From the October 01, 2010 issue of Futures Magazine • Subscribe!

The trend isn’t your only friend

Let’s take a closer look at our simple positive-correlated intermarket divergence model. We will use an eight-period moving average for the S&P 500 and a five-period one for T-bonds. From April 22, 1982, to Aug. 6, 2010, this system makes $535,000 with an $84,000 drawdown. This is not bad for a simple S&P 500 system, but when we look at the yearly breakdown you can see the problems (see "Year In, Year Out," below, for the results).

In 1998, 2004, 2007, 2009 and 2010, performance was poor. Here the positive correlation between bonds and stocks breaks down. There are ways to work around this. We can filter out signals based on correlation and turn the system off when correlation is off course; or we can add a protective stop to the system and turn the system off until, and unless, a given condition occurs if we are stopped out based on that stop.

Sub IntermarketExample
(TrLen,IntLen,OffLen)

Dim InterTrend As BarArray

Dim SPTrend As BarArray

SPTrend=Close-Average(Close,TrLen,0)

InterTrend=Close Of independent1-Average(Close Of independent1,IntLen,0)

If SPTrend<0 and intertrend>0 Then Buy(“BuyInt”,1,0,Market,Day)

If SPTrend>0 And InterTrend<0 Then Sell(“SellInt”,1,0,Market,Day)

If SPTrend<0 and intertrend>0 Then ExitShort(“SX”,””,1,0,Market,Day)

If SPTrend<0 and intertrend>0 Then ExitShort(“SX”,””,1,0,Market,Day)

ExitLong(“LongFail”,”BuyInt”,1,Max (EntryPrice-5*Average(Range,3,0), Lowest(Low,30,0)),Stop,Day)

ExitShort(“SellFail”,”SellInt”,1,Max (EntryPrice+5*Average(Range,3,0),Highest(Low,30,0)),Stop,Day)

DisableSignalAfterExit
(“BuyInt”, “LongFail”, Not (BarsSinceExitPlus(“BuyInt”) = OffLen))

DisableSignalAfterExit
(“SellInt”, “SellFail”, Not (BarsSinceExitPlus(“SellInt”) = OffLen))

End Sub

The above code, written for TradersStudio, will disable the system for OffLen days after the protective stop exits the position. The DisableSignalAfterExit function makes it easy to implement this logic, which allows protective stops to be added to countertrend systems. Turning the system off for a given period or requiring RSI to rise above 60, for example, before the next long trade and below 40 for a short trade can solve problems that occur when a countertrend system gets out-of-sync with the market.

There are many classic intermarket relationships, but not all vendors have all the data. CSI, Pinnacle and Worden Brother each has something to offer. For example, Worden Brother’s TeleChart has some interesting indexes -- Morning Star indexes for example -- that are hard to find in historical data.

Countertrend systems are not as popular as trend following systems and have not been researched as extensively, suggesting there are more inefficiencies left uncovered. As you advance your research, you’ll find that stock indexes and interest rates are good countertrend candidates, as are copper and crude oil. Both ETFs and futures are viable vehicles for these strategies.

Countertrend concepts take a deeper understanding of the markets. Without this deeper understanding, countertrend strategies will often not be as robust as trend following methods. In trend following strategies, you count on one to two trades to make your profits. Countertrend systems will have a higher win percentage, but you have to find a way to limit the large losing trades that can erase a year of gains.

Learning to develop reliable and robust countertrend trading systems to go along with profitable trend following methods is one path to consistent trading profits.

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Murray A. Ruggiero Jr. is the author of “Cybernetic Trading Strategies” (Wiley). E-mail him at ruggieroassoc@aol.com.

More from Murray A. Ruggiero

About the Author
Murray A. Ruggiero Jr.

Murray A. Ruggiero Jr. is the author of "Cybernetic Trading Strategies" (Wiley). E-mail him at ruggieroassoc@aol.com.

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