an overall ruleof thumb, the short entry should be the complete opposite of the longentry. All of the top systems that we track follow this guideline.After a position has been entered, there are three different ways asystem can get out of that position: reverse and take an opposite position with a loss or a profit, liquidate the position with a loss, liquidatethe position with a profit (break even trades are considered profitable).A system can incorporate one of these types of exits or all of them.Types of ExitsReversal: This type of exit occurs when the system has determined thatthe market is headed in the opposite direction of its original intent. Thesystem then exits the current trade and self corrects itself by entering anew trade in the opposite direction. This type of stop can be profitable ornot. The problem with this type of exit/reentry is whipsaws. Whipaawsoccur when a system chases the market; the system initiates a positionand the market goes against it, so the system reverses and tries to go inthe same direction of the market, but as it does the market then reversesand goes back in the original direction. Reversal stop baaed systems arein the market 100% of the time and are ready and waiting for the longterm trend. It doesn't use protective stops or profit objectives; it allowsthe market to determine entries and exits.Protective stop: The system was wrong and wants to get out with aminimal loss. This stop is always a loss. The problem with protective stopexits is premature trade termination. Let's say we are willing to risk$1,000 on a trade and we initiate a long position. Immediately the tradeturns ugly and we are stopped out with a $1.000 loss. The next day themarket goes down another $500; we feel confident about our decision toterminate the losing trade. The next five days the market goes back upin the initial direction $8.000. If we had used used a wider stop, then we
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would have stayed with the trade and would have been up $8,000. Determining the optimal protective stop amount is very difficult.Profit objective: The system has made a predetermined profit and thepossibility to make more money is extremely low. This stop is always awinner. Everybody would have to love this exit technique. Let's assumewe are trading a system that has an average win of $2,000 and we haveinitiated a long position. A few days later we are pleasantly informed thatwe are in the profit $2,000. Based on historical statistics, this is the optimal amount the system will make on any given trade. Why should westick with the trade if the probability of making more money is minimaland the probability of giving back some of the profit is high. The problemwith this stop similar to the protective stop, is premature trade termination, in certain situations, this stop will take $2.000 out of the marketand leave $3,000 on the table. Most systems make all of their money on aEmail handful of big winners. If you limit the big winners, then you won'thave enough money to cover the more frequent small losers.To reiterate, the exit technique, be it a reversal, protective stop, orprofit objective, requires much thought and research. For this reason,we will emphasize this aspect when we discuss the five turnkey tradingsystems.Donchian ChannelThree systems that are currently in our top ten have some type ofDonchian variation. As you saw with the indicator, this is a longer termtrend following system that buys on strength and sells on weakness.Let's start with the basic entry technique: Buy when today's high exceeds the highest high of 30 days back and sell when today's low exceeds the lowest low of 30 days back. This is a simple technique thatwill buy on strength, sell on weakness, trade infrequently and hopefullycapture some longer term trends.How do we get out of the market? Let's utilize a money managementstop and some type of profit objective in addition to the system's reversalsignal (we will use the full gambit of exit techniques). We feel that longerterm systems need more room to work when a trade is initially put on andmost of the time a pure money management stop isn't universal: a $2,000move in the Japanese Yen is quite different than a $2,000 move in sugar.All markets trend and congest, but they trend and congest in differentmagnitudes and manners. We like to normalize our protective stops sothat they are a function of the market. By doing so, the protective stop orany type of parameter becomes a characteristic of that particular market. Our stop will be the midpoint between the highest high and lowestlow of thirty days back. This type of stop is predetermined, dynamic anda reflection of current market conditions. Through past experience wehave discovered that pure profit targets do not work on longer term
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systems, unless they are huge. We like to lock in profits on longer termsystems with a trailing stop. A trailing stop is a Stop that follows themarket as it goes in your favor. When the market starts to turn backagainst you, the trailing stop locks itself in and wails for the market tocome to it, hence locking in some profit. Trailing stops work better thanprofit targets because they give an existing trend room to fluctuate. In alot of instances, a long-term trend will show exhaustion and retrace agood percentage then take off hack in the direction of the trend. We haveseen profit targets prematurely exit a trend with a $4.000 profit when atrailing stop holds an for $10,000. Similarly to the protective stop, a dynamic trailing stop seems to work better. Our trailing stop will he basedon the amount of time the system is in the market. Our initial trailingstop will simply be the highest high of the past 30 days if we are long andthe lowest low of the past 30 days if we are short. For every 5 days that weare in a trade, we will decrement the number of days by two that we lookback to attain the highest highs and lowest lows. (For example, if we arelong and we have been in a trade for 5 days, our trailing stop will changefrom being the lowest low for the past 30 days to the lowest low for thepast 28.) As you can tell, we have given as much thought to our exits aswe have our entries, if not more (Table 9.12).Now that we have the entry and exits of our system figured out,let's see how it works on a portfolio of different markets. The exactrules are:• Go long when the highest high of the past 30 days has beenpenetrated.• Go short when the lowest low of the past 30 days has been penetrated.• Place a protective stop at the mid point between the highest highof 30 days and the lowest low of 30 days.• Initialize your trailing stop to be the lowest low of 30 days back ifyou are long and the highest high of 30 days back if you are short.• For every 5 days that you are in a trade, decrement the number ofdays that you look back to calculate your trailing stop by two.Never let this number go below six.• Always use the stop that is currently closer to the market by comparing the protective stop and the trailing stop.Moving Average Cross Over andBack to the ClassicsSeveral of the top rated system utilize moving averages in the entryand/or exit techniques. We feel that the crossover method gives good
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TABLE 9.12
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Modified Donchian Breakout
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trend confirm aliens. Moving averages have been ridiculed and criticized ever since the dawn of trading systems. Why? One reason is thatthey are perceived as an over simplified approach. Another, is in thefact that they lag the current market condition and price. Bleedingedge technology and instantaneous information distribution haspushed traders away from the classical approaches to the markets. If astrategy or a system doesn't mention chaos theory, neural network, genetic algorithm, or game theory then new traders don't want anythingto do with it. It is unfathomable for many traders to believe that a simple moving average system will outperform the majority of the new
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buzz word techniques. We have known a few of the world's largestbanks and CTAs, who spent millions of dollars to research these nowage techniques, abandon them for the simplified classic approaches.Don't get us wrong, we are more than willing to embrace any idea ortechnology that proves itself. We simply haven't heard of anything thatcan outperform the moving average and Donchian systems of the world.Let's get back to our second system. Again, through experience, wehave discovered that an intermediate term moving average crossing alonger term moving average seems to work best over a broad spectrumof different markets. We will enter the market long when the 13-daymoving average of closes crosses from below the 39-day moving averageand yesterday's close is greater than the close of 40 days back. We willuse just the opposite approach to enter short; the 13-day moving averages must cross the 39-day moving average from above and yesterday'sclose must be less than the close of 40 days back.Again, let's use the full gambit of exit techniques that we have atomdisposal. Since our entry signals will be indicating longer term trends,we need to have a good size protective stop to prevent premature tradetermination. In addition, the stop should be made a function of the market as is our entry technique. An average true range calculation is a goodindication of market risk. The average true range for the past x days iscalculated by summing up the true ranges (not actual ranges—truerange differs from actual range in that the previous days close figuresin when calculating the range—true range = max(close[1] or high)min(close[l] or low)) and then dividing by the x. This calculation basically states that for the past x days the market has moved an average of yamount on a daily basis. Daily risk is defined by the amount the marketcan move against you on a daily basis. We know that in certain marketconditions, there is unlimited risk, but for the majority of time we canclosely approximate how much the market may move against our position.If we are trading a moving average crossover with longer term averages,then we must accept the fact that the market will most likely go againstus more than one average true range. Even though we are willing to takesome heat, we still need to define our threshold of pain. For this example,lets assume a protective stop in the amount of five time? the average truerange for the past 20 days. Why five times and 20 days? First, we knowthe market is going to move more than one or two ATRs against us, solet's use a stop that won't get us out on every trade and one that willlimit extreme market losses. Second, the last 20 days usually gives a goodindication of the current market's psychology. We could have optimizedover past data and come up with different values for different markets,but why kid ourselves. We will discuss the dangers of over optimisation inthe next chapter. To lock in profits, let's trail our stop whenever we getfive ATRs in profit. In other words, when the market has gone in ourfavor in the amount of five times the average true range for the past 20
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Simple Moving Average Crossover System
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days, our stop will trail the high of the day that penetrated this point byfive times the current ATR. In addition to our protective and trailingstop, we can exit and reverse our position if the opposite entry techniquesets up (Table 9.13). The exact rules for our moving average cross oversystem are:• Buy on the open when the 13-day moving average of closes crossesfrom below the 39-day moving average and yesterday's close isgreater than the close of 40 days back.
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• Sell on the open when the 13-day moving average of closes crossesfrom above the 39-day moving average and yesterday's close isless than the close of 40 days back.• Calculate the average true range for the past twenty days.• Use five times the average true range as our initial protectivestop.• Every time we move five ATRs in the profit place a trailing stopfive ATRs from the high of the day that penetrated that point.• Always use the stop that is currently closer to the market bycomparing the protective stop and the trailing stop to the reversal stop.Short-Term Volatility Based OpenRange BreakoutThe title of this system sounds complicated, but it IE quite simple inconcept and calculation. Popularized by Larry Williams, this little system is being used to manage billions of dollars. The incorporation of theopening is what makes this system so successful. The opening priceusually gives an indication of price direction for the day and many timesfor the next few days to come. The volatility aspect of the system givesthe magnitude of potential market movement in that direction.As with the other systems that have been presented, we will incorporate a trailing stop. Since we are dealing with a system that holdsonto a trade for an average of less than 12 days and can possibly tradefrequently, the trailing stop should be designed around these facts.Entry and exit techniques are related and should be designed with eachother in mind. You wouldn't have system exit a trade after three days ifits entry was based on an eighty day breakout. Our opening rangebreakout system will succeed less than 50% of the time due to the factthat a trade can be easily triggered in congestive markets and result inwhipsaw trades. Since we are going to win less than 50% of the time, weneed to let our winners run as long as they can and cut our losses beforethey get too big. We will utilize a protective stop in The amount of threetimes the average ten day true range and pull our stop to break evenwhen we attain a profit equal to three times the ten day average truerange. This may seem to be a wide protective stop for such a short-termsystem, but it is a necessary evil. We will demonstrate the ineffectiveness of using tight protective stops when system trading in the nextchapter. A trailing break even stop is one that gets us out at our entryprice after a certain amount of profit is attained. In cases where atrade only lasts for a short period of time, this type of stop seems towork better than one that tries to lock in more profit.
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Opening range breakout systems buy or sell when the market movesa certain amount from the open. With some luck, the market will breakfrom the open and continue in that direction for several days. However,most of the time the market will move a certain amount from the openand then reverse and either congest for awhile or go strong in the newdirection. The problem with this type of system is in the determinationof how far must the market move from the open to indicate a furthermove in that direction. If the distance is too close, then you will sufferfrom whipsaw mania. If too far, then you will be missing a large portionof the move on every trade.With this system we will buy/sell off of the open a certain percentage of the difference between the highest high and lowest low for thepast three days. The difference between the highest high and lowest lowprovides us a measurement of short-term volatility. Volatility is a goodindication of market indecision. High volatility usually indicates a nontrending market, because the market is swinging from high levels tolow levels. While working with open range breakout systems, we discovered chart patterns that helped indicate short-term market direction.With these patterns we were able to determine days when a tradeshould be triggered quicker than normal. This led us to the concept ofthe buy easier/sell easier day. Based on pattern recognition, if a marketcloses lower than the previous day, the following day or days usuallytrend upward. If a market closes higher than the previous day. the following day or days usually trend downward. If the market closes downfrom the previous day, then we have a buy easier day. If the marketcloses up from the previous day. then we have a sell easier day. On buyeasier days, we will buy when the market moves up 50% of the range between the highest high and lowest low for the past three days from theopen price and sell when the market moves down 100% of the samerange from the opening. On sell easier days, we will sell when the market moves down 50% of the range between the highest high and lowestlow of the past three days from the open price and buy when the marketmoves up 100% of the same range from the opening (Table 9.14). Tosummarize our opening range breakout system, here are the rules:• Calculate the highest high and lowest low for the past three daysand define the difference between the two as our volatilitymeasure.• Determine if tomorrow is a buy easier or sell easier day. Iftoday's close is greater than or equal to yesterday's close, then tomorrow is a sell easier day. If today's close is less than yesterday's close, then tomorrow is a buy easier day.• If today is a buy easier day, the buy stop is calculated by dividingthe volatility measure by two and adding the quotient to the open
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TABLE 9.14 Short-Term Volatility Based Breakout SystemONE CONTRAC'T PER TRADETEST PERIOD l/1/83-8/31/99S75 ALLOWED FOR COMMISSION AND SLIPPAGE
price. The sell stop on a buy easier day is calculated by simplysubtracting our volatility measure from the open price.• If today in a sell easier, the sell stop is calculated by dividing thevolatility measure by two and subtracting the quotient from theopen price, The buy stop on a sell easier day is calculated byadding our volatility measure to the open price.• Calculate the average true range for the past 10 days.• Use three times the average true range as our initial protectivestop.
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• Once we move three ATRs in the profit pull our protective stop tothe break even point.• Always use the stop that is currently closer to the market by comparing the protective stop or break even stop to the reversal stop.How important is our pattern and the concept of the buy easier andsell easier day? Tables 9.15 and 9.16 show the exact system without thebuy easier/sell easier setup. Table 9.15 buys and sells 50% off of theopen and Table 9.16 buys and sells 100% off of the open.
TABLE 9.15 Short-Term Volatility Based Breakout System (Test A)ONE CONTRACT PER TRADETEST PERIOD 1/1/83-8/31/99S75 ALLOWED FOR COMMISSION AND SLIPPAGE
196TABLE 9.16
THE ULTIMATE TRADING GUIDEShort-Term Volatility Based Breakout System (Test B)
ONE CONTRACT PER TRADETEST PERIOD 1/1/83-8/31/99$75 ALLOWED FOR COMMISSION AND SLIPPAGE
S&P Day TradeThe S&P day trade system is by far the most popular system out there. Inalmost every Top Ten list that we have published an S&P day trade system has been included. People are constantly drawn to the idea of daytrading. They like the idea of closing out all positions at the end of theday and not exposing themselves to overnight risk. By the end of the day.day traders know exactly how much they made or lost and can go homeand not worry about any adverse news that may affect the markets.
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Sounds to us like this is the way go, but unfortunately with most utopiantype plans, there are extensive drawbacks and obstacles involved withclay trading.Only a small handful of markets trade with enough intraday range tomake good day trading vehicles. Day traders can only capture a smallportion of a market's daily range and if that daily range is not largeenough, then there isn't enough profit potential to cover execution costs.The only markets that offer sufficient daily ranges are the stock indexfutures and the new internet stocks. The rest of the markets are besttraded on a position basis. Figure 9.3 shows a 30-day moving average ofdaily ranges on several different markets.The S&P 500 offers the most profit potential when compared to theother markets. The stock future indexes mirror the U.S. economy andare highly susceptible to rumors and reports. These markets can easilymove $10,000 in a day and have extended periods of illiquidity. We haveknown traders that were slipped more than $2000 trading the S&P 500.With this type of risk the margin requirements for the stock index futures are usually very high. These markets are usually out of reach forthe average trader or should we say should be out of reach for the average trader. Traders that only have $20.000 to trade can either trade asmall portfolio of anti correlated markets or one contract of the S&P500. Most traders unwisely risk their entire capital on trying to day
FIGURE 9.3
Where's the volatility? (Price is vertical and time is horizontal.)
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trade the stock index futures. They place more importance on profitthan on risk, which is the main recipe for self-destruction.Over the years, several different system vendors, sensing the demandfor day trade systems, have tried to come up with a successful approachto day trading the S&P 500 futures. Most of their ideas failed, but thereis one concept that has shown consistent performance and can be found inthe top five S&P day trade systems. This concept is actually a combination of two different entry techniques: open range breakout and acounter trend setup. All of the successful S&P day trade systems have aopen range breakout entry similar to the system we last discussed. In addition to this entry technique, they also can enter the market on acounter trend move or a retracement. As we discussed with the last system, the number one nemesis to breakout systems is the false breakout.This occurs when the market moves in one direction and triggers a tradeand then retraces back in the opposite direction. The retracement entrytechnique tries to take advantage of the market when the initial breakout fails. The combination of these two entry techniques have shown extraordinary performance over the past three years. The breakout is thereto capture the big trending days and the retracement is there to capturethe false breakouts.The S&P day trade system that is presented here has the same overall approach to the market as systems that cost thousands of dollars.There are other key components in this system other than the breakoutand counter trend entry techniques. First off, this system will not takea trade unless it determines that there is enough profit potential. Itdoes this by calculating the average range for the past 10 days and theaverage open to close range for the past 10 days and dividing the lattercalculation by the former. If the quotient is not greater than .5 then atrade is not allowed to take place. Since the majority of the trades andprofit w i l l probably come from the breakout from the open entry technique, there would be no use in trading if the range from the open to theclose is less than 1/2 of the actual range. On days where the average opento close range is less than 1/2 of the average actual range, the majority ofmarket movement is found between the open, and low and between thehigh and close. These areas are known as dead zones for open rangebreakout systems.The second interesting component of our system is the concept ofbuy easier and sell easier days. This system, similar to the one we discussed previously, can buy or sell easier on specific days. Once againthe determination of these easier days are based off of a chart pattern.This pattern involves the "key of the day" which is calculated by addingthe high, low, and close together and then dividing by three. This key ofthe day boils the three most important statistics down to one. If theclosing price is above the key, this usually indicates upward momentumand the opposite in true if the closing price falls below the key. With
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this in mind, we defined a buy easier day when the closing price isgreater than the key of the day and defined a sell easier day when theclosing price is less than the key.The breakout buy and sell stops are a function of market volatilityand are similar in calculation to the open range breakout system thatwe discussed earlier. In this system, our volatility measure is definedas the average actual range for the past ten days (note: actual range issimply the high of the day minus the low of the day). On buy easierdays, the buy stop is calculated by multiplying the volatility measureby thirty percent and adding this amount to the open price. Converselythe sell stop is calculated by multiplying the volatility measure bysixty percent and subtracting this amount from the open price. Onsell easier days, the buy and sell stops are calculated in the same manner, but the percentages are switched. The buy stop uses 60% and thesell stop uses 30%.The counter trend or retrace entries are functions of yesterday's actual range and the key price of yesterday and do not use the buy/selleasier day concept. The counter trend buy stop is set up when the market trends down from the open to the buy trigger point. The buy triggerpoint is calculated by subtracting 75% of yesterday's actual range fromthe key price of yesterday (remember the key price is calculated byadding the high. low. and close together and dividing by three). Oncethis point is penetrated a buy stop is placed at the key price of yesterdayminus 25% of yesterdays actual range. The counter trend sell stop is setup in a similar fashion: first the market must trend up to or past thekey price of yesterday plus 75% of yesterday's actual range and thentrend down to the same key price plus 25% of yesterday's actual range.As you can see, the counter trend entries are trying to take advantageof failed breakouts.There are no trades allowed before 10:00 A.M. eastern or after 3:30P.M. eastern. Only one trade is allowed in one direction on a daily basis.A buy and a sell is allowed in the same day, but two buys or two sellsare not; you can have up to two trade signals a day and the signals mustbe doing the opposite (buying and selling).In an attempt to keep things a little less confusing, a simple moneymanagement stop of 300 points is used. In addition, there aren't anytrailing stops or break even stops. All trades are exited at the end of theday. These are definite areas for further research. This is the most complicated system you will find in this book, so let's summarize the system (Table 9.17):• Calculate the average actual range for the past 10 days and define this as our volatility measure.• Calculate the average open to close range for the past 10 days.
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TABLE 9.17 S&P Day Trade SystemONE CONTRACT PER TRADETEST PERIOD 1/l/90-2/29/00$100 ALLOWED FOR COMMISSION AND SLIPPAGE
• Divide the average open to close range by the average actualrange and if this quotient is less than 0.5 then no trades can beplaced.• Calculate the key price of today by adding the high, low. and closetogether and divide by three,• Determine if tomorrow is a buy easier or sell easier day. If today'sclose is greater than today's key price, then tomorrow is a buyeasier day. If today's close is less than today's key price, then tomorrow is a sell easier day.• If tomorrow is a buy easier day, the buy stop is calculated by multiplying the volatility measure by 30% and adding the product tothe open price. The sell stop on a buy easier day is calculated bymultiply the volatility measure by 60% and subtracting the product from the open.
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• If tomorrow is a sell easier day, the sell stop is calculated by multiplying the volatility measure by 30% and subtracting the product from the open price. The buy stop on a sell easier day iscalculated by multiplying the volatility measure by 60% andadding it to the open price.• Determine the retrace buy trigger for tomorrow by subtracting75% of today's actual range from the key price of today. The retrace buy price is the key price of today minus 25% of today's actual range. If at any time the market trades below the retrace buytrigger, a long position can be entered at the retrace buy price.• Determine the retrace sell trigger for tomorrow by adding 75% oftoday's actual range to the key price of today. The retrace sellprice is the key price of today plus 25% of today's actual range. Ifat any time the market trades above the retrace sell trigger, ashort, position can be entered at the retrace sell price.• No trades allowed before 10:00 A.M. eastern or allowed after 3:30P.M. eastern.• A m a x i m u m of two trades are allowed on a daily basis and theymust be doing the opposite (buying and selling). You can initiateone long position and one short position on a daily basis, but youcan't initiate two position going in the same direction.• Use a simple 300 point protective stop.• Close out any open positions on the close of tomorrow.Pattern RecognitionPattern is defined as a predictable route or movement. Hence all tradingsystems are in some form or manner pattern recognition systems. Along-term moving average cross system utilizes pattern recognition it its decision when to buy or sell. The crossover in this case is thepattern An open range breakout is pattern recognition and the patternin this case is the movement from the open to the breakout point. Allsystems look for some type of reoccurring event and try to capitalize onit. These reoccurring events are the patterns.System vendors have been selling pattern recognition software for aslong as trading systems have been around. This type of software looksfor reoccurring visual chart patterns and analyses the immediate market action that follows. Japanese candlestick patterns are also of a visual pattern nature. Information concerning a day's market action canbe seen easier and quicker with a candlestick chart than with a typicalbar chart. A candlestick bar consists of a shadow and a body. Theshadow is drawn from the high of the day to the low and the body is arectangle drawn from the open price to the close price around the
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shadow. A light-colored candle body indicates the close was higher thanthe open. A dark body indicates the close was lower than the open, Candlestick or other types of visual patterns are usually quite simple andcan be recognized with the naked eye. Three candlestick chart patterns,Doji Star, Big Bullish Candle, and Hammer are shown in Figure 9.4:• Big Candle—An unusually long body with a wide range betweenhigh and low.• Doji—The open is the same as the close.• Hammer (Bullish)—A small body (either color) near the highwith a long lower shadow and a short or no upper shadow.• Hammer (Bearish)—A small black body near the low with a longupper shadow and a short or no lower shadow.Other visual chart patterns can be described in language also:• IF HIGH(l)>HIGH(2) AND OPEN<HIGH(1) THEN BUY ATHIGH (1).
FIGURE 9.4
A sample of candlestick chart patterns.
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A few system vendors have misused pattern recognition and misledtheir clients into believing that reoccurring simple visual patterns, bythemselves, can foretell future market action. Some vendors havescanned historical data and found occurrences of visual patterns thatseemed to have prophetic powers. They then bundle these patterns upwith a piece of software and sell the whole thing as a system. Absolutely nothing is wrong with this if all of the performance numbersare fully disclosed. In most, cases, the vendor has found a bunch of different patterns that when added together creates a great looking equitycurve. The problem is that most of these patterns occurred less than 30times in history. A sample of less than 30 is considered statistically insignificant. The whole pattern system may add up to over 30 trades, butthe important thing to remember is the number of occurrences of eachindividual pattern. We know of another system vendor that scanned history and developed a calendar system (another form of pattern recognition! based on probabilities of success. His research revealed that if onewere to buy or sell on certain days of the year, then those trades wouldhave a high historical probability of being profitable. These