How to develop trading system - part 3

So, after we decided what we are going to trade (South African ALSI futures) and what software and data feed we should use, we are ready to go into more depth and think about what kind of trading approach we shall pursue.

There are two basic trading approaches:

1. Trend following

2. Mean reverting

The most common method of system trading is the trend following trading. In its most fundamental form, this approach simply waits for a significant price movement, then buys or sells in that direction. This type of trading approach banks on the hope that these price movements will maintain the trend.

Systems based on trend following can be designed around two basic indicators: moving averages and price breakouts.

Moving averages are probably the most used indicator in trading. They show average of the price over predetermined period of time. There are many variations of moving averages and more could be found if you just do some Internet searching and reading on this vast subject.

There are two ways to determine start of the new trend with moving averages. One is simple crossover and the other is penetration of the moving average. In the first instance when faster moving average crosses above slower, new trend is determined and you should take new position. Second one is penetration - when you just need one moving average and price. Close above or below moving average will determine trend and position should be taken accordingly.

The fundamental concept behind price breakout systems is similar to that of a moving average system. The idea is that when a new high or low is established, the price movement is most likely to continue in the direction of the breakout. One indicator that can be used in determining breakouts is a simple Bollinger band overlay. Price breakout tactic was used by famous “Turtle Traders”. Used time periods were 25 and 50 days highs.

Trend following trading systems will always be lagging in nature. They can never hit the exact top or bottom of a trend, as trend followers don’t try to pick bottoms and tops. This inevitably results in a forfeiture of potential profits, which can sometimes be significant. What we at ALSI TRADER are trying to do for the most of the time is to catch the middle part of the trend. We will gladly leave few points on the top and bottom for somebody else.

Other way to approach trading systems is around mean reverting concept or trading countertrend moves. Basically, the goal with the countertrend system is to buy at the lowest low and sell at the highest high. Last ten or so years in United States, markets were following mean reverting principal and one of the most used indicators was relative strength index with period 2. There is lots of reading on the web about this, so please go and read if you are interested.

The main difference between mean reverting and the trend following systems is that the countertrend systems are not self-correcting, meaning that trend following systems will give you new signal when trend changes and one should go out of trade and change position. With mean reverting systems one must have hard stop, because market can just continue to go against you.

As far as ALSI TRADER is concerned, South African markets are very much trend following markets and future posts will stay on the track of that trading approach.

There were some e-mails asking me to hurry on this topic and post everything at once. One should understand that this is very sensitive topic and lots of thinking must be implemented on reader side as well. In each of three posts I’ve gave several directions for reading on related subjects and honestly I would really appreciate if all readers invest time and energy in education, as my posts can just touch several points of system design, while in-depth analysis is always going to be required.

Many decisions are to be made and please stay with us. At the end, we will have nice trading system that can be used and I am looking forward to develop it together with you as we progress.

For more information look at previous posts:

How to develop a trading system – part 1

How to develop a trading system – part 2

Trade with trend!