Issue 13 Tuesday November 30, 2010

This issue…
2 Rivers Strategy Focus
Technical
By Frederic Palmliden, CMT
Senior Market Technician, TradeStation Labs Markets
Equities
TSLabs@[Link] Futures
Forex
Summary Time Perspective
Intermediate Term
Accounting for volatility helps filter unwanted signals from a trend-following system, since highly Studies/files Included
volatile markets are partially to blame for whipsaws in such trading systems. A two-moving- Strategy
Indicator
average-cross system can partially account for volatility by varying the width of its lines depending Workspace
on the standard deviation of the security’s prices over the time period used by the moving
averages. Fewer and more reliable signals are thus generated. Bands with dynamic widths are
then created, which resemble two rivers. The smallest river needs to entirely clear the larger river
in order for a signal to be generated. Moreover, a scaling-out approach is used in order to take
partial profits and fight the tendency of this type of system to give back open profit until the system
reverses. The 2 Rivers Strategy follows the same general philosophy of the Conditional XMA
Strategy (available in the TradeStation Labs Analysis Concepts Archive folder)—to avoid or help
eliminate whipsaws and hold on to open profit more efficiently than a traditional two-moving-
average-cross system.

Chart 1 - Daily $INDU Bar Chart with the 2 Rivers Strategy and Indicator

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Introduction

The 2 Rivers Strategy is basically a two-moving-average-cross system with a twist. The widths of the two lines are
dynamic based on the standard deviation of the security’s prices over the two specified intervals. The fast
exponential moving average (smallest river) is defined by a lower and upper boundary. The upper boundary is a
six-day exponential moving average plus 1 standard deviation. The lower boundary is a six-day exponential
moving average minus 1 standard deviation. The slow exponential moving average (largest river) is defined by a
lower and upper boundary also. The upper boundary is a 280-day exponential moving average plus 1 standard
deviation. The lower boundary is a 280-day exponential moving average minus 1 standard deviation.

A 2 Rivers buy signal is generated when the lower boundary of the fast exponential moving average crosses over
the upper boundary of the slow exponential moving average. A 2 Rivers sell-short signal is generated when the
upper boundary of the fast exponential moving average crosses under the lower boundary of the slow exponential
moving average. Twenty percent of the position is exited after a holding period of at least 12 days with a profit of
at least $800. Another 20 percent of the original position is exited after a holding period of 55 days and a profit of
$6,400. Whether or not the first and/or second partial exit(s) have been taken, the entire remaining position is
exited when the price of the security moves one third of the distance back into the larger river. A trade size of
$100,000 is used for all initial positions.

The different values for the inputs listed above were derived by strategy optimization and sensitivity testing in
order to stay away from peak values. The two different percentages representing the fractional position amounts
to exit positions are logical values; no optimization was performed for these values.

An indicator, named “2 RiversIndicator,” is attached in order to better visualize the rules of the 2 Rivers Strategy.
The indicator has only four inputs: the number of standard deviations to use for the fast exponential moving
average; the number of standard deviations to use for the slow exponential moving average; the length for the
fast exponential moving average; and the length for the slow exponential moving average. The user-defined
inputs need to correspond to the values in the strategy in order to synchronize the indicator to the strategy signals
in the chart.

Strategy Settings

Strategy Style Intermediate Term

Asset Type Equities
Symbol (Traded Symbol) $INDU – Dow Jones Industrial Average
Alternate Symbols to Trade (futures) DJ and YM, Broad-based index ETFs
Data Intervals Daily
Period Tested 90 years
Initial Capital Required $100,000

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Defining Strategy Rules

Long Entries
 Buy only after the “small river” clears the “big river” to the upside.

Long Exits
 Exit 20 percent of a long position after a holding period of at least 12 trading days with an open profit of at
least $800.
 Exit another 20 percent of the original long position after a holding period of at least 55 trading days and
an open profit of at least $6,400.
 Exit remaining long position after close penetrates one third of the “big river” from the top.

Short Entries
 Sell short only after the “small river” clears the “big river” to the downside.

Short Exits
 Exit 20 percent of a short position after a holding period of at least 12 trading days and an open profit of
at least $800.
 Exit another 20 percent of the original short position after a holding period of at least 55 trading days and
an open profit of at least $6,400.
 Exit remaining short position after close penetrates one third of the “big river” from the bottom.

Note: While no fixed dollar amount or point amount is used as a stop in this strategy, entirely exiting positions
when the closing price folds one third back into the bigger river is the risk-control rule within this strategy.

Strategy Inputs

Name: Value: Description:

SmallRiverStdDev 1 Number of standard deviations used to vary the width of the “small
river” (fast exponential moving average).
BigRiverStdDev 1 Number of standard deviations used to vary the width of the “big
river” (slow exponential moving average).
FastXMA 6 Length for the fast exponential moving average.
SlowXMA 280 Length for the slow exponential moving average.
HoldPeriod1 12 Holding period for first exit.
ProfitTarget1 800 Profit target in dollars for first exit.
Reduce1stAmtPerc 20 Fraction of first exit (1/5 = 20 percent).
HoldPeriod2 55 Holding period for second exit.
ProfitTarget2 6400 Profit target in dollars for second exit.
Reduce2ndAmyPerc 20 Fraction of second exit (1/5 = 20 percent).
TradeSize$ 100,000 Position trade size.

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Performance Summary

The results of the strategy applied to the $INDU are shown below. Sections of particular interest from the
TradeStation Performance Report have been selected. As a reminder, the strategy discussed in this paper is
not meant as a trade-ready strategy. Instead, it is meant for educational and demonstration purposes only,
which is why the strategy is applied to a non-tradable security ($INDU). Moreover, past results are not a
guarantee of future performance.

In practice, a similar strategy might be used on a tracker or on Dow Jones futures with some adjustments to
the strategy (i.e., trade-size rules).

Chart 2 - Daily Equity Curve Performance Graph

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Chart 3 - Performance Summary

Chart 4 - Average Profit by Month

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Chart 5 - Weekly Equity Curve Underwater

Strategy Strengths

 The strategy made profitable trades consistently during the period studied. The largest winning and losing
trades were 8.80 percent and 7.45 percent, respectively.
 Risk-adjusted metrics are good with the K-ratio at 4.38 and RINA at 117.60.
 The strategy is in the market about 65 percent of the time with a scaling-out approach, which helps to
minimize drawdowns.

Strategy Weaknesses

 While overall consistency over time is one of the strategy’s strengths, there are long periods of time when
the strategy was flat to slightly down, which would challenge a trader’s perseverance.
 The weekly underwater graph (Chart 5) has a rounded shape mainly because the same dollar amount is
used to enter each trade. As a percentage of the account size, the trade size becomes smaller and smaller
as the account gets larger and larger; in turn, the drawdowns become smaller and smaller, to some degree
automatically. This effect provides a misleading picture for drawdowns. The initial part of the graph
provides a more realistic view of what the drawdowns would be like.

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Conclusion

The basic tenet of the strategy appears to be highly promising, but additional work would be needed to convert it to a
tradable strategy. A number of different areas could be explored. For instance, different values for the standard
deviation could be used depending on which side of the market the trade is. In addition, a scaling-in approach might be
beneficial, since the scaling-out approach appears quite successful.

A possible application of this strategy would be to use it as a long-term market indicator to complement shorter-term
systems. For example, you may want to run the following test: create and develop additional conditions around your
existing systems to take only long signals when the 2 Rivers Strategy is long, and take only short signals when the 2 Rivers
Strategy is short. Moreover, you may want to experiment and see what happens to the back-test report of your mean-
reversion strategies when you only take signals when the small river is inside the larger river, which could indicate a non-
trending phase for the underlying security.

As with the other TradeStation Labs Analysis Concepts papers, we hope this generates new ideas for you to consider and
build on. If you have questions or comments, or would like to share how you use what was presented in this report,
please feel free to email us at TSLabs@[Link].

To use the files provided with this issue of Market Concepts:

 Files with extension ‘.eld’ – These contain EasyLanguage documents: analysis techniques and strategies.
Double-clicking on this file will start the Easy Language Import Wizard. Follow the prompts to completion. The
analysis techniques or strategies will automatically be placed in the correct locations for your use in
TradeStation. This should be done before opening any workspaces provided.
 Files with extension ‘.tsw’ – These are TradeStation workspaces. These may be stored in any folder where you
choose to save TradeStation workspaces.
 Files with extension ‘.txt’ – These are text versions of the EasyLanguage documents and are generally used only
by advanced EasyLanguage users.
 Other supporting documents or files may also be attached to the report.

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purposes and to help customers learn more about how to use the power of TradeStation software and services. No type
of trading or investment advice is being made, given or in any manner provided by TradeStation Securities or its
affiliates.

This material may also discuss in detail how TradeStation is designed to help you develop, test and implement trading
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to help you design your own strategies and look at how they could have performed in the past. While we believe this is
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