Trading systems cointegrated forex pairs by volatility in two flavors: model-based and data-mining. This article deals with model based strategies. A significant market inefficiency gives a system only a relatively small edge. Any little mistake can turn a winning strategy into a losing one.

Developing a model-based strategy begins with the market inefficiency that you want to exploit. The inefficiency produces a price anomaly or price pattern that you can describe with a qualitative or quantitative model. The higher the predictive f term in relation to the nonpredictive ε term, the better is the strategy. Trading by throwing a coin loses the transaction costs. Not all price anomalies can be exploited. 16 fractions of a dollar is clearly an inefficiency, but it’s probably difficult to use it for prediction or make money from it. The working model-based strategies that I know, either from theory or because we’ve been contracted to code some of them, can be classified in several categories.

Trend Momentum in the price curve is probably the most significant and most exploited anomaly. No need to elaborate here, as trend following was the topic of a whole article series on this blog. There are many methods of trend following, the classic being a moving average crossover. The problem: momentum does not exist in all markets all the time. Any asset can have long non-trending periods.