Something happened on the way to Alpha....

So there you have it. You have spent days, weeks or even months designing, testing and re-testing a winning trading system for EUR/USD. It looks great on paper. You test it on 10 other markets in different asset classes and it 'makes money' on 7 out of 10 of those markets, albeit with varying degrees of profitability. You then 'traded' it on a demo account to generate 30 or so closed out trades and were satisfied with the results and then on a real account in small size without seeing a significant degree of variation from the demo account results. Now you're ready to go 'head to head' with the Great and the Good of the investment community.

The week on which you choose to unleash your money machine happens to include 'Big News' events such as the ECB governing council meeting as well as the release of U.S. Non-Farm Payrolls data, both of which have historically seen the pick-up in volatility on which your system really thrives. A sell signal is generated on the morning of the ECB announcement and is 'filled' right after the speech begins. Here we go!

Your system, being the embodiment of risk control, places a stop loss 1 pip above the intra-day high because test results prove that on this system, a new session high (low) for a short (long) position would negate the trade and most likely indicate higher (lower) prices to follow. Profit target levels are placed at price points only one can dream of below the entry price and now you wait to ring the cash register.

As the speech gets underway the market does indeed become volatile, so much so that your stop loss gets 'taken out' as the speaker makes a positive (for the Euro) statement presenting you with a loss. While a little disappointing this is an 'acceptable loss' and 'all part of the system' as only a small percentage of the account was at risk and one has to move on to the next trade. In the words of Freddie Mercury, "The Show Must Go On". The tone of the statement then changes and the market reverses course on a sentence that indicates a major change in monetary policy which has negative implications for the Euro and so EUR/USD collapses, hitting all of those outlandish targets your system generated only a few moments earlier. Lovely....

As the market was illiquid during the speech the price movements were exaggerated to the point where brokers had to (or were able to) execute stop orders at prices far beyond levels where their clients had placed buy stop orders, in many cases flirting with the bounds of morality. While this so called 'slippage' is seen as a necessary evil in trading the problem on this occasion was that the price feed on the charting package which generated the buy and sell signals did not reflect that the stop loss was actually filled, presenting the system trader with the nightmare scenario of a system trade which should have made a large amount of money actually taking a loss.

Clearly one could avoid such pitfalls by avoiding trading on Big News days completely but why miss out on all of that profit potential which ultimately feeds into that nice-looking equity curve? The system trader is torn between two opposing forces of following one's system 'to the letter' and the reality that short-term price dynamics on highly volatile days can be influenced by external forces for a long enough time to interfere with the operation of the system. What to do?

For me the best way to deal with these 'curve balls' is to trade in half the normal size on such days but using a stop loss price level which reflects a loss of twice the normal size, thereby keeping account risk constant. Sometime after the news is out, should the system still hold the position and the market is trading close to the system entry price, one can add the other 50% and then move the stop loss to the correct price level. The worst that can happen is that the market moves too quickly to one's target levels before the rest of the position can be opened, thereby producing half of the normal profit the system generates. That said, making 150 pips on any given trade can't be such a bad thing, right?

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