Developing a Trading Strategy


182 ratings



Tim Wreford

24 Dec, 2004

in Day Trading & Scalping and 1 more

4. The Trade Set-up

So far we have decided to develop a system to day trade the mini Dow Jones future. Next we need to identify a market characteristic that can provide a statistical edge to form the set-up for our trades.

A set-up is a standardised set of conditions that we will use to identify a potential trade. Once the market characteristic that we want to take advantage of is identified then the set-up conditions can be derived. Lets work through an example.

The open-range breakout is a very popular trading style. The theory behind it is that markets will tend to put in an extreme for the day (either the high or the low) relatively early in the trading day. How true is this though? Examining the mini Dow Jones futures data for the period January 2004 to June 2004 (124 trading days) we find the following results:

Opening range for firstNo. of extremesPercentage of total (124 days):
15 minutes4133%
30 minutes5746%
45 minutes7863%
60 minutes8669%
75 minutes9173%
90 minutes9577%
105 minutes10383%
120 minutes10585%
135 minutes11290%
150 minutes11290%
165 minutes11391%
180 minutes11593%

We can see that 1/3 (33%) of the days examined either a high or low was in place within 15 minutes of the open, more than 2/3 (69%) within 1 hour and more than 90% in 3 hours. That looks statistically significant. If we trade a break of the high or low after 60 minutes with a stop outside of the other extreme we know that we will not be stopped out on 69% of our trades. However we need to examine our data more closely as it could be the case that most of the days movement actually occurs within the opening period leaving us very little room for our trade to move into profit. So lets look at the opening range as a percentage of the total days range:

Opening range for firstPercentage of day's range
15 minutes24%
30 minutes33%
45 minutes43%
60 minutes47%
75 minutes52%
90 minutes55%
105 minutes58%
120 minutes60%
135 minutes62%
150 minutes64%
165 minutes66%
180 minutes68%

We must assume that the percentage of the days range represents our stop, as this is the point where our reason for being in the trade (the breakout) becomes invalid. Our potential profit from the trade is represented by the balance of the days range. E.g. at 30 minutes the stop loss is 33% of the days range leaving 67% as the potential profit. We can also see from the first table that we have a 46% chance of not hitting the stop.

We can calculate the maximum possible expectancy (the average percentage amount of the daily trading range that we capture) from these figures using the formula:

Maximum Expectancy = (Pw x (1-Al)) ((1-Pw) x Al)

Where Pw = percentage of days where the stop is not hit, from the first table.
And Al = stop as a percentage of the total days range, from the second table.

Opening range for firstPercentage of day's range
15 minutes9%
30 minutes13%
45 minutes20%
60 minutes22%
75 minutes21%
90 minutes22%
105 minutes25%
120 minutes25%
135 minutes28%
150 minutes26%
165 minutes25%
180 minutes25%

We can see that the best combination of opening range and potential profit occurs at 135 minutes where we can expect to capture, on average, 28% of the days range. It must be remembered that this is the maximum available profit as, at the moment, we are assuming that we close the trade at the second extreme of the day, i.e. exactly at the high or low.

The purpose of this exercise was to prove that the open range breakout has the potential to form the basis of a trading set up. From the third table we can see that every range tested has a positive expectancy and that there is very little to separate a breakout of the first hour from that of the first 3 hours. The percentage of stop outs decreases but so does the potential profit. It makes very little difference whether we choose to trade a break out of the first hour, the first three hours or anything in between, but the maximum potential comes at 135 minutes (9.30am to 11.45am ET) so well use that.

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Re: Developing a Trading Strategy

"A trading strategy is simply a pre-determined set of rules"

Some strategies change their rules on-the-fly to adjust to market conditions.

Sep 26, 2013

Member (213 posts)

I'm confused. So in the first 135mins if there was a high of 3950 on the FTSE the strategy would be to wait for the market to break this high. We would then sell the market at 3951???

Mar 26, 2009

Member (5 posts)

I'm confused. So in the first 135mins if there was a high of 3950 on the FTSE the strategy would be to wait for the market to break this high. We would then sell the market at 3951???

Mar 26, 2009

Member (5 posts)