There’s always a lot of talk about selecting the right trading system, that generates the right entry signals and exit signals, but how about the timeframe? By timeframe, I mean the frequency of data that you will use to determine whether to enter and exit the market, and the length of time you intend to hold a position. This is as much a driver of investment performance as stop losses or trading systems, but is seldom considered. Read on to find out how to select the timeframe that maximises your trading profits.

Traders have much shorter timeframes than investors. For example, Warren Buffett is an investor, and holds his investments for years at a time, while a pit trader may hold a position for 30 seconds. As a trader, you need to choose a timeframe between these two extremes.

As timeframes decrease, the frequency of data must increase in order to still keep trading.  If your average holding time is 3 hours, then daily data will not help you.

As you reduce your timeframes, it becomes more difficult for most trading systems to work with the higher frequency data, which means a smaller time window. This is because it becomes difficult to find any patterns or trends in the data. Trading systems are essentially noise filters that work over a particular time interval, but they need a pattern to lock onto within the window.  It is like looking at something very close up - it is hard to recognise it, but as you zoom out, you start to see the pattern.

At the tick level (the smallest possible interval of time), price movements appear to be almost random within the small time window. Most trading systems will perform very poorly because the signal to noise ratio is very low.  When you take them out to a 5 minute interval, some trends become evident. At 10 minutes, it becomes easier to see the big picture.  At the timeframes increase, the accuracy of trading systems increases too.

When you trade tick data, you will generally be behind the professional traders.  They have very low transacton costs and huge amounts of capital, so can afford to scalp the market to take advantage of small movements.  You can’t.

With longer timeframes, the transaction costs (which are fixed) become a smaller proportion of total profits.  This is because larger movements are possible, therefore the transaction cost is a smaller proportion, and also there are far fewer trades.

You would expect that volatility (high - low) would increase as the holding period increases, so risk is reduced by taking shorter time frames.  This is partially true but the relationship between holding period and risk is not linear.  In fact, generally the volatility for a week is not that different to the volatility for a day (on average).  This is because the market does not constantly move in one direction.

In any case, since risk is a measure of the variability of returns, it needs to include transaction costs, not just volatility.

In my experience, if you attempt to watch every tick and trade in and out of the market many times a day, your returns will be lower than trading off 30 minute, or even 1 hour or daily data.  This is because your trading systems will find it much harder to identify trends, and because your transaction costs as a proportion of profits will significantly increase.  You can run a simulation yourself to confirm this.

This is why analysis of day traders shows a far higher probability of loss for short term traders (who are off the floor) than those who hold assets for longer periods.  Don’t think that a stock trader who realises 2% one day should be able to earn 500% per annum by switching in and out of the market.  We all know that this doesn’t happen.

My recommendation is to avoid thinking that you can somehow outsmart the market by choosing a very short trading interval, and instead choose a timeframe that allows your trading system to work, that matches your risk profile and that maximises your real trading profit after transaction costs.

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Tags: holding periods, timeframes, trading, Trading Basics, volatility

This entry was posted on Friday, May 23rd, 2008 at 2:17 pm and is filed under Trading Basics. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.