I want to do a little strategy series with you guys. In the following weeks we'll be choosing a strategy and go from idea to trading it on a paper account.
As a start I thought we can work on a simple trend following strategy. When it comes to trend we have multiple things to go off of. You are likely already familiar with the moving average cross. This is a legit trading strategy. Many people like to explore all the various moving averages to find "the one" that works best across all markets, in all situations, without producing any losses. While that is a noble goal, it's also highly unrealistic. Does it make a difference whether we use a simple or an exponential average? Yes, it does, but the differences are often so small that they don't produce a significantly better result. While a Hull moving average might respond really quickly, the downside is also its speed. The point I'm trying to make is that yes, all of these different average types are legit instruments, but we're splitting hairs here. While one gets you a 0.1% better entry, it might get you out too early by like 0.5%. Another one is slower, so get you in later, which means less profit, but on flipside causes 0.3% less drawdown. If a strategy is so bad that we need to split hairs about a half percent more or less, we have a greater problem: the strategy is bad.
And that is something to remember throughout this series. If something doesn't work without requiring a tremendous amount of fitting, i.e. "trying to make it work", then just move on. Try something different. For example I'm trying to come up with a good mean reversion strategy that works well in crypto, but whatever I try, I just can't make it profitable. When I try it on Forex, however, the same strategy might turn a profit right away. That's the second big lesson here. If a guru wants to sell you on their awesome indicator, then please try it on the market you're interested in. Often I find these indicators were fitted for one specific market, and one specific time period to make it look better. Don't fall for these!
Sidenote: I know I make it sound like I know exactly what overfitting is, but I actually don't at this point. I understand the general concept, but I haven't figured out how to prove it yet. Please keep in mind that I'm just an amateur, and I'm sharing my personal learnings publicly for everyone else to learn with me.
Another idea many beginners (I was there too) have is that by trading on smaller and smaller timeframes they're going to get richer quicker. It seems logical, doesn't it? If I have a profitable strategy that works on the hourly, I could, at most, take 24 trades per day. But if I trade every minute I could take 1440 trades. With a win rate of 60% just think of all the mon… trading fees you have to pay.
A strategy doesn't have to take many trades. If you get a signal once every couple of months, just think about all the free time you're going to have. You can put all of that time into learning more about trading. Then you could really improve your strategy, or strategies, which would actually make you more money than if you spent the entire day "reading the tape".
I'm not a good tape reader. I thought at some point it's the best thing ever to learn, but I lost interest, because of the aforementioned reason. I was glued to the screen, trying to make minute-to-minute decisions, when in fact all I did was being overwhelmed, aka analysis paralysis, that after some time I was using so many different weird systems and trade ideas that I couldn't take a trade anymore. Maybe you know this feeling yourself?
Back to topic. There are more ways we can determine trend. Higher highs, higher lows, for example. We could use the Donchian channel for that. Set to twenty we can clearly see when an uptrend starts. I don't want to get too detailed here, and encourage you to learn trend reading. It is one of the most important skills to learn for your trading career! Here's a primer. Personally I'm a fan of the DC channels because the tool is simple to use, and simple to calculate.
Another trend tool we can use is William's Fractals. The calculation and the concept is a little bit more advanced. Essentially Bill Williams indicator helps you identify pivot points. We know that a high is defined by a bar that has its high higher than the surrounding bars. I'm just going to assume that you know what that means. If not, here's an article for you to read.
This means we have three indicators available -- apart from just inventing our own -- to build our strategy with. I hope this first part serves you with the right information to get you started as well. See you in part 2.