Developing a Trading Strategy
3. Choosing an Instrument to Trade
The next thing we need to do when designing a trading system is to decide what we are actually going to trade to match our objectives. There is a huge range of instruments available to traders from the underlying instruments such as stocks or currencies to derivatives such as futures or options.
Take, for example, the Dow Jones index which measures the value of 30 large US companies. There are various ways to trade this one index:
-The individual stocks that make up the index.
-An exchange trade fund. In essence the fund owns the underlying shares so itís value moves up and down with the index.
-Spread betting (tax free derivatives in the UK).
Each of these could be further divided, there are 3 exchange traded funds and 2 types of futures. Each method has its own merits and is more or less appropriate for different trading scenarios.
The objective of this article is to develop a strategy for day trading the Dow Jones index. We are looking to open and close positions within a day and so require the following attributes from the instrument we choose:
-Low commission costs. We will we be trading frequently and, therefore, need to keep costs to a minimum. This rules out trading the individual stocks.
-Liquidity. With trading frequently we will need to be able to enter and exit the market without experiencing too much slippage. This rules out the larger of the Dow Jones futures contracts.
-Narrow spreads. Generally, the more liquid a market is the narrower the spread between the bid and ask. This rules out spread betting where the spread is 5-8 pts.
The mini Dow Jones future (trading as YM on the Chicago Board of Tradesí electronic platform eCBOT) fulfils the above criteria and is most suitable for our purposes. Easily trading 100,000 contracts a day the spread is 1 point during normal market hours. Each contract is worth $5 per point movement of the Dow Jones index.
In order to develop a trading strategy it is extremely important to obtain historical data for the actual instrument that we intend to trade. Although derivatives based on the same underlying instrument will move generally in tandem with each other it will not be exact. The futures will move more quickly and to greater extremes than the underlying cash index. We cannot, therefore, develop a system using the cash index and expect it to perform to the same degree when trading futures or any other derivative.