Posted by: Bevan | July 19, 2008

Strategy Development

Whilst on holiday in Scotland recently I finished ploughing my way through Trade Your Way to Financial Freedom by Dr Van Tharp. I must admit it was hard going at first as some of his concepts were a bit foreign to the way I thought about trading, and also because the book is a bit wordy! However by the end my eyes had been opened to the importance of developing a system which suits my individual objectives, risk profile and outlook on the market. For instance there would be no point for me, with a small account and less than a years trading experience expecting an outcome of £100,000 per annum income. Equally I have a higher tolerance than most people tolerating short-term drawdowns when trading a system with a proven long term positive expectancy. Thirdly, there wouldn’t be much merit in me trading the market based on astrological signs. As the market is pretty random, there is a chance that with good techniques it could actually work, but because I didn’t believe it had any relevance its unlikely that I would be able to trade it consistently and successfully.

In terms of my day to day trading I have been using the Triple Screen approach as expounded by Alexander Elder. I think it is a sensible system because at the heart of the system is the fact that long term trends do tend to continue rather than reverse, and that placing one’s trades in line with them gives a higher probability of success. I have certainly been able to produce over 20% return over the past couple of months, but more importantly has been the discipline required to stick to a system which many days does not generate any signals that I can afford to trade with my account size. So many winning trades have been passed up, but I have learned that consistency and strictly following money management systems is essential otherwise months of small gains can so quickly be swallowed up by a few (or even a single) large loss.

Van Tharp’s book has given me many new insights about system design, and convinced me of how important testing and system development is, both to ensure a trading system that works, but also one that I can believe in. There are six important characteristics he identifies in any trading methodology:

1) Reliability, the percentage of trades that generate a positive return

2) The relative size of profits compared to losses when traded at the smallest level

3) Your cost of making a trade

4) How often you get the opportunity to trade

5) Your position sizing model – how many units are traded at one time

6) The size of your capital

I think most traders, including me, tend to think that the first point, reliability is the most important factor, however all of the other factors are important or critical. Take my current situation for instance. In terms of reliability I have won two trades out of six since I started trading the Triple Screen method at the beginning of May. Those people who are tempted by trading systems for sale with claims of 70 to 80% reliability (including me!) would probably consider 33% reliability as failure and would have tossed out the system. How come I’ve turned a 20% return though? It is a fact that most of the very successful trendfollowing system traders and hedgefunds achieve around 40% reliability on their top systems. My own results indicate that a reasonable return is certainly possible with reliability levels of well under 50%, whereas I previously believed that well over 50% of trades would need to be profitable to make money.

A Black Box trading system

A Black Box trading system

I think that point 2, the relative size of profits to losses is far more important. I actually believe that high reliability figures are usually derived from curve-fitting backtesting and can rarely be achieved in the future. The other way it would be quite easy to achieve high reliabilty would be to cut winning trades short quickly. Virtually all of my losing trades, for instance, could have been closed for 10 – 20 points of profit. The problem then though is that to achieve the high reliabilty, stops have to be reasonably wide to avoid getting constantly whipsawed. It is easy to make profits on four out of five trades using this methodology and return most if not all of the profits on the one loss. My system is working because my winning trades have been between two and twenty times the size of my losses. Having a positive risk:reward ratio is absolutely critical, and from my results has shown itself to be more important than the actual ratio of wins to losses.

Point three is the cost of making a trade. I use online spreadbetting which has spreads of a few points per trade. With my system the spread is tiny compared to the size of the returns. Also, because I don’t trade very often to make my 20% gain I’ve only had to trade six times. Contrast this with a day or short term trader who cuts their trades short after a few points. The spread or commission would account for a much higher percentage of the return (e.g. on my system £3 out of £200 return, as opposed to £3 out of £20 return). The short term trader in this scenario would at the end of the year have given 15% of profits away to his broker, whereas the longer term trader sacrificed only 1.5% for the privilege of trading.

I thought point four was the drawback with my system – insufficient opportunities to trade. But on reflection there are plenty of entry signals, its just that I usually can’t afford to take them due to point six, my account size. The size of my account also means that I have to take bigger percentage risks than I would like to. I base whether I enter the trade or not on whether the percentage risk is less than 6%, whereas I would prefer to be able to take every signal, risk 2% and increase my stake in each trade in accordance with stop placement.

To resolve these issues I am going to put more capital into my trading account in order to take more opportunities. I have also purchased Forex Tester to make the process of testing more straightforward. I have already found it useful in discarding one idea, and it will give me the power to develop a trading system that I can have confidence in, with an understanding of its expectancy and performance. Also I plan on testing the Triple Screen system, to see if I can reduce my initial stop size without impacting returns dramatically. This should mean I have a lot more opportunities to trade with my account size, potentially generating greater overall returns. My (very limited!) experience so far has been that the trades that perform tend to head straight up, so reducing my stop may in fact have little effect – testing will prove whether this is the case!

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