Diversify Your Portfolio: A Short Term Forex Trading Strategy
Forex trading is a great diversifier to core investments such as stocks and bonds, but finding a reliable system that consistently delivers returns can be a challenge. In this blog post, we explore a unique trading strategy tailored specifically for major forex pairs: EUR/USD, USD/JPY, GBP/USD, AUD/USD, and USD/CAD. This system combines both trend-following and counter-trend strategies, leveraging short-term price breakouts for optimal performance. This strategy is simple to execute as it makes use of data on the daily timeframe.
Trend Following Strategies on Forex
Long term trend following strategies tend to not work well on forex using the daily bar frequency. Here are 2 well known trend following systems applied to the portfolio of the 5 major forex pairs:
Equity Curve of 50 day – 200 day moving average system:
Equity Curve of 80 day Bollinger Band system
As we can see, the equity curves are very rough (Sharpe ratios around 0.1) and these systems are not really usable. Let us look at a short term breakout strategy and see if we can achieve better results.
Key Components of the Short Term Breakout Strategy
The system consists of two sub-models:
- Trend System – Focuses on identifying and trading short-term market trends.
- Counter-Trend System – Aims to profit from market reversals based on price breakouts.
1. Trend System: Betting on Price Breakout Continuation
We take a position based on a 50 day price breakout & hold for just one day following breakout. Here is an example on USD/JPY. The green arrow indicates that we have the highest close price of the past 50 days and therefore we hold a long position the following day (green circle):
And here is an example on USD/JPY going short. The red arrow indicates that we have the lowest close price of the past 50 days and therefore we hold a short position the following day (red circle):
Backtesting this Rule on the Portfolio of 5 Forex Major Pairs: Equity Curve:
The Sharpe ratio of this backtest is 0.19. This is better than the long term moving average or Bollinger Band systems but it is still quite volatile and is not quite usable as a standalone strategy.
2. Counter-Trend System: Profiting from Reversals
The counter-trend system revolves around taking reversal positions based on a 10-day breakout & it holds for just one day following the breakout. Here is an example on GBP/USD. The green arrow indicates that we have the lowest close price of the past 10 days and therefore we hold a long position the following day (green circle):
And here is an example on GBP/USD going short. The red arrow indicates that we have the highest close price of the past 10 days and therefore we hold a short position the following day (red circle):
Backtesting this Rule on the Portfolio of 5 Forex Major Pairs: Equity Curve:
The Sharpe ratio of this backtest is 0.24 and it has a strong negative correlation (-0.7) with the trend breakout system, making it an excellent complement. Let’s see how the 2 combine.
Blending Trend & Counter-Trend Systems
One of the standout features of this strategy is the 50-50 blend of trend and counter-trend systems. By combining these two approaches, traders can benefit from both market trends and reversals, creating a balanced trading portfolio.
Here is a chart showing the rolling correlation between the 2 systems – it ranges from about -0.4 to -0.9 from 1999. The average correlation is -0.7
Here are the blended trend + countertrend equity curves for each of the 5 forex pairs:
And here are the trend and countertrend equity curves aggregated for all 5 currency pairs:
And here is the total equity curve of trend + counter-trend for the 5 currency portfolio:
The Sharpe ratio of this blended portfolio is 0.55.
Leveraging the System for Greater Returns
Like typical forex strategies, this system needs to be leveraged to generate appreciable trading performance
At a 20x leverage, this system can achieve performance to beat returns of the stock market over the long term. Most forex brokers offer up to 50:1 leverage on the major FX pairs.
Excel Backtester
I have created an Excel spreadsheet that backtests the strategy on the 5 major forex pairs. You can download it and play with the rules as well as adjust the portfolio leverage. Enter your email below to download:
Portfolio of Strategies: Blending Forex + Equity Index Strategy
How would it look if we traded this forex strategy in combination with an equity index strategy? Let us do a 50%-50% blend with the Golden Cross + Mean Reversion strategy which trades the Nasdaq 100, which is outlined in this blog post. Combining systems that trade unrelated asset classes tends to improve equity curve smoothness and Sharpe due to low correlations.
Here is the rolling correlation chart between the forex strategy and the Nasdaq 100 strategy. They have no correlation to each other.
Here is a comparison of the equity curves:
And here is the equity curve blending the forex & Nasdaq 100 strategies (50% allocation to each)
The Sharpe ratio of this blended strategy is 0.91, which is a very good number compared to many investment strategies. For example, buying & holding the S&P500 index over the same time period yields a Sharpe ratio of 0.39.
This reveals a method of achieving good Sharpe ratios: formulate simple and robust systems for specific asset classes and then blend those into a portfolio of strategies.
Conclusion: A Robust & Easy to Execute System for Forex Traders
The Forex Major Pairs Strategy is a well-rounded system that leverages both trend-following and counter-trend techniques. By focusing on short-term price breakouts and blending two approaches, traders can effectively participate in the currency markets. This strategy provides an alternative, uncorrelated return stream which can act as an excellent diversifier of investments in other asset classes.
