In our trading, we utilize a blend of long-term trend following strategies and shorter-term scalping strategies. One of our intraday approaches centers around fading a currency pair as it expands its Average Daily Range.
This strategy is pretty basic. Currency pairs tend to move a rather predictable amount of pips per day. For example, in current market conditions, EUR/USD is moving about 120 pips per day.
Thus, when EURUSD moves close to 120 pips on the day, and hits a major level of support/resistance, then we look to fade that momentum in expectation that EUR/USD is going to revert back into the day’s range.
The basic concept underlying this strategy is no secret. ADR Exhaustion strategies have been around for decades. This article, however, is not about strategy. It is about understanding how powerful your losing trades are.
Here’s the deal—the variation of the ADR Exhaustion Strategy that we use today is a direct result of losing trades.
The 2008 Crash and Reversion-to-Mean Strategies
Any strategy that fades momentum (buying as price falls, selling as price rises) is generally classified as a “reversion-to-mean” strategy. The mathematical concept is that in any set of data, data points will tend to revert back to the average over time. In trading, that means that as price hits a certain deviation, the probability increases that it will soon revert back toward the average.
Now, this type of strategy works fine until the market shifts and there is a substantial change in market movements. In 2008, when the Sub-Prime Mortgage Crisis erupted in the fall of 2008, reversion-to-mean strategies were absolutely slaughtered as prices moved aggressively out of their standard trading ranges and normal deviations.
All of a sudden, EUR/USD started moving 200-300 pips per day!!! Prior to the crash, EUR/USD would often barely move 100 pips per day. If you were trying to fade the day’s momentum at standard daily range exhaustion points in the fall of 2008, you got killed!
One of the greatest habits you can ever build as a trader is to analyze your losing trades closely. In 2008, when ranges expanded considerably, we noticed that the winning percentage of our system was falling considerably.
Thus, we took a closer look at what was happening, and we began to notice specific commonalities among several losing trades. We then implemented these commonalities into our trading model in order to significantly increase its performance.
If you run any sort of a daily range exhaustion strategy, here is what we picked up in 2008 that we have implemented into our approach. Feel free to use these techniques.
Never Fade A Currency Pair If It Exhausts Its Range Before 9:30am EST
If the Average Daily Range on EUR/USD is 120 pips, and price expands or even nears that range before 9:30am est, then do not employ a strategy to fade the day’s momentum. If price expands its range this early in the day, then the most likely scenario is that we are actually going to see a strong range expansion on the day, and we could see price move 2x the ADR (150-200+ pips on EUR/USD).
If Volatility Is Too Strong Into The Level, Do Not Trade
Volatility is commonly defined as the distance of price movement within a specific amount of time. If volatility spikes too high as price comes into its ADR exhaustion point for the day, do not fade the momentum. Pass on the trade.
The reason is simple. If volatility spikes hard into the level, there is a strong chance that price will not react violently back into the day’s range; instead, there is a strong probability that it will get stuck into a range at or near the day’s extreme, and then continue the move in the next trading session when fresh liquidity flows into the market.
You can measure volatility by gauging the size of the 5 minute and 15 minute candles or price bars. If price is typically moving 5 or 6 pips in 5 minutes, and then all of a sudden you have three 5 minute candles in a row that are 10 pips each, that is not a price run that you want to fade.
Do Not Fade Price Moves After 3pm EST
ADR trades need to trigger between 9:30am and 2:30 pm est. If they trigger too early, there is a strong probability that price will show a strong expansion on the day. If they trigger too late, then there is a strong probability that price will simply range at the extreme of the day and not move sharply back into the range (which is, of course, what needs to happen for this strategy to perform well).
Unfortunately, there is a lot of bad information in the retail trading world. You commonly hear folks encouraging newer traders, “to simply forget about losing trades as quick as possible and move on to the next setup.”
That is terrible advice!!!
It is wise to establish a habit where you analyze every trade you take at some point during the week in order to ensure not only that you are sticking to your plan, but that your trading system is operating properly. By analyzing your losing trades, you can find gold.
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