Any trader who has visited an online trading community or message board is aware that many traders approach the markets with hardened, almost dogmatic viewpoints about the “right” or “wrong” way to trade. This fervor can at times harden into a form of “trader political correctness” where reason and evidence take a backseat to defending previously held viewpoints at all costs.
Discussions of stock index futures trading offer perfect example of this tendency. For many, it has become an article of faith that the only way to trade stock index futures is with a mean-reversion or reversal trading model. This viewpoint is not entirely unfounded; there is abundant evidence stock indices tend to experience price reversals over a wide range of time horizons.
But this isn’t the full story. There are market conditions and time horizons in which mean-reversion models experience significant failure — drawdowns and losses large enough to fray nerves and bring the entire strategy into question.
One solution to this problem is to search for a “holy grail” — that one, perfect strategy that allows you to compound wealth with no drawdown or pain. More experienced traders tend to take a different approach. Rather than attempting to find the perfect trading system, they are more likely to build a stable of effective but imperfect trading systems that rely on different concepts to make money. With this approach, each strategy is simply one player on a larger team, rather than an all-or-nothing bet.
The following analysis builds upon a simple momentum-based, intraday breakout trading model for the E-mini S&P 500 (ES) stock index futures. To keep the important concepts at the forefront (and for the sake of brevity), the discussion focuses on long signals and exits on the close. The starting point for the strategy is:
1. Buy a breakout 10 points above tomorrow’s open.
2. Exit on the close of the same day.
Next we’ll examine three additional factors that, when combined with the basic strategy (and each other), can be used to create very effective trading approaches. The factors are:
1. The opening gap (yesterday’s close to today’s open, using day-session data).
2. Where yesterday’s close occurs within the recent trading range.
3. Recent market volatility, as measured by the 40-day average true range (ATR).
While we will be looking at specific rule sets or combinations, the far more important knowledge these studies contain is conceptual: the idea that market conditions can be measured, and that these conditions largely determine what strategies will be most effective in the near future.