Monday, June 20, 2005

Payout - Payback cycle

A few weeks ago, I got hit hard in the market and, as usual, being shaken, trying to right myself up again, I found a seemingly fitting article, explaining what just happened to me. Bo Yoder wrote about the inevitable Payout / Payback cycle all trader have to go through.

As the excerpt from his book: Mastering Futures Trading did not answer all my questions, I got myself a used copy on Amazon. I know, I know, I stopped reading Trading books about two years ago, but as I said, i was emotionally shaken. And this excerpt prompted to an answer of these shakeouts my account was experiencing now and then.

Last week the book finally arrived and was put to all my other trading books, as I was out of my doldrums and steaming along nicely again. So why look into it at all. Still a nagging thought remained, Fridays trading was shaky with 2 trading errors, so over the weekend I took the time to read chapters 6 to 8. These cover amid other subjects the Payout / Payback cycle Bo discovered in his own trading.

Actually for Bo this cycle means, that due to the cyclical nature of the market your trading signals, when taken exactly according to your plan will sometimes work fabulous with huge follow through, and sometimes just die, giving you one stopped trade after the other. His answer to this cycle he discovered, is identifying the signals, which tell you, that your tradesetup is losing his edge, stepping away from the market or reducing your position size in this case and reentering the market with full force, the moment the Payout cycle is diminishing and the market is swinging back to Payout mode.

Looking at my tradebook and account, I could identify such cycles, even if in my case they are more seasaw like Payback cycles. It was 3 to 4 weeks nice regular trading with about 1 week of payback disaster, which brought me back to zero gains. Actually up to December last year that was a very common experience. Partially it might have been changing market conditions, but mostly it were trades gotten out of hand which started my drawdown periods. Thinking back usually they were accompagnied with emotional turmoil caused from other aspects of my life, which needed attendance and which should have caused me to stop trading at all. But after having broken out of this seasaw cycle, this years drawdowns were usually started by changed trading methods or plain and simple by trading errors I thought I had left behind, which suddenly reappeared under more complex conditions.

None the less, what sparked my disaggreement with Bo’s Payout/Payback cycle theory, was not the theory itself, which sure can explain nicely some of the results we see in our own trading, where sometimes we do everything right and still the trade has no follow-through, but the seemingly unavoidability of the cycle itself.

I recently heard a statement: I don’t know how much I will make each day, but I know I will make something

And tell you what, that is such a positive statement, such a great motivation to take the next trade, that I started to look for the flaws in the Payout/Payback cycle theory, which would bring this statement in line with the theory.

What is a trading edge? It is a pattern, a combination of price behavior and indicators or something else, which on average will give you winning trades with such a follow-through, that it is worth the risk to take the trade. But it is a statistical number. It sure does not give you trades with 100% probability to win. Otherwise noone in his right mind would take the other side of your trade.
Actually the longer I trade, the more it seems, that a lot of patterns in the micro-timeframes just a short time after you open your position have a probability of 50% and it is nothing but random which decides if they work or not. It’s your trade-management which decides whether the trades hurt you or not, not the tradesetup itself. This would explain the Payout / Payback cycle theory quite nicely, as sometimes the patterns you have identified to give you a good number of winning trades, suddenly are faded a bit harder by the traders on the other side of your trade and suddenly its for them to enjoy the Payout cycle, while you yourself with your flawless executed trade are in the Payback cycle until the pendulum swings back again.

But this throws a different light on the inevitability of the Payout/Payback cycle. It might be actually avoidable, if you recognise the signs, which tell you, that it is time to switch sides, to go countertrend instead of with the trend or vice versa.

A double top is usually sold short, but of 100 contracts sold near the top there are as many contracts bought. Are these traders dumb? Sure not, for them the Double Top is a fine reason to buy/add to their position, because they think the price will be higher, when it is time for them to sell their position. Recognize the signs, when it is time to join their ranks, instead of following your plan, which says “Short the Double Top” and you should be able to shorten the Payback cycle.

Sure, this adds an element of discretionary trading to a mechanical plan, but if your inuition says Go Long the Double Top after you trade a contract year in and out, you might better listen to this intuition and look for signs, which will support this thinking.

Croc_22

Short 1200 on the ES on a possible DT on May 23 with divergence between price and cci. The trade gave you about 8 points max in 2 days, but looking at the further development in hindsight, going long the possible DT into the expiration in June proved to be the right decision. Payback for the shorts, payout for the longs. Now, with quadruple witching behind us, it might be, that the shorts finally will get rewarded, that the pendulum swings back again, that shorting the 1224 high, in case it gets retested at all will work again.