Author :Arun Prakash , BIM Trichy
Introduction:
“I can calculate the motion of heavenly
bodies, but not the madness of people.”
-Sir
Isaac Newton (1643-1727)
This was the statement made by
one of the greatest geniuses known to us, when he lost around £3 million
in present day terms in the stock market during the south sea bubble in 1720.
Time
and time again the stock market has fascinated a lot of people all throughout
the years. A lot have made their fortunes with it, and some have lost them
while investing as well as trading on the stock market. However that is what
constitutes the stock market, and that is what makes stock market returns more
attractive than risk free investments. This article includes a brief
description of the Open Range Breakout system and an original experiment
conducted for testing the system in Indian Markets.
What is a Trading System?
A
trading system is simply a group of specific rules, or parameters, that
determine entry and exit points for a given security. These points, known as
signals, are often marked on a chart in real time and prompt the immediate
execution of a trade.
History:
The
most famous example of a trading system is the one developed and implemented by
Richard Dennis and Bill Eckhardt. In 1983, both had a dispute over whether a
good trader is born or made. So, they took some people off the street and
trained them based on the now-famous Turtle Trading System. They gathered 13
traders and ended up making 80% annually over the next four years. Bill
Eckhardt once said, "Anyone with average intelligence can learn to trade.
This is not rocket science. However, it is much easier to learn what you should
do in trading than to do it." Trading systems are now becoming more and
more popular among professional traders, fund managers and individual investors
alike as it takes the human emotion out of the trading.
Candlestick
basics:
The
basic knowledge of candlestick charts is essential to understanding the open
range breakout system. The candlestick techniques used today, originated
in the style of technical charting used by the Japanese for over 200 years.
This charting technique is very popular among traders.
Candlestick Components:
Like
a normal bar chart, the daily candlestick line contains the market's open,
high, low and close of a specific day. The candlestick has a wide part, which
is called "real body". This real body represents the range between
the open and close of that day's trading. When the real body is filled in or
black, it means the close was lower than the open. If the real body is empty,
it means the opposite: the close was higher than the open.
Just
above and below the real body are the "shadows". Chartists have
always considered them as the wicks of the candle, and it is the shadows that
show the high and low prices of that day's trading. If the upper shadow on the
filled-in body is short, it indicates that the open that day was closer to the
high of the day. A short upper shadow on a white or unfilled body dictates
that the close was near the high. The relationship between the day's open,
high, low and close determines the look of the daily candlestick. Real bodies
can be either long or short and either black or white. Shadows can also be
either long or short.
Open Range Breakout (ORB)
The
Opening Range is a popular concept that was first introduced by Toby Crabel in
his book “Day trading with short term price patterns and opening range
breakout” (Crabel). It has since been further developed in a variety of ways in
the literature by Geoff Bysshe, Mark Fisher and others. While OR is a powerful
concept, there is no unified method to properly identify the price trends and
the correct conditions to properly utilize them. Most of what is written on the
topic consists of guidelines and suggestions with a few examples, but very few
real performances or solid rules were introduced on how to create a successful
OR strategy.
What
makes the 30-minute Opening Range a powerful concept in trading is that it is
the period during which traders act in response to recent news and observe the
initial price movements of a particular stock with respect to the analysis they
have done since the close of the prior day. The information gap between the
opening period of the day and the prior period closing contributes to the
significance of this strategy and makes it rich in information.
Geoff
Bysshe also claims that about 35% of the time, the high and the low prices for
the day occur within the first 30 minutes. This means that it is very likely
that a stock will continue trading within the Opening Range and if its price
breaks out it will continue to move in the direction of the breakout.
Design
of the trading system
To
design an Open range breakout system that would suit the risk profile of the
user, the trader must determine the method of selection of stocks in which the
system would be used, the entry criteria, the exit criteria and a stop loss
criteria.
The
Opening range can be set as a range from initial 30 minutes to an hour. Once
the opening range time is over, the trader can enter into positions based on
opening range high & low values.
Selection
of stocks
The
stocks which have huge volumes historically are the most preferred stocks for
trading systems. To prevent including penny stocks, a price limit can be set. Liquidity
is the single most important factor in choosing the stocks to trade.
Entry
Whenever
the stock price breaks out of the opening range with two bullish candles
closing above the opening range or two bearish candles closing below the
opening range, a buy or sell call is generated respectively. If there are no
continuous candles closing above or below the opening range, the signal is
ignored. Also any entry signal during the last one hour is ignored as there may
be no reasonable price change to exit the position.
Exit
with Profit
The
target for the long or short position of the stock can be determined by using
the pivot levels. Numerous pivot value calculators are available on the
internet like www.pivotpointcalculator.com from where target values can be
determined by giving open, high, low &close price of the stock.
Stop loss (Exit with Loss)
One
of the important street knowledge on trading is that, traders must cut their
losses short and let their winning positions run. The stop loss criteria can be
designed as per the risk profile of the trader. A sample stop loss criterion can
be 1% below the opening range high for buy calls and 1% above the opening range
low for sell calls.
The following charts depict the
long & short positions along with their entry & exit:
Buy
Breakout:
Sell
Breakout:
Real time experiment in Indian
markets
The
open range breakout strategy was tested continuously for two months (25/04/2011
to 21/06/2011) by the author in the following manner. The author with an
initial fictional investment of Rs 10,000 began to use the open range breakout
strategy. The author tracked 10 stocks everyday and invested 10% of the capital
in every call generated.
No
real positions were taken and the study was carried out only for the research
purpose. Over
the two month period considering the transaction costs and leverage, the open
range breakout trading system yielded a return of 79.99%.
The
distribution of average daily returns of ORB for two months is depicted below:
Risk
Return Ratios for the system:
Coefficient
of Variation = Risk / Mean Return
= 1.79
Sharpe Ratio = (Return – Risk free
Return) / Risk
= 0.55 (for a risk free rate of
6.5%)
Conclusion
"One
of the funny things about the stock market is that every time one person buys,
another sells, and both think they are astute."- William Feather (1889-1981)
In
the current global economic scenario, with a possibility of US double dip
recession looming, markets all over the world are facing tough times & huge
volatility. The Open Range Breakout is an ideal trading system in such a
scenario as it has potential to give better returns than the simple buy &
hold strategy. Sensing the underlying trend in the market for the day, Open
Range Breakout gives signal to the trader to take long or short positions in
the market.
The
essence of the open range breakout system is the way it captures the way
information flows in the market. Most of the high impact information is
released either after market hours or during the opening session of the market.
The rules used in this trading system are universal and apply to broad range of
financial and commodity markets.
The
open range breakout trading system yielded a return of 79.99% while S&P CNX
Nifty Index for the same 2 month test period gave a return of -10.19%
A
drawback of the ORB is that, the delay in execution may lead to prices moving
away from the ideal entry point and thus will reduce the potential returns.
However, this drawback can be rectified by automating the trading system, i.e
using computer programs to trade.
The
simplicity of ORB makes it a potential candidate for algorithmic trading. With
a high Sharpe ratio of 0.55, ORB trading system can be adopted by institutions
in India, as in the developed markets. Even though algorithmic trading is still
at nascent stage in India with just 20% of the total cash market volume, it has
greater role to play in the future global Indian Markets.
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