The Expectancy of a Trade & Your Trading Plan

The Expectancy Return formula identifies the key area on which we need to focus.

Most newbies focus on the win rate. But the win and loss rate are less under our control than the Avg$win and Avg$Loss. This post will explore the reasons for this.

No matter how good a trader we may be, we will experience drawdown periods – where everything we do is wrong. On the flip side, we have long-term losing traders with periods where all they do turns to gold. I believe the reason for the phenomena lies in the nature of free markets. I liken the market to waves within a limitless circle; and I liken our market knowledge and trading plans as a rectangle within the circle. As long as the waves wash into our rectangle, we enjoy success; the more our rectangle is filled, the more success we enjoy.

But when the waves recede from our rectangle, we experience drawdown periods. In this metaphor, we have little control over our win/loss rate; it depends entirely on whether or not the tide is in our rectangle. Sure we can increase the size of rectangle (i.e. increase our self and market knowledge); but since the circle is limitless, we can never know enough to prevent the drawdown periods.

On the other hand, the Avg$Win and Avg$Loss is totally within our control because they are dependent on our entry and exit. By focusing on expanding the difference between our Avg$Win and Avg$Loss, we create our profitability.

By the way, it’s easier to decrease the loss than to increase the profit. When I take a trade I ask a series of questions whose answers prepare an exit before my stop is hit. One of the questions I ask myself is: “What does the trade have to look like for me to remain in the trade?”. Another question is: “What does the trade have to look like for me to exit?”.

The attached JPG of my personal account shows the difference between a good trading month and a poor one. October was a poor month: my total Win Rate and Loss Rate were almost equal (+17 to -16); but the $Loss was 1.3:1 to 1.0 $Win; and as a result, I lost (3%) for the month. Now have a look at Feb 2006.

In Feb I made only $5000.00 more than October, but my losses were ($38,000) compared to October’s ($114,000.00). As a result, I made a whopping +6.9% ROI!

My results for 2006 to 2007 show we’ll make money if we focus on our entries and exits and thus increase the difference between our profits and losses. The alternative is to focus on improving our Win Rate and that is much harder to achieve.

Monthly Results 2006 - 2007

The Expectancy of a Trade

A most important formula for our trading is the Expectancy Formula. Its basic formulation is in dollars terms.

(Average Dollar Win/Win Rate) – (Average Dollar Loss/Loss Rate) = Expected Profit per Trade

Let’s say:

  • My AVG$win is $750.00
  • My Win rate is 48%
  • My Avg$ loss is $183
  • My Loss rate is 52%
  • My avg trades per year is 300

My expected $ profit would be:

$((750 x .48) – $(183 x .52)) x 300 =

$(360 – 95) x 300) = $79452

The interesting thing is when using the formula in this way I seldom came close to the actual profit. I looked into the problem and found that the reason lay with the mix of instruments. If the mix remained the same, then the formula would come close to the actual results; but most times, my mix altered and when that happened, the results skewed.

It’s not hard to see why: a $300 profit in Oats is not the same as a $300 profit in the EUUS given the different volatilty of the two instruments.

I knew that if I wanted to take the formula to the next level, I had to find a way of normalizing the results across instruments. I chose to normalize the results by reference to the open on a one contract basis:

(close price of the trade – open price of the trade)/close price of the trade = % of open price of the trade

Thus I am now able to compare apples with apples. By doing it this way, I am able to anticipate more accurately the return per trade.

The ‘Rat Brain’ and Trading Success

Today I’m addressing Winning Psychology. If we look behind the reasons why traders fail we find one or both of these reasons:

  • The don’t know what to do and/or
  • They don’t do what they know.

Winning Psychology addresses the latter. I define Winning Psychology as a set of tools that facilitates the consistent execution of our trading plan. To understand why we need the set of tools, we need to understand our brain’s make-up. Let’s turn to that.

Paul D. MacLean, an American physician, made an exciting breakthrough for neurology with his concept of the Triune Brain. He postulated that our brain is composed of three brains:

  • The Reptilian (responsible for our survival instincts – our fight or flight response). When triggered the Reptilian’s response is action. Action, any action, is better than no action.
  • The Limbic (responsible for our emotions)
  • The Neocortex (responsible for our thinking processes).

Now if all we had to do was control our ‘fight or flight’ response, as traders we would find it easier to make money. But we need to add to the Triune Brain one more piece of essential information. Advances in Neurology have established that the best decisions are made when our emotions and reason are in sync. The idea that we should trade like emotionless robots has been shown to be impossible (at least for most of us) and even if possible, the emotionless decisions would be sub-optimal. The key to a robust decision-making process is to ensure that the Reptilian (Dr. Janice Dorn’s ‘rat brain’) does not overwhelm the Neocortex. This link between emotion and our decisions is an important finding.

When we trade, we tend to attach emotional significance to our profits and losses. Despite years of trading I still experience joy on profitable trades and sadness when I lose money. What I do is experience the pleasure and pain and move on. It’s important I do this or else I am likely to have unprocessed emotions and when that happens, I inevitably do some thing silly (like enter without pre-defining my loss) on my next trade.

The management and processing of emotions (managing the ‘rat brain’) is the key to Winning Psychology.

The best tools I know to managing the ‘rat brain are PREPARATION & REVIEW. In the preparation phase, I suggest you use some technique that will bring you to the Alpha state e.g. the Relaxation Response or some form of meditation. Once in the Alpha State, we use visualization to complete the preparation phase.

On occasions I have been asked why visualization and meditation help.

Studies have shown that visualization exercises help performance. Since trading is partially a performance activity, visualization does have a favourable impact. The meditative process is added because visualization has been shown to assist and bolster the meditative process.

The process I teach is a simple one – let’s take the entry as an example:

  • Complete your analysis and define your entry and exit strategies. You know what the market has to look like to take the trade and what it has to look like to remain and to exit. You have defined your stop loss and determined your potential core profit target. The risk/reward is one you consider worthwhile.
  • You consciously accept the loss. It’s essential here that you explore what the loss of $X would feel like if it occurred. The key is to imagine that the loss has taken place and that you feel it’s OK to take the dollar loss. By that I mean that you’ll be able to experience the sadness and then be able to move on without the loss constantly replaying. If you find that in your imagination you are unable to accept the loss, reduce your position size.

This usually works.

  • You slip into the meditative state using muscle relaxation, a meditation CD or any mediation technique (like ‘mindfulness’, ‘transcendental meditation’, Chopra’ Primordial Sound, ‘Natural Stress Relief’ etc). I would keep this aspect to around 10 minutes or so.
  • Once you feel you are relaxed (in the Alpha State), visualize every step of the entry and exit, profit and loss. Check again how you would feel if the loss occurred. See yourself experiencing the emotion resulting from the loss and moving on.

The Review Phase is similar.

  1. We review our equity and psychological journals for lessons about the markets and for insights into our personality.
  2. Then we slip into Alpha and ask: “What did I learn about the markets and/or myself”?
  3. We then visualize applying what we have learnt.
  4. Finally when we come out of meditation, we write down the applications in Step 3 anything other ideas we consciously think of.

There you have it: the Preparation and Review strategies to manage our’ rat brain’ for optimal decisions. The Preparation and Review does take time as does journal keeping, analysis etc. These processes are the price for success. On the other hand, the success we experience makes that price more than worthwhile.

Zones

Once we have identified the trend identification of your timeframe, we have your strategy. The next event is for us to identify a low risk entry. I see low risk entry comprised of three factors:

  • Zone

  • Setups

  • Entry and Initial Stop (and/or exit strategy)

Our zone will be a function of whether we are taking a breakout trade or looking to trade responsively (buy on dips in an uptrend, sell on rallies in a downtrend). Here the Barros Swings again play an important role. Breakout zones are the important highs and lows created by your timeframe e.g. the Turtles would buy a breakout above the highest high of the past 20 days and would sell the breakdown of the lowest low of the past 20 days. The problem with this definition is the ‘breakout or breakdown’ zones may not represent critical resistance or support zones.

Figure 1 is a good example of what I mean.

FIGURE 1 AUDUSD 1-m Swings

FIGURE 1 AUDUSD 1-m Swings

(Click on Thumbnail for Full View. Click again for clarity)

Figure 1 shows a 1-period monthly swing (the equivalent of an 18-d swing). I used a 1-m swing for the sake of clarity. Notice that after a prolonged uptrend (Sept 1 2001 to Feb 1 2004), the market formed boundaries of congestion at .8002 to .6771. The breakout occurred 33 months later. During the 33 month period there were numerous breakouts and breakdowns of 20-day highs and lows; these were trades that at best would have resulted in small profits and at worst they would have resulted in losses.

The point is this: if we are to be breakout traders, then the identification of our timeframe’s resistance and support zones is important for our win rate. Barros Swings do the job.

The flip side of breakout trading is responsive trading. The tools I use (in order of priority) to identify the zone where a correction may end are:

  • Statistical Time-Price Zones of the 18-d corrective swings

  • Statistical Time-Price Zones of the 5-d corrective swings

  • MIDAS (download free lectures from www.tradingsuccess/freestuff)

  • Various Fibonacci relations

(See the Nature of Trends, available from Amazon)

The Ray Wave (forthcoming book) indicates whether we should expect a complex correction or simple and thus indicates the boundaries of the Statistical Time Window (i.e. whether we are looking for a price correction greater than mean + 1 stdev or – 0.5 stdev). It also identifies the maximum boundary for the correction. Within the Time Window boundaries, I look for a confluence of support zones.

Notice what I have done. The Statistical Time-Price Windows have two components, an input of corrective data of the swings in my timeframe (18-d) and an impulse input of the first lower timeframe (the 5-d). The reason is a correction in one timeframe is an impulse swing in the first lower timeframe. I then look to other tools to reduce and zoom in on the zones of this window.

The idea that a correction in one timeframe is an impulse move in the first lower timeframe is an important concept for the newbie to grasp.

Once I have my zone, I look for a pattern that tells me a zone will hold (setups). I have three types of patterns:

  • Negative Development

  • Contractions

  • Reversal Bars

I’ll deal with aspects of the patterns in later blogs.

A setup pattern comes with its entry bar. Generically I am looking for evidence that not only has a zone held but also that the market has resumed its trend. If we have only end of day data, I’d be looking at a candlestick bar that shows strength for a buy and weakness for a sell. Again we’ll consider the idea of what denotes strength/weakness in later blogs.

Nowadays I have access to intra-day day data and for this reason I use the information provided by Market Delta (http://www.marketdelta.com). This software identifies buying and selling volume and allows me to enter near the start of a move rather than at the end of the day. In this way, I am able to reduce the size of my stop without substantial adverse effects on my win rate.

All entries require exit strategies. I use two types. A stop placed with my broker: a stop that represents a price beyond which I am not prepared to accept further losses. This stop is technically based.

I also have qualitative stop. Whenever I enter a trade, I ask myself three questions:

  • What does the market have to look like for me to remain in the trade?

  • What does the market have to look like for me to exit the trade?

  • For how long am I prepared to hold the trade without the market moving mean +1.5 Standard Deviations in my favour from entry?

If I am trading well, I’ll exit trades before my stop is hit and most of the time, this will prove to be the right decision in that had I not exited earlier, I’d have been stopped out.

Well we’re almost at the end of this theme.

In the next post, I’ll deal with Subsequent Trade Management, a subject that will complete this section in Trading Plans. After that I’ll have a look at some aspects of Winning Psychology. By the way, one of the better sites for psychology and ideas on trading the e-minis is Dr. Brett Steenbarger’s:

http://traderfeed.blogspot.com/

Pay it a visit, you’ll be well rewarded

Components Of A Trading Plan – A

This is the first in a series on trading plans. In this article, I shall be looking at the elements of a discretionary plan. But before I do that, let’s look at the different types of traders and plans:

  • Subjective: There is no plan as such. The traders use kinesthetic information to enter and exit trades. Subjective traders trade solely (or mainly) by intuition. Successful subjective traders with whom I am acquainted are ex-floor traders (locals). Most locals have had a difficult time making the transition to the screen. Perhaps the scalping screen traders will replace the locals – we’ll see.
  • Mechanical: On the other side of the spectrum lies the Mechanical Trader. The Mechanical Trader has a set of rules to which he always adheres. “See a signal, take a trade” is his mantra.

  • Discretionary: Between the two is the Discretionary Trader. The Discretionary Trader has a set of rules but reserves the right not to follow them. In this way, he makes room for his intuition. Newbies need to understand that intuition is the result of experience and is not to be confused with ‘into-wishing’. ‘Intuition’ in this context is the subconscious recognition of patterns. For the subconscious to amass the patterns, we must first have had the experience of consciously identifying them. Newbies are unlikely to have this experience and more often than not, call label ‘into-wishing’, intuition.

Discretionary plans have either a fundamental or a technical base or have a combination of the two. The better discretionary plan reflects some fundamental idea of the nature of markets. For example, Buffett believes that companies have an intrinsic value and that this value is assessable. The Market Profile believes that the nature of markets is fractal and is best observed via the bell curve with present tense information.

The better technical analysis based plans have certain, specific components:

  • Identification of a Trend of a Timeframe
  • Low Risk Entry

Zone

Setup, Entry and Initial Stop (or initial exit strategy)

  • Trade Management

I am heavily influenced by Pete Steidlmayer’s approach to the markets. Pete used to say that ‘traders succeed, not because of their tools but in spite of them’. I believe that his words are particularly applicable in this area of trend definition of a timeframe.

Most traditional trend definition tools rely on some form of moving average. The tools are great if a market is trending but do a poor job when the market is in a transitional phase. The reason is as a rule markets move from Bull to Sideway to Bear or Bear to Sideways to Bull. Moving Averages do a poor job in sideways markets.

Is there an alternative to moving averages?

I thought so: swing charts. But the traditional swing charts were almost as unsatisfactory as moving averages so I developed my own: a swing chart that had a time component (unlike percentage charts that only have a price component) and a price component (unlike Gann Swing Charts that have only a price component). I called the swing chart Barros Swings.

My book the Nature of Trends (available from Amazon) describes how the swings are drawn. I use on Daily Bars:

  • A 5-period swing to define a weekly trend (5-d)
  • An 18-period swing to define the monthly trend (18-d).

I also use the 13-period swing on Weekly Bars (13-w) to define the quarterly trends and the 12-period swing (12-m) to define the yearly trend.

I call the timeframe that defines our trading strategy the Trader’s Timeframe Trend. The trend of the Trader’s Timeframe is impacted by the trend status of the First and Second Higher Timeframe.

For example, if the Trader’s Timeframe is the 18-d, then the First Higher Timeframe is the 13-w and the Second Higher Timeframe is the 12-m. To know when the 18-d has a high probability to change its trend we need to know the likelihood of the 13-w changing its line direction or trend. The 12-m provides further perspective.

The swings make it easy to define the trend of a timeframe:

  • Uptrend: higher swing highs and higher swing lows
  • Downtrend: lower swing highs and lower swing lows
  • Sideways: almost equal swing highs and almost equal swing lows

Once we have assessed the Trader’s Timeframe trend, we need to ask: continuation or change? Once we answer that question, we have our trading strategy: be a buyer or seller or stand aside. I will trade against the trend only if there is a change in trend pattern. More on that in tomorrow’s post.

VISION and Trading

Yesterday I wrote that VISION, goals etc had their counterpart in out trading.

VISION is found in two components:

Our trading philosophy. Consciously or unconsciously our philosophy, Ayn Rand’s ‘sense of life’, governs our actions. So too with our trading, consciously or unconsciously, our trading philosophy governs our actions from the plans we choose to our position size to the actions we take to execute consistently our trading plan.

I adapted the statement of my philosophy when I first read it in Trader Vic – Methods of a Wall Street Master by Victor Sperandeo. The articulation there of Sperandeo’s philosophy strongly resonated with my values. So with a small amendment, I adopted it:

  • Preservations of Capital
  • Consistent Execution (leading to consistent profitability)
  • Superior Returns

You’ll see the three ideas reflected in all that I do. Our trading philosophy forms one part of our VISION.

The other component is found in the rational for a trading plan. We need a trading plan for two reasons:

  1. Before entry: it tells us when the probabilities favour our trade
  2. After entry: it tells us when the probabilities are no longer in our favour and we should quit a trade.

Both components are essential to our trading success. The key analytical insight to our success is found in the expectancy formula; the formula that tells us we can expect to make, on average, on each trade. Unless the sum is positive, we don’t have an edge i.e. we are doomed to fail in the long run. The most basic formulation of the formula finds its expression in:(Avg$Win x WinRate) – (Avg$Loss x Loss Rate) = Expected Trade Result

Where:

  • Avg$Win = Total $ profits/Total number of Winning Trade
  • WinRate = Total number of Winning Trades/Total Trades taken
  • Avg$Loss = Total $ losses/Total number of Losing Trade
  • LossRate = Total number of Losing Trades/Total Trades taken.

Most newbies focus on the Win and Loss Rate. But in my view, this is the more difficult part of the equation to control. Why this is so is best described by a story I heard about while learning Drummond Geometry (P&L Dot):

One day an ex-floor trader was told by an apprentice he had taken under his wing: ‘The 1-1 support WILL hold this decline”! The market was heading south towards what P&Lers called 1-1 support.

The ex-floor trader replied: “What are the probabilities?”

The apprentice said: “It WILL HOLD, I am certain!”

The ex-floor trader said not a word; instead, he picked up the phone and said: “Sell me 3000 Dec contracts at market”

Needless to say, the market went through the 1-1 support like knife through butter. “Remember this” said the ex-floor trader, “ we think in probabilities not certainties”.

This is a great tale. It tells us that the trading is in the realm of probabilities and as such the win/loss rate is less under our control than the Avg$Win and Avg$Loss. Both of these depend entirely on our decisions to enter and exit.

Notice that the formula explains why someone with a 90% win rate can still lose money. Let’s see why. Let’s say the Avg$Win is $10 and Avg$Loss is $100 and the win rate is 90%. The sum of the formula is:

($10 x .90) – ($100 x .10) =

(S9) – ($10) = -$1.00

So over the long term, over a large sample size, each trade we take will lose -$1.00.

Our VISION allows us to imagine a number of critical events:

  1. What does a trade need to look like – what does it have to do after entry – for me to remain in a trade?
  2. What does a trade need to look like for me to exit a trade?
  3. What does a trade have to look like for me to stop and reverse?

By visualizing the answers to these questions allows me to exit trades BEFORE my stop is hit. The technique allowed me to return 46.64 on capital (ROI) for 2007 an average dollar profit per trade of US$181.00.

By keeping detailed statistics, I am able to CANI (constant and never-ending improvement) my entry and exit. This is not to say I won’t have losses; of course, I will. My loss rate for 2007 of 50.44 attests to that. But by keeping a margin of 2:1 for my Expectancy Ratio (same formula except we divide the Avg$Win component by the Avg$Loss), I was able to return a fabulous 46.64% ROI.

In the next post, I’ll look at a trading plan and its components.

Welcome to the Inaugural Post

Welcome to my Inaugural post. I’ll be using these pages to post my thoughts on the three elements for success in the markets: Winning Psychology, Effective Money Management, and Written Trading Plan with an Edge. I’ll also address the oft-omitted subject in trading literature: the generic element for success.

What do I mean by that?

Peter Steidlmayer, whom I credit with turning my trading around, taught that the principles applicable in life are the same ones that apply to the markets. In life, there is a wealth of literature on what it takes to succeed

  1. Create a VISION
  2. Set Goals to attain that Vision
  3. Set plans and routines to take concrete steps to achieve the goals
  4. Review the effect of our actions: those that move us towards our goals do more of; those that move us away from our goals discard after seeing what can be retained.
  5. Recycle to step 2 and/or 3

I have been teaching now for over 19 years and I am amazed still by the refusal of students to move past their comfort zone. Unless we are willing to do that, we are doomed to wallow in failure. Let’s put it this way, if whatever we are doing is producing negative results, throwing more resources without changing our behaviour will only result in the same negative result.

The extreme example of this behaviour: “I’ll keep within my comfort zone no matter what” was exhibited by an Indian man at a presentation I once gave. He told the class that he had lost around S$1.7M over 3 years. When I asked him to change, what he was doing, he said: “No I won’t. It may come good!”

What chance of that happening? As Aussies say: “Buckley’s!” (i.e. no chance). A great definition of insanity is: “Doing the same thing over and over again and expecting different results”.

So if something is not working for you, change your behaviour. So ask yourself: “Is what I am doing producing the results I want? If not what behaviour will I change?”

The change that we need to make will be determined by our VISION. Vision is our compass of where we want to be within a specific period. I see it as a motivational one-page document carefully crafted with word-pictures. For most of us, pictures provide the primary stimulus. To fulfill its function, our VISION statement needs to arouse our emotions.

We all need a VISION statement, no matter how experienced we may be…..

…In the period 1998 to mid-2001, I suffered the most prolonged drawdown to date. Everything I did was wrong. If I bought, the market went down and if I sold, the market went up. The maximum drawdown was around 22% over the period. I credit my VISION statement with providing foundation to continue. The same can be said for the period mid-2002 to mid-2003. My VAMI hit a peak of about 130,000 and dipped to 80,000. Again, the VISION statement proved its worth; the changes I made allowed me to move to a current VAMI high of 246,000.

(VAMI stands for Value Added Measurement Index and tracks the increase or decrease of a theoretical $1000.00 over the life our trading. The initial capital of $1000.00 in 1990 is now worth $246,000.00).

VISION without action remains a dream. Action presupposes a plan i.e. Goals. I’ll deal with this subject in future posts but for the moment know there is a wealth of material on the nature of goals and how to set goals, much of it free. Google “goal setting” and you’ll see what I mean.

I have found that while Goals remain more or less fixed, the way to achieve them is fluid. Sure, we’ll set our plans but like our trades, we need to constantly scan and assess the horizon for stimuli that will favourably (or adversely) affect our actions. Consequently, the REVIEW process is critical.

This process of VISION, Goals, etc finds its counter-part in our trading. I’ll deal with this in tomorrow’s post.