How To Develop A Trading System – Part 1

In recent weeks I have been quite prolific regarding the current state of affairs on the equity front. There really is not much to add and if you have been following my work then you should be well prepared and ready to pull the trigger with confidence once equities decide to pick a direction later this week. Thus instead of regurgitating my long term charts I have decided to use this Labor Day as an opportunity to indulge your recent requests for some perspectives on basic trading related concepts.

As I am a big fan of the ‘jumping in feet first’ method this series will cover how one may develop a complete automated trading system. This will not only allow me to cover various pertinent concepts but more importantly put them into context. Most recently I have continued to refine our Mole entry signals in my spare time and therefore I will use some new discoveries as our starting point. This will be a comprehensive journey which we will undertake together as things are unfolding on my end. As time progresses I am going to walk you all through the various steps involved. Each consecutive part  of this series will cover important concepts to be considered at each stage of development. From the inception forming the basis of a system, the definition and tweaking of entry/exit rules, the resulting MAE and MFE, the definition of expectancy and SQN (and why I don’t care about Sharpe ratio), back testing, forward testing, tools, etc. We’ll go through all the motions and once we’re done you will not only be able to develop your own trading system but you will also have developed a deeper understanding of what separates the wheat from the chaff.

The best way to teach is to lead by example – at least that’s what they say. Let’s pretend I just came up with a promising new indicator – let’s call it the Mole, not so humbly named after yours truly. I am convinced that there may be an opportunity in developing it into a full fledged trading system. So what now?

Today we will cover the first phase – system discovery – which of course is the most exciting part. You are still wearing your rose colored glasses and are filled with hope, convinced that you have uncovered something truly remarkable. Of course throughout the remainder of this series we will go about smashing many of such dreams but that’s how we roll here at Evil Speculator.

What you see above is a screen grab of my current 1-min Mole indicator prototype. The Mole indicator you are currently seeing on the live Zero Lite runs against a 5-min E-Mini chart and  that’s a commonly favored chart interval for intra-day swing traders. However two or three signals max a day may be insufficient for a black box trading system capable of dealing with the type of tape we have been observing in the past few years. There are also other considerations based on expectancy and the frequency of trades necessary to maximize profits during a six to twelve month testing period – we’ll explore that in more detail in a future installment of this series.

It does not take much imagination to realize that this system will be based on short term reversals. In other words the aim of our Mole black box system would be to trigger near tops and lows, allowing us to scalp a few ticks and then exit. To some of you this may sound self evident – after all everyone wants to sell the top and buy the very low. But in reality many types of other trading approaches exist. FWIW – attempting to define tops and and bottoms is rather ambitious and borders the arrogant. Many have tried and most have failed – at least on a long term consistency basis. The ones that really work you’ll probably never hear about as the originators have little interest in sharing. Of course that does not keep us from trying – consider the Mole my humble contribution to the search for the Holy Grail of scalpers everywhere ;-)

As you can see from the current edition the Mole nails the tops and bottoms pretty well. The current phase of development is one of manual trial and error. Basically you produce your indicator and find some way of visualization that gives you the information you are after. For instance – on the bottom you see the various signals that comprise the original Mole indicator. A few months ago an email from a subscriber gave me an idea [1] [2] which in turn resulted in what you now see on the price panel as blue reversal arrows. And that is step one: Your indicator (or whatever you use for your system – you may be only looking at candles) exhibits some type of repeatable prescience in the context of ensuing price movements. You want to exploit that and thus you are starting to think of a possible system. Assuming you know how to code you plan to turn your indicator into a full fledged trading system.

But wait – not so fast. Before you write one line of code (or pay someone to do it) I recommend you spend a lot of time playing with the settings, changing the chart interval, looking for patterns, etc. The human brain has an amazing capacity for recognizing patterns and for putting them into context. Computers are getting pretty good these days but there are certain aspects of the human brain and imagination that still remain outside the scope of even the fastest number crunchers. So use it – get a ‘feel’ for your system. Because the better you understand what drives your system and how changes affect it the less time you will spend later optimizing it. It is tempting to immediately write code and to define a dozen or more settings you plan to later use for optimization. But believe me when I tell you that the time spent planning ahead and simply observing will save you days if not weeks or months later down the line. As many other things in life I have learned that the hard way.

This is basically what I am doing right now. I am still fiddling with various settings to arrive at something that ‘visually’ appears to provide a valid edge. This phase can take anywhere from days to months, depending on the complexity of your indicator/system, your tenacity, patience, or obsession to find the perfect settings. Which do not exist – that much I can assure you. I suggest an iterative approach in which you spend a few days or weeks and then proceed to the next phase, which is initial implementation.

The next part of this series will cover the concept of edge and in particular some theory on expectancy and system quality number (SQN). Both are basic ways to determine the expected profit (or loss) potential of your new system. And without knowing that you pretty much have nothing to rely on but your human subjectivity. Usually not a good basis for success, for we have met the enemy and it is us! Of course a predicate for defining your edge is the creation of entry and exit rules which we will cover next time as well. Once you have developed a sound understanding of how to measure success and failure, as well defined standard deviations of returns, we will be ready to implement and start testing your new system.

To be continued…

Cheers,

Scalping With The Mole

And now for something completely different – but I have a hunch you’re going to like it. If you’re a Zero sub then you are probably familiar with the Mole indicator which is located right above the Zero Lite on the 5-min panel. The basic tutorial refers to it as a different way of visualizing the Zero – as a matter of fact it represents an early version of the Zero indicator. As it shows a bit more context the Mole indicator often offers valuable clues as to impending swings in momentum or a shift in participation. For example: Be on alert when you see the Mole’s bubble expand or contract – the former indicating strengthening and the latter a weakening of the current move.

Some of you may recall that I introduced both the Mole and the Zero indicator in late 2008 and it has served us very well since. Which is why I have barely made any changes to it since about early 2010. It’s not that I’m lazy, rather I happen to be a believer in the old aphorism ‘it it ain’t broken – don’t fix it!’.

However recent events suggest that I might want to go and have my eyes checked. Let me explain: It all started earlier this week when an intrepid sub sent me an email asking why the Mole’s green line was dipping below the Zero mark. Now, I had seen this happen for years now and to me it was simply an expression of downside acceleration as it is almost always associated with red candles. And of course the inverse applies to whenever the red signal line crosses above. I was about to just bounce him back a quick note when suddenly my Spidey sense got triggered and urged me be useful for a change and take another look. I don’t know why but I had a sneaking suspicion that I may have overlooked something important.

The second I took a look the scales fell off my eyes – and Jim Morrison explains it best! When in doubt always consult a dead rock’n roller for important clues. Maybe I have to change my listening habits during trading hours.

Frankly it’s something I should have seen years ago – as you may imagine I am really kicking myself. It seems that zero mark breaches are almost always followed by snapbacks – usually within one or two candles. Also, the scope of the reversal appears to be directly correlated with the depth of the zero mark intrusion. Shown above are examples over the past three sessions – I did not change any of the settings. As you can see the reversals are not always big but they seem pretty reliable. The only exception being the last few candles of the NYSE session – obviously a lot happens in the spoos overnight and a scalper obviously would not get positioned the next day.

I poked around a bit more and the past month of Zero signals seem to strongly point towards a solid edge. As I’m not completely useless the first thing I did of course was to create a new version of the Mole – this new one changes the green or red lines to blue whenever they cross over to the other side. Since I took these snapshots I also have added handy blue arrows to the spoos panel – if you log into the Zero now then you can already see them in action.

Here I’m simply scrolling back a bit more. Another event which would have worked out nicely. This was not a very strong signal and perhaps the vehemence of the reversal was coincidence. More observation is needed I think.

And further back we go – as you can red line breaches to the upside seem to follow the same pattern. Not always are the ensuing reversals significant but that does not render them useless. Perhaps you are already long/short and you encounter an opposing signal which of course tells you that it’s time to take profits.

At least for the next few months we should stay away from any signals that occur at the open or the close. The example above would have worked and maybe the open signals are a possibility.

You can see that this was near this year’s highs but we are already in the process of rolling over. I see three valid signals and one I would declare a failure, however even that one turned back to b/e rather quickly.

And this shows you that the inverse signals seem to be equally good – we just haven’t seen many of those in the past few weeks. Which in itself is perhaps an important clue. Unfortunately I do not have more than 20 days worth of data right now but perhaps the presence of majority of downside reversal signals (i.e. buying exhaustion) may indicate that the current trend is down. A majority of upside reversal signals (i.e. selling exhaustion), as we have experienced in the past few weeks, may indicate that the current trend is up.

As we all have access to months worth of EOD wrap up videos this is of course something we can easily pursue further. If anyone is interested in spending some time on this I am sure it would be very much appreciated by everyone here. Feel free to discuss any results in the comment section – I only ask you to refrain from posting snaphots of the live chart (unless it’s from the previous day).

The good news here is that we may all have been sitting on a very handy scalping tool for the spoos and just didn’t know about it. And the really good news is that if you’re a Zero sub then you’re getting it for free :-)

Cheers,

Convexity – It’s Evil Too

So I (volar) do not have much to say for a market outlook- though the VIX 8 day stat worked out well (with hindsight and inductive reasoning bias).

Banking coin is never easy- but avoiding stupid decisions really makes the difference. Convict keeps it simple- and frankly that is why he is solvent.  Solvent traders have a better probability to make coin than the insolvent ones (law of large numbers- just saying). This post is not simple- and will be difficult for a non-options skooled persons, but it should at least give one reason to not stick one’s private parts in a blender (e.g. trading options without the proper tools/knowledge).

I figured this would be one of those informational/discussion threads. THIS IS NOT  ACADEMIC- this is real world options trading. Option theory and retail option platforms- yes even TOS- are “cool,” but they will still FUBAR your account.

I am first going to list some caveats for retail platforms and general option trading fallacies- many of which are found in one of my favorite math reads, Dynamic Hedging. Following that, I will discuss them- of course- that means charts from Volar.

Caveat A: SPX options are not the same as corn options.

Caveat B: Option skews, smiles, and decay term structures will rape you.

Caveat C: Not one, not a single greek, can be compared to another greek- even on the same commod on the same contract. This is a function of the “shadow greeks.”

Caveat A:

What do I mean? Well first off each market will have a different smile- smiles affect option valuation paths. Secondly, and most importantly, IV is correlated (inversely) to price in SPX. This is why I have talked about call rape- but its more than that.  Also SPX has no “carry” trades or spread trades, consequently, the only spread trading with options in the SPX is VOL time structure (think VIX/VXV). Whereas corn, spread trades do matter…spreads do change, and IV is not inversely correlated to price. Many do not understand that most commodity volume is actually spread volume (eg short JUL, long DEC). If you are playing options in a market where spreads move- you better be careful. A risk reversal calendar spread may have the correct direction, but horrible outcome due to shadow greeks. Even on the SPX, where there is no real spread changes, calender spreads (to capture net short theta, long vega positions), still cause havoc for traders without appropriate tools and experience.

Bottom line for caveat A: you have to have a model for each instrument. If your model does not account for correlations and spread differentials- well you are dead in the water.

Caveat B: Option skews, smiles, and decay term structures will rape you.

This chart is Corn IV over time. Clearly nothing is linear here. Notice that anything less than the 80% IV in the put tail of the first chart is not even readable in the second chart.

This chart is near expiration- yikes.

So my point is that the “VIX” is and “average” but averages the curve. The curve changes options differently. This is the largest reason for novice options traders failing- especially when they use TOS or retail option platforms. Sure your platform may give you a greek number, and even allow you to shift VOL, Time, and Price, but it wont model the IV smile term structure/decay.  Toyota has breaks and a gas pedal, but it is not a Ferrari. Even if TOS did model IV term-structure/smile decay- how could you trust it when we know that each commod is different?

Caveat C:

The smile affects option valuations over time.  This is where things get hairy- shadow greeks. All retail models use BSM (black scholes merton)- but none account for the curve.

So let’s say one is short a JUL corn call (say 750 handle today). Delta may be -0.10 but that value only holds for today- technically for about 5 minutes. A typical model, presuming no change in price, will make about 3 (priced near 4 today) with 5 days till expiration (45 trading days from today). However, when adjusting for the smile (aka what volar code does), one will lose 3 cents. This is a 6 cent or 100% difference in valuation. Why? real world vs. academics.  The IV for tails rises- there is no free lunch. Smiles occur for liquidity and “non- normal” distribution reasons. In any case, nobody holds till expiration, yet they make decisions as if they were holding till expiration. If one do not hold till expiration, one will not get expiration results. Many times OTM options (sold) will make one most of one’s money in 1 day- and waiting till expiration to capture a penny usually ends badly due to bid-ask differentials and IV premiums. Bottom line here- if one’s model does not adjust for reality.. one loses coin.

Now to further talk about how greeks are not comparable… spread trades… again.

Many think front month contracts decay more than back month. Some think the back months have more premium to sell and front months are relatively cheap. Neither is correct or wrong. Both are worthless ” all encompassing” statements- like most CNBC stuff.

A good option model should cover sensitivity to the following:

Here is the dilemma.  Is one analyzing 1 day or 1 month? The changes are not linear and they change each other. And each change is multiplied by each other (negative or positive). Yes this looks like crap- but notice that delta is the linear slope of 1 point (chart  below). This chart shows that vega moves opposite to decay, and that up gamma is not the same as down gamma. Also a gamma changes on a vol spike or time decay.

Ok so you see delta only matters at (1) a point in time (2) at a particular price (3) given a certain time (4) given a certain IV (Vol)

Now let’s look at an IV spike:

You can see the Curve is less steep, thus the gamma (delta change) is reduced.

Here is a time decay shift:

So… this goes to show that things change. Gamma up is not the same as gamma down. And gamma up for an OTM is utterly different than gamma down.  Gamma (delta sensitivity) is inverse to Theta (time decay). The math is 1/2* gamma* (vol)*(Contract price^2). This implies that not ALL front month options, when adjusted for the IV curve structure, will not decay (example above). Secondly, one is exchanging decay risk for price risk.

Consider this with 2 options on two different contracts- each has about 20 moving curves at different rates.

This means one must manage the shadow greeks (bleeds, dvol dtime, ddelta dvol, etc…). Below are the ones I follow on a spread trade. BUT one must adjust this for the IV curve. So when I input the trades I know all of the shadow greeks and I model the IV curve. Also remember the spread may not move 1:1 with front month price….

Below are a list of Greeks and bleeds (or changes to greeks for a list of options). In all reality, scenario analysis encompasses all of this into one value, but one must be able to see what and why things change.

No, retail models do not do this correctly.

I suggest using heat maps for calendar spreads- once one adjusts for the code/IV smile of course. Here is a scenario map for 1 particular point in time. When one starts to analyze options, correctly, they will find that scenario analysis is the most optimal choice.

* test the good, the bad, the ugly. Never test the great. Stay frosty.

The top is the contract spread (JUL- DEC corn), the left is CN (JUL corn).

Here is 2 different vegas (price sensitivity to change in IV) for a JUL , DEC calender corn spread. Notice that front month VEGA declines relative to DEC. This means that those who “think” deferred options carry more “premium” is bull crap. The greeks are less sensitive- even though our above example showed that the IV smile spike/shift offsets the decay.

This means one must learn to trade the greeks and shadow (future) greeks. If one plans out the option scenarios one will find that most “common” ideas from brokerage houses are stupid.

So differed options have less sensitivity, but the gamma is higher and the theta lower.

Another stupid comment I hear is that 90% of option expire worthless. I must say logic like that is pure ignorance. (1) any 400% OTM option may or may not trade, consequently how do you even run stats on an infinite number? Secondly,  if margin calls made one bankrupt 30 days before expiration (like MF global, LTCM etal), well expiration did not matter now did it?

Bottom Line: many think they are playing in the kiddy pool when they are actually swimming with a bag of meat on their back offshore Africa in shark infested waters.

Best of luck unbiased trading,

Volar





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