International Institute of Trading Mastery, Inc March 17, 2004 — Issue #161

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In this Issue:

Feature Article 

Analyzing and Improving Your Trading Performance: Part 1

Listening In

Position Sizing on Swing Trading and What is a R- Multiple?

Trading Tips

Looking at Your Analysis Style.
Don’t Step on Your Head, Part Four, by D. R. Barton, Jr.

Course 2

Creative ways to create positive cash flow. Course dates May 14-16, Raleigh NC

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Feature Article :

Analyzing And Improving Your Trading Performance: Part 1.

By Chris Anderson, Ph.D

This is the first article of a two part series that explores how we can improve our trading results by carefully observing the previous trading performance of a trader, a trading system, or a trading newsletter. This first article addresses how to use those results and then predict the range of possible future outcomes.  Next week, I address how to use these analytical results to set position sizing so that a balance can be maintained between the risk that we are comfortable with and the rewards that we hope to achieve.

Suppose we take a string of trades that have been profitable.  These trades may originate from actual transactions, or were simulated using backtesting software, or were generated by paper trading without risking actual money.  In addition, these trades may have originated from a discretionary approach, or an approach that follows precise entry and exit rules, or a middle ground between the two.  Furthermore, these trades may have originated from recommendations from a newsletter, stock advisory service, your neighbor, or your own results.  When observing a string of historical trades, regardless of their origin or their style, each trader will end up with two basic questions:

Do I trade this approach since it made money in the past? And,

How do I incorporate this approach into my trading business?

To further entice you, suppose that the previous data shows that you would have made $12,000, on a $50,000 account, in only 12 months.  Is that a good return?  Of course you would take that return if somebody guaranteed those results but the markets do not operate in that manner.  Thus saying I will make another $12,000 in the coming 12 months, if I just do the same thing, is a bit of a stretch.  As an alternative, many trading professionals ask the question if the system performs the same statistically in the future, can I accept the wide array of outcomes that are possible?  Suppose we analyze the trading system above and determine the following:

You have a 20% chance of getting 8 losses in a row;

Your equity curve could realistically be lower than your starting equity 18 months after you start;

The drawdowns in a year may get to 20 times the amount you risk (20R) per trade;

Your gains in a year are expected to be around 40 times the amount you risk (40R);

Would you trade this profitable system?  If we did a survey, some would say yes while others would say no.  We can conclude two things from that answer:  1) Traders goals and risk tolerances dramatically affect what should and should not be traded and 2) If we know a little more about the range of possible future outcomes, we can make educated decisions about our trading.

How do we know what to expect as possible outcomes for the future?  If you have reason to believe that future results might be similar to past results, we could use the historical data and ask what happens if I get the same outcomes statistically.  To accomplish this, you would take your trade results, convert them to a representative marble bag of trades (R multiple distribution), and then pick marbles at random to simulate future trading results.  Suppose you wanted to know the range of outcomes on the next 50 trades.  You would start picking marbles at random and record the win or loss amount, relative to the amount you risked, until you picked 50 marbles.  Then you could pick another 50 marbles to simulate another potential different outcome.  If you played this marble game about 10,000 times, then you would see a wide range of outcomes and this could give you a good feel for the range of expected outcomes.  Anybody that has been in one of Dr. Van Tharp’s marble game demonstrations on position sizing knows that you may not like all the outcomes.  However, in trading, ignorance is not bliss and we MUST know in advance what might happen even if the trading performs SIMILARLY to previous results.  This whole area falls under the topic of Monte Carlo simulation and is used by financial professions to understand what could happen.  Many professionals develop or buy software to help them with this understanding but for many individual traders, this is beyond their scope.  Since Van believes that it is critical to match your trading system with your goals and objectives, IITM will introduce a new Comprehensive Trading Analysis & Risk Report service next week that provides this analysis and then coaches you through the many resulting implications and position sizing issues.

So how would you perform this analysis starting with a list of profitable trading results? 

Ideally, if you knew the amount risked on each trade, then your R multiples are produced by dividing your trade profit/loss by the initial risk amount.  If you did this in a spreadsheet, you would have a column of R multiple results.  If you don’t know the original risk amount, you could take all your losing trades and find the average loss as an approximation.  Let’s consider a string of 10 trades (much too small normally but for example purposes) that had:

                 -1R losers

                 –3R loser

                 2R winners

                 6R winner

The total for these 10 trades (5+1+3+1) is positive 4R and thus our expectancy so far is 0.4.  In addition, suppose this system trades once per month.  Would you trade this system if you believed that future performance would be similar?  We found that typical drawdowns for this system might be –12R, you could expect about 7 losses in a row at some point over the next 5 years, you may be in drawdowns lasting 5 years or longer, and the average yearly gain, relative to a large drawdown was about 0.4.  Again would you trade this profitable system? 

So what does this mean to you as a trader?  First, you need to understand what you want from your trading results and you need to understand the negatives that you are willing to endure to achieve them.  Next, you must have a method to take your, or someone else’s (like a newsletter’s) results (paper or actual) and determine if it is likely to fit your future requirements. 

Next week, I will continue this discussion by using these types of quantitative results to determine 1) how we should set position sizing once we chose to trade, 2) how we might start trading a system conservatively and then scale up with market winnings, and 3) what happens if the system quits working and how will we know?

About the Author: 
Chris Anderson, Ph.D
President/Founder 99% Trading Corporation

Chris Anderson has been trading since 1986 where he first got involved with purchasing options on impending acquisitions and leveraged buyouts.  Since that time, his trading has transitioned to using a portfolio of automated systems that handle all aspects of his day or swing trading positions.   Dr. Anderson has also founded 99% Trading Corporation upon the principle that computer testing and analysis can significantly improve the performance of many investors and traders.  He has applied a unique background in engineering, statistics, computer software, and trading to develop the Know Your SystemTM software system to give traders a unique approach to improving their performance.  

Listening in....

Excerpts from Dr. Tharp's Discussion Forum

 

Position Sizing on Swing Trading 
Author: Chris F
Date: 03-11-04 20:49

Hi
I am in the process of developing a swing trading system, and I would like to see if the group has any ideas about how best to do position sizing. It doesn't seem like I would be in most trades long enough to scale in like the longer time frame systems (ie turtles) do. Any thoughts would be greatly appreciated.

Best regards,
Chris F

Reply To This Message 

Re: Position Sizing on Swing Trading 
Author: Chris Anderson 
Date: 03-12-04 08:11

Hi Chris:

You have asked a questions that is unfortunately difficult to answer without knowing more about your goals, risk tolerance, and performance of the system. So I will answer with a "rule-of-thumb" and then with my actual answer:

Answer 1-Rule-of-thumb: 
Risk no more than 1% of your equity on any given trade. Example. If your account is 30K, risk $300 per trade if experienced. If you enter a trade that has a stop that is $3 away from your entry price for example, you would purchase/short $300/$3 = 100 shares. If new to trading, I suggest you risk no more than 0.5% (or less) until you prove that you can be profitable.

Answer 2 - Real Answer:
Position sizing depends on 1) goals for gains, 2) risk tolerance, 3) historical performance of your system (backtest/paper trade). For new traders, they should set position sizing so that it is VERY unlikely to ever get a 10% drawdown if system is working and then scale up from there. In [my two part article in Tharp's Thoughts Weekly]  I will describe how to do this over the next couple of weeks. 

I hope this helps for now. 
Chris Anderson

-----------

What is a R-multiple 
Author: John A
Date: 03-11-04 04:51

What is a R-multiple? How do I determine my position sizing per trade, is there a math formula?.

-I have $7000 in my trading account-- how should I position size .

Reply To This Message 

Re: what is a R-multiple 
Author: Kevin T
Date: 03-11-04 14:53

John,

R is simply the reward/risk for any given trade, or set of trades. One good rule of thumb is for a trade, risk no more than 1% of account value. In your case, you would risk $70 per trade (you need to include broker commissions in this). 

Example, you buy stock ABCD at $20.00 with a $1.00 stop. Since you are risking $70/trade (I will assume $5 per trade, for a $10 round trip), you can buy 60 shares. This is 60 times $1.00 risked, plus the $10 for both the buy and sell costs.

You're buying $1200 worth of stock, risking $70.

If you make a total profit of $5.00 per share, your R is 5. R for a series of trades is the total R divided by number of trades.

Kevin

Reply To This Message 

Re: what is a R-multiple 
Author: Van Tharp
Date: 03-14-04 16:32

I'll say it a little more simply.

R is what you risk in a trade.

The R-multiple is your profit or loss as a ratio (multiple) of the original risk.

Van

Read the full, unedited thread  by Activate linking here. Van K. Tharp and traders, investors and wealth builders around the world connect on this site, share ideas and learn from each other. Search specific topics 

Trading Tips:

Peak Performance Trading Tips

Tip# 110

Don't Step on Your Head - Part 4
Looking at Your Analysis Style

by D. R. Barton, Jr.
 

“Enough is too little; more is better; and too much is just right.”

                                                                        --infamous shade tree mechanic

We’ve been talking about stepping on your head.  That’s just another way to describe the act of letting our thought process get in the way of good common sense.  Last week I posed some questions and asked that we all look at a set of charts that represents stocks (in this case, the S&P 500 Index) and a set that represents Gold.  After looking at these charts, we wanted to ask ourselves a few questions.  For a list of those questions, please check out last weeks tip  here.

What I was trying to do with that list of questions was to have each of us get into analysis mode.  If you did the exercises, then hopefully you can gain a little insight into how you think and analyze.  But before we start, here are a couple of things to watch for.  If you didn’t look at the S&P and Gold charts last week and are looking at them for the first time now, realize that it’s very easy to rationalize past price action.  Anyone can come up with several plausible reasons to explain market activity that has already occurred.  We have a much different mindset when explaining the past than we do when asked to develop a plan of action for the future!  If you actually did the exercise last week, but didn’t write down your answers, pay attention to the allure of hedging whatever verbal or mental answers you gave last week.  Be true to your original thoughts and don’t let that natural bravado creep in and fudge your answers.

Now let’s take a look at what happened.  In summary, the S&P 500 index continued to sell off Wednesday and Thursday of last week (3/11 3/12) and then had a minor retracement on Friday after four straight down days.  But based on the Tuesday’s (3/9) close, what did YOU anticipate?  Did you see the market turning around and retesting the highs?  Did you think that the market would be flat or have a big drop?  More importantly, what was the thought process that you used to arrive at those conclusions?  I asked you to look at daily chart each day, and at charts that had bars on a 30-minute time frame.  Here are some questions to consider:

·        Did looking at two different time frames help clarify or add confidence to your market bias?

·        Did looking at the second time frame muddy the picture for you or seem to add contradictory information?

This, I think, is an important point  to ponder.  If you liked looking at the second time frame, would a third time frame help?  How about a fourth or a fifth?  At what point will you have too many time frames?  I had a friend who was a very accomplished “shade tree mechanic.”  One day when adding some liquid gasket to an engine part, he uttered this timeless piece of philosophy, “Enough is too little; more is better; and too much is just right.”  While that wisdom is occasionally useful in repairing valve cover gaskets, it rarely works in market analysis.  If you found yourself gaining clarity from looking at a chart in a different timeframe, that’s good; many have found this technique useful.  For example, both Alexander Elder in Trading for a Living and Cynthia Kase in Trading with the Odds espouse multiple time frame analysis.  However, when applying multiple time frames, be careful that you don’t step on your head!  Don’t use this tool for every phase of your analysis.  For example, if you require that an indicator line up in three time frames in order to get you into a trade (a common practice), don’t force the same thing for the exit or you may be setting extremely wide stops or giving back all profits before getting out.

Let’s now look at the last questions I asked you to ponder last week.  What is missing from your charts?  What would help you predict future market direction better?  I asked these questions because it is often insightful to see what things we’re wishing for.  “If I only had this indicator or that magical relationship spelled out” is the refrain that I often here from someone who is already standing firmly on their own head…  Take a look at the trading chart setup that you like to use most often on your computer.  Does it have enough “bling-bling” to make a hip-hopster blush?  Said another way, does your chart have so many indicators and crisscrossing lines that you have a tough time finding the price bars?  It’s common to use too many indicators to try to describe the technical picture.  However, folks that are drawn to an abundance of indicators can easily be paralyzed by conflicting or non-confirming signals.  If you find that you need more than a few indicators, make sure that you have a straightforward algorithm for resolving conflicts between them.  A simple set of rules might help you understand what your indicators are telling you and therefore assist you in making clearer and more useful decisions.

Next week, we’ll look at the other end of the complexity scale and explore the pitfalls of over-simplification.

About the author, D.R. Barton, Jr.

R-e-m-o-v-e me

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