Day Trading & Forex Forum

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. Let’s 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 first	No. of extremes	Percentage of total (124 days):
15 minutes	41	33%
30 minutes	57	46%
45 minutes	78	63%
60 minutes	86	69%
75 minutes	91	73%
90 minutes	95	77%
105 minutes	103	83%
120 minutes	105	85%
135 minutes	112	90%
150 minutes	112	90%
165 minutes	113	91%
180 minutes	115	93%

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 day’s movement actually occurs within the opening period leaving us very little room for our trade to move into profit. So let’s look at the opening range as a percentage of the total day’s range:

Opening range for first	Percentage of day's range
15 minutes	24%
30 minutes	33%
45 minutes	43%
60 minutes	47%
75 minutes	52%
90 minutes	55%
105 minutes	58%
120 minutes	60%
135 minutes	62%
150 minutes	64%
165 minutes	66%
180 minutes	68%

We must assume that the percentage of the day’s 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 day’s 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 first	Percentage of day's range
15 minutes	9%
30 minutes	13%
45 minutes	20%
60 minutes	22%
75 minutes	21%
90 minutes	22%
105 minutes	25%
120 minutes	25%
135 minutes	28%
150 minutes	26%
165 minutes	25%
180 minutes	25%

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 day’s 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 we’ll use that.