Rule #1 Trading Strategy

Discussion in 'Trading Strategies' started by Dary, Sep 30, 2013.

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  1. Dary

    Dary Dary McGovern Staff Member

    Rule #1 Strategy Overview

    On the American Association of Individual Investors website there was a discussion about a trading strategy called, 'Trading Rule #1 Stocks'. A custom indicator was created in timetotrade to help generate alerts when the entry and exit conditions where met, as discussed on the Rule 1 Trader Alerts thread.

    In this post the strategy will be analysed for some Currencies on varying intervals to understand its behaviour in varying market conditions.

    The original strategy is a long only strategy and in this discussion it will be modified to switch between long and short positions as technically the entry and exit conditions for both are equal and opposite. The trading rules are based on the following conditions:

    1. Switch to a long buy position when the:
      • Price is above the 10 period Moving Average
      • MACD is above the SMACD with a Leading MA of 8, Trailing MA of 17, Smoothing Factor of 9
      • Stochastic %K above Stochastic %D using K Period of 14, Slowing 3 and D Period of 3
    2. Switch to a short sell position when the:
      • Price is below the 10 period Moving Average
      • MACD is below the SMACD with a Leading MA of 8, Trailing MA of 17, Smoothing Factor of 9
      • Stochastic %K below Stochastic %D using K Period of 14, Slowing 3 and D Period of 3
    To test this strategy the Rule #1 Buy & Sell Signals custom indicator will be used. The import code is ADCE-964C-7B3E and click herefor help on how to import it to your chart settings.



    Rule #1 Trading Strategy Execution

    This section will explain how to execute this trading strategy using timetotrade. Lets start by creating the Rule #1 Buy Signal Alert. To do so click on the rising threshold trigger for the 'Rule #1 Buy Signal' custom indicator to test if it rises above 0 as illustrated:

    rule_one_2.png

    Click on the 'Add Trigger' and then associate a trade to the alert. The order type will be set to a 'Buy Switch' which will buy to close a short position if it exists and then buy to open a long position. The trade should only execute if not in a long position when the alert is triggered i.e. 'When the alert is triggered, if not long, execute trade' as illustrated in the trade deal ticket:

    rule_one_strateg_1.png

    To develop an understanding of the position logic used in conjunction with a 'Buy Switch' order, consider the following scenarios when the Rule #1 Buy Switch alert conditions are met:
    1. No existing position - as there is not a long position the trade will execute only the second part of the Buy Switch, which is buy to open a long position, as there was no short position to close.
    2. In a long position - as there is a long position the 'if not long' position logic prevents the trade from executing.
    3. In a short position - as the current position is not a long position, the Buy Switch executes a buy order to close the short position and then an opening buy order to create a long position.
    Now lets create the Rule #1 Sell Signal Alert. To do so click on the chart falling threshold trigger on the 'Rule #1 Sell Signal' custom indicator to test if it falls below 0 as illustrated:

    rule_one_4.png

    Click on the 'Add Trigger' and then add a trade to the alert, which will execute the Sell Switch trade if not short when the 'Rule #1 Buy Signal' indicator rises above 0 as illustrated:

    rule_one_strateg_2.png

    To develop an understanding of the position logic used in conjunction with a 'Sell Switch' order, consider the following scenarios when the Rule #1 Sell Switch alert conditions are met:
    1. No existing position - as there is not a short position the trade will execute only the second part of the Sell Switch, which is sell to open a short position, as there was no long position to close.
    2. In a short position - as there is a short position the 'if not short' position logic prevents the trade from executing.
    3. In a long position - as the current position is not a short position, the Sell Switch executes a sell order to close the long position and then an opening sell order to create a short position.
    Rule #1 Trading Strategy Analysis

    Backing testing this strategy over the last 10 years for GBPUSD, generated a moderately profitable outcome. Overall the strategy was defined by periods of profit, offset by periods of losses, with the profit range bound, as illustrated by the blue chart in the 'Backtest Results':

    rule_one_strateg_3.png

    When analysing any strategy it is important to understand when it works and when it fails. By doing so the strategy can be evolved to dial out bad behaviour. The green arrows on the following chart illustrates the periods when strategy performed best:

    rule_one_strateg_4.png

    Looking at the historical price action relative to the profitable trades, the long and short profitable trades are associated with periods of strong direction movement and the loses are associated with periods of volatility and sideways trading. 34.6% of the trades where profitable with the reward from profitable trades being able twice the risk from lose making trade. In addition the profitable trades tend to captured approximately 75% of the trending move when you compared to the take profit optimisation results for short and long trades; this is useful to note if looking for a strategy to exit trending moves:

    rule_one_strateg_5.png

    It is interesting to note that the time frame for profitable winning trades is around 17 days for both long and short positions, where as losing trades tend to be around 7 days. This re-enforces that the strategy works best in long trending periods.

    In reality most traders will not use a daily interval chart and hold for 17 days as even a small leveraged position could result in a significant loss. The strategy was therefore retested using a 5 minute interval chart, rather than a daily interval chart, on the GBPUSD.

    The 5 minute strategy had the same behavioural characteristics as the daily interval chart, with profits being generated during large trending moves and losses arising during periods of sideways trading.

    rule_one_strateg_7.png

    Upon reviewing the following chart, note the grouping of blue arrows indicating losing trades (up arrows are 'buy'; down arrows are 'sell'; grey arrow is an opening trade; green is a profitable trade; blue is a losing trade):

    rule_one_strateg_6.png

    The losing trades tend to be clustered together during periods of range bound trading.


    Rule #1 Trading Strategy Conclusions


    This strategy is effective in markets that have periods of strong direction movement and the loses are associated with periods of volatility and sideways trading.

    The strategy is also effective at capitalising on breakouts to the up or downside, as the indicators will adjust to bullish and bearish market conditions and get on the right side of a breakout. It could therefore be useful when awaiting key news that may act as a market catalyst for a move.

    To the downside, the strategy as it will generate frequent loses during periods of range bound trading.
     

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  2. Dary

    Dary Dary McGovern Staff Member


    Apply for a trading account today and get the superb Trigger Trading™, Taxation and Investment Club Pro Package for FREE. Get your trading advantage.

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