Categories
Trading Tips

Comparing Your Trading to the Alternatives

I wrote the original version of this for the Currensee blog, but it has a broad based focus, so I wanted to post it here as well.

A thread was begun by a member of the BabyPips community on the subject of measuring and comparing trading system performance. The author had earlier initiated a discussion as to whether active portfolio management (in this case specifically talking about forex trading systems, but the same ideas apply across markets and methods) was of any value given the Efficient Market and Random Walk premises. That latter subject matter predictably generated a rather intense debate. I won’t take that up here, but I do want to discuss the upshot of it. Forum members wanted to know on what basis a system could be judged as to whether it was better than a passive approach. The performance measurement thread took that up.

Here’s the premise.

Performance of any active approach to taking on the markets must be measured against performance of a passive approach. I did a hatchet job on the original poster’s primary recommended metric because it was mathematically flawed, but his overall idea is legitimate. If you’re going to actively play the markets, then it needs to make sense doing so.

Volatility of Performance
Now, this isn’t quite so simple as comparing your own trading returns to that of the S&P 500, or sets of system returns against each other. This is where “risk-adjusted” comes in. The various markets have different levels of volatility (see Looking at Volatility Across Markets), and the same can be said of trading and investing methods. Volatility is the standard measure of risk, so we need to incorporate that into our comparative analysis.

How you measure volatility varies. In academia it’s common to measure the variation of period returns over time. That tends to focus on the consistency of performance. You could, however, use a measure of the size and/or length of drawdowns, which more focuses on the impact of adverse periods. There are other metrics as well. The important thing is identifying the one that makes the most sense for your objectives.

With a metric in place, you can then assess the performance of different approaches to the market on a risk-adjusted return basis. That would let you know that System A, with a 15% annualized average return and a 7% average drawdown, is probably better than System B, with its 16% annualized return and a 10% average drawdown. And then you can look at where System A falls within the sweep of potential uses of your money which runs from low return/low risk (like T-Bills) to high return/high risk (like penny stocks).

The Cost of Time
Assessing a given approach to employing your money is more than just looking at risk-adjusted returns, though. You must also account for the amount of time and effort you put into the process. For something like sticking your money in CDs or investing in an index fund, the time element will be small. For an active day trading strategy the time element is going to be high.

For that reason, it’s worth having a separate metric for looking at this time element. A simple $/hr calculation will suffice. Once you’ve figured out the hourly return of your trading/investment activities, you’ve got another basis for comparison – and for looking at the best application of your time overall.

But beware that the time element of trading/investing cannot just be viewed in cost terms because things like entertainment and education value come in to play. For example, when I first started coaching volleyball I calculated what my hourly rate was when factoring in all the time I was putting in to it. The result was below $1/hr. It bothered me not one bit, however, because I enjoyed the work and was developing myself as a coach such that I could increase my effective hourly rate moving forward. This is a particularly important consideration for new traders – otherwise no one would ever even think about getting into trading!

To Go Active or Passive
The bottom line here is that you need to look at whether being an active trader or investor makes sense in terms of risk-adjusted returns and the amount of time you have to put in to it all. If it’s not, then you’re going to want to look in to a passive approach.

Categories
Trading Tips

Investing vs. Trading in Forex

With the advent of the Currensee Trade Leaders program, the idea of investing in the currency market has been brought to the fore in a way it never was previously. We can now really think of “investing” in forex, not just trading.

Trading vs. Investing
Actually, the term “investing” has been used in terms of forex before. It’s been used in the same way one talks about investing in individual stocks – as a loose term that also accounts for what we would call trading. I’ve written on the subject of differentiating the two approaches (Trading vs. Investing, The Difference Between Trading and Investing), so I won’t get into a lengthy discussion here. I’ll just suggest that investors tend to be much more prone to using fundamentals and much less inclined to use leverage. This article on a personal finance site uses the term “investing” but clearly is talking about what I (and I’m guessing you) would call “trading”.

Forex trading, alas, continues have a very negative connotation among investors. A couple of comments on the aforementioned article talk about how quickly you can lose money. One commentator says “This is akin to day trading on margin & is the easiest way to ruin your financial life”. Of course this assumes all forex traders are day traders and one need only look to the Currensee community to realize that’s not the case at all. But I don’t think any of the Currensee members would call themselves a currency investor.

Forex Investing
But that’s not to say forex investing hasn’t been available. We’ve had currency ETFs and the like for some time now. They allow for both trading and investing in the forex market. Traders can obviously use them to play shorter-term term moves, though my guess is most lean toward the spot or futures market where more leverage is available. After all, day-to-day volatility in exchange rates is on the low end of the relative volatility scale among the markets.

The currency ETFs, though, allow investors to play the bigger macro themes in the market. Think the euro is going to blow apart? You can play the euro ETF. Think the Fed’s printing of money via quantitative easing is going to massively devalue the greenback? There are dollar ETFs you can play to take that position. Just in the last year we’ve seen a couple of 10%-20% swings in the USD Index that investors could certainly have played based on macro themes.

Investing in Someone Trading Forex
The Trade Leaders program adds another dimension to the possibilities of forex investing. I’ve already commented on some of its benefits (see The Benefits of Investing in Successful Traders). Above all that, though, is the opportunity the program provides you as an investor can put someone (or several someones) with a demonstrated track record to work managing your money, like mutual fund investing or other money management programs. Are there functional differences? Sure. The main concept is the same, though, in that you can have your money working in a way you likely wouldn’t be able to do yourself.

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Trading Tips

The Down Side of Day Trading

I’ve written on several occasions about the considerations involved in trading for a living and trading full-time. Most of what I talked about in those pieces was the financial and performance aspects of it all. James Altucher, though, looks at things from the other side of the equation in his post 8 Reasons Not to Day Trade. Here’s the list.

Depression
Altucher suggests that most day traders will suffer a bad patch that will make them suicidal. While things may not be quite that bad, the psychological impact of poor performance can definitely be destabilizing.

Overeating
I actually see this as one side of a two-sided coin. The other side is not getting enough exercise, which tends to be more my problem. Sitting at a desk for hours on end is definitely not conducive to keeping a narrow waistline.

Blindness
I can speak from experience here. Staring at charts all day definitely does my eyes no good and can sometimes lead to major eye fatigue. I do try to set up my desk configuration to the least stressful setting possible, but the hours still add up.

No Social Life
This one is a bit of a mixed bag. Sometimes trading war stories can improve your social life. Altucher’s point, though, is that you’re so focused on the markets that you really don’t want the distraction.

Blood Pressure
We all know how stressful trading can be. Add in a poor diet, a lack of exercise, and not getting out into the world of real people and you definitely start ticking those check boxes for risks of a heart attack.

Unproductive
Let’s face it. Trading can be very financially rewarding, but it’s not very productive in the grand scheme of things. Traders face this question all the time. Michael Lewis talked about it in his book Liar’s Poker. (If you haven’t read that one, by the way, I strongly recommend it.)

No Career
Day trading is very unlikely to be beneficial to any sort of career you may want when you decide you can’t take it anymore. Networking is limited since you have no social life or co-workers (although Currensee certainly alters that equation!). You don’t develop any marketable skills or have any demonstrable achievements you can list on a resume.

It’s Impossible
The odds of being a successful long-term day trader are very, very low. The burn-out rate is high for exactly the reasons mentioned above. This is true for institutional traders just as much as individual ones. You just don’t see that many “old” full-time traders.

Now, of course, trading for a living doesn’t necessarily mean trading full-time. I’d contend that it’s better if it isn’t. Certainly, there are those who are well suited to the full-time gig. I can think of a guy I worked with who’s just a natural, but he also has a lot of outside interests to keep things fresh for him. He’s not all markets all the time. The point is, don’t feel like you have to dedicate all your waking hours to the markets. You don’t, and if you try to there are consequences.

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Trading Tips

Looking at Random Trading

Every once in a while, the topic of random trading comes up. Normally, it’s part of a discussion about whether you could go long or short based on a coin toss and trade profitably because of a good exit and money management strategy. Let’s take a look and see if there’s any truth to that assertion by running some tests on EUR/USD daily data going back to when the euro was launched in 1999.

Random in, Random out
As a base line, I’m going to start with a totally random system – one which uses a coin toss to get into a trade and a coin toss as to whether to exit an existing position. The rules are very simple. Start with the coin toss to figure out long/short at the end of the first day’s trading. At the end of Day 2, we do a coin toss to see if we’re going to stay in the position we put on Day 1, or close it out. If we stay, we do the coin toss again the next day. If we exit, we start the process over at the end of that next day (so if we exit on Day 2, we do a coin toss as to whether to get long or short at the end of Day 3).

I ran 1000 tests on the data set to get enough information to make a reasonable conclusion. The results were pretty predictable. On average, the test resulted in a 26 pip loss, which is basically the same as being flat over more than 10 years of data. The standard deviation was 3668 pips, giving you an idea of how wide the distribution of results was over the 1000 test sample.

Random in, Strategy Out
The totally random system didn’t cut it, so let’s look at a random entry system that has a non-random set of rules for exit. I used the same coin toss entry as noted above, but for the exit I tested a reverse break approach. Specifically, the rule was that longs would be exited if the current day’s close was lower than the close from N days prior, and shorts would be exited on a close higher than the one from N days prior. I tested a range of look-back periods of 1 to 10 days. Here’s what it produced.

What the chart shows is the average result (the tick on the bar) and the range containing results one standard deviation above and below the average. So in the first bar we’re looking at an exit strategy which says get out of a position if today’s close is lower/higher (if we’re long/short) than yesterday’s. The average outcome was a loss of 3602 pips, with a standard deviation of 1846 pips. That means the 1-day test was a losing one in all or nearly all cases, and by a pretty sizable amount, generally speaking.

It is clear from this data that a random entry system can be profitable, though. We need look no further than the middle of the chart to see the performance of the longer look-back periods. The 6-day look-back provided the best result with a 5446 pip average gain and a 1236 pip standard deviation. Eyeballing the 1000 sample test results, I don’t see any negatives among them.

Maybe we’re looking at things backwards
Looking at these numbers, it’s hard not to think that maybe traders need to look at things the opposite way around from how they usually do – to think about exit first, rather than the entry. OK, I’m not really suggesting that we all just start trading random entry systems, but it certainly does provide fodder for further testing and analysis. We can use random entries to test the performance of different exit strategies. One caveat there, though. You have to make sure when you do something like that that you’re getting the same entries for each different exit approach, otherwise the results won’t be comparable.

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Trading Tips

Don’t Be Like This Trader

A reader of the market analysis service I work for emailed me after I posted a comment about GBP/USD. He started with this:

So I just read your posting about the GBP/USD on my fxdd headline. You mention that the upside is pretty limited above 1.55 and that a possible retracement might occur. Do you think it will drop back to the 1.5300 range in the next couple of days?

When I get emails like this from retail traders (I don’t normally get them from institutional readers) alarm bells go off. Is this guy in a position and wants to know what to do?

After I responded that my comment was intended for that afternoon’s trading only and that I wasn’t really comfortable with the idea of the market returning to 1.53 soon, he responded with this:

Hmm…earlier this morning an ACM analyst came out and said that there’s sellers around the 1.5470 area since 1.5490 is a strong resistance but pair continued passed 1.5500.  I asked about the 1.5300 area b/c I have a short @ 1.5350 and contemplating on what to do here.  How far down do you think the pair will retrace this afternoon?  I might just close the position around 1.5420 area.  Any suggestion?

Short you say? 🙂

The market was up around 1.55 when he sent this too me, having started to back down from highs around 1.5520. I told him I couldn’t provide specific advice, but that I didn’t think GBP/USD would get much below 1.5480 if it did in fact kept falling through the afternoon (low ended up being about 1.5465 as the day was winding down). I don’t know if he got out

If he didn’t close out the position yesterday he maybe could have gotten out closer to even early in European trading today (chart above is in GMT time), but still at a loss from his short entry. If he was hoping for further losses to get back to break-even (or better) he’s been out of luck given the snap back.

The moral to this story is that if you’re asking someone else what you should do with a position you’re in you’ve got a big problem. Your plan of action for every trade should include a specific exit strategy, and you have to stick to that strategy.

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Reader Questions Answered

What about the Forex Market?

Frequent emailer Rod is back with another worthwhile question.

Hi John,

I know you are a position trader in the stock market, using a variation of CANSLIM. You are a day trader in ES, using Market Profile. I think these are great ways to approach these markets. That’s why I would like to know how do you approach the Forex market:

– Are you a position trader? If so, do you scale-in or pyramid to build large size or do you difersify as much as possible?

– I know you use weekly Bollinger Bands and forex seasonals, but is that enough to time your entries or do you use other tools or analyses?

Thank you.

Rod

Before I talk about my forex trading, let me back fill a bit for those who haven’t followed my work. The strategy for the individual stock trading I do – which Rod correctly notes has CANSLIM as it’s foundation – can be found in an appendix to by book The Essentials of Trading. It is a strategy which combines technicals and fundamentals, and I figure on holding positions for 8 weeks when I put on a trade. The ES (mini S&P 500 futures) trading I do definitely utilizes a Market Profile approach, though I wouldn’t strictly call it day trading because I do sometimes carry positions overnight.

Now, as for forex, I do like being more of a position trader, holding trades for weeks or even months to catch good-sized trends. Sometimes I also play more swing time frame trades. Regardless of the time frame, though, my approach is basically the same. I use the Bollingers to find situations where a new trend looks likely to develop, pretty straightforward chart analysis to identify entry and exit points, and the attractor ideas from Market Profile to identify likely target points.

As for the forex seasonals, I use those to bias or filter my trading, especially the more swing oriented positions. For example, if a pair I like to trade is biased higher in September I’ll look for good long entry opportunities. I’m also planning some research into more mechanical strategies there.

In terms of scaling in and things of that nature, my history has been mixed. I’ve definitely had some times where I’ve added to positions as a trend unfolded in my direction. Other times I’ve just gone the all-in route from the start. I’m not a diversifier specifically. I do look to avoid getting overweight in any specific risk area (like being too long or short a particular currency), but because I tend to focus on one position, or at most a small number of them, at a time it really isn’t an issue very often.

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Trading Book Reviews

Book Review: Buy Don’t Hold

[easyazon-link asin=”0137045328″][/easyazon-link] [easyazon-link asin=”0137045328″]Buy – Don’t Hold[/easyazon-link] by Leslie Masonson is called a investing book, but I’m tempted to put it in the trading category. It depends on how you prefer to define the difference between the two. The book’s subtitle is “Investing with ETFs using relative strength to increase returns with less risk”.  Using relative strength makes me think trading, but there are definitely elements of the approach outlined in the book which speaks toward what I would probably think of as investing. In any case, as I noted in [easyazon-link asin=”047179063X”]The Essentials of Trading[/easyazon-link], I look at trading and investing as being functionally the same thing, with perhaps a philosophical difference in approach. I’ll leave it to the reader to make their own judgement.

This book is largely a practical text focused on application. The author outlines a very specific strategy for deciding whether the stock market is to be considered in an uptrend, downtrend, ranging, or turning. His “dashboard” comprises a collection of indicators which are very much technical analysis oriented. They include market breadth indicators, sentiment readings, and some basic price studies. The scoring of the indicators provides the user a market reading from which to develop a strategy. From there, Masonson moves on to picking the best trading/investment vehicle based on relative strength readings. In other words, it’s very much a top-down approach.

On the plus side, the author is very good about explaining the various methods he employs in his strategy. He suggests specific tools (most free, some paid, but not necessarily required) and walks the reader through applying things. On the negative side, much of the first third of the book is dedicated to proving how bad an idea buy-and-hold investing is - definitely overkill there – and I thought in general the writing could have been better. Also, while Masonson does demonstrate the value of the dashboard indicators he uses, he doesn’t actually show a good historical look at how the overall strategy would have done. Still, it’s a book which can certainly provide the fodder for research and development for those interested in longer-term stock market trading/investing and/or asset allocation between and among markets.

Make sure to check out all my trading book reviews.