Break Out Analysis

Now that I talked about money management a bit I would like to talk about the actual signal generation again. When I started with this whole experiment, I was using new high and lows as entry points. The rationale behind this being that once a new high is formed the buyer side (demand) finally increases above a certain level, triggering a momentum move upwards. Vice versa when looking at a new low. Now, I am using the same principle but more of a graphical execution. I look at the daily chart of the past 6 months and identify strong supports or resistence areas in the chart. Once those are broken, a signal is triggered. This is called a break out system (see http://www.investopedia.com/terms/b/breakouttrader.asp). Again the rationale behind it is that once such a level is broken, there is a fundamental change in the supply and demand forces of the underlying asset. For example when a resistence is broken, there are now more people willing to pay a higher price and less people are willing to sell at this price than it was the case for the time period before. This can be triggered through events such as economic news but also a shift in the general attitude of traders. Because it is a relatively efficient and quick way to identify entry levels, a lot of markets can be covered. Also Since (most the time) a former resistence becomes a new support level, it is easy to place stop-losses just below/ above those levels. Sounds good doesn't it?! There is a problem however: It is not an exact science to identify those areas. Only experience and practice improve results, and even then there is no quarantee that it might be a false break out...

For now I am using 2 particular situations:

1) Break out of a price range. by looking at the graph it becomes apparent what I mean. Highs and lows are around the same level respectively for a while. Thus they are forming resistence and support levels. Soon or later the market WILL START TRENDING and break one of teh levels in teh process. By placing an entry order just above or below those levels gives a nice opportunity to enter a trend early.

This graph of the USD/CAD shows a real life example. The USD remained within a certain range for almost 6 months.Both support and resistence levels are pretty obvious. Then in early August teh USD gained in value and the resistence is broken on a closing basis. A clear entry signal for a long position which would have performed nicely indeed...

2) Old high/ low trend break. When a trend is forming old highs are lower than new highs and old lows are lower than new ones in a uptrend. Vice versa in a down trend. When talking about a break out in this context, it means the asset price is overtaking the previous high (vice versa on low). At this point a trend is established and it is time to move in.

Here is another real life example. Strictly speaking There should have been an entry after the support break out near the top, but a trend as such is only established at the second green circle. This second break out is where the position is added to and the stop-loss moved (at the latest) or the resulting trend line used as the stop.

Alright this short overview should explain when I enter positions and why (demand-supply shift, trader sentiment shift). As such many people utilize a break out system in one way or another. For moreinformation a google search should help...

Yen Rise

China is overtaking Japan as the second biggest economy today, the Japanese GDP is stagnating, unemployment rising... In other words Japan is continuing its declline since the 90s. But why is the Yen at a 11 and 9 year high compared to the USD and EUR respectively?

1) Carry Trade: Borrowing in Yen at low interest and investing in a higher yielding currency thereby increasing demand? Has been going on for years plus the USD shows no interest either. So why would that be the reason? Doubtful...

2) Psychology: The Yen as substitute for the USD in tough times? Doesn't go well with the economic data plus there are  better subs such as the Swiss Franken in my opinion.

3) Technical trend? Definitely a trend there but such a strong trend usually has underlying fundamentals. Again not exactly sure which ones. Maybe the unattractiveness of US bond yields and other safe haven yields.Most likely it's some combination of all of the above.

In any case an entry order for USD/JPY and HKD/JPY for a short position is entered. The trend might be ending (end of 3rd Elliot Wave?) but then again it might not. As Dennis would say: Buy high, sell low...

Short update

Alright, learning how to program does take longer than expected, especially when I'm also learning Romanian, working full time and preparing a dissertation... Therefore I used some of my old data and a few new trials to semi-test a simple 3-month break out system on currencies. Performance is decent but should be pretty good using the proper risk management system. After a bit more thorough research in that area, I laid out the following:

• Initial risk per trade: 2% of free equity
• Max risk per trade before reducing position size: 3% of free equity
• No more than 22.5% of capital at risk at any time
• No more than 2 positions in 1 direction per currency (e.g. no more than 2 positions betting on a stronger euro, however opposite positions do cancel each other)
• When adjusting the stop-loss AND simultaneously favorable currency movement, lots might be added to increase exposure to 3% of free equity again
• Obviously number of contracts will always be rounded down
• positions will be adjusted daily at a set time once US markets have quiet down, so it should be early night in Europe, but I will see how well that works

I hope those rules should keep me from overexpusore and overtrading. The 22.5% of capital at risk might be a bit high as it is more than 80% of the Kelly formula's suggestion but at the same time gives enough room to hold varies positions. The no more than 2 position per direction rule should prevent any overexposure to any specific currency. I did look at some other ways to tackle this, for example geographic region, interest rate setting central bank or major industry types of the economy but in the end this solution seems to be the easiest to implement.  Maybe the rules seem a bit confusing and or weird right now,but I think they do provide a good framework to start with (again) and I will bring them to live with some cool trades :)

I wish I could try this system on futures but my account is obviously not big enough to  do so in a manner that money management actually exists (trading only 1 contract each timeis no good money management...) and stocks have astronomical trasnaction cost. Therefore I will soley focus on FX microlots (1k lot size) for now and hopefully will be able to move up  to standard lot and maybe CFDs (so I get stock and commodity exposure) next year.

The account is set up, the money on its way and I should be starting to trade again by the end of this week! Until then...