Different FOREX Trading Methods
I have mentioned trading methods en passant in the earlier section on types of managers. The primary breakdown: discretionary, computer-assisted, and automated trading methods. The latter dominates the managed FOREX landscape today.
The variety and range of automated systems is huge and complex. Though it is possible to divide them into a few types, the best approach is in studying performance and considering where they fit in the short-term-to-long-term hold continuum and in the risk-reward area that is comfortable for you.
Trend FollowingThis was the most common approach for many years. A trend-following system attempts to capture a large percentage of a trend at a specific price level, using various methods to avoid the whipsawing that may occur when the market is in a trading range or moving sideways. This is an important factor contributing to the longer-term success of these programs. Statistically, trends are in force less than 30 percent of the time. But as computer hardware and software grow more powerful, other methods have grown in popularity.
HedgeThese programs have become very common in the past five years. Their modus operandi is to have open buy and sell orders in the market at the same time. They may be long a higher time frame and simultaneously short a lower time frame. This is similar to what equity traders call trading against the box. Running these programs is prohibited in the United States by virtue of the anti-hedging clause of the NFA's Rule 2-43. This is most unfortunate, as it is a perfectly legitimate trading method.
Grids and Pac Man SystemsGrid programs attempt to capture as much price activity in a defined price-time area by going both long and short as well as scaling in and out of positions. These programs show considerable promise in the event-driven markets of today. They also require a hedge. Pac Man programs refine grid trading by emphasizing trading in some market environments, and avoiding trading in others. These are discussed in more detail in Computer Trading.
Quality of MarketThese programs endeavor to measure the quality of the underlying buying and selling in a currency pair. Such factors as volume-to-price measurements and contrary opinion are used. They may also consider how a market reacts to news to determine underlying strength or weakness. Quality of market trading is typically not fully automated, and focuses more on long-term opportunities.
DivergenceDivergence programs may be similar to quality of market programs but are more likely to be fully automated. They seek divergence in various indicators to spot a trend reversal. An example of a divergence indicator is the well-known relative strength index first detailed by Welles Wilder in his New Concepts in Technical Trading Systems (Trend Research, 1978). When the market and the RSI fail to make new highs or new lows together, a trend reversal is forecast.
Divergence tools may be used by trend-following programs to determine when a trend is faltering.
BreakoutThese are very popular at the moment. The space and variety of breakout systems is very large. In a breakout system, the program seeks price points when either buying power or selling pressure is pent up and due for release in a sharp price spike. They tend to be short-term trading methods, although trend-following systems may use a breakout tool to determine when a trend has begun.
Artificial Intelligence (AI)This is making a comeback after a two-decade hiatus. The trading program attempts to learn from its mistakes by making internal adjustments to the program. Neural networks and expert systems are the most common, although others are also in use, such as agents, bots, and genetic algorithms. Non-AI programs may have AI subroutines to perform specific functions.
Nonlinear AlgorithmsThe most recent attempt. The trail of prices is seen as an evolving process. Prices at Point A use an internal self-organizing rule set to determine prices at Point B and so forth. In theory, find that rule set and you will be able to forecast prices. The author's trend machine is such a program. It uses cellular automata (CA) to determine the specific rules involved in the price evolution. If there is a Holy Grail to tradingâand that is a very big ifâit almost certainly will be a nonlinear approach.
Performance is more important than any particular method a manager may use. But it is very useful for the prospective investor to know where in the scheme of things a manager's trading method fits. Methods sit on different areas of the risk-reward continuum.
Tip: Ask what is the inherent strength and weakness of the manager's trading method. What if anything is done to maximize the former and minimize the latter?
Most programs tend to shine in specific market environments (see Tools for Traders) and do poorly in others. The best programs work to emphasize the former and lie low during the latter. The exception are Pac Man programs, which define in advance the market environment in which they work best, and then trade only when those conditions are met.