Rotational Trading: A simple but powerful concept [Part I./II.]

This time I want to cover a topic that hasn’t been covered here before: rotational trading.  In part I. I’ll give you some background why you should look into rotational trading and later on in the second part I will introduce a simple yet powerful rotational system.

The basic idea behind rotational trading is simple: you rank a list of stocks or ETFs by any kind of measure.  Then you decide to buy or sell the worst or best number of stocks from this list. You can do this as soon as new stocks come in / go out of the top/worst  five holdings or on a predefined schedule, e.g. every week or month.

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Here are some of the reasons why you should look into rotational trading

• Diversification:  there are times when certain strategies work better than others. One shouldn’t put all his eggs into one basket. So besides of swing or mean-reversion trading this can be an interesting alternative.
• Buy into strength:  Do you remember the time from mid-February to mid-April this year? Two month with almost no set-back. Rather difficult times for swing trading. Rotational trading systems usually buy into strength, hence those do well under these conditions.
• No dependency on market timing: We are so focused on finding the best entry or the best exit. Rotational trading systems are less sensitive to finding THE best entry. You ride the best stocks as long as they are among the best stocks, then you change horses and go again.
• Simple in execution: If switching among the stocks or ETFs isn’t done too often, trading execution can be quite relaxing compared to some other strategies.  Furthermore trading cost is less of a burden, at least for infrequent rotation models.
• Easy to develop. With the right trading software this can be a rather easy task. This might not be an issue for many of you, but there are certainly people who aren’t sophisticated software developers.  One of the reasons why I switched from my former software (Tradesignal)  is Amibroker’s ability to setup these models very easy AND fast (with a few couple of lines only).

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We need to answer a few questions upfront.

• What do we want to trade and why? I like to trade NASDAQ100 stocks for this purpose, because the top or worst performers usually show a strong trend in either direction. Just think of Apple, Bidu and co.
• How many stocks do we want to trade? I choose 5 to 10 top stocks to trade. If you got to few stocks thank your enter the trade to late when most of the run might have occurred already. If you got to many then you migtht enter stocks that might not make it to the top.
• Direction of the trade:  I use rotational trading for long only trades. Upwards trends are slower (=longer) in development compared to fast and sharp downwards trends. Hence upwards moves are easier to catch.
• How to rank stocks?  Having a good way to rank stocks in order to decide what’s weak and what’s strong is critical for the success of a rotational system.  Using a short-term indicator such RSI(2) to measure strength isn’t a good idea as on the short-term many stocks tend to mean-revert. Hence the system would enter into strength and leave on weakness (as RSI(2) ranking drops). So you need a method that looks beyond the short-term trend and is able to measure true trend strength.

In part II. we will look into the details of the system as outlined above.