Short term trading is identifying and trading in the direction of Momentum. Momentum essentially is the rate at which price change takes place and it usually precedes price movement. If Momentum is showing signs of strengthening in near term, then invariably directional move occurs. Traditionally, traders have used basic Momentum indicators to enter and exit trades. Since this article is about ROC, the most common way to use it, is to be long in trades when ROC is above zero and to exit the trades once it moves below zero. The drawback of this method is that ROC frequently whipsaws around the zero zone and hence gives lot of false signals which result into draw downs. One simple yet very effective way to use the ROC is to use three daily ROC measurements and then add them together to give a modified ROC. This leads to very low draw down and effectively wins a trader 3-4 times of money lost during losing trades. By incorporating three different daily measurement of ROC, we are essentially taking into account trend confirmation on multiple shorter term time frames.
Construction of this indicator is fairly simple. ROC is available in almost all Technical Analysis Software and hence modifying the existing ROC is not that difficult. In this method, we are going to add ROC(5), ROC(10) and ROC(15) and form a modified ROC indicator. Once this is constructed, we go long in the asset when the modified ROC moves above 4%. We exit the trade once the modified ROC moves below 4%. Since momentum precedes price, as soon as the momentum on modified ROC begins to fade, we will exit the trade with whatever profits we have. The exit will be early since price is likely to move in the opposite direction only after momentum fades.
Results that we get after back testing the entry/exit criteria for modified ROC are very encouraging for Nifty futures trading. When we use the standard ROC(15) parameter, we get results which are inferior to when we use a modified ROC. Under the standard parameters, though the profit factor and the payoff ratio is robust (1.95 & 3.2), the risk reward ratio and the K-ratio (o.06) are not favorable and the drawdown is 21%. However, when the results are tested for the modified ROC, the profit factor and payoff ratio increase to 2.8 and 3.8 respectively. Whats more important is that K-ratio for the same is 0.1225, which is considered extremely good. Drawdown witnessed in the same period is 9.6% (almost half than standard parameters) and the risk reward ratio improves to 1.81 compared to 0.8 with standard settings. Equity curve for both the techniques differs a lot. While the standard parameter produces a stable curve, the curve produced by the modified ROC is smooth and low on gyrations (as reflected by K-ratio).
The reason this simple strategy works is because entry in this method is based on slightest change in momentum and while the price runs up, if momentum falls, we tend to exit without giving away much profit. Tweaking around the parameters is definitely recommended as the parameters suggested here are purely based on observations and not optimization. Further research on this topic can also be conducted by following the work of Gerald Appel.
Equity Curve - Standard Parameters - More gyrations
Drawdowns are large with Standard parameters
Equity with Modified ROC - Stability and Smoothness
Modified ROC - Lower Draw Downs
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