VOLATILITYNo one has missed the tremendous rise in volatility in september and even more in oktober: the VIX index thee-doubled in the value since the beginning of september. We saw intraday movements only normally seen in months. It is also the sudden change in volatility that has surprised many people.
Look at the VIX data at the yahoo website during the last 6 months and for a comparison a chart since 1990. It seems that all of a sudden the world has completely changed since oktober. In reality it hasnot.
(Data from Yahoo)
Quite a while ago I wrote an article about intrady movements on the German Future DAX in a magazine called Traders.
There I defined volatility as the difference between the daily Highs minus the daily Lows because this value being really of importance for daytraders as they feel this movement throughout the day.
The data were gathered and various statistical tests were performed with it. One of the aims was to see if the data would fit in some distribution. It was no surprise that these data did not fit in a normal ditribution. It is almost ridiculous now to think of normality data returns.
The best guess then was the General Extreme Value distribution (GEV). These kind of distributions are known from Extreme Value Theories, fairly complicated material and for more details I refer to my article.
Some of the conclussions drawn from the article were:
Importantly the intraday movements do not follow a normal distribution but exhibit a fat right tail and skewness to the right. The non normality of these intraday movements has consequences for risk analysis (.. as done in VaR calculations).
The observation of bigger intraday movements than could be expected when normally distributed has consequences for risk management. Fitting data in a Fisher-Tippett or GEV distribution and looking at the relevant cumulative distribution gives a much better insight in the possible intraday movements of the FDAX and thus in the risk you may expect, but also in the opportunities this gives.
This was a good thought and seems to be totally right (but not followed by the so called professionals). PREDICTION OF THE FUTURE IN TRADINGIt is a general knowledge that the future cannot be predicted. Nobody knows exactly what will happen tomorrow let alone in a year. This fact leaves us with a very uncertain feelings and no surprise that a deep drive to try to control the environment and the future.
This can be seen in almost every field where humans operate: from production processes in factories to climate change models. Also traders face the challenge of dealing with the future.
Various methods exist to control and to get grip on the future and all of them are used by traders. Indicators, chart patterns, the use of regular cycles in one or other way (Gann), astrology and so on.
A good starting point to value these methods is to understand that future prices of assets cannot be predicted in general and the only way to deal with this is to use a concept of expectation of the future. An example with throwing a dice naturally comes in mind here.
Everyone knows that throwing a fair dice enough times will result in equally divided amount of the faces coming up. This is the same as saying the probability of a one, a two etc. is exactly 1/6. Our expectation of throwing a fair dice is 1/6 and so we know the future of this dice throwing process fairly well.
There is only one key assumption made here: a dice has to be a fair one. This is crucial. The consequence of using a fair dice is that it can be shown in a mathematical way that the expectation of throwing a fair dice is 1/6. This concept is used in our daily lives over and over again and used by traders. But here is also a big bootstrap.
Mathematics is not physics. Though the assumption of a fair dice maybe in reality a fairly good one (in fact, the contrary is assumed, if throwing a dice is not coming with our expectation of it, we assume the dice to be not fair). We are never sure if a dice is a perfect dice in a way that no imperfections exist with its faces which would result in unexpected results. Even when we know that such small imperfections exist we also know that it may not lead to in a different outcome when throwing it.
The understanding of this has consequences for our daily lives and the understanding of our evolution as human and so philosophical implications too.
Two examples from Traders of February may clarify my thoughts about this. The first one is about a so called Delta phenomenon from Marko Graenitz and the second from Tomasini and Jaecle about the use of indicators.
The Delta phenomenon is proposed to predict the future moves of commodities. The author shows how this delta is performing when used for the FDAX and the FTSE. It shows a fairly good forecast at the end of 2005 to 31 December 2006 for both of them compared with the actual chart. Without going into the question how good these predictions are (goodness of fit), two remarks have to be made here.
The apparent good prediction for these two index futures does not necessarily mean much if you realize that these are made over the same period of time because many if not all index futures showed the same strong upward movement the last year and the Delta would produce the same result for all of these indices used over the same time span.
The second critical remark is the following: whenever a prediction is made about the future that afterwards proved to be accurate what does this say about other predictions over other timeframes in other circumstances? When something seems to work here, does it still work there and there and then?
Think about the predictions of soccer games on Saturday or Sunday: there will be once in while someone who predicts all twelve games correctly, as there will always be somebody who predicted in the past the current oil price and so on. In the same line, always something can be found that predicts at a certain time fairly good a price in the future.
Another example is proposed by Tomasini and Jaekle. They propose a system based on a short period indicator and a filter of a longer period to obtain trade entries. The result is a very promising equity curve based on serious performed back tests over more than 600 trade entries during 3 years.
The question is off course, does the system produce the same results in the future.
This question is basically this: are results from a certain period in the past significant for a bigger period, a period also including the future in terms of expectation? In a way this can be stated as follows: is finding a good back testing result the same as finding a fair dice?
What I missed in these tests is at least a so called out of date test (sometimes referred as a forward test), a simulation of the system in real time. It will not be the first a time a good back testing does not result in good forward testing which is sometimes partly due to wrong interpretations of the back testing or partly to other factors. Also and very important the period which was tested may just not to be significant for the overall performances o the system. CONSEQUTIVE LOSSESIn two lucid and interesting articles in Traders of January two subjects were discussed, subjects I studied extensively. Luca Barberis tried to give an answer to the question how trading of various markets can enhance the equity curve without optimising individual trading systems. Optimising hides the danger of curve fitting. Though his results are very important a few aspects remains to be answered before applying his method: how many contracts do you trade the various markets, which is not a matter of classical position sizing matters and the question of a possible trade system correlation and what effect this has on risk.
Risk is the main subject of Philip Kahler in Traders. He treats various possible types of risk in trading, especially risk due to consecutive losses and emphasizes its importance to understand how consecutive losses can influence trading results. When studying consecutive losses in series of trades a huge field opens up: many different theoretical frameworks can be set up to master this phenomenon of trading.
There is a clear relation between the win ratio of a trade system and the length of consecutive losses. In an earlier post I stressed the importance of the win ratio in a different context. But it also plays an important role in the existence, the length, and the amount of consecutive losses.
In general can be said that the higher the win ratio the higher the chance becomes for a series of losses of a certain length. In his article Kahler gives some examples and a graphic which can be used to determine 5 or 10 consecutive losses for a given win ratio. It has to be said that these probabilities occur for a given amount of trades performed and will change negatively when the total trades increases.
Though interesting to know the chance for a series of losses it would be even more interesting to know a distribution of series of losses, e.g. the probability for all possible series of losses and moreover the maximum length of consecutive losses (maximum streak) you might expect for a given win ratio.
Below you can see a figure which gives the relation for the maximum streak and the probability of a loss (loss ratio). Total trades is 500, confidence is 0.998%.
From this figure again can be seen the importance of the loss ratio: the higher this becomes (the more losses)then the maximum strak increases exponentially. E.g when q, the probability of a loss is 35% then the maximum expected streak willl be 6 but when increasing to 70% the maximum streak increases to 17 consequtive losses in a row! LUCK AND CHANGE ON THE MARKETMy partner and I spent the week around Christmas in Mumbai, India. Mumbai is the financial and economic centre of India. The Bombay Stock Exchange (BSE) had a splendid year behind with a year output of more than 33%.
From local newspapers a moderate hosanna mood can be felt. Also internationally India got much attention in the last year. It is particularly the growing middle class that forms the driving force behind the economy and which gets attention of foreign investors.
With an increase of 33% the BSE is one of the best performing markets in the world. Of course it must immediately be said that almost all markets performed very well. The phenomenon that markets are moving more or less in the same direction is called correlation.
Correlation between markets is high: data which I have collected on 15 minutes basis of the futures on the FDAX and the DOW JONES appear to have a correlation of more than 90% over the past 2 years. This is almost complete correlation.
Now the question arises if a result such as that of the Bombay Stock Exchange can be attributed to well performing of the Indian economy or that also chance may play a role in it. It cannot be denied that chance and luck play an important role on the markets.
Let’s have a look at this without going into this matter to deeply. Suppose that an invisible hand would assign the different markets worldwide a return around a certain average. Then you may expect these returns to be divided normally.
A quick lookup at the financial site of Yahoo reveals the following. Of the 17 most important markets there is not one with a negative output over 2006. The output diverges from 10% (London) up to 55% (Moscow) with an average of rounded 24%. The spread, standard deviation amounts to 23%. This means that if the 17 markets are representative for all markets in the world, about 66% of all markets will show an output of 1 standard deviation above or below the average (therefore 24% ± 23%). Of all 17 markets there are only 2 outside this range.
We can look at this also in a different way: we can consider the return of an individual market as an estimate of the world average and look at how well such an estimate would be.
It is known that such an estimate will have a standard error that equals to σ/√T where σ is the annual volatility and T the number of years:
STD = σ/√T (1)
From formula (1) it follows that the standard error of an estimate of the world average decreases with the square root of the number of years.
Let’s take Mumbai as an example. The excess return or α, of this market above the world average is 33-24 = 9%. Though in general the term α refers to the excess return of a fund with respect to the benchmark, it may also be used for the excess return of a market.
To be convinced that an excess return is the consequence of a better performing of the economy and not to pure chance or luck then the return must be bigger than the world average with a significant size. In a one-sided test at the 95% confidence level the difference between the two must be greater than 1.65 standard deviations.
Suppose the volatility to be around 20% on an annual basis for the Bombay market then the standard error according to (1) will be 20%/√1 = 20%. The 9% above the average of the market is clearly smaller than one standard deviation above the average, clearly below 95% confidence level. It lies approximately at 50% what means that 50% of the return of Bombay falls to pure chance. In fact you can say that the 33% return of Mumbai is a good estimate of the world average.
We can carry out this calculation also differently and perhaps it will even become more clearly then. We saw that the standard error of an estimate of the average decreases with the square root of the number of years taken into account.
We know that: α =9% = 1,65* STD. It follows that STD, the standard error, equals 9/1,65 = 5,45. This value substituted for the STD in formula (1) gives √T = 23% /5,45 = 4.22 ==> T = 17,8 year.
This means therefore that the Bombay Stock Exchange for at least 17 years in succession must show a return that 9% or more lies above the world average to be able to say that for 95% this is due to a better performing of the economy and only for 5% to chance.
Around these days various funds present their performances. Some will show better results than others. From the previous it must be clear that luck may play a large role besides skill of the fund managers and in any case is much larger than they will admit. Think to that. CONSISTENCY AND SHARPE RATIO (1)For me consistency has always been a very important and interesting factor in trading. By consistency I mean how long, in a given timeframe, let say 12 months or 12 weeks, my trades are giving a positive result. Can I expect 6 months out of 12 being profitable or more or less? This is one of the questions which I always try to give as best as possible an answer.
One of the most used criteria for evaluating fund managers is the Sharpe Ratio. The Sharpe Ratio is used for this because of its easy use: the bigger the Sharpe the better the fund or the fund manager. This almost has become fait accompli.
How is the Sharpe Ratio calculated? It is simple obtained by dividing the average net profit (mean or expectation E) by the standard deviation of the trades. The standard deviation is, as you may know, a measure for the spread of winners of losers around the mean. Because the deviation is a measure for the trade spread it is also considered as a measure for the risk of the fund or the fund manager, but this standard deviation is also defined as the volatility of the fund.
The Sharpe ratio is in this way defined as the mean profit of the fund (-manager) per point risk or volatility. The bigger the mean, the bigger the Sharpe the better the fund (-manager) is performing. That's the idea.
An example. Suppose trader A has a gain of 5 ES points per trade, a spread of 10 points, done over 100 trades in one year. This means that, when trader's A profits are normally distributed over the losses and the winners, 99,73% of his trade outcomes is lying between 5 minus 30 (=-20) and 5+ 30 (=35). The Sharpe ratio is now 5/10 = 0.5 .
Do you see how it works? When the trade outcomes would have a bigger spread but with the same mean the Sharpe ratio would decrease, the mean per point risk will decrease.
When you look closely at the Sharpe Ratio you will see and understand that is in fact a measure for consistency. To see this take the next example. Trader B takes 100 trades a year but with every trade being a winner (if this would be possible, but for clarity reasons taken here) for 5 points. His net profitability and mean is the same as for trader A but his Sharpe ratio becomes 5/∞ = ∞. His consistency is 100%.
We defined the Sharpe ratio as the mean defined by the spread. This is not precisely correct. The exact definition is the excess profit over a zero risk profit divided by the spread. A zero risk is generally the return of a 30 year T-bond but also a European long bond could be taken. Off course the risk is not exactly zero but is considered to be and also T- bond returns are changing over time (inflation).
Our definition of the Sharpe is a modified Sharpe, but it doesn't really matter, because the exact definition doesn't give more information. You only have bear in mind how the Sharpe is defined when it is used in comparisons.
There is a clear relation with so called z score of a normal distribution and a lookup in a table with a z 0f ∞ gives a 100% consistency. In this way consistency can be defined and I use it this way.
But before closing this post three remarks have to be made.
1. The Sharpe and the consistency is defined for normal distributed trade returns but in practice returns seldom are.
2. The spread as a measure is not a very good one because in this way it also takes positive returns as a risk and this is not what traders and investors generally feel about positive returns.
3. The longer a trader stays in business the bigger his draw downs will be. Or said otherwise: the more trades a fund manager takes the bigger his draw downs will be, or said it in another way: the more trades a fund manager takes, how bigger his drawdown. The consequence is that the longer a fund manager is in business (the longer a fund exists) he will be punished with a lowering of his Sharpe ratio. I will come back to this in my next post.
So the conclusion is that Sharpe is a useful concept but not more and so other concepts for consistency are needed. These are the Sortino Ratio, Callmar ratio and the Martin Ratio. I developed another concept of consistency which I called Excess Loss Wealth Function (ELWF) which I draw directly from the theory of random walks.TRADE SYSTEMS AS SUCHLast time I was talking about expectations and the use of stops. One of the things that interested me was the relation between a stop and other system parameters like amount of losses/winners and the average win/loss. I stated that for a given trade system a clear relation between these parameters doesn't exist.
But, as you may have noticed in earlier postings I wrote about the win ratio and it's relation to expectation. I described expectation in terms of win ratio (chance of a winner) and one of the things I found was a clear relation between the win ratio and the profit ratio (= average/average loss. From the figure given there some conclusions cold be drawn how big the profit ratio has to be with a given win ratio for the expectancy to be positive.
Now, you could ask, is this in contradiction with findings in my last post?. It is maybe a surprise but I think there isn't.
When I tried to describe a relation between expectancy and win ratio I was primarily interested to let you see the importance of a high win ratio, in contrary to some, or most, writers who stress the importance of an overall profit but ignore to tell you the serious problems you encounter when your trading systems comes up with only a few winners and a bunch of losers. They may be right but is it workable, see my last posting about expectancy and win ratio
So, in these postings I was comparingdifferent trade systems to each other. I then focussed one a particular system and its parameters. I have a strong conviction in the existence of trade systems as such, whose trade parameters are fixed. I think of trade systems as being some entity that produces so and so many trades a year, with a certain expectation per trade and profit factor. Seeing systems this way it is no longer a contradiction to say that parameters of a system in particular are dependant.
Now, the question is now as follows. When I or you try to trade this system, do we get the same results as theoretically would be possible? I already posted before about this (Luck and Randomness) and I suspected then some interesting aspects of trading on which I want to post in the future.STOPS AND TRADING SYSTEMSIt is common to use stops to avoid big losses and to avoid the psychological danger a trader can have when he is uncertain to close his positions at time.
Still sometimes no stop is proposed in trading. We all now that too small a stop the will punch out too often, sometimes leaving us behind with a potential winner while too big a stop can have a big influence on our overall results.
Suppose someone trades 100 times a year of which 80% are small winners and mall losers. This is not an unreal situation for a discretionary trader. His results are determined by the last 20% which we suppose to be big winners and big losers.
The influence of one of such a trade is substantial. A big loser or big winner can make a substantial difference to the final results of the trader.
But the question remains if how losers and winners effect each ohter.
We know the concept of Expectancy:
E = P / NP - L / NL = Average Win – Average Loss (1)
In words: The expectation of a trade is the total win divided by the total amount of losses minus the total loss divided by the total amount of losers.
The above formula has four variables, P the total win, L, the total loss, NP the amount of winners and NL the amount of losers. Each of them can be changed, e.g. decreasing the the total loss L, decreases the average loss and so increases the sum which is the expectation E.
But changing one variable in formula (1), changing one may affect the other ones. The variables are said to be dependant from each other. For a given system, changing the average loss may result in changing the average win too!
An example: a system produces 100 trades a year, 60 losers and 40 winners. When 5 potential losses could eventually turned into 5 winners by taking a bigger stop the average win will increase due to this, but you may also expect that the average loss will increase due to the bigger stop of the remaining 35 losses. We also could go for bigger winners just to see an increase in the amount of losses.
We don’t know at forehand what happens and the problem stays. Suppose there is a function G with parameters NP, NL, P, L so that :
G (NP,NL,P,L).
G produces some results in terms of expectation E:
G (NP,NL,P,L) = f (E) (2)
I did some effort to investigate some general characteristics of formula (2). Though not being very being successfully it helped me I a better understanding the concept of a trading system, in fact a way of producing losers and winners which outcomes are dependant to each other.
One of the strangest things I found was that the outcome of a system is changing over time and not seldom worsening, not necessarily in terms of expectation E or E per dollar risk but more in terms of other characteristics as drawdown, amount of losses and winners, runs of losses and winners and so on.
This is a fundamental (stochastic) principle everywhere probability plays such an important role.
AUTOMATED TRADINGOne reason of not being updating recently is a circumstance that I never thought would be important to me. I met a few years ago a trader which became also a friend and after numerous discussions about trading we decided this summer to join and trade some systems I looked at the last years.
This trader would do the actual trading so that would let me time to do my own trading. A good plan until he decided not to trade because of private reasons which left us with the question how to proceed. Go on with it or not. We wanted to proceed but it would mean I had to make the trading efforts.
It was than that I thought about a fully automated trading system (ATS), so that the computer would take the decisions of taking the trading, managing it and closing it. This is not an easy task.
First of all I had to consider my trading configuration. I trade with Interactivebrokers, a broker which also delivers the data. My charting program is SierraCharts and I use a Bracket Trader as a front end program. I am aware of the lacks and the failures of this configuration. I always look at other possibilities but it is somehow difficult to change what you are used to but besides that IB is very cheap and reliable.
I looked for programs doing he job but I did not found it. Tradebolt suggest doing just this but did not convince me. Than I found the website of this German guy, Juergen. On his website he offers a Replay module for back testing Sierra charts but also offers some kind of rudimentary ATS for SierraCharts and Bracket Trader, called fscript. It is written in VBScript of which the bron code is free; an ATS sample can be read and this was what I needed.
The last time I programmed was maybe 20 years ago in old languages as Pascal and Fortran. Programming in a script language was completely new to me and I have to admit it was by far not easy but finally succeeded. It was a very nice surprise to me that Juergen offered his help where he could.
What does fscript do? Simply said it reads data from SieraCharts, decides if a trade has to follow, and send it through Bracket trader to my broker. After weeks of testing it runs now completely free of hands. The only thing to do is to start the program. Off course I have to monitor it because with such a ATS in place something unexpected can happen.
The system is a combination of the FDAX, and two BUND future systems. I hope this will give me and my partner good trading results. The most satisfying was the completion of the ATS itself which enables us to develop and trade future systems automatically and independantly.TRADINGSYSTEMS AND THEORYYou may have wondered why I didnot update my blog regularly this summer. The resaon is quite boring: I went back to my study to work on several aspects on my tradingsystem.
I have to admit I worked at this for quite a long time before but the last months I focussed on some of them. Trading is a live time endeavour and by no means you will get all the answers but trying to see where u can go is a challenge by itself.
The things of my interest are:
1. Can something be said about drawdowns and losses for a given tradingsystem?
2. Can you expect bigger losses than your backtesting and actual trading results shows?
3. What is the nature of my return distribution?
4. How do you know if a tradingsystem gives better results than random?
5. Is there a better measure for trading performance than the Sharpe Ratio?
6. What effect does stops and targets have on my tradingsystems?
7. What effect does autocorrelation and trade dependancies have on my tradingsystem?
8. Is it possible and if so ,how, to maximise my trading in terms of risk and return by combining different tradingsystems?
As you can see, quite a lot of questions to be answered and a lot of theoretical work so it is not surprising that I was surprised pleasantly by an article in Traders of september about a traders tournement which is held every year in Europe and organised by Emilio Tomasini (www.toptradercup.com).
Asking myself if I would try to. But how are the rules of the game, eg, how do they measure somones performances?MARKET UPDATE AND PREDICTABILITYThe markets in a decline at the moment, we can recognise that off course. If we look at stocks moving above 200 and 50 day moving average (symbols: $SPXA200 and $SPXA50), we can see that both are moving at the bottoms of recent years, see charts below.
If we are not too bearish about the current markets, and why would we? we may expect a recovery or at at least a sideways movement from here.
In Business week I found an interesting article about the predictability of market prices. I was posting earlier about it. If you think markets are moving in a random way, as some theoreticists postulate, it has no use to try finding a way getting more from the markets than the average benchmark (such as an indexfund) does.
I earlier summed up some opposite opinions about this view. Make up your mind. I agree with this writer when he says:
The first thing you need to do is convince yourself that the markets are not completely random. If the markets are completely random, no amount of research, emotional detachment, etc. will help. To continue to trade when you know the markets are random is to engage in gambling. Do you think that winning traders over a period of years gamble? I've been to Las Vegas many times and never put even a quarter in a slot machine.
Once you convince yourself the markets are not completely random, your search will take on new meaning. The challenge then becomes how do I locate non-random opportunities in the market so that I can exploit them?
From: Elitetrader Forum
BEHAVIORAL FINANCE VS. EFFICIENT MARKET THEORYThere is an ungoing dispute between some scholars from financial universities and others over the effectiviness of technical analyses for predicting market movements.
Since the random walk model contends that price fluctuations occur randomly, technical systems which rely upon the existence of price trends cannot be profitable in the long run. The thought of a random walk being a condition and also an indication for the existence of an efficient market. Supportes of this theory deny the possibilty of predictability of pices on the stock market.
Others don't agree with this. There are studies that technical analyses do work, while even some question the efficient market theory itself eg. behavioral economist's as Tversky, Kahneman and Barberis. Some articles can be found below.
SYSTEM DEVELOPMENT (AGAIN)There are many aspects on trading which must be adressed before trading a system. Some of them can be found in the sidebar under Interesting Posts. The following will be treated on a next occasion.
- consistency
- robustness
- traders psychology and behaviour
As allways I am looking for new tradesytems besides retesting the current in use. You never know what the results will be of these exercises. One of the most compelling aspects of trading is the valuation of the drawdowns of a system. A drawdown defined as the maximum top-to-valley drop in the equity curve.
Drawdowns can be seen as extreme events in a ditribution of possibble events but due to their extreme values they are almost allways underestimated in statistics, especially in normal distributions.
A relatively new research field of statistics considers extreme values. This so called Extreme Value Theory not only studies the markets but has also applications to other fields as floodcontrol, sea waves and material exhaution models and so on.
The mathematics is as usual interesting but really very complicated. I will try to give a survey of my findings another time. Some articles:
The last couples of day I performed some trades, see my FDAX Trades and my DOW JONES Trades.
LUCK AND RANDOMNESSThere is no doubt that luck or more general speaking randomness plays an important and unpredictable role in trading. Nobody can escape from this, be it in business, science, love or trading.
A computer simulation of a portfolio starting with equal amounts of money and trading the same system (win ratio of .6 and profit/loss factor of 1) reveals the following result. It is by any means a profitable system but while some portfolio's made a nearly 140% return, others suffer from bad drawdowns to only a 60 % return. This cannot be attributed to skillness or whatever, but is just a matter of randomness or luck which alters someones result. See graph below.
KEEP THIS IN MIND when trading, I find this a very disturbing but also a very reassuring thought at the same time, not everything is in our hands.
I traded yesterday very carefully on the FDAX before the FED's announcements. I never trade on news and I try to avoid these to interfer with my decisions but I know all to well that some news can disturb the markets on the short term very heavily and FED news is one of those newsfacts. My entries are given in the next chart arrowed at the upper side of the graph.
I traded the intraday 5670 level (lined). At arrow X, I hesitated to go short. I connected these moves with the FED and I decided not to enter. I was clearly lucky, no skill, just lucky. Later on the evening I entered long.
The DOW JONES for a couple of days now finding resistance at the 200 SMA. Also bouncing off the support at 1245. See S&P 500 today
Looking at the markets today I am wondering if the DOW futue will show us up with a Adam and Eve doubble bottom, like the FDAX last week, see an intrady chart (eg. at yahoo finance), or below:
Daytrading
Dow Jones
FDAXTRADING DIARYI performed two trades on the FDAX and the mini DOW JONES
Normally I keep in WORD a diary after a trading day but I am looking for a software program to do this. Until now I didnot find a good program.
I finished a posting on Hellodax, about market participators, will be posted tomorrow.
Talking about diarries: this story about One Bad Trade performed is interesting stuff to read for anybody.THE MARKET NOWI was thinking the last couple of days about the market and the doom scenario's some described, comparing this market with the fall of the late nineties after 1997, talking about inflation risks and FED's chairman Greenspan commenting about the market and inflation.
Off course the usual conspiracy theories always pop up.
Niederhoffer posting about the common errors made by forecasters, quite amusing to read.
Markets started two weeks ago to go down rapidly, an end of a trend , off course I meant the trend of this year which started in November of last year; though the DAX still is in a big uptrend since 2003, see a classical uptrend in the chart below (click to enlarge).
Markets bounced up thursday, there were some clues though given by some. So Stephan Vita who posts this graph of the NYMO McClelan indicator, an indicator more often used by index followers, and asking the retorical question : "Why Does a Bounce Come?" ; it speaks for itself.
The S&P 500 bouncing off the 200 SMA very neatly: safed by the bell a least for the moment.
I am allways very cautious about predictions because who can predict the future? But to be honest I saw wednesday the FDAX nice bottoming out, with a double bottom and a positive divergence in price at C assuring at least a short term recovery.
Also read again Niederhoffer when he is Briefly Speaking about the markets and about romance too :)
FDAX
Dow Jones
EXPECTANCY AND WINRATIO (3)One of the results of my last posting on expectancy is the size of average win compared to the average loss:
"With these examples we see that increasing the average win is more favourable for the expectancy and therefore the profability than decreasing the average loss, but also that increasing the win ratio proportional increasing the expectancy."
There is a restriction to these statements: this is only true for a winratio p < 1/2. I stated it here due to my own bias towards trading in the sense that I never look at tradingsystems with a winratio smaller than 1/2.
Although completely possible for someone to trade, it is not my cup of tea. You may find and trade a sytem which produces 3 winners out of ten, the winners to be bigger than the losers. See the graph for the expectancy in this case in my posting before. I personally discard these systems because of the following reasons.
- The problem of outliers.
- Psychology involved
- Consistency
- Formal reasons
I. The outlier problem.
One of the problems of data sampling and data processing is the uneven influence outliers have on the results. A big trade outcome may be not representative but just a coincidence. You have to watch for this trap. How many data do you need to obtain reliable results? Though allways important for valuating a trade system, for a system with the need of bigger winns (a trend following system) this becomes very urgent. You may be waiting for another winner which may never show up.
There is another practical problem: you may not miss the bigger trades , this is allways possible for many reasons, your final outcome of your system being very sensitive to pick these winners.
II. The psychology involved
It can be very hard to trade a system in which many losers occur in a row. You have to be very patient and disclipined to trade a system like that. Your account has to be big enough to take this easily, the risk of a gambler's ruin is allways at stake here.
III. Consistency
Time consistenccy is an important facor in my trading and may be treated on a next occasion. For the moment it is enough to note that consistency in trade systems with lower win ratio's only may be expected in longer lasting time frames, a result badly bearable for me.
IV.Formal reasons
There exists a rigorous and formal model for a maximum betting size based on the work of Dubins and Savage (1976) in their book with the inspiring title How to Gamble if you Must. One of their results was that in an unfair game, eg. a game where your win chances are less than 1/2 (a play in which the odds are against you) your maximum chances are only achieved when staking the maximum. This is called 'bold play' in these models.
Later work confirms these results, see eg. an overview of Schweinsburg : Improving on bold play when the gambler is restricted. For a superfair game, eg when p>1/2, it has been shown that a more realistic timid strategy of staking being optimal.
Now these models cannot directly transformed to trading systems because they are restricted to so called red and black models in which outcomes are either black or red (plus 1 or minus 1 and so on, the casino games) but may give some clues to sub-optimal strategies when using winratios > 1/2.
Related:
Systemtrading
ExpectancyEXPECTANCY AND WIN RATIO (2)My posting about expectancy made very clear the importance of this quantity for developing and valuating tradesystems. A good and clear understanding of the meaning of Expectancy is therefore necessary. But how important expectancy may be, one of my last statements is that, at least for me, the winratio is of very great use. I want to place some additions and comments on expectancy here.
We know that:
- E = P(w)W - P(l)L (1)
- where:
- E = expectancy
- P(w)= probability of a loss
- P(l)= probability of a win
- W = average win
- L = average loss.
Van Thorp uses in his analyses the expectancy per dollar risk, the expected return of a trade per dollar invested. He therefore divides E by the average loss L. Three examples may clear up the influences of the varying parameters involved.
I. Suppose an average win of 200 euro, an average loss of 100 euro, a win ratio of 0.75.
E becomes 0.75*200- 0.25*100 = 125 euro. Per euro risk is this 125/00 = 1.25
II. Now suppose the average loss two times as big, eg. 200 euro.
E = 0.75*200 - 0.25* 200 = 100, per euro risk of 1 euro.
III. Now we halve in our first example the average win to 100 euro.
E = 0.75*100 - 0.25* 100 = 50 euro, per euro risk 0.5 euro.
IV. Let p be increased with a factor of 15% eg p= 0.8625 in our first example.
E = 0.8625*200 - 0.1375*100 = 158.75 euro which is almost a double of increase for E.
With these examples we see that increasing the average win is more favourable for the expectancy and therefore the profability than decreasing the average loss, but also that increasing the win ratio proportional increasing the expectancy.
We can write Expectancy per euro risk as:
- E = pW -qL, off course p+q = 1
- E/L = (pW- qL)/L
- E/L = (p/L)*W -q/L*L
- E/L = pR - q (2)
- in which R= W/L the profit factor.
(2) Describes the expectancy per euro risk as a lineair function of R, so a line with slope p. When putting E = 0 (2) becomes:
0= pR - q , so R = q/p the intersection with the horizontal R axis and -q the intersection with the vertical E axis. See the figure below
From this figure we can see that if p < q eg. p < 1/2, R the profit ratio has to be bigger than 1 and even bigger than q/p for the expectancy to become positive. When p > 1/2, R also equals q/p but because in this case the ratio q/p is less than 1, a positive expectancy can be expected sooner, eg. with a smaller profit loss ratio.
The figure also gives how big q/p has to be for a system with a positive expectancy for a given profit loss ratio R.
Another point which has to be made with relation to expectancy is that formula (1) for the expectancy is only an approximation for a real trading system. In a real live real tradingsystem we may expect many possible outcomes for a trade, positively or negatively, and each outcome with a different probability p. Let outcome X¡ with ¡= 1, 2 , 3 ..k and probability p¡.
The expectancy of this real live tradingsytem becomes more complicated and becomes:
ΣP¡X¡ /ΣP¡(X¡)^2
See for a formalism this article about Money management.
Another point to be made here is that returns, the outcomes of a system may not be normally distributed but oblique towards (hopefully!) positive returns. This may especially being the case when using a fixed stop. Such a distribution may be more precisely described as a Weibull distribution, an interesting point but beyond the scope of this posting.
I currently look at my returns with respect to a Weibull distribution. One of the nice things of this kind of representation is that a Weibull distribution has a surprisingly relatively simple calculus involved.
Systemtrading
ExpectancyA REVEARSAL CHART PATTERNMarkets clearly topping off the last days,as expecting in my post 'The end of Trends' , almost totally correct the rise of this year. You can see this in the chart of the S&P500 , the Dow Jones and the German FDAX.
Chart patterns can be very usefull, but are not easily recognised immediatelly. It is allways easy to see a top revearsal afterwards as shown in a post of Stepan Vita. He describes a classical top pattern in the chart of Toll Brothers (TOL). You can see a Shoulder, Head Shoulder (HSH) pattern and also a black cross. Now this is recognised at the moment when most of the correction of last years bullish trend has been done, but off course difficult to predict in an earlier stage, eg after the HSH patten occured.
 RANDOM WALK, GAMBLING AND TRADINGPhysical problems are sometimes modelled as random walks, sometimes also called a "drunkard's walk". In this model many successive steps are taken, but each in a random direction. The direction of each step being independant of the direction of the previous one.
A famous example is the Brownian motion of a smoke particle in very dilute gas. The invisible gasmolecules colliding at random against the, in comparison to the molecules, very big smoke particle. In two dimensions a random walk can be seen in the figure below.
Random walk of 1000 steps
Random walks have serious implications for probabilty events. When throwing a fair coin, you know the chance of a head equals the chance of a tail (50:50 or p= 1/2). But what are possible outcomes when throwing a fair coin? Suppose the coin did come with a streak of 6 tails in a row? What is the chance of the next throw also being a tail? The chance of another tail is just 1/2 independant of the foregoing outcome.
Many people intuitively assume that after a series of consequtive tails a head must show up with greater certainty. There are many examples of this assumption of what is called the expectation a regression to the mean.
Last night I watched on television a pokergame (Texas Hold'em at the Poker Den organised by PartyPoker.com). There was this beautifull young lady getting bad cards al night and the commentators just outbursted that it is not possible to get bad cards forever, she had to get good cards at last: she played out without getting a picture and only a few hands played.
The man in the casino watching slot machines which didnot pay out for a long time is also an example of an expection for a regression to the mean. Casino's know this too well and just let the slot machines produce random numbers so the next outcome is independant of the previous one: a losing game by all means, the edge is to the house, the chance of a win is smaller than 1/2.
But let's return to a coin. I found an astonishing picture in A Guide To Gambling, Love, The Stock Market & And About Everything Else, a book I noted before.
The graph shows the result of a computer-simulated sequence of thousend thosses of a fair coin, eacch time a head is coming up it adds up +1 and when a tail comes up-1. You feel since the probability of each result, tail or head, is equal, here should be as may heads as tails after a certain time.
Now this is true but only after a very long time, in fact after infinite time. Over the short term, which may relatively long periods, more heads than tails occur and vice versa. This supposes very long lasted unexpected streaks of either tails or heads. This is the random walk of a coin.
There is a formula for the probability of a streak:
- q = [1+(n-r) p]q' (1)
- n = amount of tosses (trades!)
- r = losing streak
- p = chance of a single outcome
- q' = P^r (power r)
For an explanation and an example see winning and losing streaks.
We return to our activities on the stockmarket. Market prices are sometimes also considered as random walks (especially as the outcome a of classical price theories). In a way we could see in graph above the movement of a stock price (or future or whatever) in time.
In an earlier posting I gave a distribution of one day and 5 days returns on the GBP/USD. Clearly these distributions are not random: it resembles more of a normal distribution around a mean. Whatever it is, the movements in a much smaller timeframe, eg ticks, could still be a random walk. Maybe the duration in which the one day and 5 day returns are gathered is just to small to reject a random walk.
In approximation the distance R² from a starting point in a random walk to the end point is proportional to N in which N is total of steps:
R² = N*r
(2)
r is the square root of the average squared step size or root mean squared step size. If I take r as a tick on the FDAX and normalise to 1 formula (2)becomes:
R² = N.
and R is epresssed in ticks.
(followed)
Systemtrading
gambling and tradingTHE END OF TRENDS?Trends do end in any given timeframe. We saw on the last two days what maybe an end of this years strong bull trend, although it may not be over yet.
I was thinking of this when reading Paolo Pezzutti's posting what Mr. Buffet warnes about speculation and and the investments of the public. I cite his posting:
"The price of metals, such as copper, and other commodities like oil, initially climbed on fundamentals, but the gains have now attracted more investors betting on further price gains, he explained. “What the wise man does at the beginning the fool does at the end,” he quipped. “Once a price history develops enough for other people to see it and get envious, that takes over markets. We’re seeing that some areas of the commodity markets.” "
"Selling in may and go away" be the right thing to now. The DOW still in it's trend but the broader markets aren't. See charts below, click for a full screen.
Systemtrading
Dow Jones
trendsTRADES AND MARKET MOVEMENTSAfter a couple of days I was finally able today to place some orders on the FDAX and on the DOW future.
What was the reason for not trading? Well, the market did not came up with my favourable setups but just trended upwards very strongly, every position would be unsecure. We have to see if the market wil revearse from here for a more longer time or just a blow off after FED's decision and suggestions about further interest rates.
Joao and fernando of Hello Dax, a blog on which I am invited to write something about futures, propose a setup for a winning option strategy on the DAX. I have some doubts about this.
Movements on markets are not linear as they suppose to assume but rather random walks, certainly in the short and middle long time span. Markets move in a jagged fashion which may be demonstrated by comparing distributions of returns over various time periods. Just look at the graphs below.
The fact that the range of the 5-day distribution is nowhere near five times the width of the 1-day distribution (in terms of max to min) tells you the market
almost never moves directly from point A to point B. Off course this is a valuta index but you may expect this being the case for stock indices too. Options are very susceptiable for such movements.
Dow Jones
FDAX
Systemtrading
BEARS: ALLWAYS UP ?Fridays outbreak at the markets must be something of a killer for the bears as Stephan Vita notes on his blog. They may think they are right and the markets wrong..The Dow Jones tries to hit all time high, attracted by it like a magnet.
See chart of the Dow since 1935. Allways good to see and now you know why our queen became so rich.
The European indices still some 25 to 30 % away from the highs of 2000, so they have a long way to go. See chart of the Dax since 1990.
Dow Jones
FDAX
MARKETS UPDATEBoth the S&P 500 and the Dow Jones closing to year highs eploring new territories as you can see in the charts. The broader Russel 2000 (symbol: $RUT) at all time high. We cannot go up forever, what are the underlying reasons for these uptrends? I don't know and it doesnot bother me either. I do know we will correct someday, but not now.
Dow Jones
DOW JONES UPDATEThe last days the Dow Jones wrestling with the 11400 level. Let us see if it can stay above this level maybe testing the upper trend line today. See chart.
Dow Jones
DISCIPLINE AND MISSING THE BIG ONEDiscipline has many faces when it becomes to trading. Earlier I gave the doubts and visions of globetrader. Now the word is to Victor Niederhoffer himself taken from his website. Later on I will give my experiences. He describes the subject of stubborness of traders, a must be killer to a trader. Never ever be stubborn in your vision when markets are against you. It is good to have a vision in general but never fight against the market, because you wil lose. Remember markets and trading is not of being right but of making money.
Comparing the battle between some passengers taking his bus with the operator due to possible delay and gamblers completely losing their senses in attempt not to miss even one chance.:
"....and that the remaining passengers, who were involved in a screaming battle with the bus operator over possible delay in getting to the track on time were more typical. This remnant certainly suffered from the tendency of all gamblers to completely lose their sense of balance and priorities in a desperate attempt not to miss even one chance to get even"
Traders inevitably allways see comparisons with their trading activities but this one surely being a surprising one and funny too.
He goes on:
"I once had a client from the Mediterranean who insisted on selling the stock market futures short whenever it set a five-day low. He lost about 20 times in a row after 1987 and I advised him to take a break. "I can't. The big crash might come while I was away." he said."
And than off course romance comes into play:
"remember Artie's telling me that one of his best friends missed his wedding and never married because he got into a card game on a train going to his own wedding"
I admire Niederhoffers style and the surprising turns his articles take, sometimes long-winded but allways pointing to trading and the markets.
So stubbornness and losing sense of balance leading a trader to disaster.
There is another aspect which is as deadly as those mentioned: addiction to trading. In a comment (Jared Albert) puts his experiences:
"..the anxiety of watching the market rebound and being unable to trade was unbearable and eventually he'd have to take the phones to work with him after a losing streak. Luckily I wiped out 3 times in 6 years and discovered that the pain of having no steak is worse than the pain of missed opportunities."
"The issue of compulsive trading or trading for excitement are clearly among the most dangerous."
Now misssing the big one or addiction to trading being totally different from problems whith missing some good opportunities that can arise by various reasons as abstinence or pulling the trigger fear. I wrote earlier about missing trades.
Systemtrading
|
