The 65sma-3cc Trend-Following System
This section discusses how to formulate and test a simple, nonoptimized, trend-following system that makes as few assumptions as possible about price action. It arbitrarily uses a 65-day simple moving average of the daily close to measure the trend. Sixty-five days is simply the daily equivalent of a 13-week SMA (13x5= 65), representing one-quarter of the year. This is an intermediate length moving average that will consistently follow a market's major trend.
As shown in Figure 4.1, when the market is trending up, prices are above the 65-day SMA, and vice versa. In sideways markets, this SMA flattens out and prices fluctuate on either side. Clearly, the trading system picks up and sticks with the prevailing trend (see Figure 4.2).
There are many ways to make the decision that the trend has turned up. The usual way is to use a shorter moving average of, say, 10 days, and decide that the trend has changed when the shorter average crosses over or under the longer moving average. If you decide to use a short moving average, its "length" will be crucial to your results. Another weakness is that often prices will move faster than the shorter moving average, so that the entries can seem rather slow.
76 Developing New Trading Systems
Figure 4.1 September 1995 Japanese yen contract showing the 65-day SMA and the signals generated by the system.
Figure 4.2 The 65sma-3cc system stayed long throughout this major uptrend in the S&P-500 index in 1995.
The 65sma-3cc Trend-Following System 77
Hence, the 65sma-3cc system will require three consecutive closes (3cc) above or below the 65-day SMA (65sma) to determine that the trend has changed. For example, the trend will be said to have turned up after three consecutive closes above the 65-day SMA. Similarly, the trend will have turned down after three consecutive closes below the 65sma. Once again, the requirement of three consecutive closes is arbitrary. It could be ten consecutive closes or any other number. Clearly, the results will vary with the number of confirming closes.
If you are afraid of false signals (see Figure 4.3), then the number of closes you use will act like a filter in reducing the number of trades. In a fast-moving market, requiring a large number of consecutive closes will give delayed entries (see Figure 4.4). Conversely, if a market is moving sluggishly, a small number of consecutive closes will give false signals. Thus, there is a trade-off here that determines how quickly you recognize a change in trend.
Once you recognize a change in trend, you still have to decide how to enter the trade. You should enter the trade on the next day's open, to guarantee that you can execute the signal and get a fill. For example, if the three consecutive closes criterion is satisfied as of this evening's close, you should buy at the market on the open of the next trading day. You will get a fill somewhere in the opening range the next day. It is likely that you will be filled near the top of the opening range for buy orders, and near the bottom of the opening range for sell orders. This
Figure 4.3 The choppy sideways action in December 1995 British Pound generated a string of whipsaw losses for the 65sma-3cc system.
78 Developing New Trading Systems
Figure 4.4 These swing moves in December 1995 crude oil produced many trades but small profits because the 65sma-3cc system does not have a specific exit strategy.
slippage should be ignored, and just lumped into your $100 allowance for slippage and commissions. The main effect of this entry mechanism is that you are not filtering out any entry signals, and ensuring that you will put on this position the first time the entry conditions are satisfied.
There are a number of choices on how to actually enter the trade. For example, you could enter the trade on the close of the third consecutive close above or below the 65-sma. A second choice would be to enter the next day on a stop order beyond the previous, or a nearby, high or low. In effect, you would also filter out some entry signals, because you would not get a fill on every signal. This may be useful in situations where prices briefly spike beyond the 65-sma during prolonged trends.
A third entry choice would be to delay entry for x days after the signal, and then enter beyond a nearby n-day high or low. This is another way to filter down the entry signals in order to find more profitable ones. Note that if you use a limit order for your entries, occasionally you may not be filled at all, missing the entry by just a few ticks. Hence, you should enter on the next day's open to assure an entry into the new trend.
Before we proceed, let us put this entry signal through a critical test to check if the 65sma-3cc entries are better than random. Following the approach of Le Beau and Lucas (see bibliography for details), let us
The 65sma-3cc Trend-Following System 79
test the entry signal with exit on the close of the ra-th day, without any stops, and no deductions for slippage and commissions. For simplicity, only the effect of long entries are shown. The proportion of trades that are winners should consistently be more than 55 percent. The test includes the long entry over 21 markets, stretching from January 1, 1975, through July 10, 1995, using a continuous contract. Because not all markets were trading back in 1975, all available data are used.
Table 4.1 shows that, on average, 55 percent of the long entries were profitable, suggesting that the 65sma-3cc model probably does better than random. The result for short trades is similar, and you can be reasonably confident that this model provides robust entry signals. Your task is now to combine this model with risk control and exit methods that match your trading mentality.
Table 4.1 Testing 65sma-3cc long entry for randomness over 21 markets
using all available data between 1 /1 /75 and 7/10/95. Exit on the close of the n-th day.
| Market | 5 days | 10 days | 15 days | 20 days | 30 days | 50 days |
| British pound | ||||||
| Coffee | ||||||
| Copper | ||||||
| Corn | ||||||
| Cotton | ||||||
| Crude oil | ||||||
| Deutsche mark | ||||||
| Eurodollar | ||||||
| Gold | ||||||
| Heating oil | ||||||
| Japanese yen | ||||||
| Live hogs | ||||||
| Orange juice | ||||||
| Silver | ||||||
| Soybeans | ||||||
| S&P-500 | ||||||
| Sugar | ||||||
| Swiss franc | ||||||
| 10-year T-note | ||||||
| U.S. bond | ||||||
| Wheat | ||||||
| Average | 54.62 | 55.95 | 55.86 | 55.71 | 54.52 |
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To summarize this nonopdmized system, the actual trade entry is at the market on the open of the next trading day after the close of the day the signal is received. You will notice that there are no specific exit signals at this point, which means that the short entry signal is also the long exit signal, and vice versa. In practice this means that if you are long one contract, you will sell two contracts to go net short one contract, and vice versa.
Note that for the tests below we will add a condition to prevent back-to-back entries of the same type. This will allow an apples-to-apples comparison when studying the effect of adding stops or exits. yovl do not need this condition for actual trading.
To summarize what is not defined at this point: There are no specific risk-control rules in terms of an initial money management stop, nor any money-management rules to determine the number of contracts to trade. We will just trade one contract for simplicity without any risk-control stop. This is not a recommendation to trade without a risk control stop; the calculations are done without any stops here to illustrate a point. Later, we will examine how to add risk control and study the effect of money management.
The 65sma-3cc system should make all its profits during strong trends. It should lose money in sideways or nontrending markets. And it should have between 20 and 50 percent profitable trades. We tested this model over 23 markets using 20 years of continuous contract data. If a contract was not traded for 20 years, then we used all available data from the starting date. The usual allowance of $100 per trade for slippage and commissions was made. Thus, this is a rigorous test for a nonoptimized system over a long test period, and across a large number of markets. The results are summarized in Table 4.2.
The results for this simple, nonoptimized trend-following system are encouraging. You could have made a paper profit of $1,386,747 by trading just one contract for each market, and been profitable on 19 of 23 widely diverging markets. The test sample generated 2,400 trades, so this is a highly significant test. Approximately 34 percent of all trades were profitable, a number typical of trend-following systems.
The ratio of average winning to average losing trades was excellent, at 3.3 averaged over the 2,400 trades. This number is useful for calculating the risk of ruin; a number above 2.0 is desirable, and anything over 3 is welcome news. The average trade made a profit of $558, an attractive amount, considering transaction and slippage costs. It is customary to seek a number over $250 for the average trade. The average profit per market was $60,293, approximately 2.74 times the average maximum in-
The 65sma-3cc Trend-Following System 81
Table 4.2 Test results for 65sma-3cc trend-following system
| Market | Years | Paper Profit ($) | Total Trades | Winning Trades (%) | Average Win/Loss | Average Trade (S) | Maximum Intraday Drawdown (S) |
| British pound | 7/75-7/95 | 125,344 | 3.72 | 1,193 | -25,431 | ||
| Canadian | 6/77-7/95 | -12,750 | 2.32 | -102 | -21,030 | ||
| dollar | |||||||
| Cocoa | 5/80-7/95 | -15,370 | 1.80 | -153 | -2,219 | ||
| Coffee | 5/75-7/95 | 239,096 | 5.83 | 1,993 | -36,956 | ||
| Copper, | 12/88-7/95 | -7,890 | 1.48 | -161 | -17,355 | ||
| high-grade | |||||||
| Corn | 5/75-7/95 | 26,081 | 2.98 | -4,331 | |||
| Cotton | 5/75-7/95 | 112,490 | 4.26 | 1,023 | -8,730 | ||
| Crude oil | 8/83-7/95 | 17,570 | 2.58 | -11,690 | |||
| Deutsche | 7/75-7/95 | 68,575 | 2.90 | -1 3,250 | |||
| mark | |||||||
| Eurodollar | 6/82-7/95 | 34,175 | 3.16 | -7,150 | |||
| Gold, Comex | 5/75-7/95 | 53,770 | 3.44 | -28,440 | |||
| Heating oil | 7/79-7/95 | 56,198 | 3.89 | -18,021 | |||
| Japanese | 12/76-7/95 | 143,425 | 3.80 | 1,649 | -12,963 | ||
| yen | |||||||
| Live hogs | 5/75-7/95 | 31,971 | 2.49 | -5,863 | |||
| Orange juice | 5/75-7/95 | 13,018 | 3.05 | -27,950 | |||
| Silver | 5/75-7/95 | 197,305 | 6.87 | 1,370 | -51,040 | ||
| Soybeans | 5/75-7/95 | 62,406 | 2.86 | -21,768 | |||
| S&P-500 | 9/82-7/95 | -7,260 | 3.13 | -72 | -97,470 | ||
| Sugar | 5/75-7/95 | 49,493 | 3.75 | -10,806 | |||
| Swiss franc | 7/75-7/95 | 108,475 | 3.28 | 1,086 | -11,638 | ||
| 10-year | 9/82-7/95 | 34,219 | 3.66 | -1 3,743 | |||
| T-note | |||||||
| U.S. bond | 1/78-7/95 | 50,143 | 2.62 | -38,819 | |||
| Wheat | 5/75-7/95 | 6,263 | 2.78 | -19,663 | |||
| Total | 1,386,747 | 2,400 | |||||
| Average | 60,293.3 | 3.3 | -22,014 | ||||
| Standard | 66,698.1 | 1.17 | 20,342 | ||||
| Deviation |
traday drawdown, of-$22,014. This is a healthy recovery factor, or coverage of the worst losing streak of the system.
In summary, a simple trend-following approach worked on many markets over a long time period with few assumptions and no optimization.
Developing New Trading Systems
The results also point out some weaknesses of this system. The average profit per market is 90 percent of the standard deviation of the average profit. This means that profitability varied widely from market to market. The maximum intraday drawdown was 108 percent of its standard deviation, implying that the drawdowns also varied considerably among markets. The standard deviation of the average trade also implies that results can vary substantially over time or across markets. A further weakness is the relatively small number of profitable trades. Thus, we can summarize the principal weakness as a large variability in the results over time and across markets.
Combining the strengths and weaknesses, you would say that this is a sound trend-following system with good chance of being profitable over many markets over a long time period. But because of the large variability in results, you would have to trade this system relatively conservatively. You should allow a large equity cushion to absorb drawdowns.
A look under the hood of this trading system, so to speak, and a closer examination of the results of the analysis reveal further details of