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Profitable ETF Trading startegies: Stock quality number

May 28, 2009 Leave a comment

a subtle way to find stocks beginning to quietly outperform their peers within the Dow30 industrials.

Using a formula for computing quality that considers both the gains and the relative volatility over various time periods allows us to examine relative performance improvements in a way that cannot be duplicated with reading individual charts

the first chart examines how to frame a favorable reward:risk ratio trade in PG (Proctor & Gamble) for a short term tradeis a performance table, and the second chart shows the analysis table that identified PG as a favorable candidate.

st20090528pg

 

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Profitable ETF Trading Strategies: reflections on System Quality Number

May 18, 2009 1 comment

here is my take on the IITM System Quality NUmber idea (SQN): and fat right tails. it’s what I said to chuck whitman on this topic 

on my -1R loss exits: this is the result of a single trade decision cycle on that trade that is very effective 

now, on the possibility of a 10R win that “skews” the histogram of results and increases the variability of the data set and therefore lowers SQN and therefore lowers recommended risk 

the essential question is this: was the 20R a consequence of the act of entry, of the fact of entry, independent of any trader decisionmaking along the way?

if you have no influence over the achievement of 20R in the trade, then the argument that the increased variability suggested by the 10R return should reduce the SQN is warranted 

because upside variability that is a result of the market’s “decision” ought to imply the potential of the same kind of downside variability suprising you

that is the essence of the marble game, that once you decide to play that the result is pure random function generator 

BUT: what if you had played the washout pattern in SPY on 10 March and followed every rule and were able to manage the trade thru 6 iterations of successive Washout Cointinuation patterns and as a result of 7 cycles of trade decisions, were able to bring in 10R, yet never risked more than 1R on the downside 

everything is now a function of how you classify that trade batch 

if you say: that is one episode, and the trade is 10R, and the 10R implies i could have taken a 10R loss which is beyond my management ability, then i will say i disagree 

if we have traded a WO pattern system 200 times and my 100 losses show an avg loss of less than 1R, AND my worst loss was 1.4R, and my trading mgt skills enabled me to manage risk properly all the way up the ladder, then simply treating the WOCs as 6 separate trades on avg of 1.6R (6x 1.6R = 10R) gives a true picture of the quality of the system 

the Sortino ratio which examines the stats of just the losses with StDev is the right way to understand the losses and since computation is free you SHOULD do both the standard SQN AND a Sortino to better understand your loss pattern to make your decision on how much risk to take on 

now, if i can get a 10R thru intraday trade mgt by getting a carefully engineered, risk controlled, very manageable morning hook which gives me a boost and my trade is a single continuous episode but Inever was in a position to experience a 10R loss, then you would be nuts to penalize that system

you MUST really know your edge, and where the 10R comes from and decide if it truly represents the possibility of expereincing a 10R loss 

you MUST know your system thoroughly in order to create meaning, to fully understand its risks (as much as it can be understood) 

portfolio heat rules and other heuristics must be in place to protect us against -10Rs beyond our control such as power outages, discontinuity in the mkts, so that we never commit the hubris error of LTCM 

we are no where near that in our application 

here is where SQN is VERY VALUABLE: when i have 5 sets of mechanical rules that i am testing, iindependent of trader discretion, as a check on the robustness of the mechanical framework           

SQN can give me the basis for deciding which to pursue, to revise and extend 

what your studies are revealing is that you are understanding how the SQN math works 

this is a good thing 

example: this morning in the seminar we looked at a Triple Screen on GOOG which if executed mechanically would have given a .8R win going in to the close, but which had “open risk” ie trader initial cpaital at risk AND was in the red for 5 hours until near the close 

by applying trader Quality to it, we engineered the entry timing in order to get a 2R iStop, and scratched the 1st trade, and then earned 6R on the identical setup on the next leg up. 

the open risk was 15 minutes, when we moved to no lose, and then we spent 4 hours in the green until deciding to cash a 5R before the close 

i guarantee that the 5R win should not be interpretted as implying increasing downside volatility and thus lowering SQN 

coming to that conclusion would demonstrate IN MY OPINION, an inferior understanding of interpreting SQN 

let me suggest what true Quality measure could/should include: amount of open risk x # of minutes 

1st GOOG example: 15 min red all of which was <1R and then all green rest of the day up to a 5R win 

correction that was the 2d GOOG example: the 1st GOOG exmaple eas mostkly red all day = lots of pain, low quality; compare the “time area in the red” to the “time area in the green” to really understand the “quality of each system. 

charts to follow 

bottom line: you better know where your outsize R comes from 

you must be ruthlessly focusing on your R losses to ensure you are calibrated in identifying mkt risk to your idea 

you must be open to the potentials of achieving risk managed high R wins, ie fat right tails 

the end

Profitable ETF Trading Strategies: refining the exit efficiency index

May 10, 2009 2 comments

Chuck LeBeau developed a powerful analysis tool for traders called the exit efficiency index. Briefly, it’s an analytical process to examine the quality of your average trade exit within a reasonable timeframe around your actual trades. Understanding the technique will help you tune your system to typical market conditions where you are seeking to exploit your edge. 

In a nutshell, you take your actual profit in each trade and divide it by the perfect exit from a timeframe that represents twice your actual trade to come up with a score between zero and one. If you can reliably get 30 to 40% of the perfect trade in your normal timeframe then you’re doing well. 

With a few refinements it is possible to examine the quality of the entry as well as the quality of the exit. In this way you can consider how well tuned your trading system is to the general market conditions you seek to trade. 

With another refinement you can look at the worst possible exit in the same timeframe to determine how well your profit preservation and capital preservation exits are protecting you against losses. 

The same refinement will also show you if there are profit opportunities by reversing your trade direction and going the other way when the first trade is over. 

Maybe the hardest piece of analysis to do is to look for opportunities on the other side of the trade when you have a positive expectancy system. It would not normally occur to you to see if you are missing profits by trading in exactly the opposite direction, when you have a system that makes money. 

By doing so, however you may be opening yourself up to some real surprises concerning profit opportunities when you normally trade. You may discover that you can trade both sides of your idea in sequence. An example of this would be to stop and reverse instead of just stopping out of your trade. 

I have found that there are certain market conditions favor stop and reverse strategy, while others it is appropriate to simply stop and scan for new opportunities. 

By examining your trading statistics from all angles you’ll improve your bottom line as a trader.

Profitable ETF Trading Strategies: understanding exit efficiency

May 10, 2009 Leave a comment

Chuck LeBeau is a master trader and teacher who want ed to examine the quality of his exits, based on the belief that exits are far more important than entries in a trading system.

Since there were no existing measures available to use for his analysis he decided to invent his own, which he called the exit efficiency index.

The idea behind this concept is to examine the quality of your actual exit against the perfect exit in retrospect. He decided to look at all possible trades in approximately the same timeframe as the original trade. Comparing the perfect exit to the actual exit would allow the trader to determine if the system was in tune with the market when the trader is looking to exploit his edge.

Here’s how to do it. First, define the time period between entry and exit as the variable “t”. Now examine all price action within double that timeframe and call it “2t”.  Find the highest possible price you could’ve sold at in the “2t” timeframe. In retrospect, that would be the perfect exit. Because we are creating an index of efficiency the scores will range between 1.0 for perfect and 0.0  for worst.

In order to develop the efficiency rating for each trade, divide the actual return by the perfect return and you will come out with a number between zero and one. Convert this to a percentage to see what percentage of the perfect return you actually received.

Based on Chuck’s analysis, a trading system that on average can extract 30 to 40% of the perfect trade is doing very well.  This is important information for traders who are depressed about leaving too many profits on the table. Regret at missing profits is one of the most powerful psychological forces at work making you change your trading plan. Armed with this information, a trader can maintain the willpower and discipline to stick to good trading rules in the future.

Profitable ETF Trading Strategies: reflecting on the gold ETF

May 10, 2009 Leave a comment

 There are two ETFs that focused directly on gold, the commodity. The first one has a symbol of GLD and is by far the most heavily traded of the two ETFs, probably because it was the first one to market. The second symbol is IAU. These two ETFs trade so closely together that it would be hard to fit a razor blade in between them. 

Gold has always been a popular hedge and an alternative investment asset through the years. More than other commodities it also has attracted various groups of true believers, various conspiracy theorists whose life seems to revolve around discovering secret alliances of international bankers who work tirelessly to artificially keep the price of gold low. You can find these discussions on Yahoo discussion groups at your leisure. 
 
It is true that many people consider gold as a hedge against inflation because there is a finite amount of gold in circulation and storage. We know the rate at which new supply is mined and we can predict with some certainty the consumption of gold for jewelry and other industrial uses. 
When you see the US government printing trillions of new dollars of fiat money, there is a natural inclination to look to gold as a store of value. For reasons I cannot explain there is no direct correlation with the price of gold and the rate of inflation. This is probably due to the buying and selling of gold by institutional money. 
 
For purposes of this essay I just want to look at GLD as a trading vehicle choice. 
 
It is one choice among many in the commodity area and in equity markets in general. I am neither competent nor interested in trying to uncover the true secret of gold price variability.
 
The only thing that I focus on instead is examining price performance and looking for opportunities to achieve favorable reward to risk ratio trades in the same way that I look at all ETFs. I find this approach allows me to find trade setups that fit within my parameters for risk and reward. 
 
In the last year or so it may surprise you to find out that the volatility of gold has been as little as one third of that of the broad market index, the S&P 500. In fact you could probably win money by asking people which they thought was more volatile: the stock market or gold.
 
This relative volatility of gold goes through cycles however. There are times when it is more volatile than the market. So the truth about gold as far as I can see is that it goes through cycles just like every other sector as a class and must be studied constantly to find those moments trading parameters. 
 
The one thing you can count on is that gold will continue to fascinate and delight traders and investors for years to come and this will create opportunities for effective traders living in the buying and selling at appropriate times. Remain calm, all will be well.
 
Gold will continue to provide opportunities for agile traders. The use of the ETF is a cost effective and time efficient way to participate in the opportunity without the issues of storage, accountability and liquidity.

Profitable ETF Trading Strategies: applying the laws of large numbers

May 10, 2009 Leave a comment

When you have a statistical edge in the market, the first thing you want to know is how reliable it is. If it turns out that your edge is robust, that means it can be relied upon to work for you in most if not all types of markets. When you have such an edge, the best strategy to adopt is that of a Las Vegas casino. You want to be the house. 

Being the house means that you want to play a positive expectancy game with as many iterations as possible, in order to achieve the expected average return of your system. 

The statistical edge in the games of chance played in Las Vegas casinos are very small. These small edges though are mathematically certain because of a tightly controlled conditions and the environmental attractions the casinos offer. 

Because the conditions are so carefully controlled, the house can’expect for its mathematical edge to work in its favor precisely because of the large number of iterations. If you are the house, you want 1 million people playing blackjack for one dollar hand, rather than one person playing a single hand of blackjack for $1 million. 

The results of an individual iteration of a game of chance is not knowable before hand. However, the laws of large numbers work to your advantage when you have the edge. 

In the same way, if people in your neighborhood like to gamble, then the best strategy for the whole neighborhood is to pool their money into a single pot and send that money to Las Vegas to play a single hand of blackjack, winner take all. A single iteration at blackjack is the best possible return for your money in Vegas, although it is a slightly negative expectancy gain under most circumstances. 

A short-term trader who has plenty of opportunities is better off taking five positions at 1% risk per position than a single position at 5% risk no matter how he decides to rank order the signals by quality. This assumes of course that the signals that pass the screening criteria are equally reliable in the long run. 

The greater the number of iterations in the sample size, then the greater your chance of achieving the average expected return a positive expectancy system. There is a natural tendency among traders to try to concentrate their capital on what they consider to be the best trade available. If your system is generating multiple signals though then you are better off taking all of the signals at reduced risk, provided that you have done your back testing work and admin costs of trading as low.

Profitable ETF Trading Strategies: understanding the stealth trade


Behavioral psychologists have pointed out that people do not act like rational actors when it comes to investing and trading in the stock market. In addition to fundamental factors like the business cycle, there appear to be psychological motivations at play that help to explain market performance and price fluctuation.

A short term or intermediate-term trader can take advantage of the power of human psychology to improve their trading practice with respect to timing market entry and exits.

One strategy that can be very useful is the idea of the stealth trade.

The stealth trade occurs when a market sector that is represented by an ETF for example, is in a position where it is no longer the worst performer in the market but has not yet rebounded strongly enough to be considered as a new headline story.

Newspapers, magazines and television shows that cater to traders make their money with exciting news stories and headlines. Headlines sell advertising, so there’s always a hunt for the newest and most interesting story.

Consider what might happen to a sector such as semiconductors that is beginning to outperform all other market segments dramatically. The headlines will talk about semiconductors as the way of the future and momentum money will chase this sector until there’s nobody left to buy. Semiconductors will then be at an intermediate high and then begin to lose ground as people try to lock in profits or avoid further losses if they are the latecomers to the party.

Once semiconductors have lost their shine and are beginning to descend back into the pack or lower, they are no longer news and no one is talking about the. They will probably continue to fall until they find something like a natural level where only value players are interested. There may be some headlines concerning semiconductors if they achieve bottom rung status by being the worst performing sector available. That is news  and they will be back in the headlines.

Now suppose that they have started to attract value investors. Because of their buying pressure, the panic selling will be clearly over. There’s nothing exciting about semiconductors anymore as they start putting in a bottom. Institutional money is probably quietly buying at these price levels in such a way as to avoid attention. Only after semiconductors have started to move back into the pack will you start to see headlines about the rebirth of semiconductors.

The trading psychology cycle will begin once more. Institutional money which acquired semiconductors at a value price is now unloading those positions in measured amounts to momentum money that is chasing the sector once more.

The stealth strategy then is simply trying to find the sectors that used to be the worst performers which are now not quite so bad but before they have become headline news one. Still traders are acting like institutional money, taking the other side of the trade from the masses.

This is an attractive way to use ETFs since you are able to offset or avoid individual company risk while playing the larger macro economic trends.

The difficult part of the stealth strategy is in selling a position that is now finally beginning to catch fire and you should be selling to momentum money. The temptation is always to overstate your wealth of insight that sector but this is a nice problem to have.