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Designing a high probability strategy to take advantage of trends

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Designing a high probability strategy to take advantage of trends

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  #1 (permalink)
Burlington, ON
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I would like to discuss factors that help increase odds when designing trading strategies to take advantage of trends. I don't want to focus on creating a specific trading system but rather a set of general rules that might be helpful. Please feel free to comment and/or add to the rules:

1. Trading Using Multiple Time Frames (at least 2 or even 3): align your preferred time frame off which you are trading with a higher time frame ( e.g. if you’re trading off a 15 min chart, align your trades with the direction of the 1 hr chart). The downside is that you will have to wait for the trade to be confirmed on the 1 hr chart first and thus you’ll miss the beginning of that trade on the 15 min chart.

2. Hard Stop Loss: having a hard stop either a specific amount of ticks or based on some kind of a technical rule such as a previous low or high.

3. Trailing Stop Loss: Also, since it’s not known how long the trade will last a trailing stop loss would reduce the number of losers or their size. The trailing stop could be something like a previous candle high/low or the second last candle high/low or an ATR trailing stop. Trailing stop loss might not be realistic while scalping (lower time frames such as 1 min) but would be more practical on a little longer times frames (such as 15 min's etc.).

4. Price Target: set up a specific target (at least 1 to 1 loss to win ratio or preferably higher) in addition to having a trailing stop.

5. Trading Pullbacks/Retracements: Buying or selling on price pullbacks. For example, if going long you’d place a buy order when an oscillator such as stochastics is in the oversold condition. This way you are more likely to catch a specific wave within a larger trend (if the trend is still underway).

6. Trading at a specific time of day: Trading during the times of day when trending conditions are more likely to occur (example: 7 am to 10 am EST).

7. Avoiding trades during major economic announcements (especially non-farm payrolls).

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  #3 (permalink)
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Keep in mind that an oscillator is a lagging indicator by definition.
You will always run after the facts.

I would suggest more to focus on price action, order flow and market footprint.
Look at the price, the DOM and the volume, it contains all the information of the auction.

Understand the market profile, value area-H, value area-L, POC
If you want an indicator, use a VWAP

Depending on what instrument you are trading, you might also look at some correlation.

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1. Multiple Time Frames: Agree in concept. Two or Three seems to work well, more than three I don't seeing the value added.

2. Hard Stop. If it is based on something derived from the price structure/current or historic volatility, such as 2*ATR(10), then it should work with some testing. If it is a function of your account size or how much you're comfortable risking in a trade, meaning not based on the market itself, that is arbitrary and not valid. If the account size is too small to cover the actual market risk, then the account would be over-leveraged (causing the risk of ruin to be too high) and a different position size or market should be chosen.

3. Trailing Stop. A technical stop based on price structure is the optimal strategy.

4. Price Target. Don't agree because we cannot predict in advance how far a trend will go. Better approach is to accept the average return the technical stop provides. In other words, aim for the middle of the trend for your profit, and don't worry about 'missing' the start and end of the trend. The occasional 'big wins' are what makes trend trading work.

5. Pullback entries: It works on average, but you will see a few 'false starts' inside the pullback. Also, the last pullback entry in the trend is actually the start of a trend reversal, so you will be picked off there.

6. Time of Day filters: Totally disagreed with this concept. Again we can never predict in advance when a trend will start. Wait for the trend to start, and then find a way to join the trend in progress. Aim for the middle and stop trying to predict the future.

7. Depends on your time frame of reference. Assuming you are talking about an intra-day trend found on a time frame such as the 5 minute chart or say a 2000 volume chart or something, then yes.

I would add #8. Focus on increasing / improving the Profit Factor produced by the trend trading strategy. Things like Win% are meaningless in trend trading.

Be Patient and Trade Smart
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These may all seem like good rules, but the exact opposites can work as well. Many of these are the standard book ideas, but you will find profitable traders who do otherwise, so it's better to make sure that you can implement whatever you decide to use in practice, and be open to adjusting them based on experience.

I'm not saying your rules are wrong, I'm saying that they are not quite as obvious as they may seem. For instance:

Stops: yes, it can be a good idea to use a stop, either to enforce discipline (it makes you get out), or as a protection against sudden disaster (although in a really big and fast move against you, you don't know where your stop will actually execute.) But stops that are too close, including trailing stops, are often a good way to get shaken out on a smallish pullback because they don't let you ride out a minor adverse move. Then you may end up chasing the market to get back in. Stops that are too close also open you up more to whipsaws, a major problem when trying to catch and ride trends. All this can mean your stops can add to losses instead of to profits.

Targets: A good way to kill your profits too soon is to put up a target order in the market. That guarantees you will not be letting your profits run. It is an easy way to make the profit-taking decision, though, and that is probably why they are used. So if you don't have a target how do you exit? Good question. You'll need to have a way to decide when the trend is no longer something you want to be in. This is not as simple as a target, and not as obvious. But it may make you more money.

Trading pullbacks: this is the best thing in the world to do, if you can just know when something is a pullback and not a trend reversal. That's very easy to see in hindsight, not so easy to see when it actually matters. For instance, assuming that "if going long you’d place a buy order when an oscillator such as stochastics is in the oversold condition" is a really good way to get wiped out. An oscillator does not only go "oversold" and then turn up. It also goes "oversold," and stays that way, in a downtrend. It can stay "oversold" for a very long time, and price will keep marching down.

Yes, you did say "This way you are more likely to catch a specific wave within a larger trend (if the trend is still underway)" -- but isn't whether the trend is still underway the question? If you know that, of course you buy the dips. But knowing when to do that is not a simple matter of what an oscillator says.

I'm not saying to throw all those rules out the window. I'm saying to not just take them as unquestionable truths.

I would suggest reading a lot of the threads on trading in this forum, including, if you want to take the chance that an Elite membership is worth it, in the Elite section. There is an Elite thread on trading the S&P futures where very good traders discuss their live trades all day long, every day, and, for the most part, don't follow your rules at all; often, do the opposite. But, they have their reasons. In the same way, a person could probably trade pretty much according to (most of) your rules and also do well, depending on how he applied them. (I said "most of" because buying just because something is "oversold" is not a great rule. Sorry. )

Bottom line: I would be cautious about mechanically applying this ruleset. Now, if you are trading this way and it works for you, that is the only test anything has to pass. But if the question is whether, in the abstract, these are a good collection of rules, they may fit a certain trading style, which would be kind of scalpy, but no, they are not the unquestionable, "correct" way to trade. They are "correct" if you can make them work for you, but be aware there are alternative ways to trade. You'll have to do some looking to find them.


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