When we set out to test out some of the classic forex trading strategies often mentioned in the online communities, we decided to try an old favorite: The engulf bar, a classic price action based entry method. Surprisingly, this incredibly simple approach has worked fairly well over the last few years (and even better using a multi-pair portfolio approach) when combined with the RSI (Relative Strength Index) oscillator.
First, open charts on the hourly time frame and place the RSI indicator on it. Set the RSI indicator to 11. (The RSI would be using the last 11 hours of data.) For this strategy, we're looking for trades shortly after the close of a hourly bar.
For clarity, the previous hour's hourly bar (which we'll be looking at for the engulf signal) will be referred to as the "Previous Bar" and the hour before that will be referred to as the "Mother Bar."
When to go long (buy):
1) The Mother Bar opened higher than its own midpoint and closed lower than its own midpoint. (Essentially, this means it was overall a bearish hour two hours ago.)
2) The Previous Bar's low was lower than the Mother Bar's close. (The original strict definition would need the Previous Bar's low below the Mother Bar's low but we tested with the Mother Bar's close which already identifies most of the same types of reversals as long as the other conditions are met.)
3) The Previous Bar's high was higher than the Mother Bar's high.
4) The Previous Bar's close was higher than the Mother Bar's high.
5) Trend exhaustion filter: During the Previous Bar, the 11-hour RSI reading was lower than 40.
6) Place the stop loss at the Previous Bar's low minus average spread for the pair. Place a profit target at 2.5 times the size of the stop loss above the entry price.
When to go short (sell):
1) The Mother Bar opened lower than its own midpoint and closed higher than its own midpoint. (Essentially, this means it was overall a bullish hour two hours ago.)
2) The Previous Bar's high was higher than the Mother Bar's close. (The original strict definition would need the Previous Bar's high above the Mother Bar's high but we tested with the Mother Bar's close which already identifies most of the same types of reversals as long as the other conditions are met.)
3) The Previous Bar's low was lower than the Mother Bar's low.
4) The Previous Bar's close was lower than the Mother Bar's low.
5) Trend exhaustion filter: During the Previous Bar, the 11-hour RSI reading was higher than 60.
6) Place the stop loss at the Previous Bar's high plus average spread for the pair. Place a profit target at 2.5 times the size of the stop loss below the entry price.
Every trade was sized at 2% of account equity.
As with all of our forex strategy backtests, the point of this backtest was only to code an accurate implementation of a simple strategy and see how it performed in recent history. This was among the surprising successes that resulted.
GBP/USD, EUR/USD, USD/JPY (Jan 2011 to Jan 2015)
Starting Balance: 10,000.00
Net Profit: 16,999.36
Max Drawdown in Balance: 32.98%
Max Drawdown in Equity: 34.75%
Win Rate (% of Trades Won): 34.46%
Average Reward / Average Risk: 2.5 to 1
The basic premise of this strategy is to find daily price action that shows a high probability of having reached an exhaustion point. While a 34.46% winrate doesn't exactly look to the average person like a "high probability" of anything, keep in mind that when a strategy is restricted to a 2.5:1 reward-to-risk ratio, your win rate would be far lower than that if you entered randomly with all else being equal. In fact, your breakeven point is lower, so this strategy shows actually positive expectancy in recent history.
While the typical forex gurus love to push this kind of risk-reward relationship, real traders should always keep in mind that trading this sort of strategy, no matter how profitable and how positive in expectancy, is incredibly challenging from a psychological standpoint. The issue applies to automated traders too because it's naturally hard to stomach an approximately 35% win rate and continue to keep a system running without undue interference and tweaking.
Nevertheless, this generic and simple price action based strategy (with one handy technical indicator thrown in) was surprisingly effective over the past few years so we're giving credit where credit is due.
The basic premise of this strategy is a fairly simple take on basic price action principles: When the market stalls in the hourly timeframe after a relatively strong move then reverses with an even stronger move, there's an opportunity to catch a reversal trade entry.
Despite the "naked trading" and "pure price action trading" backlash in recent years, there's still something to be said for using technical indicators at the right times. After all, technical indicators like the RSI are nothing more than primitive forms of the components in today's more complex trading algorithms, in many ways. And the backlash against them are really a matter of throwing the baby out with the bathwater.
The original intent of the "price action" movement had obvious merit at a time when beginners wasted all their effort on looking for magic combinations (read: overly curve-fitted parameters) on multiple technical indicators. The reversal into trading with nothing but price was a natural progression and, as this price action driven strategy's recent results show, had a decent point. However, as this test also shows, the use of some technical indicators as a peripheral tool - provided the tool is used for its strengths and not at random - can fortify a naked price action technique.
We wouldn't recommend looking to run this simple strategy "as is"... but the fact that it achieved these results in its simplest form shows it (and strategies with similar designs) can be a potential candidate as part of your portfolio of strategies or as the basis of your own strategy design in the process of finding what works for your own personality and goals.