When just starting out, some beginning traders will want to use all of their available funds to trade rather than buying software and data feeds. In this article, we’ll look at how that can be done, using free end of day data and indicators.
Trading software allows traders to design and back test trading systems. It also makes it easy to generate orders that need to be entered and in some cases can even automate system execution. However, trading software can be expensive. It can also be difficult to use requiring some programming skills in many cases. Less expensive software tends to require the most programming skill. Part time traders also may not have the time to learn the software.
Data represents another expense. Real-time data is needed for those wanting to day trade, but even end-of-day data feeds will cost at least a couple hundred dollars a year. Many traders start with a small account and software and data could cost more than the trader has in capital.
Without trading software, the trader will not be able to back test their strategy which means they will not know their probability of success. Back tested results offer a guide to the future and can be used as a real-time check on actual results. If the results being obtained are significantly different from the historical results, the trader should view that as a caution signal. It could mean the market is out of synch with the system and a smaller position size is merited. More importantly, it could signal that trades are not being executed efficiently and without correcting that problem, there is very little likelihood of future success.
Some traders will take a discretionary approach without software. Buy and sell signals will be derived from pattern formations or trend line breaks. A problem with this approach is that those tools require experience to be used effectively. If you believe a market is topping, it is very easy to spot head and shoulders patterns forming. However that same action could also be a consolidation and another analyst would expect to see prices continue higher. Similarly, trend lines can be drawn in a number of different ways, often based on the chartist’s expectations of the future. There are some very successful discretionary traders but the odds are against the beginning trader joining their ranks.
A number of web sites offer delayed price quotes and basic charting functions for free. It could be possible to use these resources to begin trading for a living.
First, it is important to understand the limitations. Delayed data means day trading is not possible. A lag of twenty minutes, or even ten minutes, means a position could easily move against you before you saw the market change. That introduces an unacceptable level of risk for the small trader. Free data could be used for trading an end of day system, or perhaps even a weekly strategy.
Some experts will caution that they would never trade an indicator they had not personally programmed. Most of these experts are either computer programmers or losing traders. The reality is that indicators are imprecise and there is no need to review each line of code to be sure it is accurate to the eighth decimal place. Experts advising against using indicators from a freely available source are being overly cautious.
A real concern with these indicators is the same consideration you face even with expensive custom software – the question of which indicators to use and how to generate trading signals. In all cases, simplicity is usually the best approach.
Moving averages are probably the simplest technical indicator. In trending markets they deliver big profits but suffer frequent whipsaws in trading ranges. Given that markets are range bound the majority of the time, there will be a lot of losing trades with moving average systems and success often depends on starting to trade the strategy at the right time. If you begin just as a big trend emerges, you will build enough capital to survive the inevitable whipsaw periods. Those who start trading in the middle of a protracted trading range could see their trading capital quickly depleted by a series of losing trades.
Signals can be delayed in a variety of ways with a moving average trading system. Usually this involves a time delay or requiring a close several percent above or below the moving average. These are all significant changes from the basic idea of a moving average strategy and add complexity which might not be needed.
Other indicators are designed to smooth the signals from prices, and the MACD is even designed to smooth the signals from moving averages. An advantage of this indicator is that it offers very clear signals. Buys are taken when MACD is greater than zero and positions are sold, or short positions entered, when the MACD is less than zero. The indicator is also easily found on every major free charting site.
Parameters for the indicator can often be changed, but that is an exercise in optimization. Default parameters on an end of day system are often good enough, especially for an indicator such as MACD which doesn’t offer an excessive number of signals.
The question now is whether or not default settings of MACD could deliver profits to a trader using end of day data. Testing will include stocks in a long only strategy, stocks both long and short, and a diversified basket of futures. This recognizes that many individual do not want to short stocks and evaluates the potential rewards and risks of that decision.
Stocks tested will include the components of the NASDAQ 100, testing from the beginning of 2000. Over that time, through November 23, 2011, the index itself shows a decline of more than 44 percent. Buy and hold investors in the index would have suffered significant losses.
Overall, MACD as a strategy is profitable. About a third of the total number of trades are profitable but risk at the system level is manageable. Draw down is about 15 percent of the total gains and the system was profitable in 8 of the 11 years in the test period. However, the strategy would have suffered its worst draw down in the first three years and most traders would not have had the capital to survive the initial draw down.
Looking at the stocks individually, 78 of the 100 were profitable. This is a robust and successful strategy and could be used by traders without software. Success is highly dependent on luck associated with when you start trading.
Results are significantly better using weekly data. The percentage of winning trades increases slightly to about 35 percent, but profits are three times higher than using daily data with less draw down. All 100 stocks are profitable. The beginning draw down is still the steepest a trader faces, but that problem can be addressed with other strategies like only trading long when the stock market is bullish (that means only buying when a broad index like the S&P 500 is above its 50-day moving average).
Testing shows that shorting individual stocks doesn’t add significant value in this case. There are significant costs associated with holding short positions and it is difficult to overcome those costs that include interest on short balances and commissions.
Futures offer a number of advantages to the smaller trader. They are leveraged and allow a trader to be diversified with a smaller investment than stocks. Testing will cover the same time period using cotton, crude oil, five year Treasury notes, the US dollar, cattle, copper, cotton and sugar. This basket could be traded with about $25,000 in margin and would be very profitable, delivering gains averaging almost 26 percent a year. A worst case initial draw down would be limited to about 25 percent of capital, an extreme hit but one that is survivable. The stock only trader starting at the same time would not be able to withstand three years of steady and large losses. Weekly signals are profitable, but daily signals work better in the fast moving futures market.
Forex could also be used with a small degree of leverage. Using only default MACD signals, the dollar-pound pair tests well on daily data, as does the euro-dollar or euro-Chinese Yuan pairs. Leverage should be limited to 25:1, and ideally would be even less. Higher leverage could lead to losses that completely wipe out account equity.
Trading software is a luxury many beginning traders simply can’t afford. They can still put the odds on their side by using a free web site that offers MACD signals on end of day data. These small traders should consider using futures, which offer high potential returns with less risk than other tradables. Forex offers the lowest cost of entry, but comes with the highest risks. Stocks require the most capital to trade and really will not deliver the gains a small trader needs to trade for a living.
By Michael J. Carr, CMT