Strategy Development – Identifying Patterns that Form the Basis of a Strategy

Strategy Development – Identifying Patterns that Form the Basis of a Strategy

Published by Shaun Overton
04-28-2008

Shaun Overton develops trading strategies and assists customers with automating them at OneStepRemoved.com. He is a former forex broker that got involved with strategy development through trading his personal accounts in stocks and forex.

InformedTrades community members receive a 10% discount on all of Shaun's services.

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Latest 5 articles

Strategy Development – When Will My Strategy Go Bust?

Strategy Development Steps: Historical Testing Part B

Historical Testing, Part A

Strategy Development – Identifying Patterns that Form the Basis of a Strategy

Strategy Development – Introduction

Strategy Development – Identifying Patterns that Form the Basis of a Strategy

I mentioned in the last post that I trade trending forex pairs. EUR/USD fits this description well. It trends consistently, plus it is cheap to trade.

The whole concept of RSI is to identify overbought or oversold points. It functions reasonably well in a ranging market.

But one thing I noticed is how worthless RSI looks in a trending market. Experience taught me that when RSI is wrong, it is usually catastrophically so. This almost always happens in trends.

Look at this chart. Selling when RSI is overbought is not always a good idea.

A few months after the initial observation, a thought randomly popped in my head: what would happen if I bought EUR/USD every time RSI told me to sell?

Strategy Development Rule:
Bad ideas often provide the inspiration for good ideas

Say, for example, you have two traders:

Joe breaks even on his trades
Bob almost never makes money

Who should you copy? The answer is Bob, but with a caveat. If Bob is almost always wrong, doing the opposite should almost always be right.

Strategy development sometimes works for the same reason. I learned from experience that traditional RSI signals can devastate a trading account. After digesting this observation for a few months, I decided to investigate whether fading RSI* might lead to a profitable strategy.

Have you ever noticed situations where popular indicators are likely to fail?

*Fading RSI means doing the opposite of what RSI tells you to do

By Hectormu7 on 06-16-2008, 08:34 PM

Using RSI as a trendline

Hi Shaun,
When comparing the trendlines that I draw with the RSI indicator in the S&P e-minis market I noticed that the RSI lines cross the 47 when coming down from an overbought trend and cross the 53 in the contrary direction exactly when the support or resistance trendlines are crossed by the price, that is when I consider that a trend is over.
Considering that maybe it is not a bad idea to buy when the RSI is telling us to sell, but the question is how to know when a trend is forming.
I ussually consider a trend to be forming after a 5 point rally aproximatelly.
Is this correct?
How do you determine a tend?
I have been trading for a few days with good results after 6 months with the simulators.
Thanks to you and David for helping me to have a Happy start in the markets.
Hector

By Shaun Overton on 06-16-2008, 10:46 PM

Quote:

Originally Posted by Hectormu7

Hector,

I am glad you found the article useful. You are correct to point out that RSI often forms support and resistance during trends. The specific values vary by instrument, but generally speaking:
RSI = 40 in an uptrend forms support.
RSI = 60 in a downtrend forms resistance.

Last month demonstrated this beautifully on the eminis. Seeing two consecutive trends like this is highly unusual, but it does make for an easy graphic.

The yellow lines represent instances where the price declined to the upward trendline at the same time that RSI approached 40. The brown lines represent the price hitting the downward trendline at the same time RSI approached 60.

I like to see stairsteps in trends. What I mean is that I want to see nearby resistance (R1) taken out and exceeded to form R2. The price should then pull back to resistance (R1). Once it takes out the new resistance (R2) and pulls back to R2 as support and holds, this is usually the time I consider entering the market.

Quote:

I usually consider a trend to be forming after a 5 point rally
Is this correct?

It really depends on your time frame. 5 points in 5 minutes would be a huge move. 5 points in a day draws yawns.

My personal preference is to watch how the price moves rather than how much. If the market "stairsteps" twice, there is a good chance that it will stairstep two more times while you only risk 1 stairstep.

By Hectormu7 on 06-17-2008, 09:45 AM

Shaun,
That´s right, I forgot to mention the time frame, I´m using the charts with 1 minute, 233 ticks and 9 minutes.
best regards,
Hector

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