Trading Strategies - Part 1

               
The 2nd step in the systematic trading systems design and testing phase is to read and really understand as many trading strategies as possible.

To use our earlier analogy, the car that you design and build for the race would be your trading system.  What type of car do you want to build?  How do you put those pieces together?  Does it work on grass or uneven roads?  Immediately we can see that it is more of an art rather than science and is quite complex!  Everyone would have different taste on things that they want to put on their car, there is no one size fit all solution again!

However, my general guideline would be to focus on winning the race!  Beautiful car (on concept or in reality) but mediocre performance will not work.  What type of road conditions do you expect most of the journey?  What type of different weather do you expect?  What about your own strengths and weaknesses?  Are you fast at night or day time, on tar roads on sandy one, fast at corners and winding roads?  Perform better when it rains or hot and dry conditions?

There are so many different trading strategies exist at the moment I can’t possibly discuss them all.  However, it is best to have a few different strategies that would take advantage of the different market cycles e.g. trend-following, counter-trend, for sideways and congestion such as mean-reversion, for spreads such as mean-convergence etc.  Please remember that there is no secret strategy that would be able to consistently take advantage of all the market mispricing all the time!  There is always a trade off.  Usually a strategy that is good on one type of cycle would be bad on others.  Your task is to find a strategy that you have confident in trading and to find the balance so that it would not perform too badly on the cycles that it is not designed to capture and to maximize the profits when it perform well.

For example, if look at trend-following strategies, they usually have a % of winning trades that is below 50% (some about 30%) but they make it up in the average profit per trade of usually more than twice the average loss per trade.  Whereas in counter-trend strategy, usually the % of winning trades are higher than 50% (some about 70%) but the average profit per trade is usually much less than average loss per trade.  Improving one measurement such as % of winning trades would usually suffer on the average profit per trade.  That is life; you gain some you lose some!

Try to use the simplest strategy such as Simple Moving Average as your benchmark to compare the worthiness of your new strategies.  For those of you that have experience, you would definitely think that SMA is only use for trend-following, but as I will show in my next example, we can also use SMA as a counter-trend trading strategy, and quite a good one as well.

Please make sure that for every strategy that you are interested in, you can objectively put them into clear rules that anyone who read it would be able to take the same signal and execute the same order as you design it to be (forget about slippage first).  Leave all the subjective judgments, opinions and guesswork behind.

Therefore if you are a systems trader, a lot of chart patterns such as double top, head-and-shoulders, cup-and-handle, support and resistance, flags and pennants, triangle, wedges, wave count etc can’t be used (not that they are not good) unless you can define them clearly and be able to program them!  The task is definitely not for beginners!  This process is actually quite useful in detecting the charlatans who always use vague strategies to fool beginners.  Those strategies always look very good on paper but useless when you want to apply in real trading.

A good book to start would be The Encyclopedia of Trading Strategies.  If you want to know almost all the common technical indicators (over 100), their algorithm and back-test performance summary then you can refer to The Encyclopedia of Technical Market Indicators, 2nd edition by Robert W. Colby or go to the chart school section of stockcharts.com and refer to the Technical Indicators section.

The general strategies that a beginner can use to design their trading system would be (in random order) SMA crossovers, EMA crossovers, Oscillators such as MACD, RSI, Stochastics, ADX-DMI and CCI, Parabolic , Pivot points reversal, Donchian channel breakout, Volatility based breakout e.g. Bollinger Bands breakout, ATR (average true range) breakout.  You can add in the comment section if you think I have left out some good programmable strategies that would benefit beginners.

Please take note that technical indicators are just the ingredients, it is how you use them that defines your strategy.  So, again there is no such thing as good or bad indicators!  It is how you deploy them that counts.  You could also create more complex strategies by mixing and matching different indicators, however please bear in mind that complexity doesn’t equate robustness and efficiency.  Sometimes simplicity is the best policy as there are fewer variables that will cause the systems to break down or to maintain!