trading system Archives - Algorithmic and Mechanical Forex Strategies

Developing a System Around an RSI Entry Strategy

September 12, 2013 by Andrew Selby 4 Comments

In chapter nine of their book Short Term Trading Strategies That Work, Larry Connors and Cesar Alvarez refer to Relative Strength Index (RSI) as “The Holy Grail of Indicators.” While I don’t like the implication that there is a “Holy Grail” in trading other than hard work and studying, Connors and Alvarez to provide some interesting research to back up their claim.

Connors and Alvarez Research

The standard period that is commonly used for the RSI indicator is 14, but Connors and Alvarez argue that there is no statistical evidence that 14 is the optimal period. Their testing has revealed that a period of 2 will provide the best returns.

Connors and Alvarez set out to test their theory over the time period from January 1, 1995 through December 31, 2007. During this time, they calculated that the average stock that was above its 200 day simple moving average (SMA) gained 0.05% over a 1-day period, 0.1% over a 2-day period, and 0.25% over a 3 day period. They used these numbers as a benchmark for their 2-period RSI indicator to compete against.

Focusing on the oversold side, stocks that had an RSI below 10 were able to outperform each of the three benchmarks. They recorded returns of 0.13% over a 1-day period, 0.31% over a 2-day period, and 0.74% over a 1-week period.

Not surprisingly, when they lowered the oversold requirement to an RSI below 5, the performance numbers improved even more. The numbers then improved again when they lowered the RSI requirement to 2, and once again when they lowered the RSI requirement to 1.

When the RSI requirement was lowered all the way down to one, the RSI indicator recorded returns of 0.3% for a 1-day period, 0.66% for a 2-day period, and 1.18% for a 1-week period. This indicates that the lower the RSI, the more the stock was likely to rebound. Clearly, the 2 period RSI indicator can perform extremely well on short term trades.

My Initial Resistance To Oversold Indicators

My early stock market training was a combination of William O’Neil’s CANSLIM method and the trend following approach promoted by Michael Covel. Because of that, I have always been against the concept of an overbought or oversold indicator. Following with my trend following and CANSLIM training, I believe that the stocks with the strongest relative strength are most likely to continue moving higher.

What I was missing, was the idea that short term overbought and oversold conditions can exist within long term trends. That means that overbought/oversold indicators and trend following philosophies do not necessarily have to be mutually exclusive.

Current Examples

One interesting example of using RSI to identify short-term oversold opportunities would be Take Two Interactive Software (TTWO), which took a big hit in today’s trading. My CANSLIM and Trend Following background tells me to avoid stocks that are taking big hits and crashing below their 50-day moving average on big volume, but that is a longer-term outlook. It would not be unreasonable for TTWO to bounce back over the next few days and then head further south.

TTWO shows a good chance of correcting upward over the next few days

The same case can be made for Webster Financial Corp (WBS) , which has recently lost its 50-day line and has been trending down for the past few weeks. While taking a long term position in this stock might not make much sense to a mid- or long-term trend follower, the stock’s 2-period RSI of 4.23 indicates that it is likely to see a small bounce over the next few days.

The RSI entry rules show that WBS is due for a correction in the short term.

Systematizing This Concept

It is important to keep in mind that the profitable returns that Connors and Alvarez were able to produce in their returns came from including EVERY instance of a stock falling into oversold territory. They were not picking and choosing their favorite companies.

Therefore, in order for us to use this idea, we will have to build it into a system that will be able to trade every signal generated, not just the ones we like best. This will ensure that we don’t allow our own personal biases to interfere with the system’s success.

It is also important to realize that this 2-period RSI concept is simply an entry signal. In order to develop it into a trading system, we will need to add an exit signals, position sizing, and risk management. This will require extensive testing and analysis, but it does appear that it would be possible to build a profitable short-term trading system using the 2-period RSI as an entry signal.

MACD & Stochastic Double Cross System

May 6, 2013 by Andrew Selby 4 Comments

What would happen if we combined the indicators from different systems? Would they work together to make a stronger system or would they work against each other?

I recently covered a MACD Trading System and a Stochastic Trading System. Combining these two systems can give us stronger signals. This should, in theory, help to reduce false signals.

MACD & Stochastic Double Cross System

Once again, we will use the 200 unit simple moving average (SMA) to define the direction of the long term trend. It is always better to trade in the same direction of the general trend. Using the 200 unit SMA here will keep us from attempting to swim against the current.

Basically combining the two individual systems, this system will look for a MACD cross signal within two days of a Stochastic cross signal. Due to the nature of these indicators, it is important that the Stochastic cross happens first.

Targeting the situations where both systems agree should isolate only the very strongest signals, thus increasing the win rate.

Trading Rules

Chart and Instrument: Any
Period: Any
Market Condition: Trend

Go Long When:
Price Closes > 200 Day SMA
Bullish MACD Cross < 2 Days After Bullish Stochastic Cross

Go Short When:
Price Closes < 200 Day SMA
Bearish MACD Cross < 2 Days After Bearish Stochastic Cross

Exit Long When:
Bearish MACD Cross

Exit Short When:
Bullish MACD Cross

Strategy Analysis

Combining these two indicators works well because they are both derivatives of price, but they are calculated differently. The Stochastic Oscillator illustrates the price with respect to the range, while the MACD shows us the convergence or divergence of two different moving averages. While both are completely based on price action, they focus on two different aspects of that action.

The primary advantage of this system is that it isolates the signals where the two different systems agree.

Combining the two separate systems will strengthen the advantages and reduce the disadvantages of each system. Both the MACD and Stochastic Oscillator are prone to giving false signals, this system provides an excellent way to focus on only the strongest signals.

This focus on only the strongest signals is also the biggest weakness of this system. If we are going to hold out for only the very strongest signals, then there are going to be far less signals to trade. We will have to follow a wider variety of markets in order to find regular signals.

The SPX daily chart shows a signal using the SMA200, slow stochastics and MACD.

This chart of the SPX provides a great example of a long signal for this system. At the end of 2012, the SPX had just recently crossed above its 200 day SMA. Then, just a few days before the new year, we see a bullish Stochastic cross followed by a bullish MACD cross. This system would have caught the entire month of January, which was very positive for the SPX.

One interesting note is that it would not have gotten back into this uptrend in March like either of the systems would have done on their own because the signals were more than a few days apart.

This could be compensated for by expanding the limit on the number of days between signals. However, expanding this limit will also open the system up to more false signals. This is the type of risk/reward situation that each trader must determine for himself.

Why Not Three Indicators? Or Four? Or Five?

If the two indicators used in this system make it stronger than the one indicator systems we looked at before, does that mean that bringing in a third indicator would make this system even stronger? If that logic holds true, why not use a dozen indicators? This is the slippery slope of system design.

When designing trading systems, we must keep in mind that overusing indicators can result in a system that doesn’t find enough signals to trade profitably. Having a system that is profitable on 98% of its trades won’t do you any good if it only gets a signal once every 200 years. Keep this in mind when experimenting with the wide variety of indicators available.

Do you have any thoughts on this trading system? Share your comments and ideas in the section below.

Trading System Drawdown and Emotion

January 28, 2013 by Shaun Overton 13 Comments

What do baseball and trading system drawdowns have in common? A lot more than I ever realized.

If you haven’t read the book or seen the movie Moneyball (which I highly recommend), professional baseball adopted a statistical approach to recruitment and gameplay around 2000.

The Oakland Athletics adopted the approach before any team. They experienced tremendous success in their first system-driven season, despite countless expert predictions of imminent failure.

I started reading The Signal and the Noise by Nate Silver last night. The baseball chapter picks up where Moneyball left off. Dustin Pedroia, a star second baseman for the Boston Red Sox, enters the scene as an unlikely success story.

Most scouts overlooked him. He is short. He has a paunch and bowed legs. Nobody looks at the guy and thinks “professional athlete”.

Dustin Pedroia held strong through a trading system drawdown of his own – an unexpectedly low batting average.

Sticking with the system

Pedroia batted a lackluster .198 when the Red Sox brought him to the major leagues in August of 2006. The first month of the 2007 season started off even worse at .172.

A team like the Cubs, who until recently were notorious for their haphazard decision-making process, might have cut Pedroia at this point. For many clubs, every action is met by an equal and opposite overreaction. The Red Sox, on the other hand, are disciplined by their more systematic approach. And when the Red Sox looked at Pedroia at that point in the season, James told me, they actually saw a lot to like. Pedroia was making plenty of contact with the baseball – it just hadn’t been falling for hits. The numbers, most likely, would start to trend his way.

“We all have moments of losing confidence in the data,” James told me. “You probably know this, but if you look back at the previous year, when Dustin hit .180 or something, if you go back and look at his swing-and-miss percentage, it was maybe about 8 percent, maybe 9 percent. It was the same during that period in the spring when he was struggling. It was always logically apparent – when you swing as hard as he does, there’s no way in the world that you make that much contact and keep hitting .180.”¹

Trading System Drawdown

Every trader goes through a slump – even the best of them. When your trading system drawdown reaches uncomfortable levels, how do you cope?

I had the opportunity to lead managed fund sales at one of the largest forex brokerages in the world. The product was the Sentiment Fund and it was AWESOME. When the fund took off and upper management suddenly got involved, the fund had $40 million under management and nearly 1,000 investors.

If there’s one thing that you can count on with forex traders, it’s that they are going to lose. All the time. No doubt about it.

The firm received real time information on the positions of all clients. Whenever too many traders held positions long or short, the fund did the exact opposite.

That’s it. The automated strategy was stupid simple, but the returns were amazing. The aggressive fund kept the leverage at 2:1, yet was on track to earn 40% annually.

Bad luck

Two months before the hand off, the fund experienced a sharp drawdown of -8%. Like most people, investors thought of 40% returns as 40/12 = 3.3% profit per month. They don’t think about the natural slumps that happen – just like the one Pedroia experienced.

That “surprise” drawdown caused a mass herding effect. It didn’t matter that the fundamentals of the strategy were unchanged. Forex traders didn’t wake up smart last month and know how to game the system. Bad luck happens to the best strategies. Nonetheless, investors ran for the exits from a world class strategy.

Were the guys on the systems desk worried about the strategy that they built? No way! When Pedroia went through his slump, he could have overreacted and start messing with his batting stance. He could have adjusted his distance to the plate or any number of things.

Pedroia knew that his system was good. The systems guys knew their strategy was phenomenal. In spite of all the pressure, they held firm and blew past the drawdown by the time I handed off the sales effort.

What element of trading matches the “swing-and-miss percentage”? The Red Sox clearly used it to justify sticking with their system. In Sentiment Fund’s case, it was knowledge of the underlying system.

How can quantitative traders with less obvious fundamental theories know that their system is sound? I’d love to hear your comments.

1. Excerpted from The Signal and the Noise by Nate Silver, page 104.