Jul 172012

Many traders on Twitter are using stats for their trading.  One of the simplest examples is the gap fill stat.  Many years ago traders would fade gaps because they were often filled.  That’s changed in the past few years so be careful if you do that.

Lawrence Chan has been a pioneer in this area and he has written a couple of interesting books on using stats in your trading, specifically two are for the S&P 500.  Before you rush to purchase these, I suggest reading ahead.  I think the books are worth their price, but they’re not the holy grail.  I believe most of the stats are not very applicable and I’ve found one to be invalid.  More on that later.

At first I was intrigued by the stats in the first S&P book (the 2nd is relatively new).  Some of them have 75% probabilities.  So easy right?  Just put on the trade and you have a 75% win rate.

Not so fast.  Trade expectancy is based on two levers which are the Risk-Reward and the win rate.  Expectancy of a trade is it’s reward * win rate – risk * loss rate.  So if we have a target twice as big as the stop, the R:R is 2:1 (we usually right the reward first even though we say “risk-reward”).  If the win rate is 40% then the expectancy is:

2*0.40 – 1*0.60 =  0.20 pts/trade.

So what can a trader control?  We can only control the risk and reward.  We can’t control the win rate.  However, the market is efficient in that if we take random trades, the win rate will be exactly the win rate required for us to end up exactly zero*.  I’ve proven this with random trade simulations and it’s quite fascinating.  And logical if you think about it.

So how do we make money?  We make money by controlling the R:R and getting a win rate above random win rate.  If we use 2:1 the random win rate is 33%.  So to be profitable, we must be this.  In our example we had a positive expectancy of 0.20 pts because our win rate was slightly higher than average (40% vs. 33%).  The edge was effectively slightly less than 1 tick, which coincidentally is the edge that I’ve often observed in my own trading (I wrote quite a lot about that over the past couple years).  Don Miller, a famous retail trader, has a similar edge.  It’s hard to get a win rate greater than random in something as unpredictable as the financial markets.  And I think many traders may only have an edge of a few ticks.  That means to make any reasonable money, one must trade size.  Which is exactly how Don Miller makes millions.  But trading size is not as easy as changing the order quantity on your DOM, but that’ll be for another post.

So back to our stats, this is is why having inverted R:R where risk is bigger than the target is ill-advised.  If our R:R is 1:2 we need 66% win rate.  And that’s difficult to do.  If you trade with very large stops or no stops at all, the required win rate is 85% or higher.  And that one loss will wipe out all the winnings.  This is why moving stops and cutting winners short does not work.

So how do we get a win rate above average?  We don’t enter random trades.  We enter only when we have a well-defined edge.  I say “well-defined” because intuition doesn’t work very well with trading.  When we think we have an edge, we’re often being suckered by someone who knows they have an edge.

So to be well-defined we have to be in a situation we’ve seen before, something repeatable.  And that’s where the trading plan comes in.  This has been a constant challenge for me because my trading was always so complex and had too much discretion, and therefore was not repeatable.  I’d have a good month followed by a bad month.

On the other hand, a simple setup or pattern that anyone could do isn’t going to work.  The market is too efficient for that.  And so coming up with your well-defined edge is a long trial & error process.

Stats can be used to help increase the win rate, and I’ll write more about this in a future post.


*I didn’t include the impact of commissions which will gaurantee any random trading will result in a loss.



Jun 282012

Tuesday shook me up a little and gave me a reality check.  It was 5 days in a row of losses, most of them very small losses but still losses nonetheless.  So I cut my size and focused on the essentials:  entering exactly at my levels and holding for the next level.  The result was a big success.  I think Wednesday was pretty easy to read and that should account for some of it, but most importantly I pretty much stuck to my plan.  I did scratch a would-be-winner and I did cut two short by a point, but overall I traded well and my results showed.  I made +7 trades just one lot, making this one of my best days per contract in a long time.

I will continue trading 1 lot for a few weeks and will not go back to 2 until I have a couple consistently profitable weeks where I’m sticking to my plan.  Trading 1 lot is a great exercise in patience.  I realized that scaling in and out was making me careless.  I wasn’t pinpointing my entries, I’d just enter one and know that if it got closer to my level I’d enter the second.  So why not just wait for my level and enter both?  That’s what gives the best R:R and lowest risk, in exchange for potentially missing a few trades, which in my opinion happens less than we think.

Scaling out made me careless as well.  Instead of going for my next level, which is the logical place for the market to go, I’d just take one off when I felt uncomfortable.   Remember FT and Rob can do this because when they take a small scale, it’s just a small fraction of their position.  If I do it, it’s one half of my position.

It’s too early to judge by one day but I know it just felt much better.  I can accept the 2 pt risk much easier with one lot and I can detach myself from it and let it play out.  Well almost.  But making a lot of progress.

The two winners I cut early – the first one was because price was stuck at VPOC and I wanted to go for my run.  I should have just let it ride, accepting I may give up my 2 pts in exchange for the more probable event of getting an extra point or two.  But risking my 2 for 1 more didn’t make sense at the VPOC where I felt it was 50/50 up or down.  So I closed it out.  I guess I wasn’t completely detached.

The second was on news.  I took a stop Tuesday on the news and like Great White sings, “Once bitten, twice shy”.  Oh that’s a flashback from a long time ago, I’m dating myself.  So I panicked and just got out.

I hope your day went well.  My expectation is that we poke above Wednesday’s high and then head lower, not sure if the lower part will happen this week, Sunday’s globex, or next week.  But I don’t think the move down is over.  Just a hunch, I’ll just be taking it from one level to the next, no matter which direction it goes.


Jun 272012

Yesterday I lost my discipline.  I refused to admit I was wrong and decided to “give it more room”.  A recipe for disaster.  5 losing days in a row and I’m losing confidence.  My levels worked well, it was just that I invented trades.


I’ve been debating about something for a while now and that something is scaling.  I know many trades make great use of scaling, but I think it’s a very complicated and difficult thing to master.  And right now I think it’s holding me back.  Here’s why:  On the double top at 1314 I got short with 2 lots.  Looking at the bare-bones chart here, the obvious target is the blue support level around 4.25.  So what did I do?  I took a 2 pt scale when price was holding up around 1312.  So when price got to my target I only had 1 contract.  In my view this is severely cutting that winner short.

I’ve written about scaling in the past so I don’t want to go into all that again, but to summarize:  I think the first scale should be profitable on its own, if it’s not then it’s hurting expectancy.  Sometimes people are willing to sacrifice expectancy to have a smoother equity curve or psychological comfort.  I feel like I don’t have enough expectancy to give up some of it.

So in light of my current losing streak, I’m going back to 1 lot.  I will use max 2 pt stop and I’ll go for 4 pts minimum.  And I’ll avoid scratching (another seriously bad habit of mine) and I’ll see how that works out.  In order to do this I must not invent trades.  I must trade at my levels and only trade when the next level is farther than 4 pts away.

I’m not going to worry too much about my P/L or stopping out.  I’m going to let the trades play out and see if this will work.