Here’s the thing. If you can’t spot the sucker in your first half hour at the table, then you’re the sucker – MATT DAMON from the movie Rounders
I think most of us will agree in order to be successful trading we need some kind of an edge. A good friend or relative who is willing to give us inside information where he is employed always works well, but most of us have to rely on something more fundamental or technical. I realize there are gifted people out there who have the ability to disseminate large amounts of information and draw accurate conclusions based on fundamental analysis, but I have always used technical analysis to gain my edge.
We use a model that is comprised of multiple trading systems, money management strategies and psychological disciplines, each of which give us an independent edge in that respective area. The combination of the three however is what really adds up to very playable over all edge.
When building an edge one must first consider what will drive the performance. Is it volatility, overbought and oversold counter trend conditions, or trends? Also how will you protect the capital when these conditions are not dominant?
Let’s examine one of the models that we use which is dependent on trends. It was developed in a joint effort between Angus Jackson, Inc. and Traders Tech., Inc. For all intent and purpose it is a trend capturing approach. The first basic concept that needs to be understood is we need trends to succeed and a way of protecting the capital when markets are not trending.
Dean Hoffman, system developer and president of Traders Tech said “When you think about it, trends can be seen everywhere. Temperatures gradually trend from warm to cold as winter approaches. The demand for gasoline gradually trends higher during the summer driving months. Ground moisture trends from moist to dry when a drought approaches, and interest rates trend from high to low or low to high over time, and so on. All these events, whether seemingly natural or unnatural, can create sustained price trends in the futures market, and it is from these trends that we can try to profit.”
The real difference among traders is how they determine the beginning and end of a trend. A trader may define the starting point of a trend as something as basic as a change in the direction of a moving average. Counter-trend traders, on the other hand, might use this same indicator as a sign that the market is overbought and getting ready to head lower. Both are potentially correct depending on their exits. The real question is how can we quantify these trading approaches and code them into profitable trading systems.
Along with entry and exit methods, a trader must also have a position sizing and money management plan. Even if his entry and exit points are 90% accurate, if a trader risks it all on every trade, at some point the odds are substantially in favor of him losing all his money. By the same token, a system that is only accurate 10% of the time but has proper money management could do well. The bottom line is that traders need to know precisely how much of their account to put at risk in any given trade. It is also necessary to know how many positions to buy or sell whenever there is a signal. An expert system should provide traders with all this information and therefore an edge.
The final piece of the puzzle is proper trading psychology. It does not matter how brilliant a trader’s systems are, if he is unable to take the heat during the inevitable drawdown periods, he will fail. By the same token, if he gets too ecstatic during winning periods, he will also tend to fail. The key is emotional consistency. A trader must have complete confidence in his approach. This is where extensive (and proper) testing can help. Testing can help to build up solid proof that what a trader is doing works over the long run.
The more small edges a trader can build, the greater the probability of success. The small edges built into each system combined with those built into the money management and the psychological discipline will add up to enough total edge to trade with success.
In our model we use 5 different systems simultaneously, that will give a trader an advantage over only trading one. All these systems are essentially trend capturing, yet they also incorporate features that signal counter-trend following. These different systems also communicate with one another and trade together as one integrated unit. For example, if one system has already invested heavily in Japanese Yen, the other four systems know not to take any more trades in that market. Doing so would not help to diversify but only raise the risk in the same trading idea.
Another unique edge that we have built is called “dynamic portfolio logic.” Unlike most systems that predefine a smaller portfolio to trade, our model trades almost every liquid commodity. The reason is because the systems rank the markets into percentiles on a daily basis. It then narrows the list down to only those few markets that have the highest relative trending potential. The net result of this filter is an edge that shows us where the best opportunities lie. It also guards us against the possibility that the best trends may surface in markets that are not in a static portfolio we may have chosen.
We have also paid close attention to position sizing and money management. It specifically manages how many contracts to enter when a trader gets a trading signal. This is essential because different futures contracts have different volatilities and trading them all in equal numbers would not be properly diversifying. If a contract, for example, tends to have high-volatility, a trader should trade fewer of those than another whose volatility is lower. We use a trader’s account size to determine the proper position size for each trade he makes.
Frequently the right position size is simply zero, and there are four reasons for this:
First, if the trade occurs in a market that is not strong enough in rank to be in the dynamic portfolio. Second, if, given the account size, the risk in the trade is just too high. Third, if there is already enough risk held in that given sector. And finally, if there is already enough risk across all the current positions in the portfolio.
The model does not risk more than 1.5% of a traders account size in any given trade. It will also not risk more than 5% of his account in any given sector. Let’s suppose, for example, that a trader purchases crude oil for his account. If the risk in that trade amounts to 5% or more, the model will not take new trades in any markets that are highly correlated such as unleaded gasoline.
The model will not risk more than 15% of a trader’s entire account at any given time. Meaning, if every trade a trader is in were to hit its stop price simultaneously, the total should represent no more than about 15% of the entire equity of the trader’s account. Once the risk level either reaches or goes past this 15% level, it will reject all new trades and return a position size of zero.
In summary, this was our attempt to build a model of small edges in each category of method, management and psychology, so when combined, we would have a large enough edge to trade with confidence.
The goal was to capture trends in trending periods, while protecting the capital in trendless periods.
Now, as we know, no matter how much precaution a trader takes, money can be lost and therefore any model should be monitored daily for red flags. After all, in a profession of such uncertainty, anything can happen, so we have to prepare for this before putting our money on the line. Having an edge (or a series of them) is essential.
In the movie “Rounders,” Matt Damon who plays a skilled poker player, says in the opening scene:
“Here’s the thing. If you can’t spot the sucker in your first half hour at the table, then you’re the sucker.”
So don’t get taken. Ask yourself “what is my edge and how will I be protected when my edge is not working.”
If you would like to receive a detailed research report on our model please email me at email@example.com or call (800) 858-2340 Toll Free.
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