Nasdaq 100 Gap Down Strategy

January 3rd, 2011

I saw James Altucher’s post on articles he’s tired of writing each year and one of his ideas piqued my interest. He says:

…if a Nasdaq 100 stock gaps down more than 5%, its a good buy for the day.

I thought I’d check out this idea further by doing some backtesting. Over the past 2 years there were 234 instances where a Nasdaq 100 stock gapped down by at least 5%. I tested going long right at the open and then closing the position at the close the following day.

It turns out there is an edge going long in this situation. Here are some stats:

Win Rate: 55%
Average Gain: 0.73%
Profit Factor: 1.55

So it definitely looks like there is some edge there. Whether or not it is worth trading is another question. More testing is required to determine that, but at this point it’s probably worth working on or at least continued study to see what can be learned from it.

Trend Follow or Reversion to Mean Follow Up

April 6th, 2010

A while back I posed a question about following a trend or reverting to the mean – two well known strategies. Given a specific subset of stocks defined in the post would the edge be long or short? Weijei‘s comment was very close to correct.

It turns out that there is a definite edge to the downside on stocks that have gapped up on heavy volume. If you buy at the open the following day and then hold until the next day’s open you’d end up with a win rate of 38% with total percent gain of -286%.

However, if you sold short at the open and held until the next day’s open you’d end up with a win rate of 68% with a total percent gain of 899%. There’s no doubt at least in the short term that there is more of an edge with a reversion to mean strategy with these types of stocks.

Here’s the same chart in ENT. It shows that there would have been a small gain by shorting the following day. Look also at the days after – it looks like there might be a longer term trend following edge worth exploring.

(Chart generated by the StockTickr Trading Journal)

Why Backtests Can Fool You and What To Do About It

December 10th, 2008

In this article I wrote a few months ago, I outlined 10 mistakes that new automated traders often make. Here are a couple points that I want to highlight again:

Blaming the Money You Lost on the Backtest – This is common. While I do believe the Odds Maker is the best backtester out there, it is still, well, a backtester. If you’re trading results don’t measure up to what the backtest results look like, then figure out why (there are a variety of reasons why this happens). Trust me, it’s not the backtester’s fault.

and

Not Spending Time Learning Why Some Unprofitable Strategies Backtest so Well – The quicker you learn this the better off you’ll be. Once you understand why some unprofitable strategies can be made to look awesome in a backtester, you’ll learn how to recognize if the strategies you model are showing backtest success because of these reasons and you’ll be able to avoid them.

Once you understand how a backtester works, it’s easy to see why some strategies can be made to look great in a backtest, but you’d absolutely never want to actually trade them.

Using a Stop of $0.01 Will Never Work

One of the easiest ways to make strategies look good in a backtest is to use ridiculously tight stops. Here are the results of a backtest using a stop of $0.01.

To summarize, this backtest showed this strategy taking 112 trades with a win rate of just 8.9% but get this – it made 1400R for an expectancy of 12.51. Wow – an expectancy of over 12.

You would NEVER want to actually trade this strategy even when it backtests with such an astronomical expectancy. So the backtest showed serious profitability for a strategy that would lose serious money. Why?

The problem is that any backtest is working off historical data. Regardless of the interval the backtester is using for the test, the backtester software always waits until the next bar after the entry to determine if any exits occur.

Why doesn’t it use the entry bar to test for an exit? Well, that is impossible. Think about it: let’s say you have a signal that gets you in stock XYZ during a bar that has an open of 49.70, a high of 50.00 a low of 49.50, and a close of 49.95. Let’s say the backtester used an “entry” price of 49.80 and you were long and had a stop of $0.20 which would put your stop at 49.60.

But, the low of the bar was 49.50 – should the backtester stop you out or not? There’s no way for the software to know what the price action was during that bar without zooming in and using a smaller time interval for the backtest. No matter how small the interval you’ll always have this problem, so the software always waits until the next bar to determine if any exits are hit.

This is why I think it’s so important for automated traders to understand how a backtest works – if you don’t you can easily get into a situation where you’ve gotten your hopes up for a strategy that is almost guaranteed to lose money.

Of course, if you follow the guidelines we give you for automated trading you’ll learn very quickly how to recognize these gotchas before you put any money at risk – think of it as learning the lesson without paying the “tuition”. 😉

Backtesting Can Help Improve Your Manual Trading

October 29th, 2008

When I started automated trading a few months ago, I jumped head first into backtesting with the thought that it was essential to automated trading. While there’s no doubt that automated trading and backtesting go hand in hand, what I’ve discovered over time is that learning what makes automated trading systems tick (forgive the pun) gave me a much deeper understanding of the manual systems that I trade.

By learning how certain exit strategies affect the performance of high frequency automated trading systems, I inadvertently learned a lot about certain aspects of my manual system.

Some of my beliefs about my manual trading were reinforced, while other assumptions that I thought were practically 100% true were challenged by what I learn and continue to learn by backtesting automated trading systems.

For example, the time of day that you trade is absolutely critical. Strategies that make serious money at the open are often times completely worthless a half hour later (not all though).

There are other assumptions that I had about trend following systems and taking partial profits have been challenged.

One other thing I should point out is that sometimes taking the optimal action according to a backtest might not actually be the best course of action in your manual trading. For example, a backtest might tell you that taking partial profits (locking in a portion of your trading gains) is less profitable than not taking partial profits. What the backtest can’t calculate, however, is the peace of mind that can come from taking some of that profit off the table. Of course, we all probably make less than optimal compromises in our trading in exchange for some psychological comfort.

I’d highly recommend manual traders spend a little time backtesting strategies completely different than the ones they manually trade. Certainly if you’re a Trade-Ideas user already you should spend some time with the Odds Maker.

Backtesting Your Trading

September 23rd, 2008

This is the fourth in a series of posts about how and why and how I started down the path of automated trading. Here’s the first, second, third, and fourth posts in the series (RSS). Our automated trading robot is available now. Trade your own strategy automatically with no coding required.

Now there’s a word that means a lot of things to different people: backtesting. Ask 5 traders what they think of backtesting and you’ll get at least 5 different responses – from “backtesting is worthless” to “I wouldn’t even consider trading without backtesting first”.

Here’s my take on backtesting – it can be an extremely valuable tool depending on the trading system you use it for. In fact, in some type of systems it’s just not practical to start trading without backtesting first.

You’re At Step One Of…

One thing that a lot of new backtesters overlook is that backtest results are simulated. It doesn’t reflect actual participation in the markets. What often happens is someone develops a strategy that tests really well and then they start trading with it, fall flat, and then they get mad at the backtest. There are a whole variety of reasons that actual trade results don’t match up exactly with backtested results.

The important thing to remember is that when you develop a strategy that backtests well, you’re just at the beginning stages of trading a profitable strategy – there’s a lot more work left to do after this step!

Organize your Backtesting

When you set out to backtest strategies, it can quickly become overwhelming if you don’t have a plan for organizing results. It’s very easy to make adjustments and then lose track of what you changed and where you started – especially if you use the Trade-Ideas Odds Maker, which allows you to test strategies very, very quickly.

StockTickr has a built in “version control system” for trading strategies and backtest results – it allows you to archive, combine, and compare backtest results. You can even share a backtest with others if you choose to. So basically, StockTickr does all the heavy lifting for you automatically.

Compare the Backtest with your Actual Trades

It’s a depressing feeling when you trade a strategy, lose money, and then look at the backtest and it indicates you should have made money. Remember above where I said there’s a lot more work to do? This is where that begins. A lot of traders just abandon the strategy here or just start throwing a tantrum, but understanding why most strategies underperform the backtest is part of the process.

There are a lot of techniques to use to figure out how to get more money out of your automated trading system and comparing your backtest results with your actual results should give you some hints on where to start.

I’ll address these steps in more detail in the next post.