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…


Are Trend Days Passé?

Over the weekend the old Convict sent me a pretty interesting write up discussing an increasing amount of trend day signal failures. If you are a sub then you know that this strikes very close to home as my own system sends out a trend day alert to all of you each morning at 10:15am EST. If you don’t know what a trend day alert is then please point your browser to our handy cheat sheet.

Chart courtesy of Quantifiable Edges.

The left side of this chart shows us the profit curve of a system trading trend days between January 2006 and April 2009. The right side of the chart shows the profit curve of the very same system between May 2009 to the present. We’ve gone from a pretty juicy edge to something I would consider a coin flip. And I think most of us would agree with the author’s conclusion – quite obviously since ca. late spring of 2009 those trend day alerts have been a hit and miss affair. The author opines that something has obviously changed – he doesn’t know what and neither does he care. As a quant his main job is to weed out trading rules which are not applicable anymore in today’s fast shifting market dynamics.

I cannot argue with the data – so does that mean that trend day alerts are passé and that you should ignore them going forward? Well, on that end I do approach trading a little bit differently than some of those quant boys. Let’s look at what makes a trend day in the first place.

More charts and cynical commentary below for anyone donning a secret decoder ring. If you are interested in becoming a Gold member then don’t waste time and sign up here. And if you are a Zero or Geronimo subscriber it includes access to all Gold posts, so you actually get double the bang for your buck.

Please login or register for Zero Data Feed (non-recurring) or Zero Data Feed (recurring) or ES Gold (non-recurring) or ES Gold (recurring) or geronimo/ES (recurring) to view this content.


The Day Equity Options Went Full Retard

Some days are boring- and some make seasoned traders say WTF? Friday was a WTF day for me—the market is calm as can be, and I am starring at option data that raises the hair on the back of my neck. Sure the tape had absolutely ZERO OPEX volume- and CNBC touts are saying, “Sideline money is coming in…”  but my radar screen is screaming retardation.

Seasoned option traders are not idiots – they gauge risk better than anybody else. Option trading is not for the faint of heart – if one does not understand the game- one is as good as dead. As of this week option makers are not selling puts or selling deferred IV, while call volume is surging.  Sure this stuff happens in December and these indicators can be early – but Santa is gone…

In any case, for every retail call buyer there is a seasoned call seller. There were nearly 100mm net OCC equity calls less puts over the last 30 days — drink the kool-aid if you want. Skews and IV time spreads are utterly absurd, VIX and VXV are both trading outside bollinger bands, and call buying has gone from beartard to bulltard. Yes the trend is higher, and yes we had volume capitulation on the low, and yes there are Euro shorts, but gamma has been falling like natty gas in many markets.

Last week, the equity option market went full retard IMO- here is a well analyzed look.

First here is  look at IV time spreads. IV time spreads help put the VIX in perspective and seasonality helps to show the strong seasonal tendencies.

C’mon- this is retarded- and frankly bearish as crap in the short-term. Notice that even in 2008 December expired in a predictable value- even with a VIX that traded north of 50.

This next chart is a spin off of the first chart that shows the seasonal tendency is lower- not higher here. Or contango/time spreads should be narrowing not widening…

More charts and cynical commentary below for anyone donning a secret decoder ring. If you are interested in becoming a Gold member then don’t waste time and sign up here. And if you are a Zero or Geronimo subscriber it includes access to all Gold posts, so you actually get double the bang for your buck.

Please login or register for Zero Data Feed (non-recurring) or Zero Data Feed (recurring) or ES Gold (non-recurring) or ES Gold (recurring) or geronimo/ES (recurring) to view this content.



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