Reducing Whipsaws - Two Simple Methods

[jswanson 10]

Let's take a look at a simple moving average crossover system and see if we can improve it. Specifically, can we improve the moving average system's performance by reducing the number of whipsaws during those dreaded range bound markets? Whipsaws occur when a market moves from a trending mode to a consolidation mode. During this consolidation mode the system gets whipsawed from long to short creating a string of losing trades. Long trades suddenly reverse hitting your stop. Likewise for short trades. These 'false signals' can destroy your equity curve. In this article I'm going to present two simple methods to improve the simple moving average crossover system. These ideas can easily be implemented into your trading systems and may provide a great starting point for a trend following system.

 

Baseline System

 

Our baseline system will consist of two simple moving averages (SMA) executed on a daily chart of the Euro futures. I'm picking the Euro because it has demonstrated solid trending characteristics as opposed to the stock index markets which tend to be mean reverting. If you will recall, signals are generated when a faster moving average (trigger SMA or trigger line) crosses a slower moving average (slow SMA or slow line).

 

Slow SMA 50 period

Trigger SMA 3 period

 

Go Long when trigger crosses above Slow SMA

Go Short when trigger crosses under Slow SMA

 

Dates Tested: May 2001 - September 30, 2011

Commissions & Slippage: $26 deducted per trade

Number of Contracts: 1

 

For those using TradeStation the Baseline System was created by inserting two strategies into the chart that were provided by TradeStation. Below are the two strategies. The first one controls the long entry (LE) rules and the second one controls the short entry (SE) rules. You can see the input fields contain the three and the fifty for the two different periods for our moving averages. Buy using these provided strategies you can build a moving average crossover strategy within seconds without any coding skills.

 

 

BASELINE SYSTEM EQUITY CURVE

 

 

These two simple rules produce a trading system that is actually profitable over the long term. This is a testimate to the trending characteristics of the Euro futures market. However, there are periods of large drawdowns and long periods where no new equity highs are created. It’s not likely anyone would actually trade this. The image below shows a recent period from 2011 when the Euro entered a consolidation phase during the summer months of June through August. During this time our Baseline System produced a string of eight consecutive losing trades.

 

WHIPSAW SUMMER 2011

 

 

IMPROVEMENT #1: DELAYED ENTRY

 

With this entry method we are going to delay our entry into the market after the trigger line crosses the slow SMA. So, when the trigger line crosses the slow SMA we do not open our position right away. We delay for several bars. Let’s say we wait for 10 bars after the cross occurs. On the tenth bar after the signal we see if price is still above the slow SMA (for a long entry) and enter at the open of the 11th. If price is below our slow SMA we don’t open a new position. By doing this we eliminate some whipsaws at the expense of entering the trade later than the original SMA cross. The idea behind this method is if a new bull market is about to start, price should not fall back below the slow SMA. In short, it’s another way to measure the amount of conviction for the next market phase. However, we will keep the exit the same. When an EMA cross occurs we always close our open position. We only apply the delay when opening a new position.

 

 

The equity curve with our delayed entry actually moves the entire equity curve above the zero line. Fewer trades are taken and we reduce the total net profit. The equity curve also appears a little less jagged implying a slightly more smoother climb up. Below is an image showing the whipsaw summer time period in 2011. You will notice we have reduced the number of whipsaws from eight to five. Just during these few months we reduced the number of false entries by three.

 

WHIPSAW SUMMER 2011

 

 

IMPROVEMENT #2: TRADING BANDS

 

Unlike the standard moving average crossover where the trigger line must simply cross the slow SMA, our trigger line must now demonstrate conviction by crossing beyond the slow SMA. For example, picture another band above the slow SMA that is 1 ATR above the slow SMA. In order to open a new long position we require the trigger line to penetrate that ATR band above the slow line. Now picture another band that is one ATR below the SMA. This band represents our short trigger when we open a short position. We hope to eliminate some whipsaws by delaying our entry and forcing the market to show us some strength.

 

Some of you may have already noticed that what we have is a Keltner Channel. A Keltner Channel is nothing more than a moving average (slow SMA) with an upper band X number of ATRs above and below the slow SMA. The upper and lower bands act as the trigger to enter either a long position or a short position. The bands adapt to expanding volatility requiring more price conviction to initiate a new position. Likewise, these bands contract during lower volatility times. Thus, the entry and exit rules are more dynamic to a changing market than a simple moving average crossover.

 

 

The equity graph does not look too much different than our 10-bar delayed entry system. The entire equity curve is shifted a little closer to the zero line and it appears there are fewer trades. Below is the same time period showing the Band System has reduced the number of false signals from eight to two. This is a great improvement over the Baseline System.

 

WHIPSAW SUMMER 2011

 

 

SUMMARY

 

Each of the two methods improved the results of the original Baseline System. Looking at the graph below we can see performance statistics such as profit factor, percent winners and average trade net profit all increased. The Band Entry produced the best overall statistics. However, the maximum drawdown did not change much. We certainly don’t have a trading system that is tradable with real money, but we accomplished our mission. We reduced the number of whipsaws with our Delayed Entry System and Band Entry System. You can see this by looking at the number of trades taken by each system and the percent winning trades.

 

 

Code Download

 

The band trading system is rather simple, but the delayed entry is a bit more tricky. If you would like a copy of the EasyLanguage code (text file) you can download it here.

[hansjs 10]

Hi Jeff,

Thanks sharing the system.

 

Is it possible/does it make sense to trade the system intraday? And if so what timeframe can you recommend?

[jswanson 10]

Hi Jeff,

Thanks sharing the system.

 

Is it possible/does it make sense to trade the system intraday? And if so what timeframe can you recommend?

 

While I did not test intra-day I will say this: my experience tells me that intra day with such a strategy will not work. In short, the smaller the timeframe the more noise there is.

[steve46 10]

The moving averages method simply does not adapt quickly to accomodate significant changes in volatility....especially for the intraday time frame..Keltner is a bit better but still no cigar (in my opinion)...

 

What does work is Bollinger Bands properly applied...because (obviously) they respond quicly to changes in local volatility. After a long period of testing, I am using them in my class with very nice results....

 

I think the bottom line is that people have to take the time to research and learn about the technical issues. Most will not committ to that kind of effort, because it requires a delay between the time you start and any possible improvement...I have been working on this for almost 8 months on and off, and only now seeing the benefits....

 

Edit

Swanson you are one of the few who posts, then reads the responses and thanks me for trying to add value to the conversation. I appreciate that...here is a chart of tonight's Bollinger Band reversal trade...the mechanism is simple....you wait for price to test the BB and then move in your desired direction...(of course there is more to it, but I leave that to your discretion). What I like about it is that you know quickly if you are wrong...In my Globex class, we are looking at about 72.9% favorable entries (and outcomes) using this method over nearly 170 data points. We are in forward testing at this point.

 

 

Good luck

 

Steve

Edited November 3, 2011 by steve46

[Swaminathan 0]

Hi, I am new here, but thought I could offer a way out of the whipsaw problem.

I use the moving average on the high price for longs, and on the low price for short trades.

If the price trades between the high and low SMA, it is generally found to be ranging sideways where you are prone to whipsaws.

 

For my day trading, I look for price to cross the high sma. I use period 5 for the sma.

Maybe you could put this on the charts, and adjust the sma period to suit your trading style.

I hope this will work for you guys.