Trend Following Systems
Research has shown that most trading systems are trend following systems. Our numbers show that most of the traded futures are in good trending mode in about 25% of the time. Therefore if the system is designed to trade just one asset then it has to be good enough to make money 25% of the time because it will give back 75% of the time. Compare this approach to trading only 2-3 commodities.
Currently, there are over 60 futures contracts being traded on the exchanges in the United States. The problem is that not all futures contracts offer the same trading opportunities in terms of daily price swings and volume. Lower volume comes with higher slippage and this puts the odds even more against us. It can be compared to housing edge of casinos. Therefore its important to implement a ranking system if different contracts are traded. One must rank the commodities to improve the selection process when trying to identify the best opportunities. Profits can be made only where enough volatility exists.
Opportunities across commodities can be either correlated or independent from each other. Two opportunities are mutually exclusive if the selection of one precludes the selection of the other. Accordingly, if two commodities are highly positively correlated as for example the Dow Jones Index and the S&P500, a trader would want to trade either the Dow Jones or the s&P500. Diversification theory dictates that one should not hold identical positions in both assets simultaneously. In the case of mutually exclusive commodities, the aim is to trade the one with the greatest reward potential for the given risk level. In the case of non-existent correlations between the two assets the trader is free to trade both simultaneously.
Our research has shown that in 25% of the cases the price moves into a certain direction after the opening range is defined. So for example if the second bar of the opening range closes higher and the low is not below the low of the first bar then the probability of the price being higher on the last bar of the trading day is 20%. What do you mean exactly ? The highest volume occurs during the opening hours of the exchange. Therefore the most trades and positions are established during the opening which should dictate the direction for the rest of the trading day. Unfortunately it’s not that easy, 80% of the time the market changes direction before the close.
Directional changes in the price move happen 2-3 times a day most of the time. However, if resources do not permit trading two or more commodities concurrently, the trader would select the commodity that ranks higher on his or her desirability scale. The ranking system should incorporate the daily opening and closing prices of the previous trading day. If for a longer time period the price swings are happening “randomly” without any direction then we give this commodity a higher ranking. The probability of a certain outcome increases as time passes. We will discuss the implementation of such a ranking system in one of our future posts.