Emotionally it’s a lot easier to buy on strength than to buy on weakness. Buying into a falling market feels unnatural. Your instincts warn that price may continue to fall resulting in lost capital. On the other hand buying when the market makes new highs feels more natural. Price is moving in your direction and the sky is the limit! However, with so many other aspects of trading what feels natural or easy is often the opposite of what you should be doing.
Trading psychology can make or break not only your mental state-of-mind but your trading account. In this post I’m going to compare these two different trading strategies on the S&P E-mini futures market and see which one produces better results. That is, we will look at a weak-trending bull market and a strong-trending bull market.
Our strategy will be coded in EasyLanguage and tested on the E-mini going back to 1997. All the tests within this article are going to use the following assumptions:
To compare buying into strength vs buying into weakness, two simple trading strategies will be created. Both strategies will go long only. All open positions are held for five days only.
First let’s create a simple strategy that will study buying into strength. To do this we will look for three consecutive higher closes. At that point we will buy the open of the next bar. Based on this pattern we are testing the market’s ability to follow through with continued higher closes. In short, we are buying into short-term strength in hopes it will continue into the near future. Below are the results of executing this test.
The strategy is far from profitable as the equity curve spends most of its time in negative territory. What this suggests is that short term bursts of strength are soon followed by falling prices. Remember, after we buy we only hold our position for five days and sell. It seems when we sell, price is often lower than when we bought.
Now let’s look at buying into pullbacks. We will use the same premise as buying into strength, but look to buy into a falling market. That is, we will look for three consecutive lower closes. A lower close is a closing price which is lower than yesterday’s closing price. At that point we will buy the open of the next bar. This strategy will represent our buying into weakness.
What a difference! This strategy equity graph looks completely different and suggests that short-term weakness is often followed by price moving higher. If the two equity graphs are not enough to prove this point, let’s compare strategy performance .
It’s important to remember these strategies are not trading systems per say. For example, both of these strategies have no stops so you would not blindly trade them. Think of these strategies as market indicators designed to highlight market behavior which might lead to a profitable trading edge. In this case there appears to be a significant bullish bias when buying into weakness as opposed to buying into strength.
The two strategies we tested above both used a 3-day lookback period and hold the position five days before closing it. Maybe this is a fluke? What does this test look like over different lookback periods? Are different lookback periods still profitable? While I want the holding period to remain short (five days) to mimic a short-term trading system, let’s look at different lookback periods and see if our strategy will remain profitable of several different values.
The first graph below shows buying into short-term strength with a lookback period of one through 10 days.
Notice the first two days after three consecutive days up produce some profit. But even then, the profit over such a long test period is not significant. Most of the bars show negative profit or profit around zero. In short, this does not appear to hold a market edge.
The next graph below shows buying into short-term weakness with a lookback period of one through 10 days. Notice with a loookback period between one and five we have profitable results. This shows some stability with the market behavior. However, beyond five days (one trading week), price often shows weakness.
So, it appears our short-term lookback period when buying into weakness has a nice profitable region and gives more credence to the market behavior of buying into weakness. The optimal lookback period appears to be four days. After four consecutive lower closes price can often have a strong rebound.
The idea of buying into short-term weakness seems to still hold merit for the S&P. The market edge appears for the 1-5 consecutive down days in both the futures and equity markets. This type of a market edge can lead to building a profitable trading system. Adding a market regime filter, dynamic stop, position sizing model and maybe a dynamic exit could turn this into a winning system.
Lets take a look at some other popular markets. Lets first start with two other major stock indexes, the DOW and NASDAQ.
Now lets turn our attention to currency futures
Finally, lets take a look at some other popular futures. First silver and gold.
Finally, oil and U.S. 30-Year Treasuries.