Three Strategy Types
Each of these three types of markets (Trending, Directionless and Volatile) are tradable, but with markedly different trading strategies. Let's take a look at each type of market behavior and the strategies that are appropriate to that type of market.
TREND FOLLOWING STRATEGIES
Like the name, trend-following strategies are designed for trending markets, and to take a position for all the big trending moves that may occur. In creating trendfollowing strategies, the number one priority is that the strategy must never miss the big move.
Like the name, trend-following strategies are designed for trending markets, and to take a position for all the big trending moves that may occur. In creating trendfollowing strategies, the number one priority is that the strategy must never miss the big move.
The easy way to accomplish this is to always be in the market, that is, to always be either short or long. If you always have a position, you will always be there when the big move takes place.
The other method is to always have a "stop" order in the market, resting either above or below the current price (this is the same order as a stop loss, but it is used to enter the market rather than exit). Using a stop to enter the market will protect you because if the market moves quickly in either direction, you will be stopped in before the big move begins.
I can't emphasize enough how important it is never to miss a big move in trendfollowing strategies. During the choppy, directionless phases of the market, you will experience several losses in a row and most likely significant drawdown.
Therefore, if your strategy misses a big move, you may not have enough capital to hold out through the drawdown for the next big move.
Another design priority should be to limit your losses during the market's sideways mode. Notice how I said limit losses not make profits. It is very important to recognize that no strategy will make money in every market condition. It is therefore very important to identify the market action in which the strategy will make money and the market action in which it will lose money.
Once you have found the market action in which the strategy will lose money, it becomes a strategy design priority to minimize losses during that market action. If the strategy is designed to make money in a trending market, it will lose money in the choppy phase. Your priority should be to minimize the losses in the directionless market.
Once you have found the market action in which the strategy will lose money, it becomes a strategy design priority to minimize losses during that market action. If the strategy is designed to make money in a trending market, it will lose money in the choppy phase. Your priority should be to minimize the losses in the directionless market.
Many trend-following strategies make their money in one or two trades of the year and break even or lose money for the rest. The most common indicator used for trend following is moving averages, most often two, a short moving average and a longer moving average. Chart 6 of Disney shows the 9- and 18-period moving averages with TradeStation arrows indicating where a 9- and 18-period moving average crossover strategy would go long (up arrow) and short (down arrow).
Many researchers have estimated that any market is in the trend mode 15% of the time and is directionless 85% of the time. A trend-following strategy then, by definition, has a low percentage of profitable trades. A trend-following strategy is psychologically difficult to trade, but if you think you can successfully trade without constant positive feedback, it can prove to be very profitable
Trend-following strategies are probably the most popular type of strategy. With a high percentage of losing trades, you might be wondering why is it so popular. Very simply, trend-following strategies can be very profitable over time. Another reason is that people like to follow (and make money on) the big trends. It is human nature to want to cash in on the big moves in the market. It is innately satisfying to get in early on a trend and watch your profits soar.
SUPPORT & RESISTANCE STRATEGIES
The main focus of a Support and Resistance (S/R) strategy is to profit from the price swings that occur in directionless markets. The strategy attempts to capture price movement opposite to that captured by trend-following strategies.
The main focus of a Support and Resistance (S/R) strategy is to profit from the price swings that occur in directionless markets. The strategy attempts to capture price movement opposite to that captured by trend-following strategies.
Support and resistance strategies start with the premise that markets are directionless 85% of the time. The strategy attempts to take advantage of this price movement and catch the small swings that take place in sideways or choppy markets.
This type of strategy has a higher number of winning trades, with small profits on each trade. It misses the full trend because it exits early in the trend move as the market becomes quickly overbought or oversold.
An S/R strategy is built on the concept of buying low and selling high. As you are buying when prices are low and selling when prices go up, you are actually trading against the trend. Essentially, you are attempting to pick tops and bottoms. You buy low and sell high, but the market keeps going higher. You keep selling as the market goes higher, and keep taking small losses until the market finally turns down and gives you a profitable trade.
An S/R strategy is built on the concept of buying low and selling high. As you are buying when prices are low and selling when prices go up, you are actually trading against the trend. Essentially, you are attempting to pick tops and bottoms. You buy low and sell high, but the market keeps going higher. You keep selling as the market goes higher, and keep taking small losses until the market finally turns down and gives you a profitable trade.
Although an S/R strategy is easier to trade emotionally, many traders don't trade this type of strategy because they miss the big move (by design). The most common indicator used with a support/resistance type of strategy is probably the Stochastic Oscillator.
An S/R strategy is designed to buy low and sell high, which is an easy method psychologically to trade because it makes logical sense. However, these strategies can lose money in the long run. Generally, most successful strategy traders don't trade this type of strategy. If S/R strategies are used at all, it is to complement a group of strategies that includes trending strategies and perhaps a volatility strategy or two.
VOLATILITY EXPANSION STRATEGY
Volatility expansion strategies are designed to do well in volatile markets. The trades generated by this type of strategy are usually short-term, and when trading this type of strategy, you will be out of the market a significant amount of time. Volatility expansion strategies generate a high percentage of winning trades, although these trades usually generate small profits per trade. The S&P futures is a market that I would characterize as "volatile." Neither trend-following strategies nor S/R strategies work particularly well on the S&P.
Volatility expansion strategies are designed to do well in volatile markets. The trades generated by this type of strategy are usually short-term, and when trading this type of strategy, you will be out of the market a significant amount of time. Volatility expansion strategies generate a high percentage of winning trades, although these trades usually generate small profits per trade. The S&P futures is a market that I would characterize as "volatile." Neither trend-following strategies nor S/R strategies work particularly well on the S&P.
Selecting a Market and Strategy Type
You should now have an idea as to the different types of market action and the strategy characteristics that attempt to take advantage of the action and profit from it. Each type of market has unique characteristics and takes a different thought process for strategy design.
In your own thoughts, you should begin to think about what type of market you are most comfortable with and would like to trade. Another consideration is the financial and statistical characteristics of the strategies, with specific regard as to whether you could actually trade the strategy. It is not wise to create a great strategy that would be psychologically impossible for you to trade.
The first step in strategy design is to think about the characteristics of the three market types and the strategies that are effective for each. Then decide what type of trader you are, or want to be: a trend trader, who buys low and sells high, or a volatility trader, who takes selective but high percentage trades.
I don't want to tell you what kind of strategy you should use. Everyone has to decide for him or herself, based on their personality and trading preferences. I think the best way to choose a strategy is to take a look at Table 1.
You should determine what type of strategy is best for your temperament. There are successful strategy traders using each type of strategy, but based on my experience, a higher number of traders use trend-following and volatility expansion strategies than support and resistance strategies.
Choosing a Time Frame
After you select the strategy type you want to use, you need to think about the time frame in which you want to trade, and therefore the type of data you want to collect. There are three general types of data you can collect: intra-day, daily, or weekly. Choosing the time frame that is appropriate for you is almost as important as the type of market action and strategy you want to trade.
The most common chart used by traders is the daily chart, and this is why I use daily charts for most of the examples in this book. Daily charts are the most common for several reasons. Because most traders also have day jobs, they want to keep abreast of the market as much as possible without it intruding into their workday. The daily chart is perfect for this type of trader. You are able to review the markets each night and make your decisions for the next day.
WEEKLY VS. DAILY CHARTS
Weekly charts are much more difficult to trade because it takes more discipline. To trade weekly charts, you must make your decisions on the weekends and not make any changes until the next weekend. For most traders, this is very difficult to do. It is very easy to yield to temptation and move a stop loss or a money management stop, or want to keep your profits and exit the market early.
Weekly charts are much more difficult to trade because it takes more discipline. To trade weekly charts, you must make your decisions on the weekends and not make any changes until the next weekend. For most traders, this is very difficult to do. It is very easy to yield to temptation and move a stop loss or a money management stop, or want to keep your profits and exit the market early.
To discipline yourself not to look at the market during the week is a tough thing to do. Most people don't think of trading weekly charts. My experience is that there is a lot of money to be made trading weekly charts, simply because so few traders are able to do so. To make money in the markets, you have to tread where the average traders do not tread. Weekly charts are one of those places.
Ask yourself why should a strategy, basically the same strategy, work better on a weekly chart than on a daily. I can come up with several reasons. First, very few people have the patience and the discipline to trade weekly charts. Second, by their very nature weekly charts smooth the price fluctuations of the daily chart. If there is a long trending market, we should be in the trend longer. We might get in the trend a little later than on the daily chart, and out later, but we will probably not get whipsawed as much in the directionless markets.
NTRA-DAY VS. DAILY CHARTS
Intra-day charts are the 5-, 10-, 30-, and 60-minute charts that are compiled from intra-day tick data. To trade intra-day charts, you must give almost your full attention to the markets during the day.
Intra-day charts are the 5-, 10-, 30-, and 60-minute charts that are compiled from intra-day tick data. To trade intra-day charts, you must give almost your full attention to the markets during the day.
It is virtually impossible to have a full-time job and trade intra-day charts well. As a percentage of traders, relatively few traders are able to trade during the day. I think it is for this reason that there is significant money to be made trading intraday. The relative lack of competition has to be in your favor trading intra-day. Chart 13 is an example of a 30-minute S&P futures chart placed on top of a daily chart.
 | Chart 13 There are 14 intra-day bars in a 30-minute chart. However the last bar is only 15 minutes because it covers the time from 4:00 to 4:15pm (EST). The top chart is a 30-minute chart and the bottom is a daily chart. |
Trading intra-day data permits you to put a microscope on daily activity and filter trades so that you can take advantage of the intra-day timing. I want to show you the benefits of looking at a technique and strategy through the intra-day microscope.
To do so, let's analyze a technique that I taught in my seminars many years ago. I called it a RangeLeader Breakout. A range leader is a special type of bar that has two attributes. The first is that the range of the bar must be greater than the range of the previous bar. Range is defined as the bar's high minus the bar's low.
