Here are what I have determined to be the
greatest lessons of future trading and money management
1. Break-Out systems are the best.
Moving averages and other system all work well on paper...but
they have very large drawdowns and it is easy to look at
drawdowns on paper...in real life, most people can't watch 45% of
their money disappear. I think many of the top traders prefer
channel break outs. Dennis, Seykota, Kaufman.
2. You make much of your income on BIG rare trends. I find many
break out systems to trade between 40% wins and 50% wins...almost
a coing flip. BUT I find the average win is 2 times the average
loss. So you use the trailing stops to get out of the bad trades
at 1% each time
3. Large accounts have a HUGE mathematical advantage over small
bank accounts.
I tried to explain this in my earlier letter.
Remember when I talked about the March Coffee KC
and then look at the Highest High for the last 20 days and lowest
low for the last 20 days
Trade Plan:
Question: Example Trade:
Futures Contract Gold
Contract Month Dec
Where is support on the monthly chart? 277.5
How long ago was the market BELOW support? 1979/19yrs
Where is resistance on the monthly chart? 417.5
How long ago was the market ABOVE resistance? 1990/8yrs
What is the top price of the trend (daily chart) that is
changing? 352
What is the bottom price of the trend (daily chart) that is
changing? 287.2
50% retracement of these two points (Profit Target)? 320
What is your entry point? 300
What is your stop out point (Loss Target)? 295
Entry Point minus Profit Target (Potential Profit) 20
Entry Point minus Loss Target (Potential Loss) 5
Potential Reward & Potential Profit (Reward:Risk Ratio) 20/5
(4:1)
1) Plan your trade. Trade your plan.
This means use the same sequence every time. If your plan is to
get in when the weekly and daily trend are in the same direction,
volatility is rising and a 1,2,3 is formed. Follow it.
Every time. This could also be seen as discipline which is
defined as "to train or develop by instruction and exercise
especially in self-control.
2) Money Management.
This means more about managing losers than winners. Greed will
generally keep you in a trade long enough to "Let your
winners run." But, managing your losers is the key to
trading for a lifetime. Don't add to a loser. If you owned a dry
cleaners that was losing money would you open another shop across
town? Follow your stop you set-up in Rule 1 when emotions weren't
clouding your judgment. NEVER, EVER MOVE YOUR STOP LOSS AWAY FROM
THE MARKET.
3) Proper Quantity.
Don't think, even on a trade that fits your "Trade
Plan", that you should load up to get back at the market.
Yes, there are times when you should increase your quantity above
normal, but not at the risk of placing your whole account at
risk. Similar to diversification, never diversify at the risk of
putting yourself in borderline trades. I love trading options in
three's. When the options have doubled, take profits on one,
free-trade the second and let the third one run unencumbered.
With futures, never "Reverse Pyramid". A reverse
pyramid is when you start at 1 contract, increase to 2, then
increase to 4 and so on. This is like a pyramid on it's head
(reversed), easily toppled. Instead build a strong base but never
add more in quantity than what you started with.
Math Question Challenge
From: "Andy Dunn"
To: omega-list@eskimo.com
Subject: Math Question Challenge
Can anyone write me a formula for the following.
I have a system and the average WIN is 2X the average LOSS
The system WINS exactly 50% of the time
Let's say I start with $1M
Each time I trade, I risk 1% of the bankroll (starts at 1M then
goes up with each trade)
Can anyone write an algebraic formula that will determine the
yearly Rate-Of-Return depending on HOW MANY trades this system
does each year?
----------------------------------------------------------------------------
Date: Wed, 16 Dec 1998 09:33:57 -0500
From: Val Clancy
To: andy@lips.com
CC: omega-list@eskimo.com
Subject: Re: Math Question Challenge
In this specific case:
( .99^n/2 - 1 ) *100
where n = total number of trades.
Val.
Date: Wed, 16 Dec 1998 10:12:29 -0500
From: "Gaius Marius"
To: "Val Clancy" ,
Cc:
Subject: Re: Math Question Challenge
Val,
Can you explain the formula? Is the .99 derived from (100% - 1%)
risk of the
bankroll?
Is it raised to the power of n/2? And where did the 1 come from?
Where does
the 50% of the percentage of winning trades fit in the formula?
And the
ratio of wins to losses?
Andy
----------------------------------------------------------------------------
Date: Wed, 16 Dec 1998 10:19:43 -0500
From: Bob Fulks
To: andy@lips.com
Cc: omega-list@eskimo.com
You don't say what the loss percentage is. Assume you lose
L (as
a
fraction) of your capital on each losing trade and win 2*L (as a
fraction)
of your capital on each winning trade. Assume trades occur in
pairs - one
win followed by a loss. Then:
End = Start*((1-L)*(1+2*L))^(n/2)
For example, if the loss on a losing trade ("L") is
0.5% of your capital (L
= 0.005)
and the number of trades in the year ("n") is 400
End = Start * ((0.995)*(1.01))^(400/2)
= Start * 2.68
So the ending value would be 2.68 times the starting value or a
profit of
168% in the year.
This assumes you adjust the trade size as you capital
increases/decreases.
Hope this is what you meant.
Bob Fulks
----------------------------------------------------------------------------
Date: Wed, 16 Dec 1998 10:13:36 -0500
From: Val Clancy
To: andy@lips.com
CC: omega-list@eskimo.com
Subject: Re: Math Question Challenge
win/loss trade ratio = 2
% win / loss = 50
initial accsize = 1M
losing trade ( risk ) = 1% of account size
Solve for: yearly ROA
Solution:
ROA = ( GrossProfit - GrossLoss ) / initial account size * 100;
if win/loss = 2 then GrossProfit/GrossLoss = 2 then
GrossProfit = 2*GrossLoss
ROA = ( 2GrossLoss - GrossLoss ) / initial account size * 100 or
= GrossLoss / intial account size * 100;
GrossLoss = initial accountsize* [ ( 1 - %risk )^n/2 ) - 1]
where n = total number of trades losers and winners
risk = .01 then
Gross Loss = initial accountsize ( .99^n/2 - 1 )
ROA = ( .99^n/2 - 1 ) *100
so in this case ROA depends only on number of trades you make
so at 100 total trades ROA = 39% of your account size
at 50 trades - 22%
at 2 trades - 1.99%
The general formula to use is the Compound Interest Formula:
Int = Principal [ (1 + %)^n - 1 ];
in case of trading, %risk is simply negative % so the
general formula for the total loss is:
GrossLoss = InitialAccountSize [ ( 1 - %risk )^n - 1];
general formula for the total profit is
GrossProfit = InitialAccountSize [ ( 1 + %profit )^n - 1];
Val.
Correct me if I am wrong.
Portfolio Management Subject: efficient
frontier
Author: John G. Nelson Date: 10/17/98 JNelson675@aol.com
I have read the original and to-date replies and feel that the
"efficient frontier" concept is very important for
investors and actually a rather simple concept, even though it is
also profound. Harry Markowitz, in his 1952 15-page paper
"Portfolio Selection", laid the ground-work for Modern
Portfolio Theory, and in 1990 became a co-winner of the Nobel
Prize for his work in this area. The basic equation used to
calculate the EF was in my in my elementary statistics book as
the equation for the expected variance for a weighted sum of
correlated random variables. While a correct direct application
requires an enormous table of correlations, which the small
investor is not going to get, the simplified version can be very
useful. If you assume a constant (mean) correlation, which will
approximate the correct results in a portfolio of any reasonable
size, then that part of portfolio variance (of return) which can
be reduced by diversification (~50%) can be approximated as
(N-1)/N. This is why Value Line suggests portfolios of 10 to 12
stocks, and empirical studies show little additional variance
reduction when you hold more than 16 stocks.
Date: Wed, 9 Dec 1998 09:21:31 -0500
From: "Gaius Marius"
To: omega-list@eskimo.com
Subject: Re: Money Management
:Scott, This sounds like it may be a great idea but I don't have
a
:clue as to how to treat a system as a transformation of raw
price. I
:sure would appreciate an example and / or clarification.
One way of using money management: If you have a smooth equity
curve (see attached GIF), and you can trade multiple contracts,
when you see a retracement on the equity curve, increase your
positions in the original
direction of the trade. I.E., my system has historically gone
against me by 10 points one third of the time before it reverses
direction and goes in my favour (if it goes against me by 13
points, I know it will never reverse and
go again in my favour. So I get out).
So what I do is increase my position when it goes 10 points
against me and then get out (of both positions) if it goes 13
points against me from my original entry. This reduces my average
entry price and results in another 40% ROA.
::Here's a clue for you. Treat a system as a transformation of
the
::raw price series. In futures, other than equity contracts, the
raw
::price series goes up and down. If your system has an edge, then
the
::transformed price series should be gradually upward sloping,
like a
::the long term chart of the stock market. Now treat the
transformed
::price series as an asset class and mix them altogether via MPT
and
::presto, your can get some great stuff like I have.
---------------------------------------------------------------------------------------------------------------------------------------
Date: Wed, 9 Dec 1998 18:43:18 -0800 (PST)
From: Jim Osborn
To: omega-list@eskimo.com
Subject: RE: Money Management
MARTIN MARTIN Bernardo
responds:
>I would appreciate if you or any other member of the list
could
>expand more or give me references on the following;
>1. Scaling in/out as a way of protection (not exposing to
much at the
>begining of a trade) and maximizing your profits (let profits
run)
My approach is pretty informal: Start with one contract, then
when you have enough profit in that contract that a reasonable
stop on two contracts still leaves you with a satisfactory
profit, consider adding that second contract. On the exit side,
keep a trailing stop somewhere safely back from where you think
the market shouldn't go, but OCO that with a profit target where
you think the market might, in your wildest dreams, get to.
Joe diNapoli, Mr. Fibonacci, has some interesting techniques for
being a bit more quantitative about profit targets. You might
track him down somehow and see what you can find. He's spoken at
TAG a few times, so that'd be a good starting point. Maybe
someone else can amplify on this point...
>2. You mentioned some notes of Chuck's TAG lecture some years
ago.
>How could I get them? Please give any other reference to
book,
>author, etc. you consider valid
The TAG talk I heard was in 1993, but Chuck has spoken at TAG
several other times, too, on various subjects. Contact Tim Slater
of TAG at 504-592-4550 for tapes lecture notes from old
conferences.
>3. I guess that what you mention as volatility trailing stops
is based in a
>certain X ATR of the last Y days? (I myself find it very
useful, as the
>"turtle" way of determining how many contracts to
trade related to
>percentage of equity risk and volatility (ATR).
I see in looking up that TAG phone number, that Chuck spoke on
"New Techniques Using Average True Range" at this
year's TAG conference. I should order that tape myself...
Gee, this is sounding like a ringing endorsement for Chuck
LeBeau, and I guess it is. :) You can learn a lot of good stuff
from his work.
Cheers, Jim
Dealing with excessive Volatility:
I have a rule of thumb that I try to apply in cases of high
volatility that helps me to decide if I should enter a
trade in a high volatility situation. I should warn you that this
rule sometimes saves me money and it
sometimes costs me big profitable trades. The primary benefit of
the rule is that it is objective and disciplined. The rule keeps
me from just guessing and agonizing over what to do in situations
where the volatility is obviously extreme. The rule has some
inherent logic that helps me to quantify "extreme"
volatility on a system by system and market by market basis.
The rule is that if the recent daily range is greater than the
money management stop (!!!) you are using, you
don't do the trade. The logic is that our money management stops
should be outside the range of what normally happens in one day.
To have stops closer than that is to be inside the "noise
level" where you can get randomly stopped out for no good
reason. Once the market settles down to where the range between
the high and low is less than the amount of your stop you could
then enter the trade and safely place your stop.
Now let me give you a specific example. We just took a quick but
big loss on a Yen trade today and it is now set up for a new
trade tomorrow. The range over the last day or two, as we all
know, has been far beyond
normal, several times more than our protective stop loss. The
trade for tomorrow should be skipped because
of the volatility rule described above. If you like, the trade
can be entered at a later date when the average
true range is less than our stop.
This volatility rule applies to all systems and markets. It does
not come into play very often and it is not
something we just made up for the Yen. I have found it to be a
valuable rule that I have used for years to limit
my exposure in times of excessive volatility.
Please keep in mind that high volatility is an opportunity for
unusually large profits as well as losses and if
you skip a big winner you will certainly regret it. For those
with more than adequate capital an alternative
solution is to reduce the position size and arbitrarily change
the money management stop to a much bigger
number on a temporary basis. If you can afford losses of this
size this might be a better solution because you
would avoid being stopped out needlessly and you would still be
able to participate in the big winners. Based
on past experience I would say that as a minimum a stop of about
two recent average true ranges (!!!) would be
required. Obviously this would be a huge dollar amount to be
risking in Yen or S&Ps right now.
My approach is to make stops depend on
"percentiles" of the recent true range. That is, you
take the past 59 days' true range values and sort them from
lowest to highest. The reason I use 59 is that the percentiles
are easy to calculate. The nth value is the n/60th percentile.
For example, the lowest true range is the 1/60th percentile and
the highest true range is the 59/60th percentile. The median is
the middle value, the 30th.
The 90th percentile is the 54th value. So let's assume you want a
stop that will only be hit 10 percent of the time and be missed
90 percent of the time. That's the 90th percentile, which is the
54th value in the list! If you're a little more gun-shy, take the
75th percentile, which is the 45th Value. If you're are real
risk-lover, go for the 95th percentile, the 57th value. I think
you want to use the true range rather than the high minus low
because that accounts for overnight risk.
M. Edward Borasky http://www.teleport.com/~znmeb
A Purchase stop should apply only until
the equity price rises above the purchase price. At that time,
the Trailing stop should apply, and the Purchase stop should
disappear. The Trailing (High) Stop should NOT apply until the
equity price rises above the purchase price. I contend that, in
Monacle, both the Purchase and High stops are applied at the time
of purchase.
Consequently, if the equity goes down after purchase, the lesser
of the two stops will
determine the stop condition, and, hence, the performance of the
portfolio.
This can be easily be seen by using the Optimize function with
any DAA system to simultaneously vary both the Purchase and High
stops through a range, say 1 - 10. Plot the resulting portfolio
Average Returns as follows:
Make a plot with Purshase Stop as the X-axis, and High stop as
the Y-axis.
Write down the value of the Avg. Return for each back test at the
intersection of the applicable stops. Thus, for example, if the
DAA returned 25%/yr using stops of P=7 and H=8, then write 25 at
the intersection of 7 on the x axis and 8 on the Y axis. You
won't have to fill in the entire grid before you will see a
pattern. The result is that, for any given value of High
Stop, the portfolio performance will vary for all values of
Purchase Stop less than or equal to that of the High Stop, but
will remain frozen thereafter at the value achieved when the High
Stop is equal to or greater than the Purchase Stop.
I believe that this can happen only if both the High and Purchase
stops are being applied together at the time of purchase. Thus,
if you buy a fund and its NAV heads down after purchase, you will
get stopped out at the value of the High stop, if it is less than
or equal to the Purchase stop.
Rodger - I believe that all your observations are correct - both
purchase stop and trailing high stop are in effect at the time of
purchase. The purchase stop remains fixed at the percentage below
purchase for the entire period. The trailing stop rises as the
NAV rises. Where I disagree is the statement that "A
purchase stop should apply only until the equity price rises
above the purchase price." - Why??
The next statement is also puzzling: "At that time, the
Trailing stop should apply, and the Purchase stop should disappear". - Again why??? - If you buy at $30.00 and set a
Purchase stop of 4%, you want to sell if the NAV drops below
$28.80 (-4%). Suppose the price rose to $32.00, Don't you want to
protect yourself if price turns around and drops 4% below the
purchase point? Why do you suggest that the purchase stop should
no longer be in effect if the price rises above the purchase??
However, many people put too much reliance in either stop loss option. More than 85% of the systems give better returns when
both purchase and trailing high stops are set to Zero! That is
"0". Waiting for the Cutoff about 2/3 of the way down
the ranking often produces better returns, and lots fewer trades.
Try it!!