Archive for March, 2009

Greatest Man – Weezer

March 27, 2009

Only 10% of traders are consistently successful.

You all know who you are. This is for you.


How to Create a Trading System

March 27, 2009

It’s simple, but not easy to create an effective trading system that has a positive expectancy of success.

And if you’re like me, you don’t mind skipping a few steps along the way to get to the exciting aspects of your system, that being its execution with real money. Ah, but it will cost you to skip steps. It’s like putting flour in the oven to bake a cake, even before you mixed in the sugar, eggs and milk.

Here is a recipe for creating a trading system. It has six steps. After that, you get to trade it with real money. You get to eat the cake you’ve baked.

1. Observe Patterns

Markets have recurring patterns that are reflections of the psychology of its participants, namely other traders. You can observe these patterns by simply looking at candlestick formations or by seeing how a technical indicator such as RSI responds when a price action develops. You need to notice something is happening. You need to listen. You need to be aware of your surroundings and what is happening in the moment. Remember that you have no money on the table at this point so the chances of your vested expectations clouding your observations is minimal.

2. Quantify Your Observations

Every time the 10-day simple moving average crosses the 30-day simple moving average, the price action follows in the direction of the cross. Well, maybe not always but mostly always. How can I quantify that observation? Simple. IF the 10-day crosses the 30-day to the upside, THEN price action will likely be bullish. IF the 10-day crosses the 30-day to the downside, THEN price action will likely be bearish. You will notice the use of the word ‘likely’. How likely is ‘likely’. That’s what we’re here to find out.

3. Define a Trading Criteria or Method

Based on our moving average crossover observations, we would like to exploit the price action to the upside and downside, depending on what the market is telling us at the time. A system is a specific procedure for entry, stop and exit. I don’t like the “R” word (‘rules) because of personality issues I have, but you can certainly use the “R” word if you are not prone to a blatant, rebellious penchant for breaking rules. The important thing is to feel comfortable in your own skin here. Your system must be specific or the data you’re about to glean will be rendered meaningless. If you are not consistent in execution, you will get statistically invalid testing results. This is the science part of trading. So it can run like this: IF the 10-day crosses the 30-day to the upside, THEN I enter on the open of the next 5-min bar, stop 0.30 Average True Range (ATR) below, and exit when the 10-day crosses the 30-day to the downside. There, that was simple, no?

4. Do a Backtest of 30

Thirty is generally considered the minimum sample size to get even remotely valid probabilities. With this size you can calculate average wins, average losses and compare the two for an expectancy ratio. Now, backtesting is kind of a chore. Actually, it is a chore and probably nobody really takes pleasure in this step. There will always be the few that do enjoy this part of the process, just like there is always someone that takes great delight in measuring a cup of flour. Regardless, we are going to do this thing.

Apply whatever studies you used in your previous observation and go back in time on your charts. Wherever you system says to go long, jot that number down, jot down the stop number and then observe where the system exited, whether at the stop or at the exit. Now do that 29 more times. Add up your winners versus your losers. Calculate your average winner versus your average loser. Now do simple math. Expectancy = (% winners x average winner) – (% losers x average loser). If this number is not greater than zero, throw that strategy into the trash can. If it passes the smell test, move to the next step.

5. Do a Backtest of 100

Repeat the top exercise but this time you’re investing more time to get a more statistically valid sample size. If the results still yield better than zero, go to the next step.

6. Paper Trade the System for 100 trades

This one is pretty hard for a lot of us. Paper trading is bogus and a waste of time, we tell ourselves. You don’t get the same emotional conflicts with paper money as you do with real money. That’s all true, but that is also the point. We will use results from paper trading to measure the performance of real money trading later on. Airline crews don’t jump into a new jet before executing procedures in a simulator. That’s done for some very good reasons. Once we’ve completed our 100 live paper trades, we compare it to our backtest of 100 samples. Were the results as expected? Good, it’s time to eat your cake.

7. Trade Real Money

Everyone loves this step. We now execute 100 trades with real money. Don’t stop after 7 trades just because the first 6 were losers. You’re violating the statistical requirements of your analysis. There is a random distribution of each trade, but patterns develop after a significant sample size. Now compare your real money trades to your paper money trades. Similar? You probably did worse with real money and the reason is you are prone to execution errors when real money is on the line, just like our free-throwing NCAA basketall star is with 1 second left on the clock and down by 1. The difference between your paper results and your real results represents what you need to learn.

We’ll take on trader psychology at another time. In the mean time, enjoy the bounty of your trading system as you become wealthy beyond your wildest dreams.

MNX Iron Condor closed

March 20, 2009

What started as a debit-less double diagonal, morphed into a risk-free Iron Condor and expiration has come and gone.

When the double diagonal short strikes got rolled into MAR, we received $5.01 credit with put strikes as 116/121 and call strikes at 127.5/132.5. A couple weeks ago, it looked like this was trade was gonna take its $5.00 back, but then the rally ensued. So much so that the price of MNX was trading between the short put strike and the short call strike. A homerun in the making.

MNX gets settle on Friday’s opening print, and gets settled to cash. The last day to trade it is Thursday of expiration week. As expiration was approaching, I was compelled to take off risk and consider taking profits. Taking off risk was easy. I BOT the short 127.5 call for a nickel. I’ve seen my fair share of melt-ups and quite frankly I’m not interested in getting the short end of the stick on that deal again.

With risk off the call side, the only thing left was the 116/121 put spread. If MNX prints above 121 on Friday, I get to keep all $5.01 credit (minus my nickel for the short call). If it prints below 116 on Friday, I give the credit back. Anywhere in between is a linear risk/reward. In most cases, expiration Friday has a slight bullish bias as institutions close out trades. But not always.

The cost of buying back the 116/121 put spread was around $1.30 on Thursday. If I BOT it back I would lock in the profit of around $3.70. And that’s what I did. I BOT the 116/121 put spread for $1.33, so the profit for the trade was $3.67 minus a nickel, or $3.62.

Letting the spread expire at the whim of Friday morning’s print is too risky for me. I’ve seen some very strange things happen with that print in the past, so I just don’t leave risk (in this case, $3.70) on the table through expiration. I took my profit.

MNX just published its closing print of 121.52. I would be richer $1.33 today if I had done nothing on Thursday. If this situation presents itself again in the future, I will do the exact same thing I did yesterday.

Short the SPY 83/85 call spread in APR

March 20, 2009

Just got filled on a 3-lot of APR 83/85 short call spread in SPY for a credit of $0.55.

There are 28 days until this contract expires, which is at the low end of what is acceptable with these types of spreads. Usually, you’d like between 28 and 45 days to expiration. The 45-day spreads give you more credit, but the 28-day spreads give you just enough to make the trade.

The trade assumes that SPY (S&P 500 ETF) will stay below $83.00 by next month’s expiration. Some shenanigans can happen during dividend quarters, but that happened this week so dividend risk is not a factor.

The risk on this trade is pre-defined. It is the difference between my liability at the 83 strike and my protection at the 85 strike. So, $2.00. Since we got credited money in our account to put this trade on, we can use that credit to offset the total risk and end up with $2.00 minus $0.55 equals $1.45 risk. The ratio comes out to roughly risking $3 to make $1. Kinda the opposite of what you may be used to seeing if you trend trade with stop losses and limits.

The reason we take that risk/reward is because the probability of the 83 call expiring worthless is about 77% based on current volatility. I got that number from the option software I use, but it’s pretty basic stuff.

Now, some greek talk. First up is Delta. Obviously I win if the market does not rally too much, so I’m basically short the market. Short the underlying is the same as short Deltas. Next up is Gamma. Positive Gamma works in your favor and is benefit received from buying stuff. We sold this spread so we get stuck with negative Gamma. The cost of doing business. Not to worry too much for now since Gamma usually become an issue much closer to expiration. The next greek is my favorite: Theta. It is one of the main factors in placing this trade. We want time decay to be on our side. And the short call has more negative Theta than the long call hedge, so we net a positive Theta. Finally, there is Vega or volatility. If volatility increases, we can expect that to hurt our position since it increases the chances our short strike will get hit. If you get hurt when something goes up, you must be short that something, no? In fact, we are short Vega with this spread.

This is a typical option spread to have on if you want to tempt the rally, but not tempt it recklessly. We’re basically taunting the market to reach 83 in SPY in the next four weeks. We have some insurance at the 85 strike in case the market takes our challenge and barrels past it.

Trade System Bravo

March 18, 2009

Trade System Bravo is my second ‘work-in-progress’ on developing a trade system with positive expetancy.

The chart is based on 30-minute Heikin Ashi candlesticks. They’re painted grey and black instead of red and green to tone down the emotional force behind traditional candlesticks.

The price band around prices is a Keltner band. These bands are based on Average True Range (ATR) and instead of containing price action, they signal breakouts. When price action closes outside the Keltner channel, it has a higher probability of continuing in that trend. The above chart is today’s EUR/GBP currency pair. The signal for entry is a candle closing completely outside the channel. The stop-loss is the channel boundary plus pip spread plus five pips.

The above chart triggered long entry at 9260, with the stop-loss set at 9235. Based on the definition of the stop-loss, you can see it moves up with price action. System limitations prohibit ‘loosening’ a stop once it is set. So 9235 is the lowest stop-loss permitted for the trade, but not the highest. The stop-loss is currently 9282 based on its breakout.

Indicators in lower studies include RSI and the Trendicator. The Trendicator is my super-secret proprietary indicator that shows trend.

The system’s procedure for entry and stop-loss placement is simple and clear. What is not clear is where to set the limit. A moving stop-loss is one option for setting a limit. On the above trade, it would lock in a 23 pip profit at this point. But is there another exit indicator that can maximize profits? And what would that indicator be? Maybe two Heikin Ashi candles closed against the position? Maybe an RSI value? Maybe a Trendicator value?

Where would you place your limit on the current winner?

Trade System Bravo is a work-in-progress. I’ve traded it twice. Once for about 100 pip profit, another for about 30 pip loss. I have not backtested it yet. And I’m not in the EUR/GBP trade illustrated above. Realize that two trades is obviously a small sample and not statistically valid. I’ve heard 30 is the minimum number of data points to draw statistical conclusions, but obviously the more the better.

First roll in DIA 70 put calendar

March 3, 2009

I took the first of three potential rolls a little early, but it’s good to take off 2/3 risk on the first roll. Collected $1.34 for the roll.

The DIA calendar was initially purchased for $1.99, and that represents the total risk of a long calendar. The months involved on the initial trade were MAR/JUN. After rolling MAR to APR, I essentially have a long APR/JUN put calendar at the 70 strike for $0.65 risk. Should DIA settle near 70 about 30-40 days from now, I’ll be able to completely pay for the calendar, and then start collecting profits.

$FAS trade closed for loss

March 3, 2009

I took a $2.50 loss on $FAS as my long stock hit the stop loss of $4.16 yesterday.

In retrospect, this trade was not very well thought through. I initially sold a straddle in $FAS because I was intrigued by the 250% volatility. As it turns out, high volatility can cut both ways. The only redeeming aspect of the trade is that I defined my risk after my initial indiscretion.

I don’t see myself selling straddles again any time soon. They are more useful in pricing the market expectation for a move. For example, if you add the cost of the at-the-money straddle to the just out-of-the-money strangle and divide by two, you get what the market expects to be the move in the underlying. This can be useful ahead of earnings or some sort of significant announcement.