Trading Strategies – Part 2

                
Majority of beginner traders would spend most of their time searching for a perfect entry.  They would form a strategy based on a few observations on chart patterns and then start trading, after one or two losses they would fine tune or switch to a new strategy and the process keeps repeating until either they have no more money to trade or they would find other excuses such as the market is rigged or being manipulated or I don't have time for it.

The market is unpredictable and full of random movements in the short term.  As a system trader, we don’t try to predict where it will go after we enter, the market will do what it needs to do, our job after entry is to know what point to exit, and it is the exits that determine our profits or losses!  Most beginners simply looking at the wrong place for the right answer.

In the initial stage, it is best not to limit yourself and explore as many trading ideas as possible.  After that, try to write down those ideas into a step-by-step formula or algorithm if possible, that is as clear and precise as possible.  Trust me; a lot of time you’ll find out that many good ideas is not really tradable when you try to program them.  For example, if you have a trend-following position strategy such as SMA crossover and you set your stop-loss point at 20 points trading FCPO, it just won’t do.  It is good on theory to take your losses when they are small, but bear in mind that small is a relative word!  If you use a simple 25 period ATR (average true range) to measure FCPO, the intraday range is about 50-60 points at the moment!  That means there is a very high chance that you would get stop out of your position at the same day you enter.  The best solution in this case is to use a percentage instead of a fixed price.  Of course there are many other ways, one of the famous one made popular by the turtles would be a factor of the ATR e.g. get out when the price hit 2 x ATR of your entry price.

I know, you would be saying are you nuts?  If the ATR (25) of FCPO now is 60 points that means you would only get out after you loss 120 points!  That is right, if you are a position trader.  Just imagine if your system has 5 consecutive losses over the pass 10 years of back-test, which is very common!  That would be 5 x 120 points = 600 point = 600 x MYR 25 = MYR 15,000!  And you wonder why a lot of retail traders blow out trading FCPO holding overnight position starting with MYR 10,000!  What is the lesson here?  Know the minimum startup capital needed for your chosen strategy.

Remember, a complete trading system must at least have a setup, entry, stop-loss, exit, and position size management.  Money management is about managing the size of losses as well as maximizing the profits.

What constitute a correct algorithm?  For traders trading their own account, the system must be able to enter when the market move according to your entry criteria, must be able to get out when market meets your exit criteria.

I will give you two different examples.  Let’s say you know that SMA is a lagging indicator, you want to use it as your trend-following strategy, but you have also notice that a lot of times after the crossover, the price is already too high (or too low for Short), a retest (a common process to shake-out the weak hands) will happen, and you set your entry rule to buy only on retest of the previous 3 day’s low (or previous 3 day's high for Short).  What is the problem with this perfectly logical rule?  The problem is, you may not be able to enter at all if there is no retest or the retest does not reach the 3 day’s low price!

Another example would be a triple SMA (10, 20, 50) crossover strategy.  You can have a strategy that go Long when SMA 10 crosses SMA 20 and SMA 20 is above SMA 50 and the closing price is above SMA 50 and to turn Short when SMA 10 crosses below SMA 20 and SMA 20 crosses below SMA 50 and the closing price is below SMA 50.  There is no problem so far.  But some traders decide to exit Short early with just SMA 10 crosses above SMA 20 and the closing price is below SMA 50. Now you have a problem.  As there will be instances where the closing price is maintain above SMA 50 when the SMA 10 crosses above SMA 20 and SMA 20 crosses above SMA 50.  What’s the problem?  Your system had just issue a Long entry signal but there is no exit Short signal yet!  How are you supposed to turn Long while still maintaining your Short position trading one account?  There is a conflict here, please don’t laugh, you can find the above said strategy (only different in the SMA period used) in a highly rated trading book!  The fact is, if you didn’t program the rules in and does your own verifiable back-test in excel, you would have thought that it is a very good strategy.  A lot of strategies seem very good on the surface but are not feasible when you try to implement them.

For step 3 & 4, using my previous example on the steps in designing a trading system, which is deciding on your trading strategy as well as putting it in a clear instruction, I will use the most common and quite often still among the best strategy which is a Simple Moving Average (SMA) crossover.  The rules?

1.   Go Long 1 contract at next day market open if closing price SMA (x) crosses above closing price SMA (y), if got Short position, buy 2 contracts.
2.   Go Short 1 contract at next day market open if closing price SMA (x) crosses below closing price SMA (y), if got Long position, sell 2 contracts.

It is that simple!  It is also a stop-and reverse system; meaning you will have open position all the time.

I will show you how you can do it on your own in MS Excel on my following posts. Until next time, good luck and happy trading!