BarroMetrics Views: Q&A The Thin Line
Most of the questions can be classified under four headings:
Q1: What is the difference between a discretionary rule-based method and a rule-based method (mechanical system)?
A1: At the most basic level, the difference lies in the addition of one rule for the discretionary rule-based: “follow your trading rules but there will be times when you need not”.
This addition allows for intuition to play a role. The problem is, for novice traders, this additional rule allows not for intuition but for ‘into wishing’ – they hang on to losing trades long after the used-by date.
But, the difference can be much greater than merely adding one rule. To understand this difference, we need to be aware that technical analysis can be split broadly into two main camps:
- Richard Schabacker. Robert Edwards’ Uncle (Edwards was the co-author of Technical Analysis of Stock Trends). His approach was to categorise patterns and trade the patterns. Thomas Bulkowski has a site that tests the efficacy of patterns, Bulkowski’s Pattern Index.
- Richard Wyckoff. For Wyckoff, the principles of how markets operated came first. The model was an extension of the principles. If a model stopped working, the principles provided the answer to the question ‘why’. (NB: although I have used Dr. Gary Drayton’s introduction to Wyckoff, I rate the Wyckoff Stock Market Institute as the best source to secure a Wyckoff Education. Dr Drayton is the next choice).
Most Rule-based systems adopt Schabacker’s approach, very few adopt Wyckoff’s. As a result, most Rule-Based systems lack context, and do run into periods of lon drawdowns. Long drawdowns is one of the reasons I have preferred the Discretionary Rule-Based approach. Now thanks to my friends, Mic Lim and Joshua Fong, I have been able to develop a contextual Rule-based approach.
Q2: Since Discretionary Rule-Based trades are trader-dependent for their results, shouldn’t we expect to see different results for different traders, even if they trade the same instruments and use the same method?
I alluded to the answer in yesterday’s blog.
The question confuses ‘results’ with ”positive-expectancy’. ‘Results’ are the magnitude of the return; ‘positive-expectancy’ defines the robustness of the method.
Results will differ, of course. This is true of even Rule-Based (let’s call them mechanical) systems. The famed Turtle experiment produced a wide divergence of results among the traders. However, if a group of traders execute, with consistency, the rules of a robust method , the ‘expectancy return’ ought to be positive among all the members of the group.
Q3: Why use stops?
A3: I am not sure how this question arose in the context of the discussion; but, since quite a few asked, I’ll answer it.
Long-time readers know that this issue has popped up from time to time in the blog. Some readers take the view that trading without stops is best. And they tend to equate ‘stops’ with exit strategy.
I take the opposite view.
I believe that you must always have an exit strategy – otherwise, one trade is may wipe you out. (For a more detailed view of my risk management principles see “Routines and Habits IV (B))”. Figure 1 shows what I mean. The pair happens to be the AUDUSD, it could have been any instrument; it’s a daily chart, but it could have been any timeframe. Position sizes tend to be larger when traders day-trade. Depending on his size, a trader could have wiped out his profits and even his account on just one trade.
I use two types of exits:
- A hard stop i.e. a fixed price to exit – once the market hits the price, I exit and
- A soft exit i.e. should certain conditions occur, I exit even if the hard stop is not hit.
Q4: Would I be willing to make available an introduction to Ultimate?
A1: Not as a blog. But, I am considering a two or three video series. Let me see if I can organise that. I’ll let you know by Thursday or Friday.
FIGURE 1 Exit Strategy