Saturday, October 27, 2007

Recommended reading

I'm a regular reader of Brett Steenbarger's blog (Traderfeed) and his recent discussion of intraday price patterns seen in the SPY (ES) is something everyone should follow.

I wrote a comment to his latest post, where he discussed a price pattern giving you an edge of 70% to 80% for a winning trade. I post this comment here as well as maybe some of you, who are not regular readers of Brett's Blog, have some thoughts to add which might help find a very profitable 1 trade a day trading system.

Hi Brett,

your series is becoming extremly interesting. As I've tried to develop some trading systems myself, I would like to add a few thoughts, which you might find worth following up.

First a question: "How many trades do you need to make per day, if you are not employed by a trading firm but trading for your own account only?" Actually the answer is obvious. You don't need to make a trade at all. You have the option to wait for the pattern, which gives you your trading edge.

Now according to your numbers you have identified patterns, which give you 70% or even 80% winning trades. And you ultimately want to look for variables, which will improve the odds of hitting these price benchmarks.

I don't think that's necessary at all. It doesn't matter. You will end up with filters, which will led to less and less trades, while improving the odds by 1 or 2 percentage points, but not more. Actually any filter you add, will leave you standing aside from winning trades as often as from losing trades. At least that's my experience with filters.

On the other hand searching for rules to apply within the trade, which allow you to identify losers as fast as possible and thereby keep your losses down, while letting winners run, is something often forgotten. It's part money management, part trade management.

I've written a Money Management tool, which let me simulate doing 1200 trades at a given Win%/Loss% rate and certain Win$/Loss$ settings.

(Download from You need to allow for iterations in Excel or it will give you only warnings)

Let's assume we have a Gap-up day and the odds tell us, that the chance the Gap will be closed is 80%. According to your numbers the average Gap is then something around .14% or 2 ES points. So the win$ on our average trade would be 100$/contract. But when do we know the Gap won't be closed? Ultimatly only at the end of the day of course. You start with an account size of 25,000$ and want to know, what will become of your capital if you trade with a winning chance of 80%.

Let's assume your average loss on these 20% losing trades is 400$ or 8 ES points. I have no idea what the chances are, that the close is 8 points away from the open on the ES. That's something only you can answer. What I can tell you is, that if you trade 2 contracts with these 25,000$ initial capital, your chance to go bankrupt is about 14% and that the chance to have lost money after 1200 trades is 59%.

It looks a lot better if your average loss is 300$ or 6 ES points. Then the chances to go bankrupt trading 2 contract are actually nil. And you will most likely make at least a bit of money. The minimum ending balance over 1200 trades was 27,600$ (from the initial 25,000$), the maximum was 248,200$.

Now we know, that our average losing trade shouldn't cost us more than 300$/contract, if we want to keep our edge. If less the profit potential of the system goes up expentionally.

If your average loss is 200$, then your max profit should be 541,000$. (My system assumes, that with increasing account size you will increase the number of contracts traded as well applying a margin of 10,000$/contract. So for every 10,000$ added to your account you will trade 1 contract more. After 300,000$ I apply a margin of 20,000$ for each additional contract)

But how can we tell, what our chances are, if the trade first goes against us, before it starts to close the gap? I don't have the means to answer this. But it might be worthwhile to ask what the chances are that the Gap closes, if ES after the open goes 1 point, 2 points, 3 points and so on against us before turning and closing the Gap.

Having a 83% winning chance by finding some arcane filters or rules might look great, but won't change a lot at the net numbers.

On the other hand finding a rule, which will allow us to trade with a 4 point ES stop, even if it's achieved only by adding contracts to a losing trade while keeping the whole trade risk at 4 points ES compared to a 6 point stop can mean the difference between 100,000$ and 250,000$ after 4 years of trading or doing 1200 trades.


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