All trading system have three major
components:
1. Entry and exit (filter optional).
2. Risk management.
3. Position sizing.
Trading strategy
overview
Entries and exits are the
engine or driver of trading in a strategy. They can be very simple or
extremely complex. They can be filtered by one or many different
elements. An entry can be at a specific price level or at the market
or on the open or close. A trading strategy can employ more than one
entry or exit. It can use one method to enter a trade and an entirely
unrelated method to exit. The variety of entries and exits is really
without bounds. A strategy typically consists of buy-and-sell
conditions that mirror, or are the opposite of, each other. For
example, a buy signal occurs when price rises through a three-day
high and a sell signal occurs when price breaks through a three-day
low. This is an example of what is called a symmetrical trading
strategy.
A strategy can also
consist of completely different buy-and-sell entry conditions. For
example, abuysignal occurswhenafive-day high is broken and asell
signal occurs whenafive day moving average falls below a 20-day
moving average. This is an example of an asymmetrical trading
strategy.
A trading strategy may
include risk management in the form of a stoploss order. Risk
management is a way to limit the amount of capital at risk during the
life of a trade. A typical risk management approach is to set a
stop-loss order that is the maximum, yet subject to slippage, loss to
be taken on a trade. For example, assume that a long position is
initiated at a price of 1,495.00 in S&P futures. The strategy
calls for a maximum risk of $1,000 or 4.00 points. Therefore, after
the position is entered, a protective sell stop is also entered. If
our risk is $1,000, or 4.00 points, then our sell
stop will be 1,491.00
(1,495.00 – 4.00).
A trading strategy
can also include profit management. This is a method of protecting
the open equity profit that must develop during the life of a winning
(and sometime losing) trade. A typical profit management approach for
a long position is to set a trailing stop at a fixed dollar amount
below an equity high,
that is, the highest price achieved during the trade.
Assume a strategy that
calls for a trailing stop of $2,000, or 8.00 S&P points. This
point value will trail under progressively higher prices during our
long position. Assume that the long position is entered at a price of
1,390.00 and an equity high point of 1,410.00 is reached on the
fourth day of the position. A sell stop is entered at 1,402.00
(1,410.00 – 8.00 points). This locks in
a $3,000 profit, subject
to slippage (1,402.00 – 1,390.00).
Another type of profit
management is the target order. This is a more proactive or
aggressive way of capturing trading profits. A typical approach to
the target order is to place a price order at a price above or below
the position price. Assume a strategy that employs a $2,000, or 8.00
points,
profit target. A long S&P
position is taken at 1,375.00. A price order is then entered to sell
at 1,383.00 (1,375.00 + 8.00 points). If the market rallies to this
price, our sell order will capture a profit of $2,000.
Trading system as entry
and exit
A trade is composed
of at least one buy and
one sell. A trade begins by entering, that is, taking a position in,
the market either by going long (buy) or going short (sell) and ends
with an equal and opposite offsetting or liquidating trade that
closes the trade out. For example, a long trade starts when the
trader buys ten
contracts of S&P
index futures and ends when he sells ten contracts of the same
future. A short trade takes the opposite course.
A trading strategy with a
positive expectancy enters the market on a condition(s) that has
proven itself capable of identifying an opportunity to make a trading
profit. Such a trading strategy will exit the market when there is
nothing left to be gained in the current trade.
theperfect
entryisonethatalwaysoccurs
atthebest
price(thelowestbuyandhighestsell)andproducesaprofit.The perfect exit
extracts the last dollar of profit from a trade. Of course, any
trader knows this is a perfect ideal and impossible to attain in
practice. It is valuable, however, to hold this concept in mind as a
guiding principle when designing a trading strategy. Let us now get
into some details, definitions, and examples.
Definition: An entry rule
initiates a new long or short position. An entry can occur only when
the system has no current position, or is flat. Some examples of buy,
or long, entry rules (sell, or short, entry rules are the opposite)
are:
A 5-day moving average
crosses from below to above a 20-day moving
average;
The Relative Strength
Index closes below a reading of 20;
The daily close rises by
1 percent and the weekly close rises by 1 percent;
Today’s close is higher
than yesterday’s close plus 50 percent of the daily range;
Today’s close is higher
than the previous three closes
Definition: An
exit rule closes out a current long or short position. An exit can
occur only when a strategy has an open long or short po-sition. A
symmetrical trading strategy exits its trades on an opposite
entry signal. An example of an exit from a symmetrical moving average
trading
strategy that uses
opposite entries is:
Close out, or exit from,
a long position when the 5-day moving average crosses from above to
below the 20-day moving average. A trading strategy can be reversing
or non reversing.
Definition: A reversal
rule closes out a position and initiates a new and opposite position.
Of course, a reversal can
occur only when there is a position. A reversal is an exit of the
current position and the entry into a new and opposite position. The
current position is exited and enters a new and opposite position. An
example of a reversal rule is to close out the current long position
and go short when the
5-day moving average crosses from above to below
the 20-day moving
average.
A trading strategy that
reverses position on every new entry will, of course, always have a
position in the market. Of course, a trading system can have
rules that make it reverse only under specific conditions. Under
other conditions, it will use the new signal to exit the position.
A trading strategy
can also be non reversing. In other words, it uses an opposite entry,
or some other rule, to exit the position. Such a strategy will then
wait for some other rule signal to initiate a new position. A non
reversing rule is simply an entry or some other rule used as an exit
rule as defined earlier.
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