Trading System #2–Consecutive Directional Close (Part 1)

The next strategy I wish to develop is based on Rule 2 in Larry Connors’ 2009 book Short Term Trading Strategies That Work.

For lack of a better name, I am calling this the “Consecutive Directional Close Trading System.”  If you come up with something more catchy then please pass it along.

Connors’ claim is as follows:

> From 1995-2007, after the SPX has dropped three days in a row, it has risen more
> than 4 times its average weekly gain over the next five trading days.
>
> And, after the SPX has risen three days in a row, it has on average lost money over
> the next five trading days.

Two system variables jump out at me immediately.  The first variable to test is number of consecutive closes in the same direction (e.g. up or down).  The second variable to test is number of days to hold the trade.  In thinking back to the SPY VIX trading system, I will test {3, 4, 5, 6, 7} for both variables.  This will give me 25 sets of results to study.

SPY is one of many tickers I can imagine using to test this system.  I could also test other broad-based US indices like QQQ and IWM.  I could also test international ETFs and other asset classes.  I could also test SPX-inclusive stocks in order to generate a more complete distribution of trades.

In my next post, I will start testing this system on SPY.

Drive the Monte Carlo to Consistent Trading Profits

With backtested trade results in hand for the SPY VIX system, Monte Carlo simulation can help me determine how much capital I can safely trade with the system.

Some approaches to position sizing are based on maximum drawdown (MDD).  In Day Trading Futures Online (2000), Larry Williams suggests dividing account balance by margin per contract plus (1.5 x MDD) to determine number of contracts.

Monte Carlo simulation is a technique that can offer more statistical clarity about potential results.   Rather than simply assuming the worst future DD to be 50% worse than the backtested MDD, Monte Carlo simulation uses multiple trials and randomization to determine probabilities.

Historically, Monte Carlo simulation was first used by scientists working on the atom bomb.  The technique was named for the Monaco resort town renowned for its casinos where games of chance rule the day and has been used in many fields including engineering, insurance, the environment, and finance.

In trading system development, Monte Carlo simulation generates equity curves by randomizing the order of backtested trades thousands of times (or more).  The sample distribution of system statistics can then be studied.   By using the MDD seen in any randomly shuffled backtest rather than just one specific ordering of historical data, I can quantify my confidence level about future system statistics such as MDD.

Monte Carlo simulation suggests the ordering of outcomes in the past is just one possible history out of an infinite number of equally possible histories.  Position sizing based on the average(s) or extreme would serve me best.  Out of 10 trades with win loss sequence W-L-W-L-W-W-W-L-W-W, I could have seen W-W-L-L-L-W-W-W-W-W in which case the DD would have been much worse.  Monte Carlo analysis will tell me the probability of this taking place.

Maximum Adverse Excursion

I’ve reached the point with the SPY VIX trading system where I need to analyze maximum adverse excursion (MAE).

MAE is a technique published by John Sweeney in 1997 (John Wiley & Sons, Inc.) that measures the farthest a trade ever goes against you. For long (short) trades, this is calculated with the difference between entry price and the lowest low (highest high) price ever seen during the life of the trade.

MAE is very important from a risk management perspective to help determine potential benefit of a protective stop.  A scatter plot of maximum drawdown (MDD) for each backtested trade by final trade profit/loss should be studied.  If there is an MDD level beyond which few trades ever end up profitable then it may be useful to keep a protective stop at that level.  This may lessen some extreme losers while preserving most of the winners.

The difference between MAE and MDD is that MAE pertains to each individual trade whereas MDD may pertain to an individual trade or a series of trades made by a system.

From a risk management perspective, MAE and MDD both address trader tolerance.  Both measure “the farthest X ever goes against you.”  Consider the broad stock market as an example.  Over the last several decades, the broad market has returned roughly 6% per year.  Every now and then, the market crashes and loses 40-60% (or more!) of its value. The MDD is essential to understand because that moment of worst loss is when I will be a nervous wreck, unable to sleep at night, or contemplating a jump out of the nearest 10-story window.  If I can’t tolerate the MDD (or MAE) then at best, I won’t be able to reap the benefits of a profitable trade[ing system].  At worst, I may end up suffering catastrophic loss.

In my next post, I will begin to analyze MAE for the SPY VIX trading system.

Highlights of System Development

Today I want to review a couple major points that have been covered in my last two blog posts.

Trading represents a dream because I am able to work for myself from the comfort of my own home on my own schedule.  As hard as it is in this economy to get any job, to get a gig like this will demand out of me something the vast majority of others are not putting forth.  This just makes sense because otherwise, everyone would be doing it!  For starters, I must be willing to put in extensive legwork at every turn whether or not it ends up being required.

Trading as a business can never coexist with laziness.

The trading landscape for independents is like a hot desert littered with mirage.  I am constantly bombarded with alluring returns and trading strategies that sound good.  Greed pushes me to gamble with speculative trades on a whim.  Wishful thinking accelerates the process.  Other cognitive heuristics also combine to stack the deck against me.

System development must be extremely thorough to flush out any oversights that may lead to false profit expectations.  One could say the whole point of system development is to highlight the arbitrary and determine it to be lucky or good:  discard the former and implement the latter.

This was the idea behind realizing the need to backtest 3-, 4-, 6-, and 7-day trades before moving forward with a 5-day SPY VIX trading system.  Failure to perform these additional steps could leave me unknowingly chasing an illusion.  When lucky, traders will eventually find out by losing precious capital and often going bust.  When good, traders are able to stay in the game.

All trading recommendations, whether technical strategies or stock screens, are due only one response:  backtesting within the confines of a complete system development process to assess how likely they are to perform in the future.  This is a labor-intensive process where many false leads and dead ends potentially await.

Laziness Dissected

Back in Part 1, I described the SPY VIX trading system as having three variables.  The system trades when VIX is y% extended from its z-SMA with an x-bar stop.

Full disclosure:  I don’t want to consider the x-bar stop as a system variable.  So the trade lasts five days.  That seems routine and unlike a technical indicator I employ where I set the critical value to be tested.  Why bother checking x for validity? Besides, I have already entertained y-values from 5 to 25 (five total) and z-values from 6 to 15 (10 total).  Allowing x to vary from three to seven, for example, would increase the number of potential systems from 50 to 300.  Furthermore, keeping one variable constant would now leave two to vary.  This suggests employment of college Calculus rather than high school Algebra in order to study performance.

It doesn’t take much introspection to discover that this bellyaching is simply a matter of laziness.  At some level, most people tend toward laziness.  This may be the primary reason why most new traders fail in the first 1-5 years.  They think this is an undiscovered country where hard work doesn’t exist.  They are eager and willing to pay hundreds to thousands of dollars on trading books, investment webinars, or educational programs that promise consistent profits in 10 minutes per night or a couple hours per month.  They are fertile ground for scammers and con artists, alike.

I have written this before and I’ll write it again:  no free lunch is available in the world of trading and investment.  I’m up against institutions with billions of dollars at their disposal and highly-educated quant teams with thousands of advanced degrees between them all focused exclusively on gaining the slightest bit of Edge.  The easy way out is no longer a viable option.  Screw the ego-laden label of “busywork…” when it comes to labor-intensive, painstaking tasks, I need to shut my eyes, puff out my chest, and rush headlong into the pile so I can get the job done.

The x-bar stop:  in focus with my next post.