How To Develop a Trading System Part 6

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[catlist id=2 numberposts=3 pagination=yes] PinPoint Strategy – What a Difference a Day Makes

Most people developing trading strategies are stuck in the notion that a strategy should work all the time, that is if the strategy is valid, then it should work. Right? Ummm, no, not necessarily.

The things you trade are generally tied directly to a physical business, a market, or an industry. Each of these entities have unique characteristics and dynamics. The job of the strategy designer is to uncover those characteristics and dynamics and find an edge.

Oil, bubbling crude, Texas Tea, black gold.

Let’s take oil as an example, and here we’ll use the USO ETF (United States Oil Fund). This fund seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund invests in futures contracts for light, sweet crude oil and other types of crude oil, diesel heating oil, gasoline, natural gas, and other petroleum-based fuels traded on the NYMEX and other exchanges.

Now that’s a lot to take in. USO appears to be well diversified in the energy sector, so how do we find the edge? Well, if you follow the US economic calendar for commodity reports, you would know that the Petroleum Status report is released weekly on Wednesday at 10:30 AM EST. This report can have a major affect on not only oil and other petroleum products, but also on the entire US stock market, as it can be a very good barometer on US market health.

This is the biggie, no other petroleum report has greater affect on USO and by association, the market. But there are several other regularly released reports, that could add to price action.

The challenge is to identify patterns that result from these regular reports, and see if there’s a tradable edge.

The Pin Point and Pivot Strategies

Oil related securities are very volatile, and tend to have strong intra day trends, with volatility and sharp reversals often occurring in the early part of the day, and more so on specific days, particularly when there’s an oil-related report, like the EAI report released.

The Pivot strategy, a strategy that is very good at detecting when a strong traversal has occurred, is a fine fit for oil. In fact, it’s a good overall generic strategy, but particularly good for the price action exhibited by commodities that are pushed into action by economic reports.

The problem is that these reports don’t happen every day, and so we need to limit our strategy to work only on certain days, and possibly between certain periods of that day.

So we combine the PinPoint strategy with the Pivot strategy. The PinPoint strategy is designed to pick a long or short position within specific date-time ranges. A good example of this is our OTW (Over the Weekend_ strategy, which opens a long position in AAPL in the morning on Fridays, and closes it at noon on Tuesdays. This is a remarkable stable strategy, with a definitive edge, that has been extremely profitable for over two decades.

Finding the Edge

The hard part of creating effective strategies is the search for the edge. Sometimes it appears in a particular style of strategy (volatility, momentum, trend, etc), sometimes it’s date and time released (pin point, seasonal, etc). The only way to discover the edge is to develop a hypothesis, do some experiments, refine and repeat, until you have something worth further study.

Having some knowledge of the industry can certainly help in developing the hypothesis and the parameters of your experimentation.

The PinPoint Pivot is my best guess, and based on the knowledge that the EAI report is released on Wednesdays, I’m guessing that Wednesdays we’re going to see an edge appear. The only way to find out is to setup the strategy and experiment, so that’s exactly what I did.

I applied the Pivot strategy to USO, with very basic parameters, using the philosophy of Loose Pants fit More Butts. That means I used very wide ranging parameters to avoid curve fitting and over optimization, which generally lead to good looking past results, that ultimately fail when put into practice.

But by using the Loose Pants theory, and by forward walking the strategy, I can get fairly reasonable results. Basically what I’m looking for is an equity chart that goes up. It might have some draw downs, but if the general direction over a long period of time is a chart with an equity curve that starts in the bottom left and ends in the top right, then I have something to work with.

The next step is to restrict the trading to specific days of the week, and to a lesser extent, to sweet spots during the US market session, like between 10AM and 2PM EST, with a little variance, just to see if there is any correlation to the time an EAI report is released.

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