\r\nBut was it really a loss? Let's look at the setup in detail:\r\n\r\n Setup #1\r\n SL = 49.70\t\t\t\tStop Loss\r\n OP = 50.40\t\t\t\tOpen Price\r\n Contract Risk = CR\r\n CR = TP - SL\t\t\tContract Risk\r\n = 50.40 - 49.70\r\n = 0.70\t\t\t\tRisk per contract\r\n Target Price = TP\r\n TP = OP + RR x CR\t\twin of 4 x Risk\r\n = 50.40 + 4 x 0.70\r\n = 53.20\r\n\tHighest price (bid) before stopped:\r\n\tMax = 52.93\r\n\tCumulative win (-loss)\r\n\tWin = -1%\r\n\r\nThe trade climbed $2.53 from the open, falling just shy of the $2.80 we set as our TP based on a four times risk-reward. Depending on the price you opened in the market and your broker's bid-ask spread, these numbers could be a little different in your case. All our calculations here take into account a wide bid-ask spread, although wider ones exist. Don't worry yourself over those differences, just print your own charts and use the prices and the specific oil contract that is relevant to you. You may find though with the tighter bid-ask spreads you face that this trade actually hit the TP.\r\n\r\nIn this story, however, we want to be as sceptical as possible toward the system so we are marking it down as a failure. Had it worked, the system would require that we take the next three failed trades but we would approach setup #7 being 1% up instead of 1% down.\r\n\r\nYou will come across well-meaning advice criticizing you for not selling with so much profit already in the trade. The reality is you do not know the future and you do not know at any point whether the trade will work out favorably or not. You should already have determined the appropriate RR multiplier to use from the earlier systems simulation step.\r\n\r\nClearly, the lower you set RR the more likely you are to win. But you will still face losses of 1% for every failure and those losses have to be overcome for the system as a whole to win. Winning one setup with 1.5% but losing the next two at -1% each will steadily empty your account. Also, choosing an RR that keeps you out of other failed trades so that you only lose one instead of many, as we did here, is an advantage in itself.\r\n\r\nYour best approach is to calculate the relevant SL and the optimal RR to use for each trade and stick to them.\r\n\r\nIf you feel tempted to move your stops or target price during the trade, try it first in a demo account and watch your system fail. Don't try it with real money. Never forget you are competing in the market with a huge number of very competent and determined traders. It is their *job* to shake you out of your trade. You will only win by taking on risk and part of that risk is to hold on to your plan and stay in the trade even while the market is delivering you a drubbing. Ride that bucking bronco and don't get shaken off. No one likes to lose but here you need to put each trade aside and focus instead on whether the *system* wins, not the individual setup you open.\r\n\r\n#### <a id=\"Setup7\"></a>Setup #7\r\n\r\nAfter being stopped out the next signal emitted, as the Heikin Ashi bars reverse from red to green, is on the far right of the charts above, marked **7?**. So let's move to more recent charts to see how this and the following trades fared:\r\n\r\n\r\n![H4 WTI Oil Chart #2](/media/uploads/2017/20171106_Oil/2017-11-06_Oil2.jpg \"H4 WTI Oil Chart #2\"):C100!\r\n\r\n![H4 WTI Oil HA Chart #2](/media/uploads/2017/20171106_Oil/2017-11-06_Oil-HA2.jpg \"H4 WTI Oil HA Chart #2\"):C100!\r\n\r\nIn tabular form, here is the setup for the next signal at setup **7✓**:\r\n\r\n Setup #7\r\n SL = 49.31\t\t\t\tStop Loss\r\n OP = 49.83\t\t\t\tOpen Price\r\n CR = TP - SL\t\t\tContract Risk\r\n = 0.52\t\t\t\tRisk per contract\r\n TP = OP + RR x CR\t\tTP of 4 x Risk\r\n = 49.83 + 4 x 0.52\r\n = 51.91\r\n Add a little for Bid-Ask at close:\r\n = 51.95\r\n\tCumulative win (-loss)\r\n\tWin = 3%\t\t\t\t-1% + 4%\r\n\r\nAs you can see, the trade was successful and the target price is hit at the point indicated by the blue dotted line extending from the trade open bar. The system is now winning 3%, including the first loss.\r\n\r\nThe next series of HA reversals up to **11✓** do not meet our filtering criteria. They are either one bar reversals or the retracements are all inside bars. We insist on a minimum retracement of two bars, preferably a few more.\r\n\r\n#### <a id=\"Setup11\"></a>Setup #11\r\n\r\nHere's the setup for trade marked **11✓** which also wins:\r\n\r\n Setup #7\r\n SL = 50.88\t\t\t\tStop Loss\r\n OP = 51.58\t\t\t\tOpen Price\r\n CR = TP - SL\t\t\tContract Risk\r\n = 0.70\t\t\t\tRisk per contract\r\n TP = OP + RR x CR\t\tTP of 4 x Risk\r\n = 51.58 + 4 x 0.70\r\n = 54.38\r\n Add a little for Bid-Ask at close:\r\n = 54.42\r\n\tCumulative win\r\n\tWin = 7%\t\t\t\t3% + 4%\r\n\r\nSoon after this winning position closes, there is a little inside bar reversal which is filtered out in this system. Inside bars are widely known continuation patterns and another system might include them after testing, but it's filtered out here.\r\n\r\n#### <a id=\"Setup11\"></a>Setup #14\r\n\r\nThat brings us to the last setup on the charts, **14?**. I annotate it with a question mark to indicate that the trade has yet to complete.\r\n\r\n Setup #7\r\n SL = 53.95\t\t\t\tStop Loss\r\n OP = 54.60\t\t\t\tOpen Price\r\n CR = TP - SL\t\t\tContract Risk\r\n = 0.65\t\t\t\tRisk per contract\r\n TP = OP + RR x CR\t\tTP of 4 x Risk\r\n = 54.60 + 4 x 0.65\r\n = 57.20\r\n Add a little for Bid-Ask at close:\r\n = 57.25\r\n\tCumulative win\r\n\tWin = ?\t\t\t\t\t7% + ?\r\n\r\nThis has not yet closed so to be as sceptical as possible let's assume it's a loss. We are left with two wins and two losses but the wins are four times each loss, leaving us with a 6% (2 x 4 - 2 x 1) win for the system so far.\r\n\r\n#### Conclusion\r\n\r\nEven though the chart had a rocky start with a string of losing setups threateningly lined up, the system itself proved stronger than individual trades.\r\n\r\nMany novice traders make the mistake of opening a position like one of those above and then, if it fails, walking away entirely to play another instrument or trying another indicator. When they later revisit that market they are often dismayed to discover they had been right all along and prices had moved in the anticipated direction. With a string of such failures under their belt it is no wonder they often feel the world is against them. In fact they were staring success in the face, and they blinked.\r\n\r\nIn future stories I will continue to apply the systems approach to tricky situations where every trade does not necessarily win. In the real world of trading you have to approach losses as the cost of playing the game. Never imagine a win proves you are clever or a loss shows you are flawed. Wins and losses prove no such thing, but the work you put into designing and testing your system is everything. Just play the game of odds and become better at it than your opponents.\r\n\r\n![Update WTI Oil Chart](/media/uploads/2017/20171106_Oil/2017-11-06_Oil-HA3.png \"Update WTI Oil Chart\"):R40\r\n\r\n**`UPDATE: the final trade above did indeed go on to win on November 6th, after the weekend. The system thus wins 11% (3 x 4 - 1 x 1). The success of the system did not depend on winning the final trade, but it's certainly a pleasant bonus. Experienced traders who risk 2% per trade can walk away with over 20% of their risk portfolio in winnings. Congratulations.`**\r\n\r\n\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[signal]: a price pattern in the market triggering the opening of a position\r\n*[setup]: An instance of a signal ready for trading with values for the number of contracts and the Open, Stop and Target prices\r\n*[instrument]: A particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: Particular traded forex or futures contracts such as gold or USDJPY\r\n*[indicator]: A calculated line, such as a Moving Average drawn on a chart, that is separate from the OHLC prices but often calculated from them\r\n*[indicators]: Calculated lines, such as Moving Averages drawn on a chart, that are separate from the OHLC prices but often calculated from them\r\n*[H4]: Chart of the four hour timeframe",
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"id": 43,
"title": "Building a Futures or Forex Trading System Using Trends",
"slug": "trading-systems-part-1-introduction",
"status": 2,
"publication_date": "2017-10-24T03:44:35Z",
"lead": "This first story in the series \"Introduction to Trading Systems\" explains what a system is and what you need to know about trends and signals so you will be able to build your own custom trading system.",
"excerpt": "This Introduction to Trading Systems explains what you need to know about trends and signals to help you build your own custom trading system.",
"poster": "SeanManefield",
"content": "---\r\n\r\n#### **Trading Systems Part 1**\r\n\r\nThis series shows you how to build a trading system. Within a system there is an almost limitless variety of buy and sell signals we could use, but here I purposely avoid advocating any particular method. That's because for many traders it's the system that is missing, not the ability to recognize a valid signal.\r\n\r\nBy learning how to build your own system you will have a trading method unique enough that you will be able to enter profitable positions hopefully before any advantage is arbitraged away by others. When enough traders play the same system, your entries, stops and targets would be discovered. Bigger players may find it profitable to bet against you, knowing that triggering your stops would allow them to enter in the same direction as you at a better price. By trading against you, the bigger players can reduce the profitability of your system and may even cause it to fail.\r\n\r\nFor that reason, I do not advocate you using any simple system outlined here. That's also true of just about any publically known system. It helps that there are so many systems out there, but what really helps is that so many beginning traders don't use systems at all. Instead, they make regular 'donations' to those who do, until their accounts are empty.\r\n\r\nWhat I present below is just for learning purposes. It should be easy to adapt this material to your particular trading style and favorite indicators, and I show you how.\r\n\r\nA system is simply a sequence of trades, all based on the same or similar **`signals`**. It is designed by carefully evaluating the historic data and the longer term charts. Any one trade might fail leaving you with a loss however a system covers multiple trades and the designer of a system looks for an approach where wins consistently beat losses.\r\n\r\n![Sample MA Cross System](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-MACross-EG-20171019.png \"Sample MA Cross System\"):C100\r\n\r\nAbove is an example of a system, although it makes little sense at this point. Nonetheless, you can see that we have six setups on this chart where we could place an open trade based on the crossing of two **`moving averages`** (MAs). They are marked by little crosses below where the MA cross occurred, green for success and red for failure. I will explain this in detail later on but for now it just means that whenever the five period MA, MA(5), crosses above the MA(14) we will open a long position. There is nothing significant in these MA periods, they are just to illustrate a simple system. There is also a pair of longer term MAs, the MA(100) and MA(200), which are only shown to emphasize the trend since point A.\r\n\r\nThe point here is that our first setup failed, as did the 3rd and 4th. However, three of the six trades here were successful. If the TP were twice the risk then this simplistic system would generate three times the risk in wins (2 x 3 wins - 1 x 3 losses = 3), and therefore 6% of our risk funds (2% x 3). Of course, I have to explain why we should be long and not short after point A, why I chose twice the risk for the TP, what's this crossing MA all about and what happened to the right of the chart. I hope this series on systems will answer all these questions and more.\r\n\r\nIn many of the examples I deliberately use a simple MA cross to determine when the trend starts and sometimes even the triggers that prompt us into a trade. Although simple, if we can make a system work well with MAs then imagine what you can do with all your favorite indicators. Also, MA crosses are easy to explain and draw, so just what I need.\r\n\r\nDon't expect a system to be anything complicated. A system is *consistent*, and the easier to understand the better. A consistent system applies the rules in the same way on every trade setup. By being consistent, a system becomes testable. If we subtly change the conditions whenever we feel the normal human emotions of fear or greed, the system could fail but we won't know why.\r\n\r\nIf you have not used a system before it brings a major improvement for very little extra work.\r\n\r\nBefore we can discuss a trading system, I have some ground to cover on a few very important concepts. I have already posted a series on [**setups**](/stories/38/2017/10/24/basic-trade-setup-part-1-introduction/) but we also need to discuss **trends** and **signals**. These two key topics will make up parts 1 to 4 of this series.\r\n\r\nWhile I have tried to keep this presentation simple, I imagine most readers would have already thought about many of these issues. Perhaps you have been trading a while but have become frustrated how often you are stopped out of trades that afterward move in your anticipated direction. For this reason, much of the jargon of trading is not covered here, or when it is covered, perhaps I pass over it too quickly. If you hover over underlined text, a brief explanation will pop up on many uncommon terms. Please alert us via a post in the comments section whenever something is unclear.\r\n\r\nAs you design your own systems I hope you will discuss your experiences on our forums. The best way to learn is to put your own ideas out there for discussion, get help and hopefully have your system improved by other members. Feel free to post replies to existing stories and, when you have enough points earned from posts, you will be able to post your own stories. Eventually you will be able to start and moderate your own forums when you have accumulated enough reputation.\r\n\r\nIf you have not done so already, I recommend that you first read through the series on [\"The Basic Setup\"](/stories/38/2017/10/24/basic-trade-setup-part-1-introduction/). This current series on Systems relies heavily on material discussed there on the Open Price (OP), Stop Loss (SL), Target Price (TP) and Contracts Opened (CO).\r\n\r\nFrom [\"The Basic Setup\"](/stories/40/2017/10/24/the-basic-setup-part-3-risky-trades/) we will assume in what follows a risk capital of $100,000 and a risk per trade of $2000. Because your risk capital is almost certainly different, just divide or multiply the per trade amounts depending on your available funds.\r\n\r\nAfter reading this series on systems, you should know:\r\n\r\n- how to spot a trend\r\n- the difference between a setup, a signal and a system\r\n- how to use your preferred signaling method in a full system\r\n- how to measure the number of wins and losses and\r\n- how to test whether your system has worked in the past.\r\n\r\nEverything I have to say here on trading applies equally whether short or long. However the descriptions become tedious to read when every sentence has to be qualified with something like \"or sell if short\". For this reason, in most of what follows unless otherwise stated, I will assume an uptrend (or bull market) and long positions. This is just for convenience and does not imply that being long is preferable to being short.\r\n\r\n#### <a id=\"The-Trend\"></a>The Trend\r\n\r\nMarkets spend most of their time consolidating sideways. You could build a system around this fact alone but it's not what we will do here. Instead we will focus on trending markets because those are more likely to result in a winning trade. Also the market is more likely to move to a TP that is a greater distance from the open price than the SL.\r\n\r\n![Uptrend then Consolidate](/media/uploads/2017/basic_system_trading/consolidating-trend.png \"Uptrend then Consolidate\"):R40\r\nWhen favorable information first hits the market, prices start to rise to some higher level. The prices then either consolidate, or fall back if the rise was too high or too fast. But if the asset such as gold, oil, the S&P or some currency is now worth more to the market, why doesn't the market immediately jump to that new higher level? After all, who would sell below that level and who would not be buying? Both of those factors should push the price up to the new level immediately.\r\n\r\nSometimes markets *do* adjust quickly and when that happens politicians and traders on the losing side howl that something has gone terribly wrong. But in general prices adjust slowly for several reasons:\r\n\r\n- it's rarely clear at the time prices begin to move where that higher or lower stable price range lies\r\n- funds have to be moved out of other markets first and perhaps now is not the best time\r\n- the price rising is itself confirmation to other traders that the news is in fact bullish, so the initial price rise accelerates, sometimes overshooting\r\n- some traders may think that the initial price rise was sufficient for this piece of news and either take profits or short it.\r\n\r\nThere are many different players in every market each with their own competing perspectives. Some players are central banks with a policy to push, others are major corporations hedging against a product they have committed to deliver. Still other players may have misinterpreted the significance of the news.\r\n\r\nAll of these factors combine to slow down the movement in market prices as they adjust from the previous stable trading range to the new higher one. During that period of adjustment we have a trend.\r\n\r\n![Uptrend in SPX futures](/media/uploads/2017/basic_system_trading/SPX-D1-UpT-20171012.png \"Uptrend in SPX futures\"):C85!\r\nSome trends are obvious, such as the recent behavior of the S&P500 on the daily or weekly timeframe from 2009 to 2017, arguably longer (see above). Obvious trends display a clear rise or fall in prices as you look across the chart from left to right. Within a trend, retraces or cycles may occur but they should exhibit a reasonably clear pattern of higher highs (HH) and higher lows (HL) in a bull trend, and lower highs (LH) and lower lows (LL) when the market is bearish.\r\n<div class=\"clear-floating-cols-above\"></div>\r\n![Uptrend showing HH-HL](/media/uploads/2017/basic_system_trading/UpT-EG-20171015.png \"Uptrend showing HH-HL\"):R45\r\n![Downtrend showing LH-LL](/media/uploads/2017/basic_system_trading/DnT-EG-20171015.png \"Downtrend showing LH-LL\"):R45\r\n\r\n#### <a id=\"Moving-Averages\"></a>Moving Averages\r\n\r\nMoving averages (MA) are useful to help you visualize the trend. They work well in computerized systems that need a numeric computation in the absence of being able to visualize a chart.\r\n\r\nA moving average simply takes the current price in each period and averages it with the prices from a given *number* of previous periods. That number is called its **`period`** and represents an *historic* average. The MA cannot take into account the future because that is not known in the current period. As each new period trades, its price is added into the calculation of the average while the oldest price is dropped.\r\n\r\nIn that sense, the average *moves* along from oldest to newer prices. Exponential moving averages are similar but give greater weight to more recent prices and typically have a lower weighted memory of *all* previous prices.\r\n\r\nAlthough not necessary in a trading system, it is common for charts to have at least two MAs, a longer term one and another that's shorter and therefore faster reacting. Even price action traders who have no other indicators on their charts, often have a couple of MAs.\r\n\r\n![MAs below prices in uptrend](/media/uploads/2017/basic_system_trading/UpT-MA-EG-20171015.png \"MA Uptrend\"):R45\r\n\r\nAn MA averages out today's prices with prices from the past. In a bull market, the most current price will tend to be higher than in the recent past so the MA should be below where prices are trading. An MA that averages back over a longer period will tend to be further below and slower to react to changes in current prices because it is averaging over a larger number of earlier, lower prices. The latest, higher price has less effect on a longer average.\r\n\r\nTherefore we can refer to the longer one as the **slow** MA and the shorter as the **fast** MA.\r\n\r\n![MA Cross on USDJPY](/media/uploads/2017/basic_system_trading/USDJPY-MA-Cross-20171017.png \"MA Cross on USDJPY\"):R45\r\nIf a market is moving up smoothly, the shorter MA will lie above the longer. In a bear market the pattern is reversed with the MAs lying above the prices and the longer above the shorter. If the trend changes direction from bear to bull or recovers from a severe retracement (a correction), the faster MA will move up first and may cross the slower MA.\r\n\r\nThis is shown above on the chart for USDJPY. Whether they cross or not will depend on the period used for both MAs. For some traders, this triggers a signal to enter the market. There are many ways to trigger the opening of a market position, and crossing MAs is just one.\r\n\r\n#### Summary\r\n\r\nThe trend is an essential component of a trading system because trading against the trend is more hazardous and trades aligned with the trend have a greater probability of success.\r\n\r\nMoving averages are one tool that can help you identify trends and MA crosses help recognize trend reversals.\r\n\r\nIn the [next story](/stories/44/2017/10/24/trading-systems-part-2-timeframes-fundamentals-reversals-and-retracements/) I will discuss several aspects of trend following such as timeframes and fundamentals.\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n<br>\r\n#### Disclaimers\r\n\r\nAlthough the PagooLABS site is educational and does not advocate any position in a futures or forex contract, it is important to present the following disclaimers as additional information. Trading these markets can be risky and you must be aware of the following:\r\n\r\n**U.S. Government Required Disclaimer**\r\nCommodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.\r\n\r\n** CFTC RULE 4.41 **\r\n\"These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.\"\r\n\r\nCopyright (C) PagooLABS 2017. All Rights Reserved.\r\n\r\n\r\n*[HA]: Heikin Ashi\r\n*[MA]: Moving Average over a specified period - 100 periods for eg\r\n*[EMA]: Exponential Moving Average - has a long 'memory'\r\n*[OHLC]: Open, High, Low, Close: the 4 key values for any bar on a chart\r\n*[bull]: An uptrending or rising market\r\n*[bear]: A downtrending or falling market\r\n*[SL]: stop loss\r\n*[TP]: target price\r\n*[OP]: open price\r\n*[CR]: Contract Risk\r\n*[CS]: contract size\r\n*[CO]: number of contracts opened\r\n*[MR]: Maximum Risk\r\n*[USD]: United States Dollar\r\n*[AUD]: Australian Dollar\r\n*[Yen]: The Japanese currency\r\n*[Euro]: The European currency\r\n*[EURJPY]: The Euro - Yen cross currency: buying Euros priced in Yen\r\n*[forex]: Foreign Exchange including markets and trading\r\n*[signal]: a price pattern in the market triggering the opening of a position\r\n*[setup]: An instance of a signal ready for trading with values for the number of contracts and the Open, Stop and Target prices\r\n*[instrument]: A particular traded forex or futures contract such as gold or USDJPY\r\n*[instruments]: Particular traded forex or futures contracts such as gold or USDJPY\r\n*[underlined text]: Congratulations! You have successfully hovered over text\r\n*[indicator]: A calculated line, such as a Moving Average drawn on a chart, that is separate from the OHLC prices but often calculated from them\r\n*[indicators]: Calculated lines, such as Moving Averages drawn on a chart, that are separate from the OHLC prices but often calculated from them\r\n*[H4]: Chart of the four hour timeframe\r\n*[M5]: Chart of the five minute timeframe\r\n*[H1]: Chart of the one hour timeframe",
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"title": "Trading Education"
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