Forex Trading Strategy: How to Use Trend Filters to Improve Risk Adjusted Returns in the FX Markets

by Joe Oliver, Forex Trading-Pips

Trend Filter: The Secret to Superior Risk Adjusted Performance in the Forex Markets

Forex Trading Trend Filter: ‘The trend is your friend’ is oft quoted in the markets, but what does it really mean to trade with the trend in FX? How do you measure trend? When is the Forex market in an uptrend and when is it in a downtrend?

The most simple Trend Filter to define the long term trend is as follows:

If today’s high is greater than the high of the past 130 days, the trend is up
If today’s low is less than the low of the past 130 days, the trend is down
The trend remains in force, either up or down until the opposite is proven true. 

Take a look at the equity curve results of trading Donchian Channel 4 week rule on 1 lot Euro futures contract from January 2000 to August 2011, with and without a trend filter.

Chart 1 is no trend filter:  longs or shorts are taken at all times.

Forex Trading EUR Donchian Equity Curve, no trend filter

Forex Trading EUR Donchian Equity Curve, no trend filter

The equity curve is upward sloping with profit factor of 1.5, however it is also prone to some violent draw down along the way due to market ‘chop’. Max draw down during the test period is $29,775 for total net profit of $66,975.

Chart 2 shows the Donchian equity curve net profit 1 lot per trade on euro using the 130 day up / down trend filter: if the trend is up only longs can be taken, if the trend is down only shorts can be taken.

Forex Trading EUR Donchian Equity Curve, Trend Filter

Forex Trading EUR Donchian Equity Curve, Trend Filter

Note the equity curve is far smoother when trading only in the direction of the long term trend. Profit factor has increased from 1.5 to 2.07 and max draw down has been cut by 30% from US$29,775 to $20,682.50 per contract. Total net profit is very slightly reduced from $66,975 to $63,812, however this is at the benefit of higher risk adjusted returns and a 43% reduction in the total number of trades (from 71 to 40).

Lesson: Traders who trade in the direction of the long term trend will be rewarded by higher risk adjusted returns in the forex markets.

For more information on how to trade with a quantified statistical edge in the Forex markets, get started today on a risk free trial of our Forex Signals Program

* Trend Filter Testing assumes $25 slippage and $5 commission per contract.