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Reader Questions Answered

Expectancy vs. MAR

I had this question come in recently:

Strategy A has better risk-adjusted returns (measured by Annual returns/Max Drawdown, aka the MAR ratio), but lower expectancy than strategy B. It manages to achieve this by having a larger number of trades, even though the backtest period is the same for both.

Which of the two performance measures should I rely on in choosing one strategy over the other?

When dealing with expectancy it is important to not just look at it in terms of per trade figures. You must also account for the frequency of trades. In other words, it will often be best to think in terms of expectancy on time basis rather than a trade one. For example, you could think of monthly expectancy to figure out what kind of returns you would expect to see in a meaningful time frame for your trading. This would be the better way to compare two systems or strategies.

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Trading Tips

Help to avoid setting your stops too tight

I’ve written before on how tight stops make me nervous because too often those who employ tight stops are thinking about how many points or pips they are willing to risk on a given trade, having already decided how big a position they are going to trade (“I’m trading a standard lot of EUR/USD, and I only want to risk $200, so my stop is 20 pips”). Sound familiar?

This also ties into the whole fixation on risk/reward ratios I discussed in Stop Getting Hung Up On Stops, Targets, and Risk/Reward. Too many traders fail to realize that the closer they put their stop, the higher the probability that stop gets hit. The result is normal market moves taken them out of their trades, which leads some to claim stop-hunting to place blame elsewhere. It also means a lower win %, which can severely impact their overall profitability.

What these traders should be thinking about instead is how many pips of risk there is in the trade they are looking to make, and then backing out the position size (“I’m risking 50 pips, so in order to only risk $200 I can put on 4 mini lots of EUR/USD”). Many traders figure out their risk point using some form of technical analysis, identifying a point beyond which the market should not go if the trade is to retain a good prospect of working out as expected (see Where do I put my stops to avoid being taken out?).

There’s something else which can help in this regard, particularly for those who’s trading approach does not lend itself to easy identification of exit points – or for those working on trading system development. It’s the concept of value-at-risk (VaR). The basic idea of VaR is that you develop an idea of what kind of move the market may make against you based on historical information. There are limitations to VaR, which I will address below, but it can be a starting point for developing a strategy for stop placement.

The forex broker OANDA has a VaR tool which can be used to this purpose in terms of currency pairs (I don’t know off-hand of a similar one for other markets, but if you do please post a link in the comment section below). It looks at recent history to give you an idea of the size of moves have occurred as a certain significance level. For example, if I want to look at EUR/USD in the 30-minute time frame covering 10 bars (5 hours) I get the following:

Here we have a breakdown of how EUR/USD has traded over the last 300 periods. It tells us that 95% of the time the market moved 90 pips or less, averaging 39 pips, with a maximum move of 127 pips. The report also provides a graphical representation of the types of moves the market has made.

Reports like this can be very useful in understanding how far away you should put your stop to avoid it getting hit by normal market volatility. In the example above, if you were to have your stop only 20 pips away from the market the odds would strongly favor it being hit, but if your stop was at 50 pips the odds would favor it not being reached.

I’m not suggesting you just use VaR in this fashion by itself to set your stops, but you can certainly use it to get an idea of whether a stop you are contemplating is in a high-risk position or not.

A word of caution with this kind of backward-looking VaR. The future may not look like the past. Specifically, the market may be more or less volatile (more being the bigger risk for most traders). As a result, you would be well-served in joining some kind of forward-looking indication of volatility to a VaR analysis so you don’t get caught by a major shift.

Also, don’t let the 95% or 99% confidence level stuff lull you into not taking proper risk precautions. A number of financial institutions were basically sunk during the Financial Crisis by developments beyond those confidence levels. That’s where individual traders can get destroyed too. And you don’t need to trade all that much before you effectively assure that you’re going to have to survive a market move beyond those bounds.

Categories
Trading Tips

From the data: One reason traders struggle

Over the last couple of weeks I’ve been working with the forex trader data I’m going to be using in my PhD research. I included some of the figures I’d pulled out in one of my recent newsletters, but I thought I’d share some additional stuff here.

I’ve pull the following set of numbers on trades which include USD pairs (no crosses), of which my data contains over 2 million records.

Winners: 1,280,459
Average Profit: $60.03
Average Pip Profit: 28.20

Losers: 752,614
Average Loss: $105.14
Average Pip Profit: 63.88

Notice there are many more winners than losers. They represent 63% of all trades. These are retail traders, so it just goes to show that you don’t want to get too crazy about looking to trade against the collective.

Notice also that the average loss is about 75% higher than the average profit. That completely offsets the 63% win rate and results in a negative overall expectancy for the group.

It must be noted, however, that that average loss appears to be due to holding on to losers too long rather than risking too much money. Notice how the average loss in pip terms is more than double the average gain. Traders actually had lower pip values on their losing trades than on the winning ones (on average). They just held on too long.

Here is the problem is for most traders. They are quick to take profits and slow to take losses. This is referred to as the Disposition Effect in Behavioral Finance research.

Much more analysis of the data needs to be done, but these results are very interesting nevertheless.

Categories
Trading Tips

Trader Psychology is NOT the most important thing

I came across a post on the FXStreet site with the following statement:

“The majority of trading success comes from the mental side of trading not the strategy…”

The article then goes on to say that psychology is 85% of the equation of trading success, with money management coming in at 10% and strategy at only 5%. I reject this completely.

To explain my own position (as I also did in a recent online panel discussion), which is one I share with Dr. Brett Steenbarger, who literally wrote the book on trading psychology ([easyazon-link asin=”0471267619″]The Psychology of Trading[/easyazon-link]), let me ask these questions.

If you don’t have a positive expectancy system, does your mental state matter?

If you don’t have the risk management side of things right, will it make any difference how strong your discipline is?

The answer to both questions is “No”.

Trading completely without emotion seems to be the ideal many folks are aiming for in their trading. You could turn yourself into a robot (or program a robot to trade your system), but that’s not going to turn a losing system into a winning one or overcome poor risk management.

It takes all three elements to be a successful trader. If you’re missing any of the three legs of that tripod, it won’t stand up. Psychology does become the thing you spend the most time on once you have a good system and risk management strategy, but that doesn’t make it more important.

Categories
The Basics

What do you trade and why?

A question came up on Trade2Win recently on a new thread. It asked the question of the membership, what do you trade and why? In many ways this is a fundamental question that every trader needs to have a strong answer to in order to be on the right track. So to that end, let me address it for myself.

I have traded just about everything you could think of a retail trader trading. Basically, it’s about finding good opportunities. I’m primarily a technically driven trader who operates mainly in the swing to position time frames, so I don’t need to have the narrower focus of someone who trades in the shorter time frames.

That said, stocks and forex are my two main markets.

In the case of stocks, that’s what I came up following. Back in the 80s when I got started it was still the main market available to retail market participants. I didn’t have the funding to effectively play in the futures market (there were no mini contracts back then). Also, when I read [easyazon-link asin=”0132825244″]How to Make Money in Stocks[/easyazon-link] it really resonated with me in terms of approaching the market. The strategies I use to this day have a foundation in what I learned from that book.

I got active in forex in the early 2000s. This was as online trading was really starting to develop and I was covering the forex market professionally at the time (as I am today). I liked that I could trade at any time of day or night, which you couldn’t really do in other markets at that time. I also liked how technical the forex market was. It suited my trading orientation very nicely.

These days my #3 is stock indices. I go through periods where I will lock in and fairly actively trade the likes of the mini S&P 500 futures. It’s very much a market conditions and available focus sort of thing, though.

What about you? What market(s) do you trade and why?

Categories
Trading Tips

The new trader system loop

A poster at Trade2win started a discussion recently which I think is very worth addressing here. It starts off with looking at the typical process of the unsuccessful trader:

1. Find or develop a system you think will work
2. Trade the system
3. Experience a few losers and discard the system

Sound familiar? Probably so. It’s a very common loop new traders get caught up in.

Why is this so? Why do new traders give up so easily, when successful traders follow through?

The suggestion is that this happens because of a lack of confidence. While I can understand the case to be made for that being a problem, I’d take it a step further and say that it starts much higher up than that with the fact that new traders totally fail in the vast majority of cases to think beyond the immediate and develop a proper frame for their trading.

To put it simply, if you don’t know what you’re working toward how can you have any confidence that what you’re doing will get you there?

That’s high level thinking, of course. At a more ground level view, I’d contend that most new traders never learn what the elements of a trading system really are and how they contribute to its performance in different market conditions. They just want to plug-and-play and have profits come spilling out. The markets tend to disavow them of that impression quite rapidly.

Categories
Reader Questions Answered

CANSLIM and market trend

I received the following query from a Trade2Win member the other day.

I was just re-reading the example strategy part of your book. I know you said it is inspired from CANSLIM. O’Neill generally advises staying out of the market if it is in a bear trend. Do you generally find this affects your strategy. Do you have to leave it for another or do you find it still works fine possibly with less candidates?

My personal experience with stock trading in general, and CANSLIM-related strategies in specific, is that the overall trend of the market is a major influence on the performance of most individual stocks. I think most experienced traders would back me up on this. Also, there’s been a lot of talk lately about how much more correlated individual stocks have become to the indices of late, so it would seem these days the O’Neill suggestion should be taken even more seriously.

While it’s certainly true that strong stocks will tend to outperform the market no matter the overall conditions, there’s an aspect to CANSLIM which needs to be accounted for here. The stocks identified tend to be high beta names, meaning they tend move move more aggressively than the overall market. That’s great when the market is rallying, but it can be a killer when the market’s moving the other way.