How to prevent bias in a forex trading system?

In most cases, traders or retail traders having the responsibility of their account are searching for a trading system which would help them to take decisions, control risk and eventually make profits. A majority of traders, all around the world, cope up with such successes and struggles, in all stock markets.

A trading system can be broadly defined as a methodology that stipulates expectations, position sizes, entries and exits. In this and successive chapters, we will throw some light on three components. We shall also consider the impact of various factors like technical analysis on the formation and execution of a trading strategy.

It is not difficult to build a trading system. However, testing and implementation is certainly not easy. Proper preparation is required to achieve success. As we proceed through this chapter, we will not only build some trading systems, but will also deal with the process related to decision making simultaneously.

At PFX, the bias towards forex investing and trading system prevails for a longer period because the biggest enemy of retail traders, the trading costs, is appreciably minimized without causing any significant disadvantage.

In this part, we will find out ways to overpower the two common problems that trading system builders face. Both these problems appear in the preliminary stage of system building and can ruin a trading system.

The common problems that are confronted during System Building and trading are:

1. Over-optimization
2. Attribution Bias

Over-optimization

For forex traders, attribution bias and over optimization are related to one another. Over optimization is basically, a practice of fitting the past data into a model. The problem comes to the fore when traders begin back-testing the system, and thereafter, start amending the parameters of the system until the past results reaches the maximum value. This leads to a couple of problems viz. First, over-optimization produces results that are biased, incorrect.

The second problem is that even highly accurate past results do not indicate the future returns precisely. You can find this phrase in almost every prospectus you get from an expert money manager. It is merely a trap for traders, who hope to purchase a system from a manager. It is advisable to keep away from equity curves with exceptionally high multi-year returns. They are probably over-optimized returns.

Attribution Bias

It is something that is not new to traders. It is experienced by people from all walks of life, but it can undermine a trader’s success dramatically. This issue becomes prominent whenever you try to build a fundamental relationship between two attributes that have no distinct relationship.

To help you to understand properly, here is an example: Suppose you are a new trader. You’ll find that the total time spent on the non farms payroll in US is reported each month. On the basis of this observation you perceive a fundamental relationship between the price movement and the report. The relationship will persuade you to assume that if the report falls short of the expectations, or presents results that are lesser than the previous month, the USD will automatically weaken and this movement will be quite predictable.

If you have ever made an assumption like that, then you have closely dealt with attribution bias. As a fact, the NFP report can never predict for the USD.

The blue arrows denote the state of the NFP report at the start of the month; whether it exceeded (up arrow) the expectations or disappointed (down arrow). However, if you take the full twelve months into account, the report loses its ability to predict trend accurately. As the data increases, results become more and more random. To an extent, the Non-Farm Payrolls report can influence price movement, but the actual report does give any immediate trading indicator.

In the forex market, several variables can cause price movement. Hence, the traders should be very cautious while using single variables to predict and trade. Often, system traders build systems on single variable and start predicting results, but more often than not, these variables are just one of thousands of factors that affect the prices. Thus, a system based on a wrong indicator is inconsistent before it is ever implemented.

How can you use this information?

The best thing to do is to understand the portfolio strategy and develop awareness about the system design. All this will help you to become knowledgeable of all the problems that you may face while trading. On the other hand this will help you to keep yourself open to opportunities that we will be signifying as we put together a few systems.

Let’s reconsider the Non-Farm Payrolls report. As you know that NFP does not accurately predict the trend for the USD, but it does something else quite efficiently. Traders normally, wait for this report with a lot of anticipation. Due to this, the various options, premiums and volatility swell up before the release. This information can be suitably used by a forex trader in a system.

Likewise, experimentation can be done with optimization. It can provide you a lot of information about the system’s sensitivity to different market conditions. If an indicator in the back-testing system shows small changes, but yields enormous contrast in returns, then this is not a good sign for implementation. It directly means that downfall of the normal market can destroy the system, thus rendering it non-functional. Similarly, the inverse of this is also true and can help to identify a good system.

As an experience trader you will get to find several important concepts and also to include various pointers that traders tend to often miss.

With an appropriate forex trading system as a trader you will be able to catch trends that reward at least twice as much and also have a very low risk. At some times the reward can be even 5 times more than the risk.

The trading system has got a manual which will make you understand on how the forex markets work and it also include the forex trading rules. With these rules you will be able to identify the high trading profit opportunities and you will also make use of indicators that will help you identify high extreme trade conditions.