A trading strategy is a set of rules guiding the trader from entry to exit, managing the open position, defining the risk in the trade making sure all unknown about any future trade is known ahead of time, factors like risk, drawdown, profit, and commission are well-defined before the trade is issued.
Trading a strategy rather than trading intuitively has many advantages such as
- Following a proven tested process that displayed profitability in past backtests
- Making the psychology behind making a decision much easier, as human beings, we are prone to procrastination, a well-defined process makes taking the right decision easier
- Removing emotions from the process – by following a well-defined strategy, you save yourself the pain of deliberating on every trade, the process defines exactly which asset to trade, the size of the trade and the inherent risk
- Better risk management
In this post, we will discuss the Solid Momentum Strategy which is a trading strategy based on US stock momentum.
First, it’s important to define the universe of stocks for the strategy, meaning, what is the traded group of stocks for the strategy, this strategy is trading the stocks in the S&P500, these are liquid,large-mid cap stocks that may provide a very good return on a momentum basis.
The strategy uses a ranking system that is based on volatility where each stock in the S&P500 is ranked taking under consideration its return and its volatility.
Low volatility high return stocks are ranked on top all the way down to high volatility low return stocks, the top 20% of the list is the candidate list for each trading day. In this regards our research indicates that volatility factor is more important than the return factor, meaning low volatility is more important than high return of the stock, there is not much difference between two stocks with the different positive return in ranking but if one is less volatile than the other, that stock should go higher up the list.
Second, we must define the entry and exit rules, for this type of trading strategies which have a long term view (positions are held 10-90 days), the entry and exit rules don’t have to be exact in timing but must possess high probability of trend continuation, the entry rules are to enter all stocks in the top 20% of the ranking list and short the bottom 20% of the list.
Another entry rule is to go long if the S&P500 50 days EMA is over the 200 days EMA, this ensures that we are not fighting the market but riding the wave that the market has created for us, the same case can be said for short trades, we only short the market if the 50 days EMA is below the 200 days EMA of the S&P500.
Another exit rule that may be used as stop loss is if the stock dropped below its previous price + 21-day ATR, this ensures that if a counter trend is developing in the stock and is a fast one, when it trades below or above the 21 days ATR, the position should be closed.
And last but not least, the most important part of any trading strategy is how to manage an open position or position sizing, this is by far more important than any entry/exit rule, we have tested dozens of trading strategies and the one factor that improved performance significantly was the position sizing rule, for this we will use the rule below:
Size = (risk factor X portfolio value) / ATR(21)
This rule, which is applied on the open positions every week (so that commission wouldn’t hurt the overall performance due to over-trading ), sets the correct risk for each asset, it is a well-known rule, referenced in many trading books, one of which is “Stocks on the move” by Andreas Clenow , a highly recommended book.
Implementing this strategy is a bit of a challenge in case you don’t code it in any available coding language (our favorite is Python) because of the ranking system that has to deal with the current list of the S&P500 stocks, so you may code the strategy and backtest it or you may save the bother and subscribe to one of our trading strategy alerts and receive an alert every time the strategy issues an order to the broker so you are on top of his game.
The performance of this strategy may be viewed in the Solid Momentum strategy page (click here).