Building A Trading System With A Baseline As Cornerstone

There is no one-size-fits-all type of baseline. It’s a personal decision based on your own findings. After years of backtesting, you must pick the baseline that best contributes to trigger the right entry signals to ride a trend while even more importantly, warning you when to abort the trade.

When looking to build a system from the ground up that can provide a mechanical way of entering the market, a priceless piece of information, in order to keep you disciplined to engage under the right conditions, is to incorporate what I’d refer to as a baseline to your trading.

In Search Of The Right Baseline

A baseline is simply a moving average that is going to be the roadmap to guide you as the delimitation in the chart that determines when a pair is classified as bullish or bearish by analyzing where the close occurs. Over the years, I’ve come across a handful of moving averages that do an excellent job in being accurately respected.

In my own experience, a daily exponential moving average the likes of the 5, 13 or 21 can act as great visual cue to build a personal perception of a market in a bullish or bearish phase.

Goes without saying that not only some initial backtesting will be required to filter out the wheat from the chaff in the ultimate MA you will choose, but more important is to understand your profile as a trader. If you opt to use as your baseline a 21ema, the number of entry signals triggered may come in dribs and drabs as opposed to a system that is derived from a much shorter moving average as your baseline such as the 5-day ema.

There is no one-size-fits-all type of baseline. It’s a personal decision based on your own findings. After years of backtesting, you must pick the baseline that best contributes to trigger the right entry signals to ride a trend while even more importantly, warning you when to abort the trade.

Let’s look at how a baseline alone, in this case a 13-day ema, which as a spoiler I must state would only constitute an initial component out of building one’s full system, would have fared.

The GBP/USD daily chart below triggered a total of 19 entries so far in 2019, with the simple rule being if price closes above the baseline we go long and when the close is below the baseline we go short. The exit signal occurs when the price closes in the opposite side of the baseline.

I’ve painted in a green box the potential profits that such a straightforward entry would have provided, while in red, the losses incurred following the logic of an early exit by the retake of the baseline. I haven’t cherry-picked the chart, with the only peculiar characteristic being that GBP carries wilder vol as is sadly still driven by Brexit more than 3 years since the referendum.

The compounded result is of 10 winners and 9 losers, which is slightly above a 50% win rate. In terms of the average win vs average loss, one can immediately see that those profitable trades far exceeded the times when an entry led to take a quick and generally more limited loss.

Baseline As Starting Point: Tweaking To Improve Stats

The real value in taking an approach under this logic of price closing beyond a certain moving average (baseline) includes: You can turn your methodology mechanical, you build a system from the ground up by taking as a base a visually logic and tested moving average from which you can then massively finetune it to ultimately limit or fully eliminate additional losses.

The tweaking one can achieve taking as reference a baseline offers a world of possibilities to improve one’s results from the preliminary testing phase. If you aim to do some carving work out of a stone by scraping away portions of it in order to build a beautiful piece of art, will you get better results if you have at your disposal different tools to shape it, or just one tool?

Bear in mind, each iteration of refinement in the system needs to be done with the clear objective in mind of not obsessing with maximizing winners, as the number of trades the baseline determines will always be the maximum you aspire (19 in our previous test), but it’s more about looking for venues that may allow to minimize the times when losses happen, and as critically important, to get an exit signal that can mitigate the amount lost each time.

The ATR As An Essential Tool For Risk Management

Let’s introduce an indicator to be added on top of this system as the perfect fitting for the purpose of avoiding paying up too high or low prices. I am referring to the ATR or Average True Range. While there is nothing sexy about it, it is hands down one of the best due to its amazing characteristics to account for a key component when trading forex, that is, the measurement of volatility. Its value will usually derive off the latest XX number of periods, generally 14.

The ATR, therefore, allows to pre-define the risk, hence it serves as our cornerstone to respect one of the most sacred factors to succeed in forex trading, that is, money management. How much you risk versus the amount you make on every single trade out of a large sample is key, and no other indicator I know of can be of greater assistance in this department than the ATR.

The way the ATR can be married with the baseline to make the strategy more robust in order to minimize unnecessary losses and controlling our risk management is by setting simple rules such as: If the close of the candle above or below the baseline is beyond 1 time (1x) the ATR value, we will determine that the entry price is far from ideal as the price paid is overstretched.

As those with more experience in the forex market know, when a price movement is overdone, the risk of pulling back to the mean before it continues in a particular direction increases. That’s why we need to set hard rules to avoid being filled at far from ideal entries. By incorporating this rule, you also make sure that if you have to bail from the trade or if the trade is not turning against, your stop, which I will talk about next, is far enough on the other side of the ATR.

So, as I was saying, the ATR will also be used as our go-to indicator to objectively define, based on the pair’s volatility, where the most sensible location in the chart will be to place our stop.

If the entry is subject to get a filling at a price no further than a distance 1x the ATR from the baseline, it, therefore, makes sense that the hard stop is set at a distance, with some discretion to be applied, between 1.5x and 2x ATR from the entry or perhaps your preference is to set it as a hard rule 1x on the opposite side of the ATR.

Whichever way you decide, you must find the optimal distance that doesn’t put your hard stop at risk of being hit almost never before you have the opportunity to bail out for a smaller loss. The more room you leave, which is why 1.5x ATR from the entry is my preference, the better, but all within limited parameters so that when taking profits, it still allows a decent risk reward.

The 2 examples provided above should leave no doubt that the ATR rule is a great tool to complement a baseline-derived strategy by keeping a tighter grip on risk management and in the majority of cases, given the overextended nature of the move, allowing for better entries.

Also, the virtue of the ATR is that it will provide predefined locations where you can gradually take profits off the table. Just as the stop loss gets placed, with certain discretion, 1.5x ATR beyond your entry price, the ATR should dictate the next 2 big decisions as part of your risk management strategy, which includes the different locations to take profits and when it’s sensible to move to break even.

As a rule of thumb, if the price moves in your favor by 1x ATR, that’s enough evidence that the trade is working out and so it is logical that by that time we guarantee that with enough room given to breathe, we then activate a break even move. Profits could then be taken at different intervals such as 1x, 2x, 3x ATR and subject to the percentage that resonates most with your profile as a trader and the type of market characteristics.

Volume To Separate The Wheat From The Chaff

Let’s keep moving on. The time has come to get even pickier on the type of entries we want to take. While recognizing that finding an accurate baseline alone can be an important first step, not to mention the ATR to pre-define risk parameters, we want to be able to further filter out the good quality entries from the average ones, which the ATR alone is not cut for it.

That’s why adding a few layers of complexity through an extra set of indicators to work on the removal of unnecessary losses is the next mission. In this respect, I endorse an indicator that communicates like no other the commitment of buyers or sellers in a directional play.

I am talking about tick volume. First, let’s briefly touch on why is volume such a powerful piece of information. The answer lies in the influence it has to move prices and similarly because it communicates the involvement of the smart money. Volume is the fuel to cause new cycles and tells us the degree of commitment that exists to support a certain buy or sell-side campaign. By understanding the bias of big players, we can piggyback their market bias.

Here, once again, to analyze a quality signal, we see an ATR-derived indicator camouflaged as our best ally. I am referring to monitoring when an entry trigger is given, whether or not the tick volume bar from the entry candle is equal or above the 14-period moving average. This would be an important pre-qualifier to understand the commitment of players to acts as a trigger. An acceptable alternative, upon one’s discretion, is to see tick volume on the rise from the previous candle series even if it doesn’t quite make it to the 14-period moving average.

As the chart above, once again illustrates, by factoring in the ATR to control risk management, alongside tick volume as an added pre-qualifier, in the same GBP/USD chart, we’ve gone from 19 trades at just over 50% win rate to 12 trades with only 4 well-contained losses, taking the win rate to 66%, and not to forget that the risk-reward continues skewed largely towards much larger profits than losses as the system gets us out of bad trades once the baseline is retaken.

You must be aware that once we start to reach these win rate levels at such an attractive average risk-reward, further refinement becomes trickier. The key is to find a set of variables from which the system will be built upon that performs with consistency and makes the edge be repeatable over not just a larger sample number, meaning by introducing more years of data in GBP/USD, but stress test it through other pairs, assets such as stock indices, metals...

With the caveat of over-refinement out of the way, the chart is really your oyster to keep experimenting on the different combination of indicators that can best optimize your system and maximize the edge. However, one should strongly consider the baseline, tick volume, and ATR as core elements.

Don’t Overlook Building Confidence Through Backtesting

From here, start to conduct further backtesting with the tonnes of other indicators available to hopefully nail that secondary indicator/s that could keep your entries even safer. You could consider the likes of the Aroon, money flow index, which is an RSI derived off volume, find alignment with market structure, which is something I’ve dwelled on a lot, align intermarket flows, just to name a few ideas. Your experience utilizing indicators will play a key role to discretionarily decide your preferences to put a ribbon to the system even if you will have to be constantly on the lookout for possible diminutive refinements or adaptations over time, depending on ongoing backtesting.

It is precisely this backtesting, the step you must never skip to build the necessary confidence in your system. Now, since time is of the essence and I know it’s just human nature to accumulate the most results in the least amount of time realistically possible, there are a few routes to consider aimed at fast-tracking your ability to obtain results on different suppositions. The most obvious one is to run the backtesting via MT4 automated tester or in tradingview’s strategy tester (coding skills or coder needed). 

You should always put the set of indicator variables to the test in all types of market conditions (trending, choppy, ranges, etc). If the results are successful, move to the next phase by expanding the simulations into other markets. The number of combinations can be overwhelming, but with most of the core elements in this mechanical system (ATR, volume, baseline) shared in this article, it’s more about finding the right finishing touches (refinements) that can best adapt to changing conditions, especially to the times when volatility is low and markets range-trade. Finding that indicator that keeps you away from trading ranges you may notice is the key missing piece.

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