A Simple Forex Strategy

The world of currency trading offers numerous strategies to capitalize on market movements. One way to enhance the effectiveness of a trading strategy is by combining complementary indicators that provide insights into different aspects of price action. In this blog post, we’ll explore a simple Forex trading strategy that combines the Donchian Channel High with the Internal Bar Strength (IBS) indicator, specifically designed to capitalize on short-term reversals at resistance levels.

Donchian Channels

Donchian Channels, developed by Richard Donchian, are a popular trend-following indicator that helps traders identify potential breakouts and determine support and resistance levels. The Donchian Channel consists of three lines:

  1. The upper band, which represents the highest high over a specific lookback period.
  2. The lower band, which represents the lowest low over the same lookback period.
  3. The middle line, calculated as the average of the upper and lower bands.

When the price breaks above the upper band, it may signal the beginning of an uptrend, while a break below the lower band may indicate the start of a downtrend. However, the highest high values of the Donchian Channel can also act as resistance levels, particularly in a ranging market. This is because when the price approaches these levels, market participants who previously bought at lower prices may decide to sell their positions to lock in profits, creating selling pressure. This can lead to short-term reversals or periods of consolidation as buyers and sellers battle for control.

Internal Bar Strength

The Internal Bar Strength (IBS) indicator, on the other hand, is a simple yet powerful tool for identifying potential short-term reversals within a trend. It is calculated by dividing the difference between the close and the low of a bar by the range of the bar (high – low):
IBS = (close-low) / (high-low).
The IBS ranges between 0 and 1, with values close to 0 indicating that the price closed near the low of the bar, and values close to 1 suggesting that the price closed near the high.

A Simple Forex Strategy

The proposed trading strategy combines the Donchian Channel High with the IBS indicator to capitalize on short-term reversals at resistance levels. The entry rule is as follows: Sell if the 6-period Donchian Channel High has been breached and if the last two bars have IBS scores above 0.3. Position sizing is dependent on account balance (i.e. lot size grows with higher available money). Instruments traded: Major USD FX pairs. One trade at a time.

The logic behind this rule is that when the price races against previous highs (breaching the Donchian Channel High), there will be resistance for a short-term, as market participants who previously bought near the highest high may decide to sell their positions. By requiring the last two bars to have IBS scores above 0.3, the strategy ensures that the price has not been at the lows of previous bars, increasing the likelihood of encountering selling pressure.

The exit rule for this strategy is to hold the short position for one bar. This is based on the assumption that the resistance will cause a short-term reversal or consolidation, allowing traders to capitalize on the price movement.

The Power of Combining Indicators

The effectiveness of this strategy stems from the combination of the Donchian Channel High and the IBS indicator. While the Donchian Channel High helps identify potential resistance levels in the market, the IBS indicator provides a gauge of the short-term strength of the price movement. By combining these two indicators, traders can exploit short-term reversals at resistance levels, which may otherwise be difficult to capture using either indicator on its own.

Results of the Simple Forex Strategy

Backtest with Optimized Parameters

First, let’s see the backtest, because backtesting is important. The parameters were optimized manually with few iterations. This is the equity curve against a reference of buy-and-hold USDJPY.

❗ Past performance is not indicative of future results. This is not investment advice and only for informational purposes. See the disclaimer for more information.

Simple Forex Strategy Backtest Results

It looks OK-ish. However, this is not enough for a robust trading strategy I’d use in production. Some stats are: profit factor of 1.16, exposure of 61%, max drawdown of 23%, and a CAGR of 18.7%. Although the CAGR is high, there are prolonged periods of losses, resulting in a not-so-small drawdown.

Out-of Sample Performance

It’s always important to test a strategy “out-of-sample”, i.e. on data not used for optimization. Let’s have a look at the years 2020 until now.

Simple Forex Strategy Forward Test Results

This looks less promising (PF = 1.16, Exposure = 61%, MaxDD = 28%, CAGR = 28.2%). It now seems obvious that the strategy has good and bad periods. Probably, some added filter can improve performance (e.g., volatility or moving average filter). It’s also possible to look at other pairs or instruments in general, or extend the strategy to multiple time frames.

Conclusion

In summary, the combination of the Donchian Channel High and the IBS indicator can provide a simple yet effective currency trading strategy for short-term reversals at resistance levels. By leveraging the strengths of both indicators, traders can capitalize on short-term market dynamics and potentially increase their profitability. As with any trading strategy, it’s essential to backtest and validate the approach using historical data and apply proper risk management techniques to ensure long-term success in the markets.

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