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Why Your Stop Losses Are (Probably) Wrong

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When you start to learn about trading, you'll come across plenty of material about minimising risk and money management, because they're two of the most critical areas of the business. 


Learning to manage risk and preserve trading capital is fundamental to a successful trading journey. 


One area the literature focuses on is the use of stop losses. A stop loss is simply a price level beyond which you choose not to run an unprofitable or losing trade.


But for me, stop losses are one of the most misunderstood tools in a trader's arsenal, and I wanted to offer a different perspective than what is usually found in the research.  


I'll give you a hint; it's in the name!


Knowing your risk

It's important to know the risk you are taking on any given trade, this can be calculated by multiplying the distance of your stop loss, from the entry-level of your trade, by the notional size of your trade.  


In theory, this simple calculation determines the maximum risk or loss that you face on a given trade. I say in theory because that risk figure is not cast in stone.  


Firstly, if the stop loss you use on a trade is just a mental one, i.e. a figure that you have chosen, (but will watch rather than attach to an order), then it will be down to you to monitor price action and trade it. That's a sure recipe for looking like a maniac checking your platform or mobile app every second you get.


Systemise your process

Rather than rely on them being in front of the screen to close a trade (which in a 24/5 market is not that realistic), many traders will place a stop loss to an open position. This is essentially creating an instruction to close the position should the price of the underlying instrument reach a pre-set level.


In doing so, traders are systemising this part of their trading. On the face of it, that sounds like a good idea doesn't it? 


But what if that automated stop loss level was defining the loss you make on a trade and eating away at your trading capital, not protecting it?  


The use of a stop loss should be what its name suggests – the prevention of a loss, not the realisation of losses as 90% of traders currently use their SL for.  


Crowding together

Here's the thing. Traders of all sizes fall foul of "clustering" which means they place their stop losses in the same areas, at the same time.  


For example, at or around round numbers, (e.g. USDJPY 110) just above or just below a moving average or indeed close by the same support or resistance levels everyone else is keenly watching.  


The market is aware of this behaviour and is often on the lookout for these clusters of stop losses. When they are, it's known as a stop hunt.  


But what exactly does that mean? 

Well, a big bank (a price "Maker") might see on their books that they have a cluster of orders around 1.10 on EURUSD, and then be willing to commit large sums of capital to "hunting down" that stop loss level. They do this by moving the underlying price towards it, in a selfish way, to reward themselves, rather than because of natural order flow (and they wonder why they have bad reputations!).  


As an aside, a broker such as Fusion Markets, that typically services "retail" clients, e.g. mum and dad investors, often get accused of doing the same thing, despite the fact we are a price "Taker" not a price "Maker", and have no control over the prices coming through to you, as a client.  


Think about it if the market can find these groups of stop losses and trigger them, then that's easy money for the banks and traders who have the opposing view and positions.  


Remember that in FX trading there is a winner for every loser and vice versa. A successful trader endeavour's to be on the winning side of that relationship more often than not.


A different approach to stop losses

Are we saying then that you should trade without a stop loss? No, we are not! 


But what if we took a different approach to stop loss placement? Instead of lining up to provide a free lunch for the banks, what if we placed our stop losses above our entry price rather than below it?   


Of course, that means that we'd have to risk-manage our trades in a different way.


For example, employing less leverage and taking smaller positions relative to our account size. But that is really what we should be doing anyway. And of course, we would have to monitor performance closely in a trade's early stages, as we should.  


However, if the trade we have taken is the correct one, then our position will soon be on-side, and once we have a buffer between the current price and our entry-level. Then, our stop loss can be locking in profits rather than minimising (or realisation of) our losses.  


Trailing a stop-loss behind a profitable position is something of a holy grail in trading it's often talked about, but rarely seen in the markets. By not acting like the crowd, maybe we can turn the tables on the stop hunters.  


What are you waiting for? Why not stop your losses in the way they're supposed to be stopped? 





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The Power of Backtesting in Forex Trading

10 Minute Read time.


Developing a reliable and effective trading strategy is essential. One of the most powerful tools at a trader’s disposal is backtesting – a process in which you can evaluate a trading strategy’s potential profitability and consistency against historical market data.


This process helps identify strengths and weaknesses in your strategies, enabling you to make necessary adjustments before trading real money.


Given the volatile nature of Forex trading, especially in currency pairs like AUD/USD and EUR/NZD, backtesting is essential for gaining a competitive edge. These currency pairs are known for their dynamic movements, influenced by various factors such as economic indicators, geopolitical events, and central bank policies. By backtesting your strategy on these pairs, you can better understand how your approach might perform under different market conditions, providing you with the confidence to execute trades in real time.



Contents




Key Takeaways



  • Backtesting is a critical process that involves evaluating a trading strategy against historical data to determine its effectiveness and reliability.

  • It offers a risk-free environment to test strategies, enabling traders to gain valuable insights into performance metrics and refine their approach without financial loss.

  • Avoid common backtesting pitfalls such as overlooking varying market conditions, ignoring psychological impacts, and neglecting the importance of forward testing.

  • Integrating backtesting into your trading routine ensures continuous improvement of strategies, promotes a data-driven approach, and helps build trading confidence.



Benefits of Backtesting



1. Risk-Free Strategy Evaluation


As mentioned, one of the most significant advantages of backtesting is the ability to evaluate a trading strategy without risking real capital. In live trading, every decision carries financial risk, and mistakes can be costly. Backtesting, however, offers a simulated environment where you can see how your strategies would have performed in real market conditions.


As an example, imagine developing a new trading strategy based on technical indicators such as moving averages and RSI. By backtesting this strategy against historical data from the AUD/USD pair over the past five years, you can see how it would have fared during various market phases – whether trending, ranging, or volatile.


2. Performance Insights


Backtesting provides insights into invaluable performance metrics that provide a deeper understanding of a strategy's effectiveness. These insights include key metrics such as win/loss ratios, maximum drawdowns, average returns, and the strategy's performance during different market conditions.


For example, a backtest might reveal that your strategy performs exceptionally well during trending markets but struggles in sideways markets. With this information, you can tweak your approach to improve its performance in different conditions.


Backtesting also allows you to assess the strategy's versatility by testing it across different timeframes and market environments. This allows you to not only determine the best market conditions for your strategy but also the most effective chart time frame.


3. Cost-Effective Learning


The financial markets are unforgiving, and mistakes can be costly. Losses can be discouraging and detrimental to your trading psychology and, ultimately, your account. Backtesting, on the other hand, offers a cost-effective way to learn from mistakes without incurring actual losses.


This allows you to identify potential pitfalls, such as poor entry or exit points, and refine your strategy accordingly. In doing so, you avoid the financial costs associated with real-world trading errors.


Additionally, backtesting can reveal hidden costs in your strategy, such as slippage and commissions, which can significantly impact your profitability. Understanding these costs upfront helps you make more informed decisions, such as choosing a broker with lower trading fees or adjusting your trade sizes to minimise slippage.


We highly recommend you read our post on the real cost of trading here.


4. Confidence Building


Confidence is a critical component of successful trading. Without confidence in your strategy, it’s challenging to stick to your trading plan, especially during periods of drawdown or market volatility. Backtesting allows you to build confidence by providing yourself with evidence that your strategy has performed well in the past.


After backtesting your strategy, you might find that it consistently generates positive returns over several years of historical data. This allows you to execute your strategy in live trading with confidence, knowing that it has been tested and proven to work. This also includes major market events – such as the 2008 financial crisis or the Brexit referendum – allowing you to be prepared for any major market events in the future.



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How to Conduct Effective Backtesting



1. Choose Reliable and Comprehensive Historical Data


The quality of your backtesting results heavily depends on the quality of the historical data you use. It’s essential to choose a reliable data source that provides comprehensive and accurate data, including bid/ask prices, spreads, and market conditions.


For instance, if you’re backtesting a strategy on the AUD/NZD pair, you’ll need historical data that covers various market conditions, such as periods of low liquidity or high volatility. This ensures that your backtesting results are reflective of real market conditions and not skewed by inaccurate or incomplete data.



2. Select Appropriate Timeframes Covering Various Market Conditions


You need to ensure that your data covers a sufficient time frame to test your strategy effectively. If you’re developing a long-term trading strategy, backtesting on at least 10 years of historical data is recommended. This provides a broader perspective on how your strategy would have performed in trending and ranging markets during different market phases over the long-term.


The relevance of the time frame to your strategy is important in order to achieve the most accurate results. For example, a day trader might backtest their strategy on 1-minute or 5-minute charts, whereas a swing trader might backtest on daily or weekly charts.



3. Account for All Trading Costs, Including Slippage and Commissions


As mentioned earlier, there are other costs to consider in trading other than losing trades, and backtesting is no different. To obtain accurate results, it’s essential to account for all trading costs, including slippage, commissions, and spreads. These costs can significantly impact your strategy’s profitability and ignoring them can lead to an overestimation of your strategy’s success.


These additional costs affect all styles of trading – spreads and slippage can quickly eat up a day trader’s profits, and overnight swap rates over a sustained period of time can reduce a swing trader’s overall profit. By incorporating these costs into your backtesting, you can get a more realistic picture of your strategy’s potential performance.



4. Use Proper Risk Management


Risk management is a critical component of any trading strategy, and it should be an integral part of your backtesting process. Proper risk management ensures that you’re not risking more than you can afford to lose on any single trade, helping to protect your trading capital.


For example, when backtesting, ensure you incorporate stop-loss and take-profit levels to assess how they impact your strategy’s performance. You might find that adjusting your stop-loss levels slightly improves your overall risk-to-reward ratio, leading to better long-term results.


Additionally, consider position sizing as part of your risk management strategy. For instance, using a fixed percentage of your trading capital for each trade can help you manage risk more effectively. Backtesting different position sizing methods can provide insights into which approach works best for your trading style.



5. Avoid Curve Fitting and Data Dredging


Curve fitting, also known as data dredging, is a common pitfall in backtesting that occurs when a strategy is overly optimised to fit historical data. While this might result in impressive backtesting results, it often leads to poor performance in live trading, as the strategy is tailored to past data rather than being robust enough to handle future market conditions.


For example, you might develop a strategy that performs exceptionally well on the EUR/NZD pair during a specific time period. However, if the strategy is too tightly fitted to this historical data, it may fail when applied to different market conditions or time frames.


To avoid curve fitting, focus on creating a strategy that works well across different market conditions and time frames. Instead of optimising your strategy to maximise historical profits, aim for a balanced approach that considers various factors, such as risk management and market volatility. This ensures that your strategy is more likely to succeed in live trading.



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Common Backtesting Pitfalls



1. Overlooking Market Conditions


One of the most common mistakes in backtesting is overlooking the impact of different market conditions on a strategy’s performance. Markets are dynamic, and a strategy that works well in one market environment might fail in another.


Consider backtesting your strategy on currency pairs during different market phases, such as high volatility periods, ranging markets, and low liquidity conditions. This helps you understand how your strategy adapts to changing market conditions and allows you to make necessary adjustments to improve its performance.


2. Ignoring Psychological Factors


Whilst backtesting provides valuable technical insights, it doesn’t account for the psychological pressures of live trading. Emotions such as fear, greed, and overconfidence can significantly impact trading decisions, leading to deviations from your trading plan.


For example, a backtested strategy might show excellent results, but when applied in live trading, you might find it difficult to stick to the plan due to emotional factors. This is why it’s important to complement backtesting with forward testing or real-time simulations on a demo account to experience the psychological challenges of live trading.


Forward testing provides a more realistic environment to assess how you react to market movements and psychological pressures. By combining backtesting with forward testing, you can develop a more comprehensive understanding of your strategy’s performance and your ability to execute it under real-world conditions.


3. Neglecting to Forward Test


After completing a thorough backtest, the next logical step is forward testing – testing your strategy in real-time using a simulated trading environment. Forward testing helps validate the results obtained from backtesting and ensures that your strategy holds up under live market conditions.


For example, after backtesting your strategy on the AUD/USD pair, you might move on to forward testing by executing simulated trades on a demo account. This allows you to observe how the strategy performs in real-time, taking into account factors such as slippage, order execution, and market psychology.


Forward testing also helps identify any issues that may not have been apparent during backtesting, such as execution delays or unexpected market reactions. By incorporating forward testing into your strategy development process, you can gain a more realistic idea of the strategy’s effectiveness.


4. Bias in Strategy Development


Bias in strategy development is another common pitfall in backtesting. Confirmation bias, where traders subconsciously look for data that supports their pre-existing beliefs, can lead to skewed backtesting results and overconfidence in a strategy’s success.


For example, you might develop a strategy based on a specific technical indicator that you believe is highly effective. However, if you only test the strategy on historical data that supports your belief, you might overlook its weaknesses in other market conditions.


To avoid bias, it’s important to remain objective in your approach and test your strategy across a wide range of market conditions and timeframes. You can read more about the psychological aspects of trading here.



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Integrating Backtesting into Your Trading Routine



1. Regular Strategy Updates


The forex market is constantly evolving, and trading strategies that work today may not be effective tomorrow. To stay ahead of the curve, it’s essential to regularly update your strategies with the latest market data and insights.


For example, if you’ve been trading a specific currency pair for several years, you might notice changes in market behaviour due to factors such as new economic policies, shifts in global trade dynamics, or changes in central bank interest rates. By regularly updating your backtesting data and incorporating these changes into your strategy, you can ensure that your approach remains relevant and effective.


Consider re-testing your strategy periodically to ensure that it continues to perform well under current market conditions – especially after significant changes in the relevant currency’s economy or government.


2. Continuous Refinement


Backtesting should not be a one-time exercise but an ongoing process of continuous refinement. As you gain more experience and insights from your trading activities, you can use backtesting to further fine-tune your strategies and improve their performance.


After gaining more trading experience, you might notice that certain patterns or market behaviours are more predictive of future price movements. By incorporating these insights into your backtesting process, you can refine your strategy to better capitalise on future opportunities.


Continuous refinement also involves staying up to date with new trading tools, techniques, and market trends. As the financial markets evolve, more and more resources and tools become available to traders. Some of which you might find are beneficial to your strategy or trading style.



3. Testing New Ideas


As we touched on earlier, backtesting provides a safe and controlled environment to experiment with new trading ideas without the risk of losing capital. Whether you’re exploring new technical indicators, adjusting your entry and exit criteria, or testing different risk management techniques, backtesting allows you to evaluate these ideas objectively.


Testing new ideas through backtesting also encourages innovation and creativity in your trading approach. Instead of relying solely on conventional strategies, you can explore new methodologies and discover unique approaches that better align with your trading style and goals.



4. Building a Data-Driven Approach


Incorporating backtesting into your trading routine fosters a data-driven mindset, where trading decisions are based on empirical evidence rather than intuition or emotion. This approach leads to more consistent and successful trading outcomes, as it allows you to make informed decisions based on historical performance data.


By analysing the results of your back tests, you can identify patterns and trends that are statistically significant and use this information to guide your trading decisions. This data-driven approach helps you avoid common trading pitfalls, such as chasing losses or making impulsive decisions and provides you with the true performance potential of your strategy.


A data-driven approach encourages a systematic and disciplined trading process. By adhering to a well-defined strategy that has been thoroughly backtested, you can reduce the impact of emotions on your trading decisions and improve your overall performance.




Conclusion


Backtesting is an indispensable tool in the development and refinement of Forex trading strategies. By providing a risk-free environment to evaluate the effectiveness of your strategies, backtesting helps build confidence, improve performance, and foster a data-driven approach to trading.


Incorporating backtesting into your trading routine is essential if you want to stay competitive in the ever-evolving forex market. Whether you’re a novice trader looking to develop your first strategy or an experienced trader seeking to refine your approach, backtesting offers invaluable insights that can help you navigate the complexities of the Forex market with greater precision and confidence.


As you continue to develop your trading skills, make backtesting a regular part of your routine. The insights gained from backtesting will empower you to trade with greater confidence and discipline, ultimately leading to more successful and profitable trading outcomes. Don’t wait—start incorporating backtesting into your trading process today and unlock the full potential of your trading strategies.


The information provided in this article is for educational and informational purposes only. Backtesting, while a useful tool, does not guarantee future results


Backtesting
Forex
12.09.2024
Market Analysis
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USD/BRL: An Overview
Fusion Markets

The forex symbol USD/BRL indicates the exchange rate value between the USD (US dollar) and the BRL (Brazilian Real)

 




Currency background


USD (US dollar)

 

The USD dollar is the United States of America’s official currency. Each dollar is made up of 100 cents. It is represented by US$ when differentiating it from other countries’ dollar currencies. However, they are more often just marked as $.

 

This currency has become the benchmark for other currencies because it is the most popularly used one. Even territories beyond the US have commonly used it as an unofficial currency.

 

Because it is often at the core of foreign-exchange trades, it has its own index – the USDX. It is regarded as the world’s most stable currency.

 

Brazilian Real (BRL)

 

The Brazilian Real (BRL) is Brazil’s official currency. Each Brazilian real is made up of 100 centavos. It is represented by the R$ symbol.

 

It was first used as the country’s official currency in July 1994. It replaced the cruzeiro real. The exchange ratio between the former and the current currencies are not 1:1, either. 1 real is equals to 2,750 cruzeiro real.

 

From 1994 to 1999, BRL was pegged to the USD as an attempt to maintain stability. As the largest Latin American economy, it is worth looking into. It is also the 9th largest in the world.

 

If you’re considering taking the USD/BRL pair, here are the things to consider:

 

Economic Conditions

 

Currency values depend on the economic conditions and public reception of their country’s stability.

 

Since the mid-twentieth century, the USD dollar has established itself as a powerhouse in the global economy. However, because it is a fiat currency, it is also affected by the United States’ economic outlook and activity.

 

Its strength may be good for the country itself. It can also be good for those who may be relying on its general strength to earn in foreign exchanges.

 

However, a powerful USD can be detrimental to countries relying on exports from the United States.

 

While the USD is obviously strong throughout, much can be said about Brazil’s economy as well. It is believed to be one of the strongest emerging economies due to its rich natural resources.

 

Its diversity in economy has spurred foreign investment to pour in. With an estimated $200 billion of direct investments, Brazil’s currency is doing great.

 

It wasn’t always the case. The currency faced several currency crises such as the Mexican currency one from 1994 to 1995, and the one with Asia and Russia in 1997 and 1999. Investors then didn’t want to have anything to do with the Brazilian real.

 

Supply and Demand

 

When the US exports more products, it triggers more demand for its currency because customers must change their money to dollars to be able to pay for the goods.

 

The US government and top American corporations may also issue bonds that can be purchased only with the US Dollar. Foreign investors must buy dollars to buy those financial instruments.

 

Because of the overall reliability and strength of the US dollar, a lot of investors will still buy the currency as a reserve.

 

Perception

 

Currencies depend on perception or market sentiment. For example, if people have been watching the news, finding out about a weakened US economy or increased unemployment, the tendency is to buy back their local currency. This will lower the value of the dollar.

 

The same goes with the BRL, but even worse since it is a less popular currency. While its economy is doing well and has it placed up there among emerging markets, political corruption could be its downfall.

 

Geopolitical Conditions and Global Risks

 

One of the factors that affect perception is geopolitical conditions. How are the politics in the country?

 

USD is a dominant global reserve. It may experience some lows, but it is always generally high in value. Recent events have this fiat currency on the rise, too. On the other hand, Brazil also started strong this year and has been pulling from Russian assets.

 

What can provide some volatility in the USD/BRL pair is Lula’s recent election as the President of Brazil.

 

How to trade USD/BRL

 

Now that you know the strength of the individual currencies, how do you trade the USD/BRL pair?

 

The value you get will depend on the exchange rate between the two.

 

While USD is a stable currency, Brazilian real is the currency of an emerging market. It means that Brazil’s GDP has been steadily growing from 2000. A similar trend is expected to continue.

 

You will earn a profit because an emerging market’s GDP tends to grow rapidly. However, you must be vigilant because it is also at risk of being negatively impacted by political instability and currency fluctuations. Weigh risks against rewards.

 

Pick the right time frame

 

Trade when the USD/BRL is at its busiest, and potentially at its most volatile. The 8:00 to 12:00 Eastern Time frame is also the time when USD details are more readily available.

 

It is when significant chunks of data have been released that a currency pair’s volatility increases. Be watchful at this time because you will have increased opportunities for profitable trades.

 

Conclusion

 

USD/BRL is useful if you want to diversify your foreign exchange portfolio. Your portfolio may see increased gains/losses when one of the fiat currencies in your portfolio is an emerging one.

 

Why?

 

Emerging currencies are more likely to display greater volatility. They have also been steadily rising since 2000. Though the previous formation is not a guarantee of future performance, the current strength of currencies like the Brazilian Real is reassuring.

 

Of course, you will be dealing with two currencies that can give you a lot of value. The USD is always strong. Meanwhile, BRL performs well because of the resources and commodities that Brazil can export. Exports can strengthen both currencies because they prompt investors to buy them.


Currency Trading
BRL
Trading Tips
USD
17.11.2022
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