Trade Forex Fundamentally

In my post on forex mechanical system trading I showed how $10k could’ve turned into nearly $51,000 using my long gamma forex trading strategy with a currency strength meter. Using a currency strength meter was just one edge that contributed to profits.  But just think if we added more edges to our strategy—it would increase the probability of success for each trade, decrease the magnitude of negative drawdowns, and  increase the bottom-line profits of your account! So what can we add to form an “arsenal” of edges?

Using the Commitment of Traders (COT) indicator to confirm direction

COT data gives you information on the positioning of other major players in the market (see previous post on COT forex trading strategy), so why not combine it with the currency strength meter so that you have two pieces of confirming evidence for making a trade in a certain direction?

Your forex trading edge can be as simple as looking at the net futures positioning for your currency pair of interest (it’s the red line on the COT indicator at Timingcharts.com charts) and ascribing a positive direction if the positioning is net long (number of positions is positive) and ascribe a negative direction for the currency if the positioning is net short (number of positions is negative). Why? The net positioning (a.k.a. “small speculators”) is the difference in the number of currency contracts between the commercial traders and the large speculators, both representing a huge share of market volume. It takes a lot of time for these types of traders to turn their positions around, so their net positioning represents the sentiment of the currency for the medium time frame.

I simply took the technique described in the above paragraph to determine the direction of the pair and compared it to the direction suggested by the currency strength meter, which was used in isolation for my previous strategy. If the two were in agreement of direction I had a confirmation and would look for an entry, depending on my other filter criteria.

Before and after using the secret weapon

Let’s take a look at how the long gamma strategy performed for the EUR/USD pair from 2007 to 2010 (the strategy was backtested using the MetaTrader4 program). I selected a pair that didn’t have exceptional performance with this strategy over this time period (meaning it may have suffered longer and larger drawdowns than desirable) to emphasize how negative aspects of trading such as drawdowns can be alleviated by having multiple edges for confirmation. The first chart shows the equity growth of a $10,000 account throughout the testing period–$24,000 is not bad in that time period, but notice how it suffered a dip (42% of account lost) and just barely made up for it after a lot of time passed.

FX trading performance with just currency meter (click to make larger)

Now let’s look at the same currency pair, strategy, and conditions, except we use COT to help us confirm direction.  Now the drawdown is only 31% (vs. 42 from previous) and the account increases well beyond the initial high in account equity at nearly $25,000. Here we make $265 per trade vs. $196 per trade with just the currency meter. Are you starting to see how important getting the direction right with different indicators is?

FX trading performance with both currency meter AND COT (click to enlarge)

There’s your secret weapon for forex profits. If you can keep adding edges like this to your trading, you will find that your win rate goes up, your expected profit per trade goes up, your drawdowns go down, and most importantly, your confidence soars!