Ebb and Flow II (Success Series)

BarroMetrics Views: Ebb and Flow II

This last post in this series. I have decided to produce an e-book based on the series. I will be updating the entries by adding some info and expanding some sections.

Turning to today’s blog…..

The question I posed in the previous blog in the series was: “How do we tell when we are in Ebb or Flow phase?”

There are two answers to the question, a quantitative one and a qualitative one. The quantitative one is based upon a frequency distribution in Excel of our profits and losses.

For example, Figure 1 shows my frequency distribution for the years 2006 – 2014. (Note that because my patterns of losses and profits changed in 2015, I have had to create a new frequency distribution.). A word of explanation:

  1. The numbers with a yellow shading are profits and losses within the first standard deviation i.e. these are normal returns.
  2. The numbers with a green shading are numbers within the second standard deviation, i.e. these are moderately larger than normal losses or profits.
  3. The numbers with a white shading are numbers representing extreme profits and losses.

My quantitative test for Ebb“Three consecutive losses that were greater than 2.01 but less than 5.48.” Whenever this used to occur, I would immediately reduce position size and implement my other Ebb protective measures. My quantitative test for Flow“Three consecutive profitable trades that are greater than 3.65%.”

You will note, that my test for Ebb will reduce position size more quickly than I’d increase position size when in Flow.  Also, note that once in Flow stage, I increase my position size to a maximum of 2.5 of normal.

You will recall from Ebb and Flow I that I have another rule which says that if I lose 7% or more, I shall immediately reduce position size. This rule is merely another measure to deal with the Ebb phase.

How do I determine the standard deviations in my frequency distribution?

From Figure 1, it’s clear that I do not use the normal mathematical formula. The reason I don’t is because the normal bell curve assumes that the average and the mode will be one and the same. In fact, most trading results have a skew. Consequently, a better way of assessing the standard deviations….

Use Pete Steidlmayer’s method for calculating the value area (see How is the Value Area Calculated…) (use method B).

That’s the quantitative way. Nowadays, I tend to rely more on my gut (i.e. the qualitative approach). It’s not hard for me to tell when I’ve entered into Ebb. Just about everything I do will be wrong:

  • I’ll choose the wrong pairs.
  • I’ll enter at the wrong zones.
  • If I go long, the market will drop.
  • If I go short, the market will rise.

To cope with Ebb, 2015 saw a change in strategy. Nowadays, whenever I believe I am in Ebb, the dominant strategy is to exit my positions as soon as they fail to behave in an optimal manner. The change in strategy has been successful.

For example, since mid-February 2016, I have had eight trades. Of these, one attained my core profit target, one was a scratch trade, and six were losing trades.

Despite the poor win-loss ratio, my results are positive to the tune of around 1.6%. I have achieved this result because the six losses amounted to -0.26% whereas the one profitable trade produced a result of 1.89%. Pre-2015, the six trades would have produced a loss of around 10 to 12%.

So you can say that the new strategy has been successful in reducing losses. It has reduced drawdown, and has successfully increased the positive expectancy return – the aim of the Ebb and Flow concept.

——————————————-

 

Chris from Australia was kind enough to produce an Excel sheet for determining the consecutive theoretical number of losses and positive expectancy for blog readers. I attach his sheet.


I trust you have enjoyed reading the series as much as I enjoyed writing it.

4-25-2016 08-17-32 Frequency Distribution

FIGURE 1 Frequency Distribution

2016-04-25 Estimating consecutive losses and Expectancy

Attachment Excel Spreadsheet

Ebb and Flow (Success Series)

BarroMetrics Views: Ebb and Flow 

First off, John Gault sent me a question: “Why are you not adding the profit immediately to your capital”. I’ll answer this question later in the week.

Turning to Ebb and Flow, the last posts in the Success Series.

I subscribe to the view that there is order in the market over the long term, but that it is random on a trade-by-trade basis. As a result, there will be times when we, as traders, can do no wrong – we go short, and the market declines; we go long, and the marker moves up. We feel on top of the world; we’re God’s gift to the trading world. These times I call  Flow.

And as is the wont in trading, the reverse also happens: the times when all we do is ‘wrong’. If we go short, the market moves up. If we stop out, the market then reverses and moves, in what would have been, our favour; if we add to losing positions, the market continues against us. The result is a humongous loss.  I call this the Ebb Stage.

Ebb and Flow are the outlier zones. Like Black Swans, they occur more frequently than the stats suggest they should. For the trader, both states are dangerous to their wealth.

Flow engenders hubris and we throw caution to the winds – position sizing too large for our capital, no exit strategies in case the trade heads South, entries on a whim, etc.

Ebb engenders unhappiness, perhaps attacks on our self-esteem, anger, etc.

And there is a third state, what I call ‘Normal’ – the ‘win-some, loss-some’ zone where the trading results are line with the stats.

How do we protect ourselves against Ebb and Flow? A better question is how to we take advantage of Ebb and Flow.  The tools I use are stats and awareness.

Let’s first take stats first.

I have what I call a normal size position. In an Ebb state, I reduce my normal size to 50% and then 25%. I also look to cut my positions much earlier. The last is a relatively new idea. It came about because, at Sydney presentation, an attendee asked:

“Can’t we just exit earlier?”.

Of course we can! We don’t because we’re afraid that if we exit, the market will move in our favour. So, the next question is: what stops us from re-entering? Answer, nothing except the fear of loss.

I adopted this strategy in March 2015, and I have to say I am impressed.

In the past, an Ebb stage would cost me 8% (+/- 3.23%). In the past 12-months, my largest losing month has been 3%. Most Ebb months showed marginal results i.e. where the losses and profits are so small, I consider the trade breakeven.

In Flow stage, I increase size (maximum of 2.5 x normal) and give the initial exit more latitude. The leads to maximising my returns.

My Equity Journal gives me the Expectancy Returns for both my trade

results (i.e. accepting the results with for size as traded) and on a 1-contract basis. (for FX 1-contract is user-defined). By comparing the two, I know if my position sizing is producing optimal results.

I know what you are thinking….how do I decide that I am in Ebb or Flow? I’ll answer that question next week

When Is A Profit, A Profit? 2 (Success Series)

BarroMetrics Views: When Is A Profit, A Profit? 2 (Success Series)

In the last issue, I considered the question: when do we add profits to capital? When do we deduct losses from capital? I introduced Ryan Jones’ approach.

(An aside.

Speaking of Ryan Jones, he has a sale on for his course starting Tuesday, April 19 and running for two days: see Fixed Ratio on Tuesday.

His course is normally USD 797.00; on the sale, his price will be, USD 197.00. And ‘no’ to those who will ask, “I am not receiving a fee for referring the course’. In fact, Ryan does not even know I have mentioned the saving).

Turning back to my subject……

Ryan’s approach does not suit me. I prefer to use another method – not better, just one with which I am more comfortable. My take requires we know:

  1. Number of historical consecutive losses
  2. Avg consecutive losses
  3. Loss Rate
  4. Population Size
  5. Avg pa return on capital (Avg ROI)

Let’s take my trading. Taking my trading results since 1990 (when I began the private limited partnership fund), we have the following results:

  • Historical consecutive losses: 16
  • Avg Consecutive losses: 4
  • Loss Rate: .485
  • Population size: 2210 (i.e. number of trades over the period, about 7 trades per month)
  • Avg pa return on capital:  27.63%

Firstly, the data allows me to calculate the theoretical consecutive loss: 10.64 (say 11). So, I would not consider the consecutive loss sequence of 16 as an outlier. (If I did, I would need to reassess the data. For example does the data show a period of extraordinary losses?) With a run of 16 losses, if I risk 2% per trade, I’d risk a loss of 32%. Since my average profit is only 27.63%, I am not prepared to run that risk.

What if I risked 1%? My possible loss would be 16%. Still a little high – I am aiming for a risk of around 50% of average ROI (14%). So, I’d bring down the risk per trade to around 0.90% which I find an acceptable risk; I treat the 0.9% as my ‘normal’ size.

Secondly, when to add to capital? I’d add on any increase above 50% of average ROI = 14%. And finally, when to subtract losses from capital? I’d subtract losses whenever I’d lose 50% of the increased value (i.e. 50% of 14 = 7%).

So far we have determined what I would consider ‘normal size.’ I have one more step to determine my position size for the current trade: I have to decide whether my trading is currently in Ebb, Flow or Normal State. 

More on this tomorrow.

 

When Is A Profit, A Profit? (Success Series)

BarroMetrics Views:  When Is A Profit, A Profit?

Actually, what I am asking is: when do we add profits to our capital, and when do we deduct losses?

The question is not an academic one as the Excel attachment shows.  Click the link below to download the video for an explanation of the spreadsheet.

https://dl.dropboxusercontent.com/u/10422981/2016-04-14%20Excel%20Blog.wmv

(Link  to Excel: https://dl.dropboxusercontent.com/u/10422981/2016-04-14%20Profit%20and%20Loss%20Sequence.xlsx)

When using the ‘% of capital’ approach, it’s important to appreciate this:

“If encounter an ebb phase at peak equity we’ll suffer our largest loss. And, if we encounter a flow phase at equity trough, our profits will be the smallest.”

To seek to even out the fluctuations, I use a dictum of Don Scott.

Now, if you aren’t Aussie, and over 40 years old, you aren’t  likely to know of him. So, I have attached a short bio.

But, if you lived in that era, you’ll remember how much of a splash Don made in the punting (betting on horses) world. He placed the endeavour on a rigorous approach. Part of this approach revolved around money management. He took the view that, if yesterday’s bet for a 33% selection was $X, then today, the bet size for a 33% choice, should be the same.

While Don’s logic is inescapable,  it doesn’t quite fit my number one guideline, ‘preservation of capital’.  The issue was this:

  • I wanted to keep the dollar risk the same when I experienced the ‘normal’ loss, and 
  • I wanted to reduce the dollar risk in drawdown mode (ebb phase). 

The question was how to do this?

Ryan Jones suggested an approach, Fixed Ratio Money Management (see PDF). Unfortunately, for me, the approach did not suit me. So, I had to find my own path. What it is, we’ll look at the next blog.

don-scott-bio.pdf

fixed-ratio-money-management.pdf

Left Brain Thinking IV

BarroMetrics Views: Left Brain Thinking IV

Shame on me. For Left Brain III, I got lazy, did a minimum blog, and assumed all would be able to follow my line of thought. Thank goodness for readers like Sorin and Paul – they keep me focused.

For context to this piece, I’ll leave it to you to read Left Brain Thinking and Left Brain  Thinking II. Here, I’ll provide a detailed outline to my thinking.

To understand the approach, you need to bear in mind the functions of  my Rule of 3:

  1. The first third exit covers the loss on the remaining two-thirds. It’s function is purely defensive. If your approach is similar to mine, after entry, the trade tends to move in my favour even if subsequently stopped out. The first third seeks to make use of this pattern.
  2. The second third exit is the core profit. If I am to make money, it will be on the exit of this third.
  3. The last third, a friend once called, the ‘Blue Sky’ contract. It seeks to capture those moves that are greater than I expect. Often these moves fail to provide a location for safe entry; so, holding the last third removes much of the pressure.

OK, lets’ turn to the series…..

The point I was seeking to make was to illustrate the flaw so prevalent the plans of retail traders  (at least among those whom I have coached): they treat their profit target on an all or nothing basis i.e stop out or profit with nothing in between.

This is a fatal flaw – whether you are a discretionary rule-based trader or mechanical trader. If the latter, the omission is a trailing stop rule once the instrument moves into the Expectancy Ratio Profit Zone.

Here I am addressing the discussion Paul and I had. I agree that rule-based traders need to follow their rules; but that does not mean they cannot amend their rules should they see a weakness that needs correction – failing to have a trailing stop in this context would be such a weakness.

I use the Expectancy Ratio profit zone  to answer the question: when is there enough profit in a trade to say that we need to protect it: if we take too early, we are failing to let our profits run; if we take too late, we are guilty of allowing a profit turn to a loss or too small a profit.

In Left Brain  Thinking II, I referred you to an explanation on the calculation and use of the The Expectancy Ratio. I’ll leave it to you to read the piece before turning to the track records of Traders A &B (Figure 1).

Starting from C1:

  • Col C is the current low of the move.
  • Col D is the entry
  • Col E is the initial stop
  • Col F is the stop range (entry – stop)
  • Col G is the 2x stop range for the 1st third (not needed in this example).
  • Col H is the 1st third exit price  (not needed in this example).
  • Col I is the trader defined 2nd third profit target exit price.
  • Col J is the profit range.
  • Col L is the R:R (profit range/stop range)
  • Col M is the R:R required by the ExpRatio. We’ll be using this in our assessment of the ‘moat’ for the second third.
  • Col N is the ‘moat’ i.e. the number of points from the low that trader has before having to take profits  i.e. Trader B has a ‘moat 69’ points from 0.8034, i.e. at .8103, Trader B must take profits or risk losing money long-term even if he exits at a profitable price BUT above .8103.
  • Col O is the calculation of the price, in this case, .8103.
  • Col R win rate
  • Col S loss rate
  • Col T Avg $ win and
  • Col U Avg $ loss.
  • Col ExpReturn  (not needed in this example)
  • Col X ExpRatio: Notice that both Trader A & B have the same ratio by adjusting the R:R to allow for Trader’s A better win rate.

What Figure 1 tells us is allowing for the win rate and avg $win and avg $loss, both Traders have a 20% edge. Note that for the example, the winrate:lossrate is taken from the Traders’ own statistics.

With that in mind, let’s apply the ExpRatio.

We know that:

  • the trade’s R:R is 2.15:1.
  • we know that Trader B’s MUST have Reward:Risk is 2:1.
  • Subtracting (trade’s R:R) 2.15 – 2:00 (Must Have R:R)= .15 (Moat).

By multiplying the moat to the profit range and adding it to the low of the move, we have the maximum allowable retracement to stay with the R:R of 2:1.

Sorin asked why a R:R 2:1?

For the purposes of the example I have assumed that both traders want a 0.20% edge. After that I just adjusted the Col V inputs until I had the 0.20% edge. I am sure that there is a maths formula that covers the calculation. But, since I don’t know it, I used the trial and error method.

Turning now to Andrea Unger. In reply to Paul’s insight that Andrea does not use stops….I made the comment that other well-known traders. So?

My point is there has to be some quantification of what is ‘near’ enough to our price targets. Once that is defined, we can then create strategies to ensure we take second third profits close to that required by the Expectancy Ratio.

Final comments……

…For those who have done my courses, I remind you that the Rule of 3 is best applied to end-of-day trading. It is less useful when day trading. For day-trading, you are better off using expected range of the day….but that is another story.

…..Finally I posted today  because on Monday I want to talk about the S&P.

expratio.jpg

FIGURE 1

Left Brain Thinking III

BarroMetrics Views: Left Brain Thinking III

Yesterday I said that Trader B had to exit immediately. Why?

Figure 1 shows that, given his win rate, his required reward:risk return (2:1) is secured at 0.8103; in our example this was where the AUDUSD was trading. So, he had no safety moat; and with the AUDUSD now trading at long-term support, a bounce has to be included in the possible scenarios – especially with the view I have taken on the FOMC (see blog later tonight around 8:00 PM HK time).

For risk management reasons, then, Trader B needs to exit now.

Trader A on the other hand, given his win rate, can afford  a bounce of 520 pips. That being the case, Trader A can review his technicals to see where he can place his trailing stop in an attempt to maximise his core profit exit. As long as the trailing stop is below .8555, he will secure his targeted outcome, even if a bounce occurs.

So there you have it. Feel to comment.

expratio.png

FIGURE 1

Federer & Wawrinka II

BarroMetrics Views: Federer & Wawrinka II

Opps – I was wrong! Feels like a trade.

Federer  beat Wawrinka in four sets. I knew I was ‘in trouble’ at the end of the first set: Wawrinka was clearly running out of steam. His visit to the doctor at the end of the second, confirmed what I had been thinking. If this had been a trade, I’d have taken an early exit……

Where did I go wrong?

I failed to give due weight to the fact that this was Wawrinka’s third consecutive match in three days whereas Federer had had a day’s rest. The fatigue factor was clearly a telling factor. That is not to say that Federer would not still have won. Let’s see next time.

Despite the result, there is a clear difference on the approach we need to take to events like trading and events like this tennis match. And, knowing that difference is an essential insight into trading success. I promise to tell you the difference at the July 19 event; and if I forget, I am sure someone will be there to remind me 🙂

Federer & Wawrinka

BarroMetrics Views: Federer & Wawrinka

I am writing this ahead of the Federer-Wawrinka result. It’s important I  mention this for reasons that will be clear by the end of the blog. I publishing the blog now; so, your are getting tomorrow’s blog today!

I should also add that Federer is my sentimental pick. My Mom loved to watch him play and would never miss his matches on TV. For that reason, I’d love to see him win. But, I doubt it.

And, I say this even though Federer has an imposing record against Wawrinka:

  • 17-1 in Grand Slam events, and
  • 13-2 career record

So, you’d say that Federer has the edge, right?In that case, why do I say ………….

…….. I rate Wawrinka the better prospect?

I say that because of the nature of tennis. Those that understand the difference between the nature of tennis and the nature of trading, would probably see it the same way I do.

What is this difference?

Unfortunately, the difference is one of the major themes of my talk on July 19. So divulging now would be telling. But, I will promise to  complete this blog after July 19.

By the way, Federer is the bookies choice to win at 1-3, with Wawrinka at around 5-2. If I were a betting man, especially at those odds, I’d bet on Wawrinka.

Trailing Stops

BarroMetrics Views:  Trailing Stops

Baz wrote” ….if we take a trade based on high probabilities, how do we know if its a high probability to continue, at what point does the high probability diminish. Then at what point does it register in our brains to exit”.

The point is we need to paint clear pictures about what has to happen for us to exit a trade …. what I call a qualitative exit. My quantitative exit (initial stop)is not the same as my qualitative exit.

The stop is the price at which my trend analysis is incorrect or trade analysis is incorrect.   The qualitative analysis are the conditions under which I’ll exit a trade even if the stop is not hit.

Trailing stops tend to be quant exits, but need not be.

Where my quant stops are placed depend entirely on the structure of the market – because their location identify where my view of the market structure is incorrect.

An example of a qualitative stop: in a recent GBPAUD trade, I took the view that the 290-min chart was showing the Ray Wave 3rd of a 3rd pattern. This implied we would see a strong directional move. When instead of a prolonged move down, the directional move went mean impulse and started to stall, I exited on the first bar that suggested an upward move was beginning (see Figure 1) – because the market was not behaving in a way that was consistent with the reason I took the trade.

Figure 2 illustrates my approach to a quant trailing stop.

I was long gold going into the June high. (Note for long term charts I use CSI-data’s perpetual series – useless for entry and exit prices but excellent for long-term analysis).

The first warning that we may be seeing a high was the price action at D. The spike down was the greatest retracement since the Jan 28 low.  For me it marked the ‘preliminary point of support’; if this were true the next high and sell-off would mark the buying climax.

Using C, I then  calculated some price targets:

  • The 13-week swing (black lines) suggested that the high at C was in a zone that may terminate the upmove.
  • The 18-day swing (red lines) showed a 3-wave structure that suggested a termination at the 30 % to 33% increase. The C high was within the target zone.

At E, Gold provided an upthrust change in trend pattern. That was enough for me to exit the trade. At time of exit, the stops has been raised to below the low at D.

Hope this helps Baz

gbp-aud-290-min.png

FIGURE 1  GBPAUD

gc-18d-73h.png

FIGURE 2 Gold

Risk Management VIII

BarroMetrics Views: Risk Management VI

Turning to the last post in this series.

Paul’s second question:

2. Fund Managers advise clients to ?Buy and Hold?, with average-costing strategy.
This is investing/trading without stop-loss.
Does it work consistently?

That would depend on market conditions, and the lifetime of the investor has wouldn’t it? For example if I had bought the DJIA in Jan 1931 at 197, I would not have broken even till Oct 1945. Now at my age, that almost 20 year wait would have probably exceeded my lifetime. And this assumes, that the stock I bought had remained solvent.

On the other hand, if you had bought at  14,198 in Oct 2007, with the DJIA now at above 16,000 you would be sitting pretty.

Buy and hold is a viable strategy at the right time and in the right hands. According to me service we did see buy and hold funds post a negative return for 2012 and the first quarter of 2013.  And this brings me to the final question.

3. What should be the Money Management to trade without stop-loss?

By that I suppose you mean your position sizing.

The first point would be my admonition that ‘no stop loss’ does not mean ‘no predefined exit conditions’.  So, for me, I’d use the average loss for your predefined exit conditions, and vary that up or down depending on whether I was in Ebb or Flow stage.

Happy Easter everyone!