Thursday, February 22, 2007

Profiting From Short-Term Momentum: A Best Practice in Trading

From Brett: Today's best practice comes from reader Steve, who generously shares one of his setups in the Russell index market. His methodology is based on trading in the direction of short-term momentum, as long as this is aligned within a greater trend. Recall that Lord Tedders and Henry Carstens recently offered their perspectives on testing trading ideas. This would be an excellent core idea to test out and tweak with filters, stops, etc. Many thanks to Steve for passing this along. My reaction comments follow at the end of his post.

From Steve:

I call this best practice "Trading Short Term Momentum"...

I suggest that for futures trading, a setup geared to trading short term momentum can be profitable.

My chart setup for the Mini-Russell (ER contract) would include two (2) simple moving averages

1. Three (3) period sma with two (2) period offset (+2 offset)
2. Eighty (80) period sma

System rules

No trades within the first half hour.

On a close above the three (3) period sma, enter long on a stop at the next open

On a close below the three (3) period sma, enter short on a stop at the next open

Long only above the eighty (80) period sma (Enter long positions only on a close above the 80 sma)

Short only below the eighty (80) period sma (Enter short positions only on a close below the 80 sma)

Stop loss of one (1) Russell point

Min profit target of two (2) Russell points
(Once price "touches" two (2) points profit, trader must close at least 1 contract)

Maximum three (3) losing trades/session

Maximum three (3) consecutive losing days/week...stop trading for 7 trading days.

Minimum position size two (2) contracts

Chart time frames 3-7 minute candles/bars

From Brett: There are several things I like about Steve's idea. First, he is selective. He will only take trades after the first half-hour, and he will only take trades when the 3 SMA and 80 SMA are aligned. Note that he is using 3-7 minute bars. That means that the 80 period SMA will put him in trades in which the market has been strong or weak for a day or so. My best hunch is that this would work best in an environment of above average volume/volatility. I also like the money management--taking quick profits with half the position--and I like the discipline of limiting the number of losing trades per day and week to avoid catastrophic drawdowns during periods in which there is poor follow through on short-term trends. All in all, it's a great example of what I've called "rule-governed trading". By formulating rules for good trading practice, Steve is able to capitalize on short moves that go with the trend. By avoiding the first half hour of trading (during which we sometimes get economic releases), he lets the trend show itself before he commits capital. Very nice window on some best trading practices; thanks, Steve.


bananajoe said...

I like the idea of this setup. Maybe it could be improved by using rate of change, i.e. ( P(t) - P(t-3) ) / 3 instead of Moving Averages. This way, you will get rid of lags. Here is my point:

You take care of the lags by offseting the 2 periods, but in fact you need 2 future periods for a signal (If I get it right). In this very short term window it is not that big problem, you enter the trade if there is no significant change.

But if you used the relative change of price, you would get instant signal. Of course, this would need to alter your exact entries and exits. But the idea is very similar, in an uptrend (determined by longer-term rate of change), go long if 3 hours rate of change dropped significantly and started to recover. In downtrend vice versa. i find this "indicator" very interesting.

All the best, Jozef.

Brett Steenbarger, Ph.D. said...

Very nice idea, Jozef; thank you very much. This is the kind of system tweaking that can take good ideas and improve upon them.


Gary said...

I have a question about the chart setup; when I applied the three period sma with +2 period offset to the chart, it almost never touched the ER price action. Can you explain? Thank you.