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THE SIMULATION

Employing these definitions, we ran a trading simulation that tested the following strategy (rules 1A, 1B, 2, 3A and 3B):

A long position was initiated when the market closed above the highest price of a tight, narrow and lengthy trading range and the size of that day's price range expanded to more than 125% of the average daily price range of the last eight days. The long position was then held until the market closed below the eight-day moving average of the lows. A short position was initiated when the market closed below the lowest price of a tight, narrow and lengthy range and the size of that day's price range expanded to more than 125% of the average daily price range of the last eight days. The short position was then held until the market closed above the 10-day moving average of the highs. (See Figure 3.)

FIGURE 3: JUNE 1987 T-BONDS. A breakout to the downside occurred when the market closed outside of the trading range, with the day's range greater than 125% of the eight-day average range.

This strategy was back-tested from 1984 to 1994. In the simulation, one Treasury bond contract was traded and no slippage or commission was charged.

THE RESULTS

Looking at the table of results in Figure 4, the average profit per trade was an impressive $636. Before commission and slippage charges, the typical bond trade made more than 5/8 of one point. Looking closer, the strategy did well on both fronts of profitability; there were more winning trades than losers and the size of the average winning trade was larger than the average loser. In addition, the total profit ($21,625) was high, and it grew throughout the 10-year period (see Figure 5).

FIGURE 4: The average profit per trade before commissions and slippage was $636.
FIGURE 5: TOTAL PROFIT. The total profit was $21,625.

In reviewing these results, two points are clear. In the bond market, there is some validity to the logic behind the range breakout concept. In addition, through the process of laying out the logic and defining its key terms, formulating a strategy, testing that strategy and analyzing the results, a subjective market concept can be captured and turned into a profitable and objective trading strategy. Identifying a trading range and trading the breakout can be quantified profitably.

Alex Saitta is a technical analyst and vice president for Salomon Brothers. Research assistant Jason Wang contributed to this article.