Market Environment Filter For Adaptive Trading Systems

[jswanson 10]

In this article I'm going to demonstrate a technique to help adapt your trading systems to the changing market conditions. In a previous article entitled, Trend Testing Indicators for Adaptive Trading Systems, I tested several indicators that could be used to divide the market into two modes: bullish and bearish. These two modes were then used to dictate how the trading system should execute its trades. For example, during a bull mode only open long trades. During a bear mode only open short trades. In essence we made our system adapt to the given market conditions. However, we can take this concept further by looking at a different market characteristic: trend strength.

 

A market may be in a bull mode, but how strong is the trend? Is the market rising fast or is it range bound? We would like to know if the market is trending strong or not because we would like to trade them differently. It's clear a range bound market should be traded differently than a trending market. In general you may want to hold an open position longer if the trend is strong. By measuring the strength of the trend we can further divide the market to make our trading system more adaptive. By introducing trend strength we now create four distinct market environments that can be used to determine how an automated system trades.

 

 

THE BASELINE SYSTEM

 

For the by and sell signal I’m going to borrow what is known as the Cumulative RSI Strategy from the book, ”Short Term Trading Strategies That Work” by Larry Connors and Ceasar Alvarez. The system only goes long. There is no shorting. This strategy goes long the S&P 500 E-mini when the market experiences a pullback in a long-term uptrend. A long-term uptrend is defined by our familiar 200-day simple moving average. We will also be using a 2-period RSI to locate high probability entry points, but with a slight twist. Instead of a single calculation we will be computing a running daily total of the 2-period RSI. In this case, the total of the 2-period RSI for the past three days. We exit the trade when the 2-period RSI rises above 65 . The rules are:

 

* Price must be above its 200-day moving average

* Buy on close when cumulative RSI(2) of the past three days is below 45

* Exit when RSI(2) of the close of current day is above 65

 

This system is applied to a daily bar chart going back to 1997 with$ $26 deducted from each trade.

 

 

Looking at the chart the equity graph looks great up until the very end! That’s when the sudden market drop occurred this summer (2011). Remember, the strategy code has no stops. Overall, these rules do a fine job of trading the S&P E-mini.

 

Looking at the trading rules, you can see the Baseline System has a market mode filter (the 200-day SMA) to identify the overall bullishness or bearishness of the market. But we make no distinction between a strong trending bull market and weak trending bull market. If we are in a strong bullish market it makes sense to hold on to our trade in an attempt to capture a bigger move. On the other hand, if we are not in a strong trending market we may want to exit our long position rather quickly. Yet, our Baseline System always sells when a 2-period RSI rises above 65. The exit makes no adjustment for the trendiness of the market.

 

INTRODUCING TREND STRENGTH

 

Let’s use TSI to gage the trend strength of the market and define a strong trend as >= 1.5 and a weak trend as < 1.5. These are not optimized numbers. They are simply a generalization from experience. Now, let’s modify our exit parameter to hold longer during a strong trend. We’ll exit when a 5-period RSI rises above 65. By increasing the period of the RSI calculation we required price to move further from out entry before triggering our exit. This should allow us to hold our position longer and capture more profit during a strong trend.

 

Our new bull market exit rules look like…

 

If TSI >= 1.5 Exit when RSI(5) of the close of current day is above 65

Else Exit when RSI(2) of the close of current day is above 65.

 

 

 

By introducing a simple trend strength indicator and holding our long position a little longer when the trend is strong we generate more net profit and more profit per trade. We also reduce the number of trades. This is a good improvement and demonstrates we are on the right track by holding our position longer during a strong trend.

 

GOING LONG DURING A BEAR MARKET

 

What can we do during the bear mode? Bear markets tend to have very sharp, dramatic down days. These can often be followed by violent short-covering rallies. It makes sense that if we want to find a buying opportunity we must be a bit more choosy on our entry. We can accomplish this by requiring price to be VERY oversold by reducing the cumulative RSI(2) value to be below 20. I just basically took the default value of 45 and cut it in half. We’ll use the Baseline System’s exit rule to exit quickly since we are in a bear market.

 

 

Bear market entry rule…

 

Buy on close when cumulative RSI(2) of the past three days is below 25.

 

 

 

There you have it. A system that adapts to several different market conditions. I did not cover the non-trending side of the bear market, but you are certainly free to explore that. Likewise, you can expand this concept to create an automated system that actually changes its trading behavior based on which of the four market environments we defined. Maybe a mean reversion system vs a long term trend following system. You can also try different indicators for measuring trend strength of market mode.

 

You can download the strategy code for the final system here (text file).

 

If you are not familiar with the TSI indicator, you can learn about it and download the code here.

[BlueHorseshoe 10]

Thanks for a useful post - I always find something of benefit in your system development threads.

 

When adapting the exit criteria to the market condition, what made you decide to adjust the RSI lookback rather than the exit level on the RSI itself?

 

Bluehorseshoe

[jswanson 10]

Thanks for a useful post - I always find something of benefit in your system development threads.

 

When adapting the exit criteria to the market condition, what made you decide to adjust the RSI lookback rather than the exit level on the RSI itself?

 

Bluehorseshoe

 

Experience, I guess. When you have an extreme value on RSI(2) it's really easy for it to pop in the other direction. Thus, I was simply looking for a price action move that had a little more strength behind it. By adjusting the lookback to 5 price has to work a little harder in my direction before trigging an exit.

 

Of course, there are probably several other exists that may work better. Exits are always a prime candidate to test and test again.