Making a 2+2 trading system

[kimchi]

I’ve found a stock (RGU) which looks to have some nice swings. Notice that this would be refered to as a "penny stock" in the US. It's currenctly trading around 80 pence. Penny stocks are sometimes avoided for various reasons in the US, but the price of a stock isn't really so relevant outside the US. Blue chips can be priced below a pound.



There was a nice uptrend beginning after the tech meltdown and lasting until Q2 2005 when it entered quite a wide trading range until the recent summer volatility during which is has tanked. This is a weekly chart using a daily scale, but markets are fractal allowing me to illustrate a basic concept.

I’ve drawn a basic trend line with channels either side 2 std devs away each side from the main trend. This is easy to do in the middle of the chart, but I’ll look for effective ways to quantify (or at least qualify) the trend and the channel when thinking about set-ups making it less ambiguous at the right edge of the chart.

I’ve drawn green circles around oversold (value) areas of the uptrend and red circle around overbought areas. The old adage “the trend is your friend” can be illustrated with this market trend. Assuming 2 trades in either direction:

Long:
2 – 3 (35p to 70p) = 35p move
4a – 5 (75p to 105p) = 30p move
TOTAL 65p

Short:
1 – 2 (45p to 35p) = 10p move
3a – 4 (75p to 55p) = 20p move
TOTAL 30p

So trading with the trend gives more than double the potential rewards here. Obviously only a fraction of each swing can be caught and perhaps most trades will lose money, but the basic concept remains valid.

This means I will be filtering out shorting signals during uptrends and long signals during downtrends. – Another basic fundamental but very important concept.

This stock appears to be following an Elliot Wave pattern during this uptrend. 1-2-3a-4-5a followed by the first retrace of the down-leg (a). The final leg (4a - 5a on this chart) being the most tradable move - but I’m not going to concern myself with market cycles at this point.

This next chart zooms in to the upleg 2 – 3 on the above chart.



Again there is the solid blue line representing the underlying trend with blue dashed confidence lines 2 standard deviations away – easy to draw in hindsight. This time I’ve overlaid a black 13-bar exponential moving average (EMA13). This EMA is enveloped by a channel drawn by shifting this EMA 20% in either direction. This isn’t a Bollinger Band as we are not yet concerned with volatility, but this EMA envelope can be modified later so that volatility data is used in its construction. Notice how wide this envelope is. The distance between the top and the bottom of the envelope represents approximately 40% of the value of the market, yet it contains around 90-95% of the market’s prices. An equity index’s envelope by comparison, might only be as wide as 4-5% of the market. A market with a wide trading envelope represent a bigger target from which we can extract profits with less room for error and a lesser impact from trading costs.

We can better see a similar patter being played out on a smaller scale. 3 legs up with 2 retraces in between. I haven’t labeled these #1-#5 as the chart is already a little cluttered. The green circles again show areas of value in an uptrend and the red circles show areas where the market might be temporarily overbought. The blue ovals show brief areas of potential consolidation which might lead to whipsaws and getting stopped out of losing trades. We can look for ways to limit these losses and potentially eliminate them to some degree through the use of filters – can be discussed further in the ‘set-ups’ sub-thread.

I think we need to be looking for entries in the green areas (below the EMA in an uptrend), looking for exits in the red areas (below the upper envelope in an uptrend) and looking for ways to preserve our capital in the blue areas (when the short-term trend become undefined).

Please make any suggestions that come to mind.

[Mr. Now]

kimchi,

I am watching this with some interest. You might want to set some parameters that limit your scope, focus your attention and simplify the universe of options. For example, you might decide to go with

1. Long equities no margin;
2. Selecting only stocks with 1B or more marketcap, selling for more than $10 and avg volume of at least 500K shares a day.

This criteria eliminates shorting, options and thinly traded stocks. I do believe that a trader must get experience beating long-stock without margin before getting fancy. I know this from first-hand experience.

You appear to have done considerable homework. You seem to have an good grasp on many important trading concepts. Given my impression of your study in trading, I am surprised to see that you are apparently thinking about zeroing in on one equity instrument.

Using such an instrument exposes you to the temptation of over-optimizing your system parameters, potentially leading to all sorts of trading tragedies.

Truly robust systems work well using a very narrow range of 'optimal' parameters tested against a great many instruments. Such systems allow you to screen for potential longs that exhibit a sought-for chart pattern or price-action state. The instruments that come through the screen often provide the dividend of helping to identify promising sectors that are on the way up. For example using a screen for specific chart states often reveals several issues in the same sector that exhibit that state.

The book New Trading Systems and Methods 4rd edition by Perry Kaufman is an excellent resource for more information on this and many other essential system construction concepts.

Book:Trading Systems and Methods

[kimchi]

[ QUOTE ]
Aside: I never understood the idea of "forward testing". It is just the slowest possible way to do backtesting: later.

eastbay


[/ QUOTE ]


I meant more about splitting data into chunks and doing separate test on each.

Yeah, I wouldn't use forward testing for strategy testing so much. I think forward testing is more useful to see how you get along with actually using your system day to day. For example, I spent some time backtesting some ideas on The US markets only to discover during forward testing that my broker didn't allow the movement of guaranteed stops outside of market hours. And US market hours didn't fit into my normal daily routine.

Or maybe searching, screening, filtering, datamining and entering/adjusting orders is proven to take too much time.

[ QUOTE ]
You appear to have done considerable homework. You seem to have an good grasp on many important trading concepts. Given my impression of your study in trading, I am surprised to see that you are apparently thinking about zeroing in on one equity instrument.

[/ QUOTE ]

I'm not thinking about trading a single market, and certainly not necessarily RGU. It's just that RGU exhibits some of the qualities that I feel might suit this type of trading. I think we can discuss markets and trading vehicles more later in a 'markets' sub-thread.

Hopefully, the forum will suggest a basket of (perhaps lowly/non correlated) markets to try and trade after we've made a list of criteria needed to be condidered before a market is included in the system.

[ QUOTE ]
Truly robust systems work well using a very narrow range of 'optimal' parameters tested against a great many instruments

[/ QUOTE ]

I intend to do some testing using the same parameters across different markets which will include some stress conditions (ie - 10/1987, bond/debt crises, 9-11, etc)

[ QUOTE ]
The book New Trading Systems and Methods 4rd edition by Perry Kaufman is an excellent resource for more information on this and many other essential system construction concepts.

[/ QUOTE ]

Thanks for the suggestion. I have a few of Kaufman's books on my bloated Amazon wishlist but I've only read some articles and such, and never a book. I have tried to incorporate his adaptive moving average into some systems without successs. I suppose I should just read more about his ideas in his books. I think his adaptive MA is one of those fantastically simple ideas which I've been unable to implement. I actually spent a long frustrating, fruitless time trying to develop my own AMA before I realised it had already been done before - Doh!

[kimchi]

Here’s another chart. This time a forex pair (GBP/CAD) showing a transition from a long term uptrend to downtrend earlier this year.



This time I’ve overlaid a longer EMA (70) to illustrate the medium-term trend, which might help us to trade in the direction of least resistance. It’s blue during uptrends (when the previous bar’s EMA value is below the most recent value) and red in downtrends. I have the same EMA15 with an envelope, but this time an envelope shift of 1.5% away from the EMA15 is enough to enclose most of the recent prices. Compare this with the 20% shift needed for the volatile mid/small cap stock (RGU) discusses in my previous post.

So again, we have 2 good potential trades. Point 1 to 2 shows a similar entry/exit area as before, but then there was a change of trend which prevented us from looking for longs as the trend was down, according to the EMA70. Area 6 – 7 shows a good potential trade from the short side.. Notice how we would have covered our short just inside the lower envelope (around 2.26 to 2.22 – a decent profit) preventing us from following the downtrend to around 2.08 – a huge move lost. We may have had other opportunities to enter the trade, but this illustrates a psychologically difficult part of trading. Watching as some big fish get away is tough, but if that isn’t part of your objectives or part of your trade plan, then you must be satisfied with just making a correct trade. Save following trends for another system.

Points 3,4, and 5 are the tricky areas. They would probably have made us enter positions destined to be losers as they were in the middle of a transitioning trend as EMA 70 changed from up to down trending. This creates nasty, but often unavoidable, whipsaws. These losses can be limited though careful use of stops, exits, and/or applying some filters. This is a good example of the importance of getting your stops and exits right. Filters remove some opportunities to trade but hopefully leave the cream of the set-ups to trade. These can be discussed later, but a quick look at the chart suggests a few possible filters. For example, if the entire bar is below the short term trend (EMA15) during an uptrend (blueEMA70), then stand aside – and vice-versa. Or another one – The long-term trend needs to be a certain strength before a trade is taken. There are ways to objectively quantify the trend strength.

These ideas can be discussed later but illustrate the 3 market states; up, down, sideways, and hopefully the 3 trade positions you will match to the market state; long, short, stand aside. Trying to incorporate these concepts into a simple system is difficult.

[Mr. Now]

You are on the right track about using price and volume as indicators over 1st and 2nd derivative indicators and oscillators.

Here is an idea:

0. Settle on the value of N and determine when the N-day trend of the S&P is 'up'. Use simple MA values or even simpler compares (if current price is higher than N-ago price).
When the trend is up by your measure, proceed to next step.

1. For the set of all stocks with price > 10
and daily average volume > 500K
and market cap >= 1B

a. If close is > (1.3 * close from X days ago ) //price is 30% up in X days
b. and close is <= (Y-day MA)and close is >= Z% below Y-day MA //price is at or slightly below Y-day MA
c. and Y-day MA is >= (1.2 * close from ((X * .80) days ago) //price is 20% up in (x * .80) days

..Then consider for purchase. This is a starting point. It narrows the universe down to a small list of stocks that:

a. Are trending higher in both X days (30% or more higher) and X*.80 days (20% or more higher)

The hi-order filter (Step 0) limits your universe of stocks for consideration.

The lower order criteria selects stocks that are trending higher but for some reason are challenging the trendline treshhold you define.
Stocks that are doing this while the market is trending higher may be mispriced temporarily.
The risk characteristics are good because a tight stop can be placed very close to entry.

This is just the beginning of a decent robust trend-following system concept.
It buys strongly trending stocks that are threatening to violate a major trend line,
at a time when the market overall is trending higher. It allows a tight stop, since you
are buying at a spot where the instrument is likely to bounce.

I notice that this approach is good at selecting candidate longs when the overall market is trending higher.

I also notice that this approach is- somewhat suprisingly-- good at selecting candidate SHORTS when the overall market is trending lower.

Here are the candidate names generated from this screen, as of yesterdays close for the following values:

X = 300 (EMA)
Y = 60 (EMA)
z = 5

PDA PTR PKX SDA BBL LFC BTM

Thus the universe of over 8000 USA names is reduced to 6 or 7 promising names.
Note that when the overall market is in a strong period, the list shrinks and may have zero members.
When the overall market is in a weak period, the list of names tends to grow.

yahoo link:
http://finance.yahoo.com/q/cq?d=v1&s...DA+BBL+LFC+BTM
Date of screen, and this post: 11/30/2007

Keep in mind that the market may not be in an uptrend as of 11/30/2007; that depends on your subjective value for N.
Looking at the names and industries can often help you ID promising sectors as well.

This is a very simple concept and a mere 1st-step starting point.

However, looking at the names and charts and industries of these instruments
may be interesting to some readers.

[kimchi]

That looks like a good set-up for a longer term system. I'll have a proper look at your screen tomorrow when I have more time.

I've just had a look at the chart for the first stock you mentioned: PDA




If I understand it right, you are buying short-term value in a longer-term uptrend. Maybe a little similar to what I've been working on above - but using a much longer timeframe.

I think the exits on longer term systems pretty much decide whether they are workable or not. They are so difficult to get right and I think giving up some EV is sometimes worth making them easier to trade.

[ QUOTE ]
he risk characteristics are good because a tight stop can be placed very close to entry.

[/ QUOTE ]

I'm wondering about your entry here. I always think it's best to find a long entry above the market with the intention of getting stopped in as/if the market moves in your expected direction. If the market retreats and fails to trigger your buy-stop, then this stop is simply lowered to the new latest high. This allows for tight stops, depending upon the timeframe you're using. I've highlighted a possible placing for a buy stop - just above the last high. A stop loss can be placed just under the last bar's low or under a low of previous bars depending on how long-term you want to trade this market. Obviously longer term stops will mean higher risk trades but potentially higher rewards if you give the stock a suitably wider trailing stop or some other looser exit.

Using stop loss 1 ($45.50) and assuming an entry around $49, then we have $3.50 per share initial risk. Quite high, but not for a volatile stock like this. I like to incorporate average true range (ATR) into calculation of stop placement as a temporary contraction in volatility can otherwise mean placing relatively illogical stops.

I've also highlighted another interesting bar I'm currently trying to work into another system. Pin bars often signal reversals in the opposite direction of 'Pinocchio's nose' and this stock shows an excellent example of that on 16th August.

[Mr. Now]

Here are the instruments generated by the screen described, as of Friday's closing prices:

NOV PTR PKX PCU LFC

[Uglyowl]

Sorry for the somewhat sloppy nature of my post, I see we are both commodity plays although different ones. How does your screen backtest?

For my relative strength #'s, I am using below 2 for my long, the higher the # the less profitable, but still good #'s.

Currently the long screen is really quiet with only a few commodity plays: USO, CFC, OIL

Close reached a new 5 Day Low
and Close above MA(50)
and Close above MA(200)
and RSI(2) below 2
and Close above 10
and average volume(30) is above 25000

---------------------------------------------------

For shorts I have alot more, the most I think I have ever seen going back a few years! The last 9 times (as far as I went back) that there have been 5 or more that met the criteria, 8 times the S&P was down 4 days at an average of 0.74%

CRH
GVA
HIX
HUBG
IMKTA
MINI
MQY
MUS
NAD
NIF
NPT
EAD
JPC
JPS
BMTI
NZF
FHY
HYT
HPS
FHI
FRB
BAC-W
KEY-E

[Uglyowl]

[ QUOTE ]
1. Long equities no margin

[/ QUOTE ]

I looked at my last 4 months of trading and my short trades have been horrible, "Right stock, wrong time" seems to sum up this aspect. Why is it so hard to get shorting correct?

Awful November wiped out my large gains of my last 3 months and back to square one of figuring this out. It was too easy for awhile!

[kimchi]

[ QUOTE ]
[ QUOTE ]
1. Long equities no margin

[/ QUOTE ]

I looked at my last 4 months of trading and my short trades have been horrible, "Right stock, wrong time" seems to sum up this aspect. Why is it so hard to get shorting correct?


[/ QUOTE ]

I think it is quite different to shorting futures or the like due to their upward bias. Even shorting futures is less EV than going long.

What methodology are you using for trading? I find that equities break quicker than they go up and a different technique or method is needed. I tested some long-term trend following systems on a basket of international equity indexes over 10 years or so. I managed an expectancy of $0.30 per dollar risked on the long side but only $0.08 on the short side - and this included the long bear market that started in 2000.