In this article, we will develop a strategy that can be used by part-time traders to capture the large moves being seen in the markets from day-to-day.
Markets in 2011 have been characterized by volatility, with daily moves of more than 1 percent seeming to have become fairly common. This is true in stocks, as measured by the large cap or small indexes. Futures markets also seem more volatile than normal with many commentators questioning whether or not gold and silver are in bubbles, as an example of how the volatility has even captured the attention of non-traders. Almost as consensus was building around the bubble conclusion, metal prices plunged. Long-term investors were reminded of risk, and traders were able to capture rapid gains with short positions.
In volatile markets like this, day trading can be very profitable. If you only plan on holding a position for a single trading day, you need to capture as much of the market move as possible. Considering that the odds are against the day trader, bigger moves on winning trades need to overcome frequent small losses. A successful trading strategy also needs to be able overcome significant trading costs and incur the minimum amount of costs necessary.
All of those requirements can be used as rules for a trading system. After developing a fully mechanical system, we will test it on gold, silver, and stocks using the emini Russell 2000. The Russell 2000 seems to trend better than the other emini contracts and is very useful for small traders looking at stock futures.
It has always been challenging to find mechanical systems that work on metals, but given the extreme volatility over the past months in the markets it should be possible to apply simple rules in the current environment.
Day trading means that any open positions will be closed at the end of trading. This can easily be handled with a sell, market on close order as an exit strategy. This type of exit also maximizes the amount of gains available on a winning day trade by holding the position as long as possible in a day. Closing all positions at the end of the end also decreases margin requirements. Some brokers allow day traders to hold positions with margins of as little as $500 per contract.
Odds truly are against day traders and one of the reasons is the high cost of trading. In system testing, we will assume round-turn commissions and slippage of $45 per contract. For perspective, this is almost 10 percent of the margin and some will argue that is high, but it really is best to use a high estimate of trading costs in back testing. If costs turn out to be lower in the real world, you will have more profits than expected.
To minimize trading costs, we will limit the system to one trade a day. Many day trading strategies suffer from frequent whip saws, establishing repeated positions trying to capture a trend. Each losing trade will incur trading costs and a loss of capital. On a trendless, low volatility day, there may be many losing trades without a single winner. With only one trade a day, there will still be a large number of losers, but the commissions will be limited to one round turn a day. This also creates the kind of system a part-time trader can actually use since intraday updates of the strategy will not be required.
Taking only one position a day leads to the question of whether or not a stop loss should be used. This would limit the amount of dollars that could be lost in a day, but we need to test to see whether or not the stop loss order will add value to the system. We’ll look at that question after presenting a winning system that doesn’t use a stop loss.
After considering stops, we can now look at an entry strategy. The strategy will use end of day data so that part time traders can apply the strategy. Basing entry orders on the previous close allows for orders to be entered before trading starts.
An opening range breakout strategy work well for day trading, but requires traders to base entry orders on the opening of the market, requiring a time commitment that the part-time trader can not make. We will use this concept with end of day data.
The rules for an opening range breakout are to find trade entries by adding and subtracting a multiple of the range to the close of the range. An example using the S&P 500 and a 10-minute bar will make this clearer The S&P 500 opens at 9:30 eastern time, so we will have all the data we need at 9:40. Assume there is a 10-point range and the index is at 1200 at 9:40. We can simply add the range to the close to find a buy order and enter a buy stop at 1210. A sell stop at 1190 would be used to enter a short position. The sell level is found by subtracting the range in the first ten minutes from the close of the 10-minute bar.
There are an infinite number of variations to this strategy. Any time frame could be used to calculate the range or multiples of the range can be used. A multiple of 0.5 would enter traders sooner and multiples greater than 1.0 would lead to fewer trades.
No matter what variation is used, the system is designed so that winning positions can be closed at the end of the day. Some losing positions could be closed on an intraday move and reversed. If you are long at 1210 in this example, a market drop to 1190 would cause you to exit the position and enter a short. To limit trading to once a day, when entering trades before the open, they should be entered as ‘one cancels other’ which kills one order as soon as one is filled.
We will use closing data to calculate orders for the next day. To account for changing markets, we will use the average true range (ATR) to define the breakout, an indicator that was defined by Welles Wilder in the 1978 book, “New Concepts in Technical Trading Systems.” The ATR measures volatility by looking at an average of the recent ranges. It could easily be calculated with a spreadsheet, which means this strategy can be implemented without trading software. We will use a look back period of 8 days for the ATR, which is simply a random Fibonacci number to use in the calculation.
The idea is to trade long if price breaks above the recent level of normal volatility and short when prices move below the recent range defined by the ATR. Since closing prices are used, before the next day’s open trades can be entered using the following formulas:
Long entry at Close + (atr_mult * Avg True Range (8))
Short entry at Close – (atr_mult * Avg True Range (8))
For testing, we’ll use a multiple of 0.5 to be sure we have enough trades for a statistically significant sample. Exits will be at the end of the day.
Starting with gold, since the beginning of 2011 through mid-October, this system traded 154 times, about 75 percent of the trading days. Total profits, after a $45 per trade deduction for trading costs, are $24,560 and the maximum draw down was $9,030. About half the trades are winners and shorts are more profitable than longs.
Silver delivers even better results with gains of $69,035 and a maximum draw down of $2,365. Only 28 percent of the trades are winners, but the average loss is relatively small and the strategy works.
With stocks, using the emini Russell 2000, profits total $13,500 but draw down is higher than with the other tests and reaches a little more than $8,500.
In all three cases, adding a stop loss helps to reduce the draw down but it does so by also reducing the profits. It is a question of how much risk you can accept and this is a decision each trader should make on their own since some will prefer lower draw downs even at the expense of profits.
Opening range breakout strategies are widely used by day traders. That concept can be easily adapted to the needs of the part-time trader and a profitable day trading strategy, using end of day data, can be created. The system shown here works in any volatile market.
By Michael J. Carr, CMT