Improving both ends of a system
By Kevin J. DaveyIf you’ve read any installments of Active Trader’s ongoing System Design series, you know building a viable trading strategy from scratch is more difficult than it seems. Strategy development is a marathon, not a sprint, but traders are often lured into chasing the latest approaches with the best-looking performance.
Unfortunately, this quest may cause traders to discard good but not great strategies. Sometimes, however, you might already have a viable strategy that simply needs an extra boost. Straightforward steps that can potentially enhance system performance include adding to open positions, exiting winning trades early with a profit target, or simply getting out after holding trades a certain amount of time.
The following examples show how and why a basic moving-average strategy can be improved without changing its basic trade-entry rules.
Identifying the trendThe easiest way to identify the market’s trend is with a simple moving average (SMA). If price crosses below a moving average, the trend is down; if price crosses above a moving average, the trend is up. This strategy buys the market when price exceeds a 30-day SMA and sells when price drops below a 30-day SMA.
We chose a 30-day look-back period for the moving average because it represents an intermediate-term trend. It wasn’t optimized in any fashion. For simplicity, the approach focuses on daily soybean futures over the past five years — from Dec. 15, 2004 to Dec. 15, 2009.
Figure 1 shows five trades in soybean futures (S) from December 2008 to March 2009. The strategy caught the soybean uptrend in late December and early January, and it also sold short as the market slipped sharply in mid-February. But it wasn’t perfect, generating two losing trades in early February when the trend was unclear.
This trading approach is in the market most of the time as long signals end short trades and then trigger buy orders, and short signals end long trades and trigger short trades. To prevent catastrophic losses, the system includes a $1,000 stop-loss, an amount that also wasn’t optimized. The trade rules are:
1. Go long (and exit shorts) at tomorrow’s open if today’s closing price crosses above the 30-day SMA.
2. Sell short (and exit longs) at tomorrow’s open if today’s closing price crosses below the 30-day SMA.
3. Exit any trade if its open loss climbs to $1,000 per contract.
For the complete article, see the April 2010 issue of Active Trader magazine. Click here to subscribe.
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