Reader Questions Answered Trading Tips

Improving the Win Rate of Trend System With Oscillators

This question came in over the weekend from a gentleman working on improving his trend trading system.

Hi John ,

I have a question for you I’m hoping you might be able help with . I recently started researching Donchian’s Channel Breakout System to trade Forex with. Using Donchian’s 4 week rule I have my price bands set at 20 days. I ‘m sure you are probably very familiar with it. If price closed above the upper band you enter a long position and if price closed below the lower band you enter short. I like the system because of its simplicity and it appears to work on any time-frame. My question is in order to improve the winning % of trades, I have been playing with using a filter like MACD histogram but it doesnt seem to filter out many bad trades? Do you know of an oscillator that might work to help filter bad entries to incerase the winning % of trades?

Best of trades ,

John W

I am not a Donchian expert by any stretch of the imagination. As I understand its basic go with break-out premise, though, the approach is one which is focused on trend trading. That means we need to keep two things in mind.

1) Trend trading systems have low Win %
It is the nature of systems which attempt to get on and ride trends that they tend to lose more often than they win. It’s a simple function of the markets not being in real trends most of the time. Of course the idea is that when you get a good trend it more than makes up for the losses suffered during those periods when there is no trend going on. Trend trading is probably as simple as it gets in terms of trading. The problem, however, is that riding out the inevitable drawdown periods and low Win% makes the approach something many traders struggle with on a psychological level.

2) Oscillators are range trading indicators
John asked whether I know of any oscillators which could help him filter out bad trades. The problem is that oscillators are used for range trading, not trend trading. As such, they really work at cross purposes to things like Donchian. The trend trader is going with a break out at basically the same point as RSI (for example) would call the market overbought.

The only way to improve the Win % of a trend trading system is to await further confirmation of the trend being in place by using some kind of indicator or reading that is a bit more lagged than the one you normally use. Of course that then means your gains are reduced. In the final analysis you may find it doesn’t increase the expectancy of your system at all.

Don’t fixate on Win Rate!
I’ve said it many, many times. One of the biggest mistakes traders make is getting to caught up in how often they having profitable trades. It’s only one part of the equation. You also need to factor in the size of the wins relative to the losers and the frequency with which trades are made. All of that comes together in expectancy.

Trading Tips

Stop Getting Hung Up On Stops, Targets, and Risk/Reward

“Is 30 pips a good stop?”
“Should I use 50 pips as my target?”
“Your risk/reward ratio should be at least 3:1.”

These are some of the types of questions and statements I see in trading forum discussions on a pretty regular basis. New traders are always asking about the placement of stops, how much profit they should be taking  from a trade, what a good risk/reward ratio is and all of that. Usually they are doing it in isolation, without considering the big picture.

Let me make a few statements of my own.

A good stop allows a trade sufficient room to handle normal price volatility.
How far away that is from your entry point depends on things like your trading time frame and your trading methodology. No one can specifically tell you where that stop should be, unless they are trading the exact same way you are. New traders have a tendency to put stops too close because they think that means they are being less risky when in fact they are probably increasing their loss % and thus making their trading more risky.

There is no such thing as a stop that is “too wide”.
I see traders make statements like “I don’t want to risk 150 pips. That’s too much.” This completely misses the point. Your risk is defined by your trade size in conjunction with how far away you place your stop, not just your stop. If you need a “wide” stop, then trade smaller.

The Reward/Risk ratio is meaningless if you don’t know the Win%
Traders have a bias toward high R/R ratios. They think bigger is better. On the face of it, they’re right, but it’s only part of the equation. The R/R can only really be applied meaningfully in conjunction with the Win %. A system with a 4:1 R/R can be a loser (imagine a 20% win%) while a system with a 1:1 R/R can be a big winner (imagine a 70% win%). The two go hand in hand. If you have a low win % you need a high R/R. If you have a higher win%, then a lower R/R is fine, and in fact is probably all you’re going to get. If you’re winning at 75% and waiting only for 3:1 R/R trades then you are practically giving away profits.

Stops and Targets and Reward/Risk ratios are generally speaking not things you can just pick. They need to come from somewhere. That is, usually, your trading system. In particular, R/R is a metric like win % and average drawdown and all of that, not a variable for you to input. My advice to new traders is that they should spend a lot of time trying out different types of trading systems (ones which fit in with their overall trading plan, of course) to see what the metrics from them look like by way of comparison. The more of this you do, the better you will understand the way systems work and by extension how the market works.