The Limits of Trade Management
We are currently issuing a series of articles on Trade Management and within our exploration and testing, we have demonstrated just how important trade management can be. It can literally make or break a trading system.
However influential it may be, we need to remember that trade management remains just one piece of the puzzle. In today’s article we will illustrate this point, and show how different trade management vehicles cannot save a system that, on it’s own, does not exploit a decent behavioural trait in the market.
Meet the 5×5 System
This is a simple system that was presented to us by a client (who uses a variation on the theme). Here are the rules:
On the daily chart, overlay the 5-Day Simple Moving Average and the 5-Day RSI.
- Long Setup: the price is initially below the 5 SMA and closes above the 5 SMA and the RSI must be over 50.
- Short Setup: the price is initially above the 5 SMA and closes below the 5 SMA and the RSI must be less than 50.
Trigger: price breaks the setup candle by 10 pips in the direction of the SMA.
Stop Loss: Behind the Setup Candle high/low.
So essentially it’s a short-term trend-momentum seeking model, which without any further filters suffers from rangebound or volatile markets.
As the chart above illustrates, there is a wide dispersion of equity curves and only 2 remain constantly above zero. This doesn’t look like a good starting point. Also, we used MAE/MFE analysis to identify a decent stop loss for our testing. We settled on 1 ATR as an initial stop loss.
Trend Filters Help, But Cannot Straighten Out the Situation
As with previous tests, we attempted to add a trend filter to the model. In this case we started with the Weekly Market Type. However, the results did not change materially. There is still a large dispersion of the equity curves, which probably means that the setup/entry criteria aren’t really viable.
We repeated the test with another trend filter (60 SMA Slope) with slightly better results but at the same time common sense started to kick in and suggest we were getting close to curve-fitting this model. The dispersion in equity curves was still not solved.
Trade Management: a Strong Companion but No Panacea
At this point we had noticed that the 2-Bar trailing stop was the best performer and we decided to analyze various trend filters with this same trailing stop.
Once again there is a significant dispersion in the equity curves. Despite our best attempts, this system remains untradable and does not even inspire us to do further testing. The risk parameters of the system are just not strong enough.
Over To You
The conclusion is simple: trade management alone cannot save the day. It is only one of the 4 components of a complete trading model.
If the model itself is weak or unprofitable, trade management cannot rectify things. However, trade management can work wonders for models that do exploit a solid recurring behavioural trait.
In terms of rule-based discretionary trading, trade management gives you peace of mind. You should always know what constitutes neutral or good behaviour (hold until you have more information) or bad behaviour (trail stop or close position).
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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