Ever wondered if you can design a profitable trading strategy by trading volatility ETFs ? Well, yes you can. Those ETFs are highly ineffective vehicles on a long term investment horizon. However short term strategies have shown to be a rewarding way to trade these ETFs. Before we move onto strategy design we have to choose two volatility ETFs for backtesting. We will backtest our strategies with VXX and XIV ETFs since they are the most widely traded ones and have enough trading volume to keep our slippage low and guarantee fast order execution.
The first step in building such a system is to define what mean reversion is. Mean reversion systems are looking for markets that are unusually high or low and will eventually return back to the mean. We want a system that looks at a particular market with a significant deviation from their average. Our previous research we did on opening range breakout systems already showed us that opening range breakouts define the trend for the rest of the day in about 30% of the time. Which means that out of 20 trading days we have 14 days of price patterns that are reverting back to the mean.
Time frames are used in order to forecast future price trends. Many traders are missing out on this important aspect of trading by only looking at one time frame when trying to define a trend. Therefore its important to categorize trends as primary, intermediate and short term trends. As a rule of thumb the primary trend is filtering out much of the market noise and is giving us more reliable signals in which direction the market is heading
The goal of this research is to find various set-ups and exit strategies that could be used for trading the opening range breakouts. The fact that important economic news are often announced at 10:00 am makes it even more significant. Some analysts even claim that about 35% of the time the high or the low of the day occur within the first 30 minutes of trading and it defines the direction of the trend for the rest of the day. Our analysis will show if this argument holds true.
When it comes to trading there is a common belief that most behavior in markets can be explained by assuming that market participants make ‘logical’ trading decisions. In reality we know it’s not that easy. However there are market movements that are predictable because they repeat every year. These patterns are created by the collective actions of market traders themselves and can be used to predict the market.
The trend following model by Kaufman says that trading by the direction of the trend is a conservative approach to the markets. Kaufman’s Market Efficient Model states that longer trends are the most reliable but they respond rather slowly to changing market conditions. The main argument of the Market Efficiency Model is that an adaptive method must be applied to the markets for proper trend following.