Trading Strategies That Work

Trading strategies, what makes them work?

One of the best questions I have ever been asked is do you have an edge that works for you, and if so what is it? I'm always impressed when someone asks me this so directly because it means that they really 'get it'. Finding an edge, then applying it frequently and consistently (along with an appropriate risk management strategy) is the only way to succeed in trading. Trading strategies without an edge, even if they employed the best risk management techniques in the world, will always fail because in trading without an edge you are essentially taking trades at random and the cost of trading (i.e. the spread) will, over time, cause you to lose your entire account in exactly the same way as you would eventually lose all your money if you kept playing roulette against a fair and balanced wheel. In order to succeed your strategy must have an edge, something that is not random and tips the odds of success in your favour. Trading is about probabilities, not certainties; no single trade is certain to pay off but it doesn't have to be, if trades are taken with an appropriate risk management strategy then it's enough that the odds are stacked in the trader's favour. If you keep playing when the odds are in your favour you will eventually win – once you have figured out how to tip the odds of success in your favour all you need to do is put a suitable risk management strategy in place to ensure that you stay in the game long enough to realise your winnings.

Between finding an edge and finding a suitable risk management strategy to employ along with it, finding the edge is by far the most difficult part. And it's with finding the edge that I will concern myself with in this article.

Finding an edge,

As I wrote on the technical trading systems page there are only three things (that I know of) that aren't random in the markets and there are therefore only three ways that I know of to gain an edge, these are –

• The long-term underlying trend.
• Support and resistance.
• Momentum.

Trend following: Buying strength & selling weakness,

Systems that aim to buy strength and sell weakness seek to capitalise on the edge provided by the trend. These systems aim to buy when the market is high and sell when it is even higher during up trends, and sell when the marker is low during down trends and buy it back again when it is even lower still. These systems only perform well on markets that trend well, as I said above, markets that are mainly driven by macro economic fundamentals such as the Forex market (especially the EUR/USD) tend to have the longest lasting and cleanest trends and are therefore ideal for trend following systems. Good trend following systems are usually long-term trading systems with good trades often lasting for several months if not more.

My favourite trend following entry signal is a form of Donchian Channel breakout, but there are many different types of entries such as price compared to moving average price, moving average crossovers, large weekly movements etc, etc... The form of Donchian Channel breakout that I generally use is where you enter long when the price closes higher than it has ever closed in the previous x number of days and enter short when the price closes lower than it has ever closed in the previous x number of days.

For exits, trend following systems tend to use trend reversal signals (such as a 20 day low during an uptrend or a moving average crossover against your position), lack of follow through signals (such as the market failing to make a new high for several weeks during an uptrend or the market failing to make a new low for several weeks during a downtrend), or a simple time-based exit.

I now only trade trend following systems on the EUR/USD currency pair. To demonstrate the edge produced by the long-term trend I'm going to perform an experiment on the EUR/USD pair from the beginning of the year 2000 to the end of the year 2010. For long trades I will buy whenever the price closes higher than it has ever closed in the previous 120 trading days and hold the position for 10 trading days. For short trades I will sell whenever the price closes lower than it has ever closed in the previous 120 trading days and hold the position for 10 trading days. The results are –

Number of winning trades: 200
Number of losing trades: 141
Percentage of winning trades: 58.65%
Number of pips/points won: 36,825
Number of pips/points lost: 25,667
Winnings to losses ratio: 1.43 to 1
This test was performed with 6 day data, that is there are 6 closes a week (the FX market is open 5 and a half days per week). To download the full results right click and save target as here.

Trading the effects of support & resistance: Buying low and selling high,

Buying low and selling high typically works well on stocks/shares and especially on indexes like the FTSE 100, the Dow Jones Industrial Average and the S&P 500. This type of trading strategy is often referred to as 'buying value' and generally works because of the effects of support and resistance. Speculators and investors, especially those looking to buy and sell shares, usually wait for prices to retrace back slightly before buying and then look to sell at recent highs (at least the speculators do, most investors simply hold on to good stocks once they own them). This type of behaviour from speculators creates a series of peaks and dips and causes significant levels of support and resistance to emerge, especially around psychologically significant numbers - i.e. numbers like 1200, 1250, 1300 or 1350 on the S&P 500 and numbers like 12,000, 13,000, 14,000 etc on the Dow Jones. In my experience, when the market is rising or falling towards a significant round number acting as support or resistance it will usually reach it before bouncing back.

Speculative trading to profit from the almost never-ending series of short-term dips and peaks should not be confused with buying and holding. Buying value to sell higher in a few days or a few weeks time is speculating, and speculating is essentially gambling. Buying value to hold for the long-term is investing; these types of investors usually seek to buy a good company at a fair price, or better yet, a great company at a good price to paraphrase a quote from Warren Buffet. Gambling on short term price movements should never be confused with investing. If you're interested in investing in stocks and shares and you think you might be interested in value investing I would recommend you take a look at the website BuyingValue.com.

To demonstrate the effectiveness of buying low and selling high on speculative driven markets I will perform the following experiment on the S&P 500 from the beginning of the year 2000 to the end of 2010 -

• When the price closes higher than it closed 100 days ago but is lower than it has ever closed in the previous 10 days then that is to be considered a short-term dip in a bull market, so we will go long with a 10 day time-based exit.
• When the price closes lower than it closed 100 days ago but is higher than it has ever closed in the previous 10 days then that is to be considered a short-term peak in a bear market, so we will go short with a 10 day time-based exit.

Trading momentum: Getting in on the side of a big movement,

For those that are interested in trading using momentum on the GBP/USD currency pair, a trading system based on this experiment already exists in this website's technical trading systems library, it is called Cable Momentum. The system was designed for the GBP/USD currency pair only.

The rules for trading momentum are as follows: we will enter in the direction of a daily movement at the close of the day when the day's movement has been bigger than any movement in the previous 10 days, and exit 2 days later using a time-based exit. An up (or long) movement is defined as the price closing higher than it opened, and a down (or short) movement is defined as the price closing lower than it opened. For an up day the size of the movement is calculated as the difference between the day's low and the day's closing price (Close-Low). For a down day the size of the movement is calculated as the difference between the day's high and the day's closing price (High-Close).

Trading strategies that work: my conclusion,

In this short article we have demonstrated the existence of three distinct and very different types of edges on three different markets.

The edge produced by the trend works best on the EUR/USD currency pair and also seems to be fairly effective on most of the major Forex currency pairs, yet it almost certainly would not even be significant enough to be 'tradable' on the S&P 500 or other stock market indexes. Obviously, the edge produced by trend will only exist on markets that trend fairly well and markets only tend to trend fairly well when they are being driven by real economic fundamentals – when a market is being driven by speculation there are a lot of small peaks and dips as speculators jump in and out like yoyos, except when the speculation has gotten out of control and the speculators have (for the most part) lost touch with reality and are creating a bubble.

As time goes on speculators seem to have become increasingly important and influential and there is now more speculation in the markets than there has ever been. This probably explains why trend following systems no longer seem to work as well as they once did on many markets. Nevertheless, on large liquid currency pairs like the EUR/USD I still believe that macro economic fundamentals such as interest rate policies and the will of various central banks will have far more influence than speculation, simply because markets like the EUR/USD are just to large for speculators to have the money to really move them to the point where they create a long-term trend in one direction.

The edge produced by the effects of support & resistance seems to work best on markets like the S&P 500 where the underlying markets (i.e. the indexes component stocks) are being driven by speculation, this is because it's speculation (not economic fundamentals) that creates areas of support & resistance. For example, on the EUR/USD the experiment that we performed on the S&P 500 produced a pips won to pips lost ratio of 1.20 to 1. An edge of this size is probably not even big enough to be worth trading, especially on a system that trades relatively infrequently.

As I said before, the origins of the edge produced by momentum is a little harder to nail down and for those interested in trading momentum I would recommend that they thoroughly test it on various markets for themselves, in the Forex market, the GBP/USD seems to be one pair that works well with momentum trading systems. In other markets such as stocks or shares for example, you can get reliable information on not just the price but the volume traded, volume can often be used as a reliable sign as to whether the momentum is significant and worth getting in on or not.

These experiments should not be used as complete trading systems and they can easily be improved upon; the experiments were done simply to try and prove the existence of different types of edges on different markets. I hope this information will be useful to someone.

Thanks for reading, David.

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