1. System Name:The5 Down Days (5DD) short term trading strategy

(Version 1.2 Feb 01, 2011)

  1. System description, key beliefs, and Discussion:
  1. A short term trading strategy that seeks to buy large caps and broad ETFs that have had an unusually long losing streak (5 days in a row of declining closes)and in which there is a probability of a short term counter-reaction to the upside. Because this move can often be very sharp, we are positioned to take advantage of a price signal in our favor right from the opening, if we can frame the trade with a favorable Reward :Risk ratio.
  2. The most important contrarian belief in this strategy is to not believe in the trade. There is every reason to believe the target will fail as a continuation of the reasons (whatever they may be) that caused the abnormally long consecutive losing streak.
  3. This system has its basis in these observations.
  4. First, in my trading practice, I have observed a heuristic that short term substantial selling of 3 days in a row (The candlestick pattern is called 3 Black Crows) is often followed by a reversal back to the upside, and this has been a vigorous short term move.
  5. In late 2005, Larry Connors published some materials that showed a statistically significant (but small) edge in short term returns if you bought any NYSE stocks the close of the 5th down day in a row. His study showed a persistent advantage using mechanical time based exit rules of various lengths and did not seek to optimize the entry. This robustness was attractive.
  6. Follow up independent testing by other Tortoise partners found robust, persistent edges in all market conditions with mechanical entries and exits in the 5DD area
  7. Since I prefer to see price moving in my direction before I commit, I began experimenting with adding the Universal Entry rather than buying the 5th down day and was satisfied with the prototype results, especially when coupled with standard position sizing, my usual short term exit strategies, and applied to a trading population of large caps and liquid ETFs.
  8. I reasoned that institutional money is always interested in buying value when tactical opportunities arise.
  9. We want the best return in the shortest time period and would love to see a 5% move in a day or 2
  10. I was satisfied with the results of adapting the Washout Continuation pattern rules to the 5DD, and now also trade the 5DDC in almost exactly the same manner
  11. The 5DD and 5DDC pattern has an important difference from the WO and WOC pattern in that we have a much wider range of candidates to choose from because we do not need to see Oversold conditions on a long term basis, only a short term losing streak anomaly that creates the opportunity. There are some important consequences of this:
  12. In practice this means that 5DD and 5DDC opportunities are much more frequent than the WO and WOC
  13. You will not only get bottom-feeder rebound targets, but in fact high relative strength targets that are in a pullback, similar to a buy-on-dip strategy, as well as candidates in the middle of the pack.
  14. There is much less psychological strength required to buy this pattern as it does not confront the aversion to trying to call a bottom to be successful.
  15. In addition, it is much easier to execute your exits when you know there will be plenty of signals
  16. It is easier to let go of marginal trades and entries, knowing that there are plenty more coming, and soon, in all kinds of market conditions.
  17. The discipline of waiting for the Universal Entry (UE) means that often you will see the spring continue to become compressed into a 6DD, 7DD, 8DD setup and these have often been even more rewarding than the “usual” 5DD. In fact you are eager to see this phenomenon, as you can continue to ratchet your entry , and any subsequent retracement back towards previous swing highs only improves your Reward:Risk ratio, generally speaking.
  18. The most important contrarian belief in this strategy is to not believe in the trade. There is every reason to believe the target will fail as a continuation of the reasons (whatever they may be) that caused the abnormally long consecutive losing streak..
  19. Some additional distinctions between 5DD and WO:
  20. We only need to see the UE to enter; we do not need the extra price action confidence of the WO setup criteria, which are extra risk control measures required to protect you when you are bottom-feeding.
  21. There are some important similarities to the WO and WOC, too
  22. Position-sizing, exit strategies, re-entry considerations, and awareness of the prevailing market condition are all the same.
  23. There is an implied margin of safety, in that the short term holders who could be tempted to sell may have already sold (from the pain of 5 losing days in a row)
  24. There is another margin of safety in that by focusing on large caps, there is an implied level of fundamental value in the business and business model. Because institutional money which is slow and large, must seek to buy large caps at moments of value, it may very well be that if this initial washout trade starts to work that institutional money may be tempted to begin a program of buying, if in fact the Big Sell has produced a temporary overreaction and created value in the current price.
  25. If institutional money does begin to come into this trade, you would not be surprised to see that the target does not hesitate at the first logical tactical resistance level, but continues to forge right on ahead past the previous swing high.
  26. We are not troubled by false starts along the way, since the 5DD Continuation pattern and the Universal Entry allow us to get back on board after paying a minor insurance fee to protect against a resumption of the downward trend, whatever caused it, to have created the extreme oversold conditions to begin with.
  27. I want to restate the most important belief however, the one that will prevent you from blowing up: The most important belief in all the “contrarian beliefs” is to not believe in the trade. There is every reason to believe the target will fail after the momentary pause that made us interested in it as a turnaround possibility.
  28. In Bear markets, signals that fail, ie hit their stop loss if entered, or if they hit the stop loss before the entry was ever hit, are excellent signals for immediately going short. Whatever caused the anomoly to lose for 5DD, is turning out to not be an anomaly at all. This 5DDF is a reliable trade in Bear markets
  1. System logic, concepts and definitions:
  1. “The market” = SPY (the S&P 500 Index; highly correlated to our target trading population)
  2. “Short term”=5 days down in a row
  3. Tentative Mechanical Entry = .05 above the Setup day’s High
  4. Tentative mechanical Initial Stop = .05 below yesterday’s low, which turns out to be the swing low, after the fact.
  5. Reward:Risk Ratio = (Target – Entry) / (Entry – Initial Stop)
  6. Maximum Entry = the highest price you can pay and still retain the 2:1 Reward:Risk Ratio.
  7. Tentative Profit target: this must be done by inspection of charts. Here are candidates
  8. Recent swing high
  9. Closing the previous gap
  10. Return to a 50day, or 200 day MA
  11. “Obvious “ resistance levels that can be seen from afar
  12. Anything else that more obviously meets the criteria of “An obvious point for short term traders to cash their profits, having just successfully picked a bottom”
  13. 5DD Continuation (5DDC) pattern: if we have a successful 5DD trade, and the target makes a swing low higher than the original swing low of the first 5DD trade, then we can re-enter the trade when we see the Universal Entry (UE). It does not matter how many days the target sellsoff. Functionally identical to the WOC.
  14. Universal Entry (UE): yesterday was a selling day, today opened inside yesterday’s range, and price goes higher than yesterday’s High
  15. “The Big Sell”: what I describe as whatever reason(s) that caused the market to dramatically cut the price of the target 5 days in a row. Our hypothesis is that this may have been an overreaction, and that a moment of value may have been created, and that we want to be positioned from the open tomorrow to get on board any retracement to the upside. We want the best return in the shortest time period and would love to see a 5% move in a day or 2. We will respect the power of whatever caused such a traumatic price shock though, and remember that the aftershocks may not yet be over.
  1. Trading population:
  2. Large liquid ETFs (minimum 100K shares per day)
  3. Large cap US stocks: Dow 30 Industrials, S&P 100, NAS100, S&P 500
  4. US Midcaps: S&P 400 companies
  5. Historical performance:

5DD results

Summary
Start Date / 5/2/2006
End Date / 9/21/2007
Days in Test / 507
Total Number of Trades / 311
Number of Winning Trades / 151
Number of Losing Trades / 160
Reliability / 49%
Average R Win / 2.15
Average R Loss / -1.04
Max R Win / 8.75
Max R Loss / -3.00
Profit Factor / 1.95
Total R Gain / 324.92
Total R Loss / -166.65
Net R Gain / 158.27
StDev ( R ) / 2.07
System Quality / 2.46
T-score / 4.34
Expectancy (mean R gain) / 0.51
Annualized R gain / 113.94
Period (days per signal) / 1.63

5DDC results

Summary
Start Date / 1/10/2007
End Date / 9/8/2007
Days in Test / 241
Total Number of Trades / 115
Number of Winning Trades / 81
Number of Losing Trades / 34
Reliability / 70%
Average R Win / 2.03
Average R Loss / -1.05
Max R Win / 16.00
Max R Loss / -3.33
Profit Factor / 4.60
Total R Gain / 164.36
Total R Loss / -35.72
Net R Gain / 128.65
StDev ( R ) / 2.38
System Quality / 4.70
T-score / 5.04
Expectancy (mean R gain) / 1.12
Annualized R gain / 194.84
Period (days per signal) / 2.10
  1. Setup rules:

Here is a screen shot of the Stockcharts screen that finds these candidates for S&P100

  1. 5ddOEX
    •For the last market close:
    •S&P 100 Stocks with...
    •Daily Close for today is less than Daily Close for yesterday
    •Daily Close for yesterday is less than Daily Close for 2 days ago
    •Daily Close for 2 days ago is less than Daily Close for 3 days ago
    •Daily Close for 3 days ago is less than Daily Close for 4 days ago
    •Daily Close for 4 days ago is less than Daily Close for 5 days ago
  1. Determine if the trade meets the 2:1 Reward to Risk ratio
  2. Calculate the Tentative Initial Stop, Tentative Entry, and Tentative Profit Target: If that gives you a minimum 2:1 reward to risk ratio, you can frame the trade
  3. Calculate the maximum price you can pay and still retain a 2:1 Reward:Risk Ratio. That way, if you get a gap, you know if you can still buy it.
  1. Entry rules:
  1. If the setup is valid, and Reward:Risk is > 2:1, then enter on Price > yesterday’s high plus .05 but not higher than the Maximum Entry
  2. Entry conditions remain valid for as long as the losing streak remains in effect. If the losing streak continues, we keep ratcheting down the entry for the following day provided that the favorable 2:1 Reward: Risk ratio is in effect.
  1. Exit rules:
  2. Market stops you out:
  3. Initial Stop is hit
  4. the recent swing low minus .05 OR .50, whichever is lower
  5. Optional rule:If the setup day was a gap open and kept going, consider using the low of the setup day minus .05 OR .50, whichever is larger, in order to make the 2:1 Reward:Risk ratio work (The market might be in violent agreement that this is a screaming value)
  6. Gap open below your initial stop = exit immediately
  7. If trailing stop is hit
  8. If we are in the trade, and see a sell day that doesn’t trigger a stop, and the next day we see both the position and the market selling, then exit, but be prepared for the 5DD Continuation trade.
  9. Another way to define rule iv is: a nickel below the low of the first selling day. (Yesterday’s Low minus .05)
  10. Trailing stops: after 2 days of success, convert the initial stop to a trailing stop. Several methods:
  11. Trail by the size of the initial stop
  12. Trail by 1x ATR
  13. Trail by the 2 day low
  14. Pre-emptive harvesting/Profit-preservation exits:
  15. If we have a 3R winner, and it is starting to stall at an expected hesitation point, you are never wrong to cash it, and remain prepared for the 5DD Continuation pattern. However, if you want more, then consult the market condition:
  16. If it’s BULL and Shortterm OVERSOLD: Hold
  17. If it’s BULL and Shortterm NEUTRAL or OVERBOUGHT, cash it, and be prepared to resume the trade with the Universal Entry.
  18. If the Market is SIDEWAYS or BEAR, cash the trade
  19. If we have a position that has not hit a stop, but the market (SPY) is crashing all around us, then you can conclude our position is working better than the market. Make a decision:
  20. exit the position favorably, anticipating that today’s market weakness will carry over to our weak trading target (even though today was strong)
  21. Examine SPY market condition state to inform your acceptable level of overnight risk to accept, and adjust your position size accordingly.
  22. Exit on evidence of weakness tomorrow (exposes us to a gap)
  23. Use Elder’s “Noise sensitive exit” to calibrate your overnight risk and adjust your position size accordingly
  24. Use a 2x ATR stop to protect you from the possibility of an adverse gap and adjust position size accordingly
  25. Run “Average True Gap Analysis” and decide on the level of risk you are willing to accept overnight to stay in this position, and adjust your position size so that you do not accept any more risk than the initial trade risk.
  1. Position sizing rules:
  2. Normal calculation to determine number of shares.
  3. I use between .5% and 1% portfolio risk per position
  1. Optional decisions/rules:
  1. To reduce volatility you could take only large cap signals and not midcaps
  2. To operate within a retirement account, you could employ Powershares inverse ETFs to go long on inverse ETFs and actually be taking a short side position.
  3. To try for more profits, you could elect to trail successful trades with a 1x ATR% trailing stop or 3% trailing stop and try to convert this trade into a longer term trend following position.
  4. To reduce trading frequency, you could elect to treat the first signal in an index as a setup and only take the 2d signal.
  5. Intraday traders could elect to try to improve intraday entries and exits through the use of pivot points or other intraday indicators
  6. Aggressive traders could elect to use Powershares leveraged indices to get more volatility out of each trade, when the primary unleveraged index signals.
  7. Futures traders could use these ETF signals as signals to be implemented in the futures markets
  1. 5DD Continuation (5DDC) Pattern Notes.
  2. This is a re-entry trade.
  3. Requires a successful 5DD trade as a setup.
  4. If we have a successful 5DD trade, and the target makes a swing low higher than the original swing low of the first 5DD trade, then we can re-enter the trade when we see the Universal Entry (UE).
  5. It does not matter how many days the target sells off, provided it does not make a new swing low.
  6. The Universal Entry is the first white candle that makes a price higher than yesterday’s High.
  7. The Initial Stop is the new swing low made since we exited the successful WO trade.
  8. Concept of the 5DD + 5DDC. For purposes of this slide, consider bar 1 as the first 4 down days and bar 2 as the 5th down day.

  1. Preferred brokers: low cost transaction per share is the most important decision criteria for this system. If you are an intraday trader trying for more, then consider slippage and speed of execution as well. Any large deep discount broker should satisfy these requirements.
  1. How to start the portfolio from all cash: Paper trade this for 3 months or until you are comfortable with the number and type of signals you receive, and that you are comfortable that you can respond to the signals and set the buy/sell orders and trailing stops. Consider trading at a reduced equity size with real money at a deep discount broker in order to build confidence and professionalism with real money before increasing size.
  2. Example setup:

  1. Example trade (completed 5DD with notes on 5DDC)