As you design your forex trading system, remind yourself that one of your key goals is to control the downside risk. You will quickly discover that risk is a many-splendored thing. This section briefly discusses some of the areas of risk you may wish to consider as you take a portfolio-level look at your forex trading system. A trailing stop is a popular method to control portfolio volatility and protect profits. A trailing stop is simply a stop order that is placed some fixed distance away from the highest profit point in the trade. When the market reverses, or when market volatility increases, this stop will be touched off and will protect your profits. If you are using long-term systems that are slow to react to trend changes, then such a stop may smooth out your equity curve.
An important type of risk arises from correlation among markets. You know that correlated markets move roughly together. A good example is the currency markets such as the Swiss franc and deutsche mark (see Figure 2.10). These markets tend to experience broadly similar moves versus the U.S. dollar. As we saw in chapter 2, trading correlated markets in the same portfolio is equivalent to trading multiple contracts in a single market. This may increase your risk to market events such as unexpected and unexplained news events.
There is an execution risk to your portfolio due to market liquidity or lack of it. For example, lightly traded markets can produce significant slippage. You. experience slippage getting in and out, reducing profits, and increasing losses. In these markets your paper testing may not adequately account for slippage and commissions, thereby overestimating potential profitability.
Liquidity can be a particular problem near major holidays, such as Christmas and New Year’s Day. During these thin market periods, it is common to see large one-day moves (see Figure 3.9) that can scramble the best-laid risk-control plans. These moves do not change the underlying trend, but can be difficult to model when you test your forex trading system.
Global trading produces a new set of risks to your portfolio. If news events occur when the U.S. markets are closed, then large price moves could occur in foreign markets. This is particularly true for currencies such as the Swiss franc, Japanese yen, or deutsche mark; energy markets such as crude oil; and metals markets such as gold and silver. Often, an emotional reaction in foreign markets will produce a large opening gap stopping you out at extraordinary slippage. You may find that your profits are lower than anticipated due to these large opening gaps. Then to make matters worse, the markets may stage a recovery to close well inside your stop loss point. Thus, round-the-clock trading adds new risks to your portfolio.
The DM contract in 1995 showed some large gaps during a volatile period (see Figure 3.10, page 63). Large overnight moves in foreign currency markets produced these large gaps, which are difficult to simulate correctly in historical testing. The first encircled gap was for $2,112.50, a big move against you if you were short. The island reversal in the middle ellipse in late March 1995 also left huge gaps, about $1,300 per contract. The gap circled in May was about $1,500. Here, your signal a day off on either side would show significantly different results.
The large intraday ranges in this contract also increases the diffi-culty with entering a market on the close. For example, you may lose a big move if you had the right signal on the right day, but entered the market on the close rather than on a stop. Say you had a sell order at 71.80 stop close only. ^bur fill would have been after a slippage of $2,400, quite unacceptable to most traders (see Figure 3.11).
The type of data you use often poses hidden risk. Consider a situ-ation in which you are using weekly data to develop your forex trading system. Let us suppose you generate a signal at the Friday close, and purchase with a delay on Tuesday open. Since daily opening gaps are missing from weekly data, you can easily underestimate the slippage from actual trading. Another potential problem area is using systems that generate signals this week and ask you to trade next week. You could have a large move this week, and have missed a big portion of the profits by the time you enter the trade next week.
Your system could also experience a time-based risk. For example, the best moves seem to occur when the market moves rapidly immediately after a signal. Suppose the market consolidates immediately after giving you a new breakout signal. The risk of being stopped out is sig-nificantly higher in a sideways trend. Hence, you may want a filter that will exit within 5 days of entry if the trade shows a loss.
Another quirky situation arises when you get a new signal very close to a rollover date. It is possible to generate an entry signal on the contract about to expire, but not on the next active futures contract. In this case you must decide whether to take the signal as is, and then roll-over immediately or in a few days, or just to wait until the next active contract generates its signal.
In testing with continuous contracts, you could easily underesti-mate the effects of rollovers on trading costs and profitability. You must also resolve the issue of where to place your initial stop on the new rollover position. Your real position may hit the stop, while your continuous contract merrily rolls along with its position intact.
This discussion does not include all types of risk, but highlights why you should consider risk control early in your forex trading system design process.