Trading The Nasdaq: Improving A Strategy With The Day Drop Pattern As A Downtrend Filter

Price patterns are an essential tool in trading systems, not so much as a starting point but rather as a filter applied to the operation of the 'engine' of a particular strategy.

This article will discuss the "Day Drop" pattern, a downtrend filter tested with a real strategy on a highly volatile market like the Nasdaq.

The Day Drop Pattern

What is a Day Drop? A daily bar is called a day drop (DDr) when its closing price is at the lower end of the trading range. This downtrend configuration is stronger the closer the closing price is to the session lows. In other words, the DDr indicates to us that the strength of the sellers pushed the market down to close the session near the lows. To incorporate this into a trading system, we could use the following EasyLanguage code written for use in an intraday chart:

(closeS(1)-lowS(1)) < DayDropValue*(highS(1)-lowS(1))

In the formula, the DayDropValue parameter can be a value between 0 and 1, and tells us the degree of strength of our DDr: the smaller the DayDropValue, the stronger the downtrend of the last session since the close will have been all the closer to the day's low.

When this line of code is associated with a Boolean variable (True or False), it can take the value True or False, depending on whether the abovementioned inequality occurred. In other words, the variable is True or False, depending on whether there was a DDr yesterday.

So, it is clear that the lower the DayDropValue is, the more selective our filter is. As a consequence, the lower the DayDropValue is, the fewer trades there will be.

Nasdaq Trading Strategy Based On The Day Drop Pattern

Assuming a DayDropValue equal to 20%, we apply the simple strategy below on the CME-listed Nasdaq Future, with a 15-minute timeframe and using data from 2008 to the present.

The strategy will open long positions only when there is a DDr in the previous session. Open positions will then be closed at the end of the session or upon reaching the stoploss of $1,500, chosen as the first attempt value. The code will therefore attempt to ride a market rebound after a down day.

Figure 1 - Equity Line and Total Trade Analysis of the Nasdaq trading strategy based on the Day Drop pattern.

Figure 2 - Main metrics of the Nasdaq trading strategy based on the Day Drop pattern

The metrics are encouraging, but let’s test whether adding a time filter applied to entries would improve performance. One might consider, for example, limiting the trading to the two days of the week when it is more favorable to trade (there are behaviors in the markets that favor upward rather than downward trading on some days). To do this, we enter two inputs into the strategy, myday1 and myday2, to perform an optimization.

As can be seen from the results, limiting entries to only the second and third sessions of the week seems to provide a benefit.

Figure 3 - Entry optimization of the Nasdaq trading strategy based on the Day Drop pattern

We note how the Net Profit of the system has increased, even though we are only trading 2 out of 5 days a week; the maximum drawdown (Max DD) has more than halved and the average trade has risen from $168 to an impressive $541, having eliminated many unsuccessful trades. We therefore decide to maintain the chosen time filter.

Can we improve the system further? We are operating intraday, closing each trade at the end of the session. What would happen if we allowed more time for trades to be able to develop? To answer this question, we insert a new input, MaxDays, to define the maximum number of sessions each trade can stay open, instead of closing them at the end of the session. Optimizing values from 1 to 15, we find that letting trades run up to a maximum of 10 sessions would increase Net Profit at the expense of a clear deterioration in Max DD. We, therefore, decide to keep MaxDays=1, continuing to trade only until the end of the session.

Figure 4 - Time exit optimization of Nasdaq trading strategy based on Day Drop pattern

Let us try inserting a Take Profit, to assess whether this can help us further contain the Max DD of the system.

Figure 5 - Take profit optimization of Nasdaq trading strategy based on Day Drop pattern

Optimizing it between $0 and $10,000, by steps of $500, we see how around $9,000 we reach rather stable values, lowering the Max DD and simultaneously raising the Net Profit and Average trade. We are, therefore, satisfied with the latter choice. We conclude that it is as if the power of the rebound fades once these levels are reached.

Can we go even further? The strategy is straightforward and gives us excellent metrics. Adding particular conditions could also improve it, but this would increase the risk of overfitting.

Conclusions On Nasdaq Trading Strategy Based On Day Drop Pattern

We have been using DDr as an filter to trade only long on the Nasdaq, and this pattern has proven to be effective. From the very first system shown, we have been getting good results, which has prompted us to develop a complete strategy, that could fit fully into our portfolio.

The final system has few conditions, which leaves us confident about the robustness of the strategy. As evidence, we show equity from 2008 to the present (red color) compared with Buy & Hold (black color).

The Nasdaq suffered considerable shocks, while our strategy continued its march more smoothly. This reduced the potential total gain, but would have allowed the trader to sleep more soundly.

Until next time and Happy trading!

Andrea Unger