We begin by examining the effect of adding a trailing stop to the usual channel breakout system. Our purpose is to convert the channel breakout logic into a short-term trading system. The logic of the channel breakout on close is probably familiar to you. The symmetrical long and short entry rules are as follows:
1. If today's close is higher than the highest high of the last 20 days, then buy on the close.
2. If today's close is lower than the lowest low of the last 20 days, then sell on the close.
The exit condition is a simple trailing stop placed at the highest high or lowest low of the last few days. In our case, we want to use a 5-day trailing stop. The exit conditions are as follows:
3. Exit the long trade at the lowest low of the last 5 days on a stop.
4. Exit the short trade at the highest high of the last 5 days on a stop.
We assume that the market will make quick, decisive moves once it breaks out of the 20-day channel. The implication is that we can use a relatively tight trailing stop to protect most of the profits. A close stop works well in markets that make swing moves. Conversely, this close trailing stop will exit too soon during prolonged trends. You may see more than one trade during long-trending periods because the system will generate a new trade on a fresh breakout beyond the barrier. Table 5.2 gives the results of the historical tests using a $ 1,500 initial stop, trading one contract per signal, and allowing $ 100 for slippage and commissions.
The basic 20-bar breakout system is a typical trend-following system, with 36 percent profitable trades and an average win-loss ratio greater than 2. Sixty-three percent of the profits are from just one market, coffee. The average profit factor (the ratio of gross profit to gross loss) is 1.19, so the system produces slightly more profits than losses.
150 Developing Trading System Variations
Table 5.2 Historical results for 20-bar breakout on the close with exit on the 5-day high or low
|Market||Profit ($)||Number of Trades||Percentage of Wins||Win / Loss Ratio||Average Trade ($)||Maximum Intraday Drawdown (S)||Profit Factor|
The average trade at $ 112 is barely acceptable, partly the result of staying in the trade for only a short time.
The 2,195 total trades suggest that trading costs and slippage are a significant factor in overall performance. Losses in four of the ten markets tested are a bit worrisome. The average profit is not much greater than the average maximum drawdown, which is another concern.
These tests used an exit on the highest high or lowest low of the last 5 days. The 5-day high or low exit strategy assumes that the market will make a strong move after making new 20-day highs. The following two cases show how this exit works in practice. In the case of wheat (see Figure 5.1), the market was in a choppy uptrend. A choppy uptrend is weak, because the market consolidates after making new highs. Our exit on the 5-day high or low closes out the trade in the consolidation region following new highs. Hence, in the choppy uptrend of the wheat market, there is a string of short-lived trades.
The next case (see Figure 5.2), presents the ideal trade for the current exit strategy. The coffee market made a strong move upward once it broke out of the 20-day price range. The first significant correction triggered the trailing stop on the 5-day low. Comparing the two cases,
Channel Breakout on Close with Trailing Stops151
|-450 * 0|
|-425 * 0|
|-400 * 0|
|-375 * 0|
|-350 * 0|
Figure 5.1 The close on the 5-day high or low gives frequent exits in a choppy uptrend in the wheat market.
|140.00 135.00 130.00 125.00 .120.00-II 5.00-I 10.00-105.00-100.00-95.00-90.00-85.00|
Figure 5.2 The coffee perpetual contract shows ideal market action for the 5-day trailing exit, which works best with markets that move quickly after a breakout.
152 Developing Trading System Variations
we see that the trailing exit works best with swing moves. If you wish to use discretion, you should remember this exit strategy in swing markets. The limitation of having to specify the number of days to "look back" to set the trailing stop is not ideal. In the next section we discuss how a volatility-based exit overcomes this limitation.
Summary | Channel Breakout with 20-Tick Barrier | Channel Breakout System with Inside Volatility Barrier | Statistical Significance of Channel Breakout Variations | Day Exit Reference System | Two ADX Variations | The Pullback System | The Long Bomb - A Pattern-based System | Summary | Introduction |