Trend Following Strategy Based on Nadaraya-Watson Envelopes and ROC Indicator

Overview

This strategy is named “Dual Envelope Trend Following Strategy”. It utilizes Nadaraya-Watson (NW) envelopes and ROC indicator to identify trend direction for trend following. It goes long when NW envelope expands and ROC is positive; goes short when NW envelope contracts and ROC is negative. Stop loss and take profit conditions are also configured to control risks.

Strategy Logic

The dual envelope trend following strategy mainly uses NW envelopes and ROC indicator to determine entry signals. NW envelope is a nonparametric smoothing technique that depicts price high-low range. ROC indicator identifies price change speed and strength.

Specifically, this strategy first calculates upper and lower limit of NW envelopes. When price breaks through NW upper limit and ROC>0, it indicates an uptrend, so goes long. When price breaks through NW lower limit and ROC<0, it indicates a downtrend, so goes short.

After entering long or short, stop loss and take profit points are set. Stop loss is fixed pips below entry price. Take profit is certain multiplier of stop loss pips above entry price. This effectively controls risks for each trade.

In summary, the dual envelope trend following strategy combines NW envelopes and ROC indicator to judge trend direction, and uses stop loss and take profit to control risks, realizing trend following trading.

Advantage Analysis

The dual envelope trend following strategy has the following advantages:

1. Using NW envelopes to determine trend direction can effectively identify price trend and reduce false signals.

2. Combining with ROC indicator to judge trend strength avoids wrong trades in ranging markets.

3. Setting stop loss and take profit controls risks, allowing to stop out before loss expands. Also locks in some profits.

4. The strategy has few parameters and is simple to understand and optimize.

5. It can be applied to any market including forex, crypto and stocks.

Risk Analysis

The dual envelope trend following strategy also has the following risks:

1. Trend following strategies are vulnerable to severe losses during trend reversal. Parameters should be adjusted or intervene manually.

2. A too wide stop loss may expand losses. Can properly tighten stop loss pips.

3. In high volatility markets, stop loss may be penetrated, failing to control losses. Consider real-time or dynamic stop loss.

4. Transaction costs and slippage are not considered which can add to losses in high frequency trading.

In general the risks can be reduced through parameter optimization, stop loss strategy improvement and proper manual intervention.

Optimization Directions

The strategy can be optimized in the following aspects:

1. Optimize NW parameters like window period and bandwidth to find best combination.

2. Optimize ROC window size to reduce false signals.

3. Try other indicators like KDJ and MACD for trend and entry judgment.

4. Incorporate machine learning models to dynamically optimize stop loss and take profit.

5. Add trend reversal signals to actively exit when trend reverses.

6. Consider practical details like slippage, fees, stop loss failure probabilities to make strategy closer to live trading.

Parameter optimization, indicator and algorithm introduction can further improve strategy stability and profitability.

Summary

In summary, this strategy is named “Dual Envelope Trend Following Strategy”. It uses NW envelopes and ROC indicator to determine trend direction and entries, and sets stop loss and take profit for trend following trading. The strategy is simple and effective, good at following trends and controlling risks, and can be applied to various markets. Shortcomings are severe losses during trend reversals and difficulty in capturing reversals. Further enhancements can be made through parameter optimization, algorithm incorporation and manual intervention to improve stability. Overall it is a recommended trend following trading strategy.