A trading strategy is a predefined set of rules that a trader has developed to govern his or her trade. The development of a trading strategy gives the trader the following advantages:
- It removes emotion from trading. The trader using the strategy knows what to do depending on what the market is doing. A trader who has no strategy tries to make decisions when the market is open and becomes emotionally attached to positions. He may panic and hesitate when the market moves against him because he does not have a prepared answer.
- – Saving time. Developing a trading strategy that has the edge is hard work. However, once the rules are developed, they can be easily automated to free the trader from having to watch the chart all day and provide time to develop a further strategy.
However, developing a trading strategy that is effective can be a daunting process. There are computer programs (such as TradeStation and WealthLab) that automate the process. Unfortunately, the ease with which systems can be designed and optimized using these programs can be confusing for the unwary trader. The strategy should be built around some kind of statistical advantage. This is an advantage that will last for a long time and create positive cash flow for the system and the trader.
In this article, which will be published in three parts, we will look at each stage of the process of developing a trading strategy, from identifying a possible advantage to writing a trading plan. Along the way, we will be developing a simple intraday trading strategy for the Dow Jones Index.
Conditions for opening a position
So, we decided to develop a system for intraday trading of mini-futures on the Dow Jones Index. Next, we need to define the characteristics of the market that can provide a statistical advantage in order to shape the conditions for our trades.
The conditions for opening a position (setup) is a standardized set of conditions that we will use to determine a potential trade. After determining the characteristics of the market, with which we want to get an advantage, the conditions for opening a position can be obtained. Let's take the following example.
We see that 1/3 (33%) of the reviewed days set a high or low within 15 minutes from the open, more than 2/3 (69%) – within 1 hour, and more than 90% – within 3 hours. This looks statistically significant. If we trade high or low breakouts after 60 minutes with a stop outside another extreme, then we know that the stop will not hit 69% of our trades. However, we need to examine our data more closely, as it may be that most of the day's move actually occurs in the early period, leaving very little room for our trades to turn into profit. So let's take a look at the opening range as a percentage of the total range of the day:
We must assume that the daily range percentage determines our stop since this is the point where our reason to be in the trade (breakout) disappears. Our potential trading profits are determined by the balance of the day's range. For example, for 30 minutes, the stop loss is triggered on 33% of the days, leaving 67% of the days for potential profit. We can also see from the first table that we have a 46% chance that the stop will not be hit.
From these numbers, we can calculate the maximum possible expectation (the average sum of the percentages of the daily trading range that we capture) using the formula:
Maximum expectation = (Pw x (1-Al)) – ((1-PW) x Al)
Where Pw = percentage of days where the stop is not hit, from the first table.
And Al = stop as a percentage of the total range of the day, from the second table.
We see that the best combination of open range and profit potential is 135 minutes, where we can expect to capture an average of 28% of the day's range. It should be remembered that this is the maximum possible profit since at the moment we believe that we close the deal at the second extreme of the day, that is, exactly on the high or low.
The purpose of this exercise is to prove that a range breakout from an open has the potential to form the basis for a trade. From the third table, we can see that each testing range has a positive expectation and that the difference between the breakout of the range of the first hour and the first 3 hours is small. The percentage of triggered stops decreases, but the potential profit also decreases. This means that the difference between trading the breakout of the first hour, the first three hours, or something in between is very small, and the maximum potential falls on 135 minutes (from 9:30 am to 11:45 am), so we will use it.
Login rules
We now have trading conditions and we must decide exactly how we will enter the market after these conditions appear. The conditions for our strategy are very simple, we will wait until 11:45 a.m. and then go long (buy) if the high of the opening range (from 9.30 to 11:45) is broken, or short (sell) if the low is broken. range from opening. The easiest way to set this up is to place a buy stop order in the market 1 tick above the high of the range and a sell stops order in the market 1 tick below the low of the range.
Let's take a trading day on January 2, 2004, as an example. The open range sets a high of 10510 at 10:58 am and a low of 10462 at 10:00 am. At 11.45 we place the following orders:
Buy stop at 10511
Sell stop 10461
When the market hits one of the stop orders to open a position, we will leave another stop on the market as our initial stop loss. If the stop loss is reached, then our reason for being in the market will be gone.
Our entry rules are pretty simple, but we could look at how they change in two ways:
- We could wait for a few more ticks after breaking the opening range before opening our trade. For example, we could put our stop at 5 pips behind the high and low of the range, in the January 2, 2004 example, this would be a buy at 10515 and a sell at 10457. The point is to protect against the market only hitting the stop at high or low of the day and then come back. We can view this theory by looking at the maximum favorable move (MFE) for each trade, that is, the maximum move in our favor during the day.
The table shows that in 2 cases the market hit our order and immediately returned, which cost us 40 points in total at the end of the day. To avoid this, we could have a 2 pip trigger instead of 1 to enter the market. However, there are 109 trades in total, adding 1 pip to each market entry will cost an additional 107 points for the remaining trades and a net loss of 67 pips.
We can conclude that waiting for more than 1 tick to enter a trade reduces the overall profitability of the system.
- In addition, after the conditions for entering a trade are met, we could wait for a pullback before entering a trade. For example, on January 2, 2004, after the 10462 low is broken, we enter, say, 5 pips better at 10467. The danger here is that we may miss the biggest moves if the price does not return, however, we will earn points on the trades we get. We need to study the maximum move against our entry price (MAE):
The table shows that in 6 cases the market did not retrace more than 1 point back from our entry point and these 6 trades gave a total of 348 points of profit at the end. If we had waited for a return of just 1 pip on each trade, we could have kept 103 pips (assuming the limit orders were filled) and a net loss of 245 pips.
We can conclude that waiting for a return before entering the market lowers the overall profitability because the most profitable trades are skipped.
