I want to discuss three trading “truths” that I often heard but when I finally got into testing ideas found them to be myths. These discoveries were instrumental in turning my trading around.
Build Alpha: For those that know my story, it was not all roses and rainbows – what trading story is?!? I actually “learned” like a lot of traders from online sources, chat rooms, webinars, and eventually found the right circles to roam in after a LOT of trial and error. I was then lucky enough to land a job with a high frequency trading firm. I was quickly made to realized that much of what I thought trading “was” was most certainly false.
In an attempt to show me the light, a few of the quick trading axioms they wanted to disprove to me were simple “well known” trading ideas that have been around for years but were in fact large falsehoods. I quickly realized beyond this list of three examples there must have been many, many more “trading truths” that were causing my account harm and doing my trading aspirations a disservice.
I then realized the value in testing everything and quantifying my entire approach. It wasn’t until this point in my journey did I get out of the “rat race” of trading… the ups and downs, the barely consistent, always doing slightly better but not really getting anywhere trading most of the traders I meet today are going through.
I cannot stress the importance of testing everything and quantifying your edge. Investigate these trading axioms. Otherwise you will be stuck in randomness until your account random walks to 0. For more on my journey check out this podcast I did chatwithtraders.com/103 Below you will find my three favorite trading “truths” quantified.
Trading “Truth” #1 – Bearish Engulfing Candle
This one is great because many are familiar with Japanese candle stick patterns and the name implies such a negative move in price that one cannot help but to shift their bias to the downside. These candlestick patterns are often traders first introduction to technical analysis.
The pattern is defined as a bearish candle that “engulfs” the range of the previous day. I also like to look for a negative close and preferably a close below the previous session’s low. Here are a few pictures of bearish engulfing candles.
BuildAlpha: The truth is that this pattern has been one of the most bullish (not bearish) one day signals for the SP 500 over the past 15+ years. Did you know that the day following a bearish engulfing candle actually closes higher 61.72% of the time in the SP500 futures and 65.33% of the time in SPY ETF? The day following a bullish engulfing candle only closes higher 54.05% of the time in the SP500 futures and 51.70% of the time in SPY. You tell me why they’re named how they are!
Trading Truth #2 – Above a moving average is bullish and below is bearish
Most of the time this is true but it depends on the moving average, moving average length, and the market. I recently came across a few blogs that mentioned using a short term moving average as a sign to exit long market exposure and wait for sunnier days. In reality, this sounds great; however, analyzing the data this can be an extremely misleading “truth”.
Below is a chart plotting the equity curve if you would buy every close when the SP500 is BELOW the 8 period simple moving average (8SMA) and sell the next bar (repeating until above 8SMA). The second chart is if you were to buy every close when the SP500 is ABOVE the 8SMA and exit the next bar (repeating until below 8SMA). Yes, being below this moving average is actually better for long returns.
Of course this is not true for all markets and moving averages, as mentioned. I pointed this out in another post on SeeItMarket where I dissected popular stocks and different moving average lengths here: https://www.seeitmarket.com/testing-moving-averages-popular-stocks-etfs-16809/
The point is that these trading truths like “above a moving average is bullish” and “below a moving average is bearish” need to be quantified and tested. It is important to stop thinking trading truths can be generalized to every market, timeframe, indicator value, etc. and just verify them yourself and you’ll be much better off!
Trading Truth #3 – Overnight Exposure is Risky
Sure earnings announcements and large unexpected news announcements typically happen after market close. Does this mean we should avoid trading overnight, if possible? So many want to day trade and be flat on the close that they miss a lot of gains from the overnight session (sometimes all of them).
Below you will see 30 top stocks where I breakdown their returns in the day session compared to the overnight session. The blue line signifies if you bought the open and sold the close the same day (day session) and the orange line signifies buying the close and selling on the next day’s open (simulating overnight exposure). As expected, there are no generalities in trading truths. Some stocks exhibit that most, if not all, returns come from the overnight.
Don’t get me wrong there are certainly edges to be had from avoiding overnight exposure and there can also be value added by increasing overnight exposure. Again, I am just making the point to dig deep into the data and understand where the edge(s) actually live.
Quick note: You can easily test overnight holds in Build Alpha by setting max hold to 1 bar and setting entry to this bar close and exit to next bar open in the settings menu.
Originally Posted: https://www.buildalpha.com/truths/