Simple Trend Following System

The simple trend following system seeks to make a successful day trading strategy by
capitalizing on short term trends.

It originally started when I was studying charts and trying to make sense of day trading. I
chanced upon an article on a website where the author mentioned he was successfully day
trading using the daily chart. The essence of his strategy was to take high probability trade
entries on daily timeframe by looking at trends.

At around the same time, I watched a youtube video on “Trading the T line. This put a
perspective of riding the short term trends into focus.

Next step was to integrate this information into my trading style. I thought if one could enter an
uptrend and keep buying everyday as long as the uptrend lasted, I would be in profit overall.
Likewise for downtrends.

I had taken on a challenge from some friends to create wealth using only Rs.5000 as initial
capital. To do this, I realized I would need to compound my earnings every day. Added to the
fact zerodha was offering good margin on MIS Intraday positions, I decided to use leverage in
addition to compounding, to accelerate the wealth creation. But the primary system remained
as it was, and I traded by identifying short term up trends and buying every day till the trend
ended.

The next step was to define the trend, identify its strength, and add additional filters to reduce
the risk.

Trend Identification

After experimenting with emas of various periods, I settled on 3 EMA as my choice to identify
the trend. Price above 3 ema would indicate a buy decision, and price below 3 ema would
indicate a sell decision.

Trend Strength

To confirm that the trend is in fact strong, I used RSI (5) with level above 60 confirming a strong
move up, and level of 40 to confirm a strong down move. It is to be noted that I was not using
concepts of overbought and oversold as taught in conventional books.

The normal accepted interpretation of RSI is bullish if >50, and bearish if <50.
It can also be observed that when RSI values are between 40 and 60, the stocks were moving in
sideways range.

Momentum Confirmation

To add a confirmation to momentum of the move, I used MACD signal line cross over. IF MACD
is above the signal line, it indicates bullish momentum, and if MACD is below the signal line it is
a bearish momentum.

Internal Bar Strength (IBS):

The last filter added was to look at whether the price closed at the top of its range or at the
bottom of the range. If the price closes at the top of the range, the market is telling us that
prices want to move upward. If the price closes at the bottom of the day’s range, the inclination
of the market is to push prices further down.

The IBS is calculated as (Close-Low)/ (High – Low). If the value is above 80, we know that the
price wants to go up. If it less than 20, we know the price wants to go down.

This is an additional fiter added so that the stock scan gives the highest probability
opportunities.

Price Above 8 ema High and below 8 EMA Low

This was an additional filter I added to leave out sideways moves.

For entry levels, stop loss and targets:

My initial approach was to enter at market price. I naively used the logic that in a buy call if a
green candle forms I would be in profit. I realized this was a mistake (as prices could be pushed
up and then brought down by considerable selling pressure, as in a shooting star candle
formation) and started optimizing entry levels using Fibonacci levels to determine entry points.

The Fibonacci levels used are 0.618, 0.5, and 0.382

Calculation of entry levels:

Scenario 1 - Yesterday’s close < Yesterday’s open

Entry 1 Low+((High-Low)*0.618)

Entry 2 Low+((High-Low)*0.5)

Entry 3 Low+((High-Low)*0.382)

Scenario 2 - Yesterday’s close > Yesterday’s open

Entry 1 High-((High-Low)*0.618)

Entry 2 High-((High-Low)*0.5

Entry 3 High-((High-Low)*0.382)

Stop Loss : 0.886 Fibo level

Scenario 1: Low+((High-Low)*0.886)

Scenario 2: High-((High-Low)*0.886)

Tradable Quantity Return Required and targets:

I wanted a minimum return of 10% on the capital invested. The computation of traded
quantity and the returns were based on an approximate average leverage offered by Zerodha,
and the entry price.

Tradable Quantity =(Own capital x 20.8)/ Entry price

Return required:

Own capital x 10% (this can be varied depending on risk appetite etc.)
Target Price move required to achieve the return.

Return required / Tradable quantity

It has been my experience that the 10% return targeted is achieved in 90%+ of the trades, and it
is not a rare occurrence to even achieve 30% return.

Losses

Losses are an integral part of trading – any system cannot claim to be profitable 100% of the
time. Therefore, it is prudent to expect losses in this trading method too.

However, the losses in this system are caused by corrective moves, and at tlimes when the trend
itself reverses. In the case of corrective moves, if the trade is held till eod, the losses are quite
small. In the case of reversal, it could happen that on the day of reversal the loss could be big –
but it can’t be bigger than the day’s price move.

Trading Rules:

Long Trades

Price is above 3 day ema of close &

Price is above 8 day ema on high price

RSI is above 60

IBS is above 80%

MACD is above the signal line.

Short Trades

Price is below 3 day ema of close &

Price is below 8 day ema on low price

RSI is below 40

IBS is below 20%

MACD is below the signal line.

Last thoughts

Though the system was originally formulated to trade a single stock through its trend till the
trend ended, over time I found I was able to define the parameters for stock selection by
creating a custom indicator in Jstock, an open source software I found at www.jstock.org. The
windows version has scanning capabilities based on user defined parameters in the form of a
custom indicator. Creation of the indicator itself is just a flow of logic and computational
parameters.

With the advent of Jstock in my toolkit, I now scan the entire list of scrips for which Zerodha
provides margin, and the output contains the most high probability buy or sell
recommendations for the next day.