Once you decide on a system trading strategy, one of the first hangups you will encounter will be determining the best markets for system trading. Like most of the important questions we are confronted with in life, there is not a simple answer to be found here.
Depending on your appetite for risk and your hunger for profits, you may find it acceptable to trade only one index fund or hundreds of stocks, bonds, currencies, and commodities. You may determine that you want to trade each of these markets through ETFs or use options to take your positions.
There is not a “right” answer here. There are arguments for and against trading a single market, just as there are arguments for and against trading 200 markets. The only definite when it comes to choosing which markets to trade, is that you have to invest some careful thought into your approach.
With that said, here are a few ideas that are popular among system traders:
This is the most basic approach, which is perfect for the investor who believes in systematic trend following, but just wants to use it to outperform a traditional buy and hold approach. This investor might be using a strategy as simple as going long when the index is above the 200 day simple moving average (SMA) and going to cash when it is below the 200 day SMA.
Using ETFs that mirror the performance of the indexes is a great way to implement these strategies. Investors can use the QQQ to track the Nasdaq or the SPY to track the S&P 500. A simple approach like this has the power to provide investors with all of the upside of the general market, while avoiding the Black Swan crashes.
The problem with only trading a few index funds is that you need the stock market to move in order to make money. If the general market spends an entire year (or an entire decade) churning sideways, there aren’t going to be many profits to be had for traders.
Having the ability to trade your system in other markets while stocks aren’t trending is the difference between just beating the market and posting significant returns. However, exposing your trading capital to more markets can also mean taking on more positions, thus increasing your risk. This is where you need to have a strong understanding of what you want to achieve from your trading and how much risk you will be able to tolerate.
Connors & Alvarez ETF Markets
Authors Larry Connors and Cesar Alvarez used a collection of 20 different EFTs for each of the systems they documented and tested in their book, High Probability ETF Trading. Their selected ETFs provided a diverse cross section of the stock market as well as exposure to Gold and Diamond markets.
The ETFs they used were:
- Diamonds Trust (DIA)
- iShares MSCI Emerging Markets Indx (EEM)
- iShares MSCI EAFE Index Fund (EFA)
- iShares MSCI Hong King Index Fund (EWH)
- iShares MSCI Japan Index (EWJ)
- iShares MSCI Taiwan Index (EWT)
- iShares FTSE / Xinhua China 25 Index (FXI)
- SPDR Gold Trush (GLD)
- iShares S&P Latin America 40 Index (ILF)
- iShares Russell 2000 Index (IWM)
- iShares Dow Jones US Real Estate (IYR)
- PowerShares QQQ Trust (QQQ)
- SPDR S&P 500 (SPY)
- SPDR S&P Homebuilders (XHB)
- Materials SPDR (XLB)
- Energy Select Sector SPDR (ELE)
- Financial Select SPRD (XLF)
- Industrial Select SPDR (XLI)
- Health Care SPDR (XLV)
As you can see, Connors and Alvarez take a big step beyond the standard index ETF approach. They are able to bring a number of foreign markets and specific industry sectors into their trading by using many different markets. Incorporating foreign markets and commodities is a good way to allow your system to find trading opportunities while the general equities markets are moving sideways.
If the strategy you are looking to implement is robust enough to handle any type of market, increasing the number of markets that you are trading can be an excellent way to increase the number of trade signals you will receive. As long as your strategy accounts for differences in volatility, this should make it more profitable overall.
While Connors and Alvarez take a step forward with their trading universe, they still omit the foreign exchange markets and most of the commodity markets. Since most stocks are correlated, at least to some degree, there is a good chance that there will be times when none of these markets present profitable opportunities.
Clenow’s Diverse Markets
In his book, Following The Trend, Andreas Clenow recommends trading a systematic strategy across a wide collection of markets in order to ensure diversification. He insists that any systematic trend following approach needs to have exposure to agricultural commodities, nonagricultural commodities, currency futures, equity futures, and bond rate futures. He suggests following ten markets in each of these five categories.
- Live Cattle
- Lean Hogs
- Rough Rice
- Crude Oil
- Heating Oil
- Natural Gas
- Gasoline, Gold
- CAC 40
- HS China Enterprises
- Hang Seng
- Nasdaq 100
- Nikkei 225
- S&P 500
- EuroStoxx 50
- Russell 2000
- Long Gilt
- Canadian Bankers’ Acceptance
- US 2-Year Note
- US 10-Year Note
- Short Sterling
Clearly, Clenow’s diversification is far more thorough than either of the first two methods. Of course, he also recommends you have a least $1 million in trading capital before you start implementing his strategy. Clenow actually makes that point for us in his book, saying:
“More markets can increase diversification and create more trading opportunities but adding too many will complicate your strategy and your operational side. The exact number you settle on should be a result of your own simulations and matching your risk acceptance.” – Clenow
Trading 50 different markets may be way too much for someone who is just beginning to explore system trading, however this is what the hedge funds we are competing with are doing. Therefore, we should have a good understanding of their thinking.
The bottom line when it comes to selecting which markets to trade is to start where you feel comfortable, and then build in diversification as soon as possible. You should also be extremely cautious to avoid increasing your risk of ruin by trading too many markets.