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Developing a Trading Strategy

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by Tim Wreford - Dec 24, 2004

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5. Entry Rules

Now we have our trade set-up established, we must decide exactly how we will enter a trade once the set-up criteria are met. The set-up for our strategy is very straight forward, we will wait until 11.45am ET and then enter a long (buy) if the high of the opening range (9.30am to 11.45am) is broken or a short (sell) if the low of the opening range is broken. The easiest way to establish this is to place a stop order to buy in the market at 1 tick above the high of the range and a stop order to sell in the market at 1 tick below the low of the range.

As an example, let�s take the trading day of 2 Jan 04. The opening range gives a high of 10510 at 10.58am and a low of 10462 at 10.00am. At 11.45 we place the following orders:

When the market hits one of the stops to open a trade we will leave the other stop in the market as our initial stop loss. If that stop loss was hit then our reason for being in the trade would be invalid.

Our entry rules are fairly simple but we could look at altering these in two ways:

1. We could wait a few more ticks after a break of the opening range before opening our trade. E.g. we could set our stops at 5 pts past the high and low of the range, in the example for 2 Jan 04 that would be a buy at 10515 and a sell at 10457. The reasoning behind this is to protect against the market just triggering our stop at just past the day�s high or low and then reversing. We can examine this theory by looking at the maximum favourable movement (MFE) on each trade that is triggered, that is the maximum amount the trade moves in our favour during the day.

MFE	No of trades	Cost Saving	Avoidance cost	Net gain (loss)
0	2	40	107	(67)
1	2	40	214	(174)
2	6	168	309	(141)
3	9	203	400	(197)
4	11	238	490	(252)

From the table we can see that on 2 occasions the market hit our stop and reversed immediately, costing 40 pts in total at the end of the day. To avoid this we could have a trigger of 2 points instead of 1 for the trade entry. However there are 109 trades in total for the sample and adding 1 point to each trade entry would cost an extra 107 points on the remaining trades, a net loss of 67 points.

We can conclude that waiting more than 1 tick to enter the trade reduces the overall profitability of the system.

2. Alternatively, once the set-up is triggered we could wait for a retracement to occur before entering the trade. For example on 2 Jan 04 once the low of 10462 is broken we enter a limit order to sell at, say, 5 pts better at 10467. The danger here is that we may miss out on the biggest moves if the price does not retrace, however, we will make points on those that do. We need to examine the maximum move against our entry price (MAE):

MFE	No of trades	Missed trades	Savings	Net gain (loss)
0	5	305	0	(305)
1	6	348	103	(245)
2	9	534	200	(334)
3	11	634	294	(340)
4	15	717	376	(341)

From the table we can see that on 6 occasions the market did not retrace more than 1 point past our entry point and these 6 trades alone made a total of 348 points profit at the close. If we had waited for a retracement of just 1 point on every trade we would have saved 103 points (assuming the limit orders were filled), a net loss of 245 points.

We can conclude that waiting for a retracement before entering a trade reduces overall profitability because the most profitable trades are missed.

For our strategy we will stick with entering the trades on a buy stop or a sell stop at 1 point beyond the high/low of the opening range (9.30-11.45am ET).

Part 2 of this article can be read here.

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Tim Wreford