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Wednesday, November 13, 2013

Which is more profitable: Continuation Inside Bars or Reversal Inside Bars

What are inside bars

For the benefit of anyone who may not have heard of it, an inside bar is a bar (or a series of bars) that is (are) completely contained within the range of the preceding bar. The inside bar has a high that is lower than the high of the previous bar (aka the mother bar), and a low that is higher than the low of the previous bar . Some traders use a more lenient definition of inside bars to include equal bars (bars with equal highs and/or equal lows).

Psychology Behind Inside Bars

Inside bars typically occur after a large directional move, and reflects a balancing of sentiment between bulls and bears. This balancing of sentiment may indicate that the previous trend is running out of steam and price is ready to reverse, or it may simply indicate that price is consolidating before continuing in the same direction.
After a large sustained move, traders tend to adopt a wait-and-see attitude, and neither bulls nor bears are willing to bid above or below the previous day’s extremes. When traders finally make up their minds, volatility increases and price will either reverse or continue in the same direction. Either way, when price breaks out from an inside bar formation, it indicates that traders have enough conviction to push prices in their desired direction. A breakout from an inside bar formation is like a vote of confidence from the traders. They’ve pondered over which direction they want price to move, and have cast their votes with their money.

How to Trade Inside Bars

In this post, we are interested in investigating the profitability of trading continuation inside bars vs reversal inside bars. Are inside bars more reliable when they signal a reversal, or when trend continue in the same direction? I’ve written an inside bars EA to test this.
In this EA, I define reversal as a breakout of the inside bar in the direction opposite to its previous trend. The previous trend is defined using a 20-Days moving average. If price is above the moving average, it is in an uptrend. If it is below the moving average, it is in a downtrend. Therefore, a bullish inside bar reversal is defined as a break above the high of the mother bar when the mother bar is BELOW the moving average. Conversely, a bullish inside bar continuation is defined as a break above the high of the mother bar when the mother bar is ABOVE the moving average.
For exit, I used a 3 ATR trailing stop. In addition, I used an averaging up strategy that adds a new position whenever price moves 1 ATR in my favor, up to a maximum of 4 positions. All tests were done on daily charts, from Jan 2001 to Oct 2012, with a 1% risk on each trade and an account size of $100000.
So, what did I find?
Comparing Profits and Max DrawDown of Reversal and Continuation Inside Bars
DD: 27.05%
DD: 39.29%
DD: 33.77%
DD: 51.68%
DD: 46.83%
DD: 23.21%
DD: 33.05%
DD: 37.79%
DD: 32.87%
DD: 40.51%
DD: 37.28%
DD: 34.8%
REVERSAL inside bars are much more profitable, at least for 5 of the pairs. This means that more often than not, an inside bar indicates that the previous trend is running out of steam and ready to reverse. In addition, the maximum drawdown for reversal inside bars is also lower in 4 of the 6 pairs.

How can you apply this knowledge to your Forex Trading?

For one, if you trade inside bars, you can choose to trade only when price reverses. Alternatively, you can choose to take both reversal and continuation trades, but use a tighter stop or smaller profit target for continuation trades.
Secondly, even if you are not trading inside bars per se, you should still be alert to their presence. If you are currently in a profitable position, consider tightening your stops because an inside bar is a warning signal that the current trend is likely to reverse.
Either way, make use of this test result and incorporate it into your forex trading strategy. Then backtest your strategy and see if it improves your results.
That’s all I have for you today. Cheers and trade well!

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