Along with your other forex trading tools, consider evaluating your strategy mathematically. A number of mathematical tools can give you an objective analysis of your strategy or even provide a predictive advantage that will make a difference in your profits.
A forex guide calculates your profitable mathematical expectation (PME)—the mathematical probability that your strategy will yield profits rather than losses. This method is essentially a form of financial self-discipline, because it forces you to assess the risks and potential costs. If you calculated your values accurately and your formula renders a positive number, you have a positive expectation. Naturally, you should abandon a strategy with a negative expectation, but the higher the number, the better you can expect your strategy to perform. The value of this method, therefore, is in the discipline of evaluating your risks and critically testing your strategy.
The put-call ratio is a simple mathematical tool for gauging the mood of the market towards a specific currency. To use this tool, simply divide the number of traded put options by the number of traded call options. (More simply, you can use this as a fraction with the puts as the numerator and calls as denominator.) As the ratio goes up, it signals a pessimistic sentiment—traders expect the currency you are evaluating to go down. The value of this tool is that it lets you read the market’s mood objectively and respond as quickly as possible.
Z-score is a mathematical tool that helps you evaluate whether there are any trends in the pattern of your wins and losses. For instance, you might discover that your trading strategy generates wins and losses in streaks rather than randomly. This conclusion can guide your trading, making you more wiling to strengthen your position at the beginning of a winning streak or pull back at the beginning of a loss. The value of this method is in evaluating whether you should trust the hunch that your winnings come in streaks or if your winnings are actually random.
Implied volatility is a complex tool for calculating the expectation that a currency’s price will be volatile in the future. By definition, this tool has to assume a pricing model, which is the Black-Scholes model in the case of foreign exchange. Implied volatility is priced into the premiums for options, meaning that quiet markets offer lower premiums than markets with high implied volatility. Recent studies have demonstrated that implied volatility can helpfully predict price uncertainty within a short time-span—about a month. Beyond this, there are too many biases and uncertainties for the tool to be helpful. The value of implied volatility is in evaluating the amount of risk you accept by making a call. It is usually best to use financial software for this calculation. Consult a forex broker list to see which firms include this and other statistical calculations in their software.
Of course, these mathematical tools are only one part of the total package necessary for successful forex trading. There are other helpful models, such as Fibonacci retracement and pivot points, which are more of techniques than mathematical evaluations. But along with knowledge, experience, and discipline, mathematical analysis can make a successful trader even more successful.
Article courtesy of Forex Traders