Better To Buy Strength Or Weakness?

[jswanson 10]

Emotionally it's a lot easier to buy on strength than to buy into weakness. Buying into a falling market feels unnatural. Your instincts warn that price may continue to fall resulting in lost capital. On the other hand buying when the market makes new highs feels more natural. Price is moving in your direction and the sky is the limit!

 

However, what feels natural or easy is often the opposite of what you should be doing. In this post I'm going to compare these two different trading strategies on the S&P E-mini futures market and see which one produces better results.

 

I created two simple trading systems in EasyLanguage. Both systems will go long only. Both systems will utilize a 200-day simple moving average (SMA) for an environment filter. Long trades will only be opened if the closing price is above the 200-day SMA. All open positions are closed at the end of the 5th day. No commissions or slippage will be deducted for these tests. The tests were all executed on the S&P E-mini futures market between September 1997 and September 2011.

 

BUY NEW HIGHS

 

First let's create a system that goes long if price creates a new three day high. In other words, when price creates a short term breakout on the up side, we will open our long position. This will represent our buying into strength test. Below is the equity curve.

 

 

The system is profitable, but we have an ugly looking equity curve with deep drawdown.

 

BUY PULLBACKS

 

Instead of going long on a new three day high, we are going to go long after three consecutive lower closes. This system will represent our buying into weakness test. The equity curve below depicts this system.

 

 

What a difference! This equity graph looks great all the way until the recent market volatility that hit during the summer of 2011. Our last trade produced a large loss at the very end of our equity curve. Remember, both of these trading systems have no stops.

 

The point is clear. Buying into weakness outperforms buying into strength for the S&P.

[T2CTrading 10]

Seems like common sense but it is one of the hardest lessons for a new trader to learn.

 

We see the market move fast and furious to new highs or lows and are upset that we missed the move.... then there is usually a secondary push when we attempt to get in and make back the money we missed in the first push up or down...

 

More often than not, the last flury of price action is caused by the "strong handed traders" offloading to the "weaker hands", usually institutionals unloading to the retail traders, when that supply is exhausted the market will retrace... stop the retail traders out, who are now forced to unload back to the institutionals at a loss and the cycle repeats.

 

Learn how to break the cycle. Remember that the market will always have another tradeable move, you have never missed the "last trade ever". Why buy the high or sell the low, makes no sense to me.

[MightyMouse 12]

You have nicely demonstrated that you buying pullbacks without a stop in a bull market is a good strategy.

 

How would it work with stops?

[jswanson 10]

You have nicely demonstrated that you buying pullbacks without a stop in a bull market is a good strategy.

 

How would it work with stops?

 

The charts above are not strategies. They are market studies designed to highlight market characteristics. Sorry if I did not make this clear. The intent of this thread is to show the mean-reverting characteristic of the S&P E-mini futures market. This may be helpful to those who wish to trade or design a trading system. It's a starting point.

 

As for designing a system around this mean reverting concept, I have done this as well. The chart below is a custom trading system written in EasyLanguage that trades the S&P E-mini futures market with a $500 stop per contract. Trades are entered at the close of the day session and monitored on a 5-minute bar.

 

[BlueHorseshoe 10]

Hi jswanson,

 

Thanks for yet another interesting post and study.

 

The swing strategy that I trade is very similar to the one you use in your 'buying weakness' example. My entry criteria are a little more sophisticated (or that's what I like to tell myself!), but my equity curve in the S&P bears very close resemblance to the one you display, complete with the big one trade drawdown from last August. So although I know you're only presenting it as a study, I think that with very little tweaking it can form the basis of a good mechanical strategy. Incidentally, the precise criteria you use - 200SMA trend filter and 3 higher/lower closes - has been offered as a complete ETF trading system by Larry Connors.

 

I believe that you'll most likely find the optimum filter MA length in your test above to be 180 periods, or thereabouts. Which leads to the inevitable question - should this be optimised?

 

Then there's the subject of other markets. The Euro, which is one of the few super-liquid markets still capable of supportant a breakout trading style, is a no-go, although you would have been profitable with this strategy in the Euro until about five years ago. Oil was similarly profitable, though here the equity curve flatlined more recently, yet without any significant drawdown. Gold has been very kind, and in the past twelve months there have even been trading opportunities to the downside! The Dow has been great, and with suprisingly less correlation to the S&P than you might expect. European indices tend to be mean-reverting as well, and the Nikkei can also be good, although I don't trade it.

 

Does anybody else trade with this type of strategy on a daily chart, and if so, what does your porftfolio contain?

 

What I would also love to see is a study of this type of strategy in Interest Rate products - it's on my 'to-do' list but I haven't got around to it yet . . .

 

Thanks again,

 

Bluehorseshoe.

[BlueHorseshoe 10]

You have nicely demonstrated that you buying pullbacks without a stop in a bull market is a good strategy.

 

How would it work with stops?

 

This is one of those arrogant, patronising posts that I know people will deservedly give me grief about but . . .

 

MightyMouse, go and look again at the second equity curve that jswanson has diplayed. Have a good look at it. Think about what has been required to produce that equity curve - how simple and robust the trading rules are. Take a good long look at that equity curve.

 

Now why on earth would you want to add a stop-loss? (It's a rhetorical question).

 

Bluehorseshoe

[Obsidian 10]

it says number of trades=158. what is the starting date?

[jswanson 10]

Hi jswanson,

 

Thanks for yet another interesting post and study.

 

The swing strategy that I trade is very similar to the one you use in your 'buying weakness' example. My entry criteria are a little more sophisticated (or that's what I like to tell myself!), but my equity curve in the S&P bears very close resemblance to the one you display, complete with the big one trade drawdown from last August. So although I know you're only presenting it as a study, I think that with very little tweaking it can form the basis of a good mechanical strategy. Incidentally, the precise criteria you use - 200SMA trend filter and 3 higher/lower closes - has been offered as a complete ETF trading system by Larry Connors.

 

I believe that you'll most likely find the optimum filter MA length in your test above to be 180 periods, or thereabouts. Which leads to the inevitable question - should this be optimised?

 

Then there's the subject of other markets. The Euro, which is one of the few super-liquid markets still capable of supportant a breakout trading style, is a no-go, although you would have been profitable with this strategy in the Euro until about five years ago. Oil was similarly profitable, though here the equity curve flatlined more recently, yet without any significant drawdown. Gold has been very kind, and in the past twelve months there have even been trading opportunities to the downside! The Dow has been great, and with suprisingly less correlation to the S&P than you might expect. European indices tend to be mean-reverting as well, and the Nikkei can also be good, although I don't trade it.

 

Does anybody else trade with this type of strategy on a daily chart, and if so, what does your porftfolio contain?

 

What I would also love to see is a study of this type of strategy in Interest Rate products - it's on my 'to-do' list but I haven't got around to it yet . . .

 

Thanks again,

 

 

Bluehorseshoe.

 

 

Yes, I believe I was inspired by Larry on the concept.

 

The blue equity curve above, is from a system that trades with RSI(2) as a key indicator. But there is more behind it as well. You're probably right about 180 being an ideal period. However, I always avoid picking the best values. I would rather keep the 200.

 

I'll have to look at the Euro with such a strategy.

[jswanson 10]

it says number of trades=158. what is the starting date?

 

The system does not trade often. About once a month. The chart is 11 year period through 2011.

[BlueHorseshoe 10]

Yes, I believe I was inspired by Larry on the concept.

 

The blue equity curve above, is from a system that trades with RSI(2) as a key indicator. But there is more behind it as well. You're probably right about 180 being an ideal period. However, I always avoid picking the best values. I would rather keep the 200.

 

I'll have to look at the Euro with such a strategy.

 

Thanks for your reply.

 

I remember reading about the Larry Connors set of strategies and thinking that, though they sounded very plausible and made sense in terms of things I'd already discovered for myself, they'd most likely be disappointing. So I was suprised when I started testing them and seeing very positive results. Nevertheless, Connors leaves a hell of a lot of unanswered questions, and I have no idea whether he has any sort of a consistent track record as a trader. And of course, his focus is on ETFs and individual stocks, so a leap of faith is needed to start looking at his ideas if you want to trade corn or lumber. Fortunately there is some commodities overlap, as ETFs exist for things like oil and gold.

 

I have used the 2 period RSI strategy you mention (also with additional filter criteria) to create a strategy for intraday trading. I've been monitoring this since last November, and it seems to be performing about as well as could be expected. Unfortunately I don't have the cash, the technology, or the guts to trade it, so I'm sticking with swing trading for now.

 

I also took a look at the RSI(2) for the Euro this afternoon - it seems that it can be made to perform much better than I recalled, but only with significant optimisation. I think the filter MA needs to come down to about 120 and the overbought/oversold levels at +70/+30. I think when I examined this last year it was maybe backtesting with a 4 period RSI (another Connors idea), hence the discrepancy. So if you do find the time to take it further, I'd much sooner hear about how this performs in Bonds (I can't access t-bill charts in TS as I haven't subscribed for the data feed!!!)

 

Oh, and one final thing to note - if you're using EasyLanguage for testing, the TS RSI formula is some rather weird modification of the original, and does produce slightly different results.

 

Will look forward to hearing more from you about this type of trading - it's somehow reassuring to know that there are other traders out there looking at the same kind of things as I am!

[Obsidian 10]

The system does not trade often. About once a month. The chart is 11 year period through 2011.

ah I see...I would be glad if you attach a screenshot on a daily chart so that we can visualize the trades taken

[MightyMouse 12]

This is one of those arrogant, patronising posts that I know people will deservedly give me grief about but . . .

 

MightyMouse, go and look again at the second equity curve that jswanson has diplayed. Have a good look at it. Think about what has been required to produce that equity curve - how simple and robust the trading rules are. Take a good long look at that equity curve.

 

Now why on earth would you want to add a stop-loss? (It's a rhetorical question).

 

Bluehorseshoe

 

Your question is a good question.

 

You wouldn't want a stop if you have the advantage of foreknowledge that the second curve would prevail. You can argue too that you wouldn't want a stop if the top curve would prevail. The fact is that you do not know what the curve is going to look like until you get it.

 

If you looked closely at the raw data from the period being tested and not the resulting equity curve, you'll understand better why the curves look the way it does. The trouble is that the data only occurred in the past and you can't back test the future, so you need a stop a stop in place if you want to survive.

 

Looking at the two curves, though, why would anyone pick the top curve? Personally, I look at both curves and know damn well that I would never attempt to commit real money to the market with a system of commands that buy the market after A occurs and sell after B occurs on a chart. I know the curves were posted for exposition purposes only, but a trading system should seek to reap profits from traders, not from price movements on a chart.

 

Just my opinion.

[jswanson 10]

I have used the 2 period RSI strategy you mention (also with additional filter criteria) to create a strategy for intraday trading. I've been monitoring this since last November, and it seems to be performing about as well as could be expected. Unfortunately I don't have the cash, the technology, or the guts to trade it, so I'm sticking with swing trading for now.

 

Are you using the RSI(2) indicator on the same timeframe as you trade it? The system I've currently built uses the RSI on a daily chart and manages the trade on a 5-minute. It only trades on average once per month. I'm looking at in increasing the number of trades and would be interested in how you utilize it. Do you have any of the stats on your system?

 

I also took a look at the RSI(2) for the Euro this afternoon - it seems that it can be made to perform much better than I recalled, but only with significant optimisation. I think the filter MA needs to come down to about 120 and the overbought/oversold levels at +70/+30. I think when I examined this last year it was maybe backtesting with a 4 period RSI (another Connors idea), hence the discrepancy. So if you do find the time to take it further, I'd much sooner hear about how this performs in Bonds (I can't access t-bill charts in TS as I haven't subscribed for the data feed!!!)

 

My general experience has been the currency markets tend to exhibit a bit more trending behavior instead of mean reverting. But, I've not looked at it much lately.

[jswanson 10]

ah I see...I would be glad if you attach a screenshot on a daily chart so that we can visualize the trades taken

 

It actually trades on a five minute bar but takes it's signals from a daily chart. So, I don't have a daily chart.

[BlueHorseshoe 10]

Are you using the RSI(2) indicator on the same timeframe as you trade it? The system I've currently built uses the RSI on a daily chart and manages the trade on a 5-minute. It only trades on average once per month. I'm looking at in increasing the number of trades and would be interested in how you utilize it. Do you have any of the stats on your system?

 

Hello,

 

The strategy uses the RSI on the timeframe being traded, yes. The filters are MAs across this and two higher timeframes (nothing at all original there). A buy limit order is placed at the low of the signal bar (to do so and then instruct the backtest to only fill orders where price trades through the limit is the only way I have of knowing absolutely that I would have been filled without adverse slippage - the strategy works equally well with a order to buy at market at the close of the bar, if you can be confident that slippage is not a huge issue). Another filter rule that I recall working well for the S&Ps was to only buy following a down day, and visa versa.

 

Another interesting indicator to look at for this type of strategy is the CCI. Because this is already quite sensitive and 'jumpy', there isn't the need to shorten the lookback to the same extent as with the RSI.

 

Let me know if there's any more info you'd like.

 

Bluehorseshoe

[BlueHorseshoe 10]

Your question is a good question.

 

You wouldn't want a stop if you have the advantage of foreknowledge that the second curve would prevail. You can argue too that you wouldn't want a stop if the top curve would prevail. The fact is that you do not know what the curve is going to look like until you get it.

 

Hi MightyMouse,

 

Thanks for your reply. I totally agree with you about inference from historical equity curves - there is absolutely no way that you can know that the equity curve will prevail. But if the trading concept here (buying three day pullbacks) ceases to work, then it will cease to work both with stops and without stops. As it currently performs far better without stops, then it is not an unreasonable assumption that its failing performance would be better without stops.

 

The equity curve is a function of this strategy (which doesn't contain stops). So I don't believe that it's simply a case of adding stops to the strategy; you'd be creating a whole new strategy (with stops) that just happened to share the same entry criteria.

 

I personally trade without stops. If the S&Ps fell to zero today I would lose most of the money in my trading account - this wouldn't be a huge delight, but it wouldn't be anything more than a dissappointment - I can afford to lose that money, otherwise it wouldn't be in the trading account. So there are other ways to control risk beside using a stop loss that massively reduces the perfomance of your strategy.

 

Not that I'm desperately trying to convert anyone reading to stop using stop-losses - that would just be irresponsible.

 

In an effort to try and provide a less confrontational response to your original question, I'll re-run JSwanson's strategy and post a report for different stop-losses within the next few days. Hope that's helpful.

 

Bluehorseshoe.

[BlueHorseshoe 10]

The trouble is that the data only occurred in the past and you can't back test the future, so you need a stop a stop in place if you want to survive.

 

I suppose what you really want is a stop-loss on your equity curve - a rule that states to cease trading if a certain drawdown is reached (including intra-trade). Just a thought though, and equity curve trading is a whole other topic . . .

[Tradewinds 12]

I created two simple trading systems in EasyLanguage. Both systems will go long only. Both systems will utilize a 200-day simple moving average (SMA) for an environment filter. Long trades will only be opened if the closing price is above the 200-day SMA. All open positions are closed at the end of the 5th day.

 

Can you attach the ELD strategy file? For those people with TradeStation, we could look at the results of the strategy.

[MightyMouse 12]

Hi MightyMouse,

 

Thanks for your reply. I totally agree with you about inference from historical equity curves - there is absolutely no way that you can know that the equity curve will prevail. But if the trading concept here (buying three day pullbacks) ceases to work, then it will cease to work both with stops and without stops. As it currently performs far better without stops, then it is not an unreasonable assumption that its failing performance would be better without stops.

 

The equity curve is a function of this strategy (which doesn't contain stops). So I don't believe that it's simply a case of adding stops to the strategy; you'd be creating a whole new strategy (with stops) that just happened to share the same entry criteria.

 

I personally trade without stops. If the S&Ps fell to zero today I would lose most of the money in my trading account - this wouldn't be a huge delight, but it wouldn't be anything more than a dissappointment - I can afford to lose that money, otherwise it wouldn't be in the trading account. So there are other ways to control risk beside using a stop loss that massively reduces the perfomance of your strategy.

 

Not that I'm desperately trying to convert anyone reading to stop using stop-losses - that would just be irresponsible.

 

In an effort to try and provide a less confrontational response to your original question, I'll re-run JSwanson's strategy and post a report for different stop-losses within the next few days. Hope that's helpful.

 

Bluehorseshoe.

 

I am "old fashioned" maybe. I believe I should get out as soon as reasonably possible when a trade isn't working.

 

Trading 1 es contract limits one's ability to leverage and manage a trade. I es contract also has the value of about $67k. That would hurt me if I lost that. I am not going to lie about that. When I am positive and I add leverage to the trade, I can have a position of over 10 contracts or more. Trading without a stop at that point becomes insane with for an individual with my net worth. If 67k is no big deal to you, I salute you.

 

As far as curve A or B, I would trade the strategy behind the curve that made the most sense to me, regardless of the equity curve and even if it tested negative for the same period. The reason for this potentially limiting thinking is that I need to be able to understand why there is going to be money in the market for me to take. If I do not understand, then I will begin to hesitate, second guess my trade, get out too early, get in to late, etc. My understanding leads me to taking 1000 out of 1000 trades that occur that fit the particular criteria that I am looking for. I really care less if I lose for a day, week or month, etc. because I know that what I am doing is sound.

 

In my opinion, "counting to 3" and dropping a trade in the market is nuts. But, if someone would have done just that over the test period, they would have made a hell of a lot more money per contract than I did over the same period, so they would have laughed all the way to the bank. In fact, the guy who would have traded the strategy that bought the high over the same period would have kicked my ass too if that data is per contract results. I am pretty sure too that both curves would have outperformed most professionally managed accounts.

 

As far as the topic of the thread is concerned, there are times when I will only buy the high, but it has nothing to do with clock or calender time.

[BlueHorseshoe 10]

I am "old fashioned" maybe. I believe I should get out as soon as reasonably possible when a trade isn't working.

 

I don't think that it's in any way old-fashioned . . . But I do think that it's more relevant to other styles of trading (trend-following, momentum and breakout trading etc). In my experience, with the type of strategy that JSwanson is describing, then when you catch a falling movement you need to give it plenty of room to carry on falling before you get the desired bounce. Would that I could catch the bottom every time, but in reality no system does this. Using a very wide stop is a necessary evil with this type of trading, and the wider the stop, the better the results typically are. No stop-loss is the next logical step.

 

If 67k is no big deal to you, I salute you.

 

Ha! Alas, it's a very big deal to me - I hope my comment didn't come across as bragging! I'm based in the UK, where we can spread bet for amounts as little as 20c per tick. This is a massive advantage for traders with small accounts. So a complete collapse of the ES when I was long would probably only cost me $5-6k ( I currently trade at a few dollars per tick) - not really the end of the world for me.

 

But the point I was making was that a complete collapse of the S&Ps is highly improbable. At least, I am willing to bet on the unlikelihood of it. In fact, I'm willing to bet against any selloff that would significantly damage my equity curve over the long term. As an example - last summer I bought the market immediately before the big selloff. This was a comparatively disasterous trade for my strategy - and the subsequent dent in my equity curve was worse than anything in ten years of historical backtesting. Still, had I been holding a full e-mini contract the loss would only have been about 7k, not 67k. And since then? My equity curve is now back to where it was prior to this event.

 

The reason for this potentially limiting thinking is that I need to be able to understand why there is going to be money in the market for me to take.

 

I agree with this sentiment, but I think that there are reasons to believe that a strategy of this type can be profitable. There are more complicated ways of rationalising JSwanson's strategy (mean reversion etc), but here is the fairly simple way in which I like to view it:

 

Futures contracts exist to transfer risk. To make money trading you need to take risks. Therefore when most market participants are desperate to transfer risk, I want to take on that risk. I buy into weakness because I want to take the other side of the order flow and facilitate the transfer of risk.

 

My understanding leads me to taking 1000 out of 1000 trades that occur that fit the particular criteria that I am looking for. I really care less if I lose for a day, week or month, etc. because I know that what I am doing is sound.

That's my thinking entirely - I couldn't agree more.

 

In my opinion, "counting to 3" and dropping a trade in the market is nuts.

 

Have you ever tested a system with completely random entries? Although I wouldn't claim it's an advisable way to trade, simply dropping in a random order with a large stop and small target if often profitable over time in a mean-reverting market such as the S&Ps.

 

I am pretty sure too that both curves would have outperformed most professionally managed accounts.

 

Yes, quite possibly, if a money-management formula was brought into play, but then there may be reasons why the strategy wouldn't have performed quite as well in reality as in JSwanson's backtesting. Having said this, buying a falling market means you can establish positions with limit orders, thereby removing the possibility of adverse slippage.

 

Thanks for an interesting discussion, MightyMouse.

[Nemesis 10]

Hi MightyMouse,

 

 

 

I personally trade without stops. If the S&Ps fell to zero today I would lose most of the money in my trading account - this wouldn't be a huge delight, but it wouldn't be anything more than a dissappointment - I can afford to lose that money, otherwise it wouldn't be in the trading account. So there are other ways to control risk beside using a stop loss that massively reduces the perfomance of your strategy.

 

Bluehorseshoe.

 

It seems to me that your method for trading without stops is underleverage ?

[BlueHorseshoe 10]

It seems to me that your method for trading without stops is underleverage ?

 

Thanks Nemesis - you've described in one word what took me several paragraphs to explain!

 

I wouldn't say that I'm under-leveraged against my account though. I would say that I'm underleveraged against my 'net worth', if that makes sense?

 

The obvious downside of this is that I'm not making anywhere near as much money in real dollar terms as I would be if I took advantage of the opportunities to use greater leverage. The reason I avoid this is because although I am prepared to weather what many would probably consider a very significant risk in percentage terms (a risk that any single trade could potentially wipe out my entire account), in real dollar terms I am not prepared to risk my net worth in this same fashion.

 

Bluehorseshoe

[fxdummie 10]

A big fund with deep pockets would like to trade with no stop loss. But most of us don't have the privilege of playing with our money. This system would be great If your life span is hundreds of years. But in my case I rather have my stop loss hit and look for another entry than have an immaculate curve pointed in the far far beyond.

 

The main call of this thread for me is to buy pullbacks with the trend = buy temporary weakness in an overall strength! And to minimize the risk find your entries in a smaller time frame.

 

The real work for each trader is directed in designing/testing a system which will fit his/her trading reality: account size, temperament, time to trade ... In a way trade management is related to the individual psychology and account size:

 

This means small accounts have to use a system with good win/loss ratio or high winning probability. In my experience high probability systems usually require smaller targets. On the other hand, system with great win/loss ratio require more patience and trust in your system because there are many scratch trades or small losses. Some people's temperament and time to trade would allow them to be in a trade for short time therefore they better use high probability-small targets systems. Other would like to stick with their few winners and let them run - but they have to have the nerve to stay longer.

Of course this is gross generalization - there is always an exception plus for me the best system is the one with O.K. win probability and great win/loss ratio.

 

The problem with not using stop loss is problem of scarcity. If your wealth is limitless then no need for stops. If you have limited resources and are trying to build wealth without using stop loss - it is ignoring the reality of your limited resources. And from a practical stand point - I wouldn't know how to assess win/loss ratio of a system with no "losses"!!

[BlueHorseshoe 10]

And from a practical stand point - I wouldn't know how to assess win/loss ratio of a system with no "losses"!!

 

Hello,

 

You would calculate the win/loss ratio exactly the same as you do for any other system. A win occurs when a position is exited for a profit, and a loss when it is exited for a . . . loss.

 

Just to be clear - I am not saying that I will allow a position to run indefinitely against me. Hence I still have losing trades when I exit at a loss. I am saying that I don't have a hard stop in the market. This means that the theoretical size of my loss, if the market moves hard against me, is the entire value of the contract for longs, and infinite for shorts. I am willing to bet that though this is the case in theory, it won't be the case in practice.

 

With regard to how deep a trader's (or fund's) pockets are, please see my response to MightyMouse above - you don't need deep pockets to do this, you just need to trade within your means.

[BlueHorseshoe 10]

I am aware that I appear to have hijacked JSwanson's thread with digressions - so no more posts from me here now.