Making a 2+2 trading system

[kimchi]

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...but there is NO magic bullet foolproof sytstem that will conquer the markets.....period.

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I mentioned this is my OP. Everybody starts off thinking thsy have some magic key. I have discovered myself over the years that there's no magic key. The only wizardry (imo) would be mastering your own behaviour as you make discretionary trades.

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This is what makes the best traders in the world what they are...they have the talent/discipline/split second ability making qualities needed to be flexible in their decisions,and not being tied into a numbers specific system or program.Their money management disciplines are uncanny as well


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I agree too. Ed Seykota (paraphrased):

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There are 3 golden rules for trading
1. Always follow the rules
2. Always follow the rules
3. Know when to break the rules

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A good trader knows when to follow his rules and when to change or modify the rules. A machanical system eventually degrades, but only an expert knows when this is simply an expected drawdown, or the system has lost its edge.

Richard Dennis and his crew did fantastically in the 1980s trading a simple trend-following method. But markets do change (from a trader's perpective) and this model no longer is practically tradeable - although it still has an edge as I've tested it recently. There just aren't the susutained trends available in today's markets.

Also: (I think) William Eckhardt said:

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You have to know when to really step on the gas

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In refering to money management. Opportunity factors may limit the number of high-probablility trades you can make, forcing you to take lower EV trades while waiting. When all your ducks are in a row, a good trader knows when to increase their bet-size and thus improve their edge and expectancy.

I developed a system with a very high profitability. It's losers were both smaller in number and value than winners - and I've never seen another system like it. The problem was, it would only be in the market about 0.5% of the time - ie. one quick trade per year per market, I would have had to scan 1000s markets every night looking for that trade. The opportunity factor wasn't there to make the system worthwhile. It would be these trades when a good trader would increase their position sizes. Since I am not a good trader, I was unable to trade this system.

I think many successful systems traders have these subtle discretionary elements in them. After all, if these human inputs were not needed, then the greatest math and computer brains would have developed a system happily chugging on autopilot vacuuming up the world's money while they slept.

[kimchi]

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4. Equity Index (to smooth for unexpected exogenous events)

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Stops can protect against nasty surprises and if I trade a volatile stock which regularly gaps overnight, then I have the option to use guaranteed stops.

My bias (illusion) is that any market can be traded in a simlar way, but I'm leaning towards liquid midcap equities with little or no dividends (dividends screw up my simple models). However, I'm planning on trading shorter term than I have previously and a quick eyeball at my broker's FTSE ex-350 quotes (ie somewhere between FTSE AIM and 250) shows spreads approaching 0.5% which may be too much like paddling upstream. I haven't checked other markets' small cap spreads but I imagine they're at best the same.

The upward bias in stocks however (and the limit on the amount a market can fall), has made trading from the short side significantly less EV than the long side during previous backtests.

I think following highly liquid, highly traded markets like some commodities, forex, DJIA puts you up against the high stakes pros:


from the above Simons article:
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As the selloffs in July and August showed, many quant funds are chasing the same investments. For example, as of June, Renaissance and rival AQR Capital Management LLC had four of the same top 10 stock holdings: Johnson & Johnson, Lockheed Martin Corp., International Business Machines Corp. and Chevron Corp.

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These guys have to trade the same big markets as their position sizing limits their scope. The little guy with his piddly little account (me) can skip around these guys without worrying about slippage, but can probably also do so on relatively illiquid and less followed (less efficient?) markets.

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5. Trade set up is the money engine obv
Start simple and expand from there
6,7,8,9 are all subsets of 5 imo


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I'm wondering why you think so. I believe money management is the most important part of a system as your edge is worthless if you bust out. Exits are also more important than entries as they define your initial risks and your profits.

It's evident from many threads on these boards that most people concentrate on entries. "When do I sell GOOG" suggests the investor bought without clearly defined exit criteria. He might have made a perfectly timed elegant entry, but appear not to have considered the exit. It's so easy to allow a winner to turn into a loser, or to prevent a small winner turning into a big winner without proper exits.

I think all the above points (1-11) are related, but need to be considered individually to meet whatever objectives are decided upon in #2

[mak15]

i think talking about points 2-11 is kind of pointless until you/we figure out point 1.

i'm quite interested in following such a project and possibly contributing and even putting some money into the market if we actually devise a decent system, but discussing exit points and money management seems silly when we havn't even begun figuring out an edge.

[RockyElsom]

What security would this hypothetically trade?

[PRE]

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I just read that before I saw this post. Since this is 2+2, also:

"At MIT, Simons worked hard and played hard -- mostly late- night poker."

and link: http://www.bloomberg.com/apps/news?p...efer=exclusive

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I don't think they're quite on the same level.

[Ps3tn0NcYk]

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I'm wondering why you think so. I believe money management is the most important part of a system as your edge is worthless if you bust out. Exits are also more important than entries as they define your initial risks and your profits.

It's evident from many threads on these boards that most people concentrate on entries. "When do I sell GOOG" suggests the investor bought without clearly defined exit criteria. He might have made a perfectly timed elegant entry, but appear not to have considered the exit. It's so easy to allow a winner to turn into a loser, or to prevent a small winner turning into a big winner without proper exits.


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In short term trading entries and exits points are all you have- so we are agreeing here. The points sit at the center of a trading system. Specific price zones will define the risk of a particular trade- which is equally important.

Probably most important is stress testing a system for situations that might lead to a total blow-up of the account capital. The equivalent of a "major leak" in poker.

I always ask "how much can I lose" or "where am I going to sell and take a loss" before assessing the potential for upside opportunity. A randomly picked backroll number -- ie "$5000" -- is not a target or a stop loss because it runs the risk of being determined by your personal financial situation rather than the specific influences impacting the direction of the trade. One ought to size positions in a fashion where bankroll never faces a crippling loss with one trade.

But risk management is irrelevant in the absence of the logic layer that determines when one enters and exits a trade.

[kimchi]

I decided to think about my objectives first, since until I make some kind of inventory, I won’t really have any guidelines on what I want from this exercise. What is it I want to achieve? I think this is pretty much mostly a personal issue, but I’ll make a few generalisations about my own situation as it relates to the mechanics of using a trading system.

I’ll have available the equivalent of $25,000 for this particular system. I have stable money tied up elsewhere but while it isn’t money I can really afford to lose, I won’t top myself if I did. I think this is a reasonable amount so that it is meaningful and I’ll be able to practice decent position sizing using most of the instruments I intend to trade.

I have an income and don’t need profits from trading. If I take this system live, then I hope to have more than $22500 after 1 year in this account. I think it is reasonable to assume I might not make any money (at least in the first year) but my initial profit objectives are actually to limit my losses to less than an average 1% per month over the course of a year. People might flame me for this, but it is not easy losing this little while learning to actively trade. Unless you’ve never tried actively trading, or your name is Timothy Sykes, you’ll know what I mean.

Attainable objectives, baby!

I work during the day but have enough free time. I want to trade using EOD data, but may only be able to adjust (guaranteed) stops during trading hours. I currently live in Asia, so the easiest markets for me to trade would trade during European business hours (GMT 0 - +2) so I can enter orders before the open and adjust them before, or close to the close.

I have a little more time to devote to this system than others. One of my systems involves spending 5-10 minutes per day checking some prices. The medium term system takes a little longer, plus some time to prepare a trade if there’s one available or being managed. I expect to spend a few hours each night managing this system and record keeping depending upon how many markets I can trade, or how often signals are issued.

I need to learn more about statistics as related to trading so I can properly analyse results. (if anybody gas a recommended book/website then let me know).

I also need to learn to program some backtesting software. The entries, exits, and position sizing I use is simple yet still difficult to program (for me) into various backtesting software. I've previously done all testing in Excel and while it allows you to become more intimately aware of your systems behaviour, it takes a [censored] long time.

I’m not going into detail about my personal finances or experience except to say I’m not flush and have limited experience and reasonable success (ie-haven't busted yet!) trading. Follow me to stockmarket rags, SHOE.

[kimchi]

Also, if people are interested and want to contribute/flame - please keep responses in the relevant sub-threads.

ie-this subthread is titled 'objectives'

[kimchi]

Many traders don’t have a plan. A plan should be a set of rules to guide each trade. Writing down what you intend to do and how you will react to each situation. A plan helps to remove pesky emotions from trades and helps you become somewhat detached from the market on an emotional level. A plan should remove panic and indecision since we have predetermined responses which have been tested, are logical, understandable concepts, and are known to work.

I suggest we try and trade a simple concept. I don’t have the knowledge or expertise to start looking for arbs or deep statistical relationships to exploit. Simple concepts work well and tend to be more robust. I’ve spent years trying to re-invent the wheel doing this in the past I am currently studying some well-known statistically relevant relationships in various markets. There are lots of apparently good relationships, but it’s difficult to formulate a tradable plan around them, and I suspect I’m still busy trying to re-invent the wheel here…..

The first simple concept I think is whether we are going to buy high or buy low (and sell high or sell low). My first system buys high and sells higher (I can’t short this one for tax reasons) – which is opposite to what people intuitively try to do. This is essentially a trend-following system which follows the strongest uptrends in 25 stock markets/sectors, 10 bond markets and 1 moneymarket. It holds a maximum of 5 positions at any one time and makes approximately 2 round-trip trades per year, and holds positions for usually a few months or years.

Another system I use is a mixture between swing and trend trading. I look for value in 7 long-term stock index uptrends (and v-v) and hold the position for as long as I can until the trend reverses. This holds positions for weeks or months. It has worked wonders on Asian markets but bombed in US markets.

Both the above are relatively difficult to trade psychologically because of the poor win-rate (~30% for #1) and heavy drawdowns accompanied by many consecutive losses, (12 in a row stings) and watching and waiting as yet another tidy winner turns around into a loser.

I propose we develop a shorter-term modification of the latter system. Look for value in uptrends and sell rallies in downtrends – nothing new here. The main difference (aside from the timeframe) from system #2 will be profit targets. I’ve never liked profit targets as it is often the profit from one wild runaway trade that makes up for all the little losers and accounts for more than your year’s profit. Limiting profits by using a target may or may not make sense. It will, however increase the systems win-rate at the expense of perhaps reduced expectancy (possibly negative), and despite the reduction in profit expectancy, may make the system easier to follow and thus more likely to be stuck to during nasty drawdowns.

It will involve selling longs in a runaway uptrend, but avoid holding positions during failed breakouts which gap back or holding on to winners as they retrace back to somewhere near our initial stop – you can’t have it all.

I’ll dig out some charts to better illustrate this concept – but it’s really simple. Then we can try and look for an edge together, or at least a way to trade the concept.

It’s difficult to define or quantify an edge without proper testing and much experience. If the concept makes logical sense then we can move onto the next step.

Obviously, I hope others can make suggestions/flameless criticisms along the way and maybe propose superior ideas before I start digging too much into anything.

[kimchi]

I’ve found a stock (RGU) which looks to have some nice swings. Notice that this would be refered to as a "penny stock" in the US. It's currenctly trading around 80 pence. Penny stocks are sometimes avoided for various reasons in the US, but the price of a stock isn't really so relevant outside the US. Blue chips can be priced below a pound.



There was a nice uptrend beginning after the tech meltdown and lasting until Q2 2005 when it entered quite a wide trading range until the recent summer volatility during which is has tanked. This is a weekly chart using a daily scale, but markets are fractal allowing me to illustrate a basic concept.

I’ve drawn a basic trend line with channels either side 2 std devs away each side from the main trend. This is easy to do in the middle of the chart, but I’ll look for effective ways to quantify (or at least qualify) the trend and the channel when thinking about set-ups making it less ambiguous at the right edge of the chart.

I’ve drawn green circles around oversold (value) areas of the uptrend and red circle around overbought areas. The old adage “the trend is your friend” can be illustrated with this market trend. Assuming 2 trades in either direction:

Long:
2 – 3 (35p to 70p) = 35p move
4a – 5 (75p to 105p) = 30p move
TOTAL 65p

Short:
1 – 2 (45p to 35p) = 10p move
3a – 4 (75p to 55p) = 20p move
TOTAL 30p

So trading with the trend gives more than double the potential rewards here. Obviously only a fraction of each swing can be caught and perhaps most trades will lose money, but the basic concept remains valid.

This means I will be filtering out shorting signals during uptrends and long signals during downtrends. – Another basic fundamental but very important concept.

This stock appears to be following an Elliot Wave pattern during this uptrend. 1-2-3a-4-5a followed by the first retrace of the down-leg (a). The final leg (4a - 5a on this chart) being the most tradable move - but I’m not going to concern myself with market cycles at this point.

This next chart zooms in to the upleg 2 – 3 on the above chart.



Again there is the solid blue line representing the underlying trend with blue dashed confidence lines 2 standard deviations away – easy to draw in hindsight. This time I’ve overlaid a black 13-bar exponential moving average (EMA13). This EMA is enveloped by a channel drawn by shifting this EMA 20% in either direction. This isn’t a Bollinger Band as we are not yet concerned with volatility, but this EMA envelope can be modified later so that volatility data is used in its construction. Notice how wide this envelope is. The distance between the top and the bottom of the envelope represents approximately 40% of the value of the market, yet it contains around 90-95% of the market’s prices. An equity index’s envelope by comparison, might only be as wide as 4-5% of the market. A market with a wide trading envelope represent a bigger target from which we can extract profits with less room for error and a lesser impact from trading costs.

We can better see a similar patter being played out on a smaller scale. 3 legs up with 2 retraces in between. I haven’t labeled these #1-#5 as the chart is already a little cluttered. The green circles again show areas of value in an uptrend and the red circles show areas where the market might be temporarily overbought. The blue ovals show brief areas of potential consolidation which might lead to whipsaws and getting stopped out of losing trades. We can look for ways to limit these losses and potentially eliminate them to some degree through the use of filters – can be discussed further in the ‘set-ups’ sub-thread.

I think we need to be looking for entries in the green areas (below the EMA in an uptrend), looking for exits in the red areas (below the upper envelope in an uptrend) and looking for ways to preserve our capital in the blue areas (when the short-term trend become undefined).

Please make any suggestions that come to mind.