A few years back I wrote a post  in which I profiled one of the main deadly sins of retail trader ignominy – the ubiquitous and often almost fanatic anticipation of mean reversion. I am not going to regurgitate my point; if you are a culprit (and you know you are) then I strongly recommend you read my old post and perhaps also one of my more recent ones . If you’re a noob here then you may also want to point your browser toward our all time favorites page . The holidays are nigh and tis the season to debug your brain and start the new year fresh.
However book knowledge is one thing – seeing things play out in reality is quite another. Let me present to you Ms. Gold, our first runner up for our ‘Misses Mean Reversion 2015′ contest. She’s quite a tease, enjoys frustrating gold bugs for months in sideways ranges for months on end, only to finally slam them with a relentless sell off which counts eight consecutive lower lows (CLLs) followed by 7 CLLs.
Not to be outdone here’s Ms. Copper – she’s been popular since the bronze age, thrives in industrial production, but is particular fond of electric circuits. She managed to paint 11 consecutive lower lows this year and she doesn’t look she’s breaking a sweat just yet.
Last but not least here here’s Ms. Silver – she’s got a special shine and is particularly interested in jewelry and fancy cutlery. Most recently she managed to paint 15 consecutive lower lows and thus far is our official winner of the Misses Mean Reversion 2015 contest. Congratulations!!
Moral of the story – whatever you have been told about mean reversion is a lie and will fail you when you most expect it. This spells true in particular when it comes to trading the futures as well as forex. So next time someone suggests mean reversion to you – keep calm and just say no.
On the equities side we seem to be building a base on top of the 100-hour SMA after the initial short squeeze higher. So far so good…
I really like the context on the daily NQ futures which I have highlighted above.
EUR/CHF update – that was quite a ride in the past few days but it seems it’s finally ready to bust higher. Putting my stop below the current Net-Line Sell Level.
Soybeans update – that was one of yesterday’s setups. Moving my stop to break/even here.
More goodies below the fold…
More charts and 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 subscriber you get free access to all Gold posts, which gives you double the bang for your buck!
A bit of even risk later today when get the FOMC minutes, so I don’t expect too much activity before 2:00pm Eastern.
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   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…
Let me precede this post with a warning: I am not saying that it’s impossible for equities to push any higher. Quite on the contrary – there are signs that indicate that we soon may run into a little short squeeze. If that outlook sounds contradictory to you then you may want to go back and read Volar’s excellent excerpt on platykurtotic vs. leptokurtotic markets which he posted almost a year ago. Simply put – it all depends – August is a good month for trend traders and if you are betting on mean reversion you may get burned.
Now as stainless steel rats we are sworn to trade by our rules (whatever they are) and to only take setups which strongly suggest that the odds are in our favor. And it’s that last little detail that is the problem right now – momo and sentiment is all over the place. Meaning if you look hard enough you will find plenty of reasons to be short and plenty of reasons to be long. Unfortunately as human beings we all have a tendency to discard information that contradicts our current point of view and at the same time embrace information that supports it. Which easily translates into trading losses.
The purpose of today’s post is to show you the upside risk that is present right now. If you are a trend trader then you don’t care as you have been long for a while and your rules tell you to stay in until your stops take you out. Your system thrives on leptokurtotic markets and the few times you get away with it you win big. For the rest of you guys I have collected seven charts that demonstrate why holding long here represents significant risk. Over the next few days these charts may be meaningless but medium to long term I believe that their combined message advocates caution.
Exhibit 1 – the Dow vs. the TRAN: According to Dow theory those two should on average be moving in the same direction. When the performance of the average diverges it is a warning that change is in the air. Again, bear in mind that this is a long term chart – nevertheless it started to detach in July and the present divergence resembles a mirror image.
Exhibit 2: Similar situation on the Russell 2000 which obviously represents quite a bit more risk than the trannies. That little trend line I painted has been breached but I’m still labeling this as divergent.
A lot more where this came from – I will also show you two charts that suggest that we may head into a short squeeze before gravity sets in. As the old saying goes – the bus moves fastest once everyone got off. Please step into my lair:
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.
Exhibit 3: NYSE up vs. down volume – it’s been somewhat supportive thus far but there was a steep drop on Friday which I deemed worthwhile pointing out. This chart can be worthless during short squeezes (see Jan/Feb of this year) but that steep drop in one session may be a tell.
Exhibit 4: NYSE Advancing vs. Declining issues – rather surprised to see that divergence holding thus far. Judging by the recent past, this can go on for quite a while but once we drop into 1.5 territory we are usually close to rolling over, even it’s just for a quick wipeout.
Exhibit 5: NYA50:NYA200 ratio – measures quality of the current rally. And it’s starting to lag – I will keep an eye on this as it may just be summer tape. Admittedly it’s rather early and we may push higher here soon. Also, the Fed’s recent machinations have seemingly prolonged the lifetime of bearish divergences.
Exhibit 6 – copper. Which is not supporting this rally at all. Neither is gold or silver for that matter – almost everything else has been stuck in sideways purgatory.
Exhibit 7: My JNK:TLT ratio. Yes, you could call it supportive but I call this a lot less confident than what we see on the equities front.
Exhibit 8: I didn’t count this one as I posted it last Friday. But it’s a pretty strong argument and bodes repeating: With a VIX below 15 (as of the Friday close) I simply cannot be long here for more than a day or two.
Now as I want to be fair and balanced I found it to be my duty to also present two charts that point in the exact opposite direction:
VIX:VXO – this one measures the delta between front month strikes risk vs. front month ATM strikes risk. I use it to determine whether or not market makers are pricing in the possibility of a short term correction – which would obviously affect ATM options more than OTM options. I sometimes call it the MM lie detector. And it’s looking supportive to me – no doubt. Which suggests that market makers are pricing for a leptokurtotic market (i.e. trending market).
And even on the more long term VXV:VIX ratio I see nothing bearish. Even measuring three months out it seems that market makers are in general positive. Which is a bit confusing as August/September and sometimes October are not exactly seasonally bullish periods.
Bottom Line: Frankly I do not want to be long here and I cannot really be short just yet. Based on where we are right now I need to either see a short squeeze or a wipeout before I want to think directional again. HOWEVER, it is the long term VIX chart I presented on Friday that has me looking at a few lottery short tickets. In combination with the charts presented here I think the risk to benefit ratio is reasonable to devote a tiny amount of my assets to this setup. But that’s pretty much it – until I see some serious movement in either direction I would strongly discourage you from making any directional bets. Not sure when that wil happen thus I advocate patience. Don’t try to make wild guesses here – it’s a waste of time and most likely you will get taken to the cleaners.