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Trading as a Business:
The Art of Strategy Design - In Practice
By Charlie Wright
Let's walk through the process of creating a strategy discussing the steps along the way. I think we should be able to develop a strategy using the up key reversals (UKR) that I pointed out in the last chapter. If you recall, we had looked at a full chart of UKRs and realized that there was more substance there than we had originally thought. UKRs were not only at bottoms but occurred all over the chart. I have reproduced the chart as Chart 1 below.
The first question we will ask ourselves is what type of strategy are we trying to create? Will it be a trend-following, support and resistance, or volatility expansion strategy? In this case, I will choose to create a volatility expansion strategy, making the assumption that with a UKR will come an increase in volatility that will last for a few days. We could also try to create a trend-following strategy based on the UKR as the long entry and a down key reversal as the short entry, but you can try that on your own. For this example, we will stick to a volatility expansion strategy based only on the up key reversal.
So at this point we have chosen the market type: volatile. For our time frame we’ll choose daily charts. We have designed and charted the indicator (UKR) and written the criteria as a ShowMe study (Chart 1) and have started to modify our thinking based on what we saw in the ShowMe study.
Now let's test the UKRs knowing that there might be some problems we will find along the way. Our set-up will be the UKR itself. The current bar’s low lower than the previous bar, and the close higher than the close of the previous bar.
For the entry, we want to start with something that meets our two entry rules. First, our entry must force prices to move in the direction of the set-up (in this case up). Second, our entry must guarantee that we get in the market after a UKR (we won’t miss a move after an UKR). We could justify a market on close order because the close is in the direction of the set-up, but I always try to use a breakout entry with a stop order. So I chose to force prices to get us long with a buy stop one tick above the high of the UKR.
I write this signal so that the breakout must occur on the day following the UKR, reasoning that if it did not, the volatility has diminished and that I didn’t want to be in the trade. The result is that if we are not filled on the following day, we will have to cancel the order, and wait for the next signal.
We also need an exit for this strategy. A volatility expansion strategy is not in the market all the time, and it is not a reversal strategy, so an exit is necessary. As I view Chart 1, it looks as if we might make a profit by exiting the market on the entry day at the close. A significant number of these trades look as if they will make money. SPF 1 outlines the parameters of this strategy. Strategy Parameter File
At this point, we will test this on the S&P futures. I have not used any slippage and commission, although please note that I always recommend at least $100 for this cost. I keep an eye on this cost by watching the profit per trade results on the Performance Summary, and I always put it in the last test of the strategy. PS 1 shows the results of this strategy.
This obviously was unsuccessful. The only way we are going to find out what went wrong is to look at the chart. We need to scroll through the trades and look at the execution to see what is going on.
Out of the ten trades shown on Chart 2, I count four winners, with only one being very profitable (mid-February). In several cases, had we held on for a few more days, we would have made more money. It looks like the exit may be the problem. Also, remember from our previous discussion that we were concerned about taking all of the trades, that we wanted some sort of filter to ensure that the market was in a downtrend before we used the UKR.
So we now have two things to try as we attempt to improve the strategy. The first is varying the length of the holding period, and the second is filtering the signals themselves so that the market is in more of a downtrend before we use a UKR.
First, let's look at making sure that the market is in a downtrend before we take a UKR. To do this we require that instead of the low being lower than the previous low, we will require that the low be lower than the last 10 lows. Using a two-week low rather than only the previous day’s low should make sure that the market is in a downtrend.