Thursday, October 25, 2012

USD/JPY: A trading-rules ambiguity

The currency exchange between the U.S. dollar and Japanese yen (USD/JPY) has uncovered an ambiguity in my trading rules.

You can read the rules here, accompanied by a discussion of why I set things up as I did.

The problem is with the exit test using the relative strength index (RSI), a popular momentum measure.

The RSI divides its field into overbought when the indicator is above 70 and oversold when it is below 30. The rule is that when the indicator drops out of the overbought or oversold region back into the neutral ground between 30 and 70, that's a signal to sell.

I've adopted that for my own trading as an over-ride for the other exit rules, with my usual half-hour delay before acting on the signal, just in case it's a momentary head-fakie.

The indicator on the USD/JPY chart moved into over bought territory on Oct. 22, the third trading day after it had moved above its 20-day high, producing a bull signal.

Two days later, on Oct. 24, it dipped below the 70 mark, producing an exit signal. So far so good. The indicator was below 70 for more than half an hour, so it was considered valid under my rules.

Today, however, the RSI reversed course, rising to 74 (so far).

Remember, under the rules, I closed the position yesterday. So what do I do today?

I see two reasonable possibilities:

I could re-enter the trade -- the Turtle bull signal remains in place.

But that would set up the possibility of a series of trades in and out as the indicator bounces along the 70 level. That could get expensive quickly, since each transaction costs me the difference between the ask price and the bid.

Or I could stay out, and not re-enter USD/JPY on the bullside until it produces a classic Turtle sell signal by falling below the 10-day low price. Basically, this adds a rule forbidding new positions when the RSI is in overbought or oversold territory.

But sometimes the RSI jitterbug along with a series sell signals as the price continues to move a considerable distance. That rule could impose a huge lost-opportunity cost.

And the third possibility is to allow entry, but with a barrier. And there are several possible barriers.

Time: For example, I could use time, requiring that the RSI remain overbought or oversold for two days before I re-enter.

Level: Or I could set up a indicator level barrier, raising the over bought level to 75 or lowering the oversold the 25, making it more difficult for the indicator to break through again.

Trend: Or I could set a trend barrier -- no re-entry unless the RSI sets a higher high compared to its previous peak.

On the USD/JPY chart, it will have met the Time barrier of two days above 70 at 5 p.m. Eastern today, assuming it doesn't drop in the next few hours.

It is still at this writing about half a point shy of meeting the Level test, standing at 74.51.

And it has met the trend test. The high point on Oct. 22 was 73.48, and today's high point is 74.51.

I dislike the Level barrier because it is arbitrary -- what makes 5 points a magic number?

The Time barrier suffers from the same flaw.

The Trend barrier, however, is intrinsic to the chart action, and I think that's where I'll go for now, with the added provision that the price must be beyond the 20-day extreme. USD/JPY meets the latter test, as well.

And to be clear, I'll treat this as a new breakout beyond the current 20-day extreme, with an initial one-unit position added to incrementally according to my rules. It is in no way a reconstitution of the old position.

I've bold-faced the new language; it's near the bottom of the rules.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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