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,

Seven More Reasons Not To Be Long

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.

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.

Cheers,

How To Trade Vega At Market Bottoms

As I was perusing the comment thread this morning I saw a few musings on how to best get positioned near a potential market bottom. The option strategies that were suggested are definitely reasonable (i.e. regular credit spreads) but IMNSHO non-optimal during times of rapid volatility spikes.

In order to set the stage observe that IV as expressed by the VIX has jumped by 30% in the past month. Thus I decided to put a together a quick and dirty write up on an exotic beast called a ‘reverse calendar spread’ – a.k.a. ‘reverse diagonal spread’.

Let me however precede the following with a caveat – I am not suggesting that a market bottom is already in the works but I’m pretty comfortable in proposing that we will see one in the next five sessions.

We all know that high volatility associated rapid sell offs offers tremendous profit potential – in theory. The truth of the matter is that even seasoned traders are often only familiar with the most basic option strategies, which unfortunately do not apply well in an environment of high volatility. Obviously the most straight forward approach here would be to simply sell vega via shorting puts but unless you have suicidal tendencies I would not recommend that as an actual option (pun intended).

Bull and bear debit spreads are generally poorly priced when there is high implied volatility (IV). When a bottom is finally achieved, the ensuing collapse in premium due to volatility crush often strips away much of your profit potential. Many a traders have been punished this way and often they are not even aware of what happened and that vega is to blame. So even if you get the timing right and are able to get positioned you may easily see yourself being stripped of most of your ill gotten gains during a snapback move following a capitulation sell-off.

This is why I propose at a simple strategy that actually profits from imploding volatility irrespective of market direction (theoretically – more on that below) and requires little up-front capital if used with options on futures or ETFs. Even better, as long as IV drops or remains stable (e.g. after a big push outside the 2.0 BB) it has little or no downside risk, thus reducing the bottom-picking dilemma. The strategy also offers some very juicy upside profit potential if things start accelerating to the upside and vega is being crushed, thus causing an increase in pain that is often referred to as a short squeeze. The basic idea of this strategy is the inherent opportunity offered by a sharp drop in IV. By neutralizing delta and gamma and getting short volatility, or short vega, the strategy is a great tool in our arsenal for banking coin near market bottoms.

As most of you rats already know a high VIX means that options have become extremely expensive because of a surge in volatility, which massively affects option premiums – calls and puts alike. This presents a conundrum for option buyers – whether of puts or calls – because it leaves you long vega just when you should be short vega.

Thus the most straight forward solution is to sell options which leaves you short vega and thus able to profit from a volatility crush. However, especially during times of a potential medium to long term trend change (i.e. bull market rolling into a bear market) it is of course very much possible for IV to push even higher. And if you are being caught short vega under these condition then it can very quickly lead to significant losses.

The Solution: Reverse Calendar Spreads

Traditionally calendar spreads are considered neutral strategies, involving selling a near-term option and buying a longer-term option, usually at the same strike price.  The idea is to have the market stay confined to a range so that the near-term option, which has a higher theta (the rate of time-value decay), will lose value more quickly than the long-term option.

Another way to use calendar spreads is to reverse them – thus buying the near-term and selling the long-term, which works best when volatility is very high. The reverse calendar spread is not neutral and can generate a profit if the underlying makes a huge move in either direction. The risk lies in the possibility of the underlying going nowhere, whereby the short-term option loses time value more quickly than the long-term option, which leads to a widening of the spread – exactly what is desired by the neutral calendar spreader. Having covered the concept of a normal and reverse calendar spread, let’s apply the latter to SPY call options.

Back To The Real World – SPY Example:

All the above may be confusing to you so I put together an example with regular SPY options on the trusty TOS option simulator – a fun diversion for lonely weekends, for example if the local nudie bar is closed for renovations. Heck, it beats reruns of Friends – at minimum it’ll teach you a lot about option greeks.

As we are optimists I’m showing you the winning side first. The ThinkOrSwim simulator does a great job of showing you that you are effectively neutral delta and gamma. We have SPY trading near 130 and are currently counting 63 days to the expiration of the July 130 call. The trade is constructed using simple SPY call options. I think initial margin requirement for the spread shown above is around $200.

So assuming SPY trading near 130 and expecting a bottom in place soon (which again may not be the case – this is just an example) we buy one July 130 call and simultaneously sell one September 130 call, which leaves a net credit of ~$217 before any commission or fees. This should best be done by an experienced broker who can place a limit order using a limit price on the spread or you can use the TOS platform which allows you to automate the process and ensures that you are not being partially filled. It is very important to understand that the goal for this spread is to close the position at maximum 30 days ahead of expiration of the near-term option (Oct expiry), a bit sooner is better.

As you can see in the above chart – as long as vega drops from here you really don’t care where prices are going as you should be able to bank some mighty coin. If you expect only a short term spike then you may have to play this one with weekly options with the sell side being three or four weeks away but that is really outside the scope of this little example.

But of course we all know that vega would explode even higher should prices continue to drop lower – in particular if we breach the proposed support clusters I have pointed out in the past few days. Which really renders your profit potential during a drop associated with dropping IV nothing but academic. In essence on the very first chart you can ignore the simulated profit curve below the 130 price point. Why? Because it is unreasonable to assume that vega will drop if we continue much lower from here – most likely it’ll jump higher. On the inverse anything above 130 on the loss simulation above can be ignored as well as we most likely won’t see IV run higher if prices are starting to snap back.

Obviously I have skipped much of the meat on how to calculate and structure each side of an reverse calendar spread. But that really wasn’t my focus and there are plenty of great tutorials out there if you want to get into the nitty gritty. What’s important to understand is that a RCS can effectively be used during supposed market bottoms and may be preferable to other credit spreads.

Here’s an example of a regular vertical credit spread and with volatility falling in 5% increments. As you can see those profit curves flatten out rather quickly.

Getting the timing right of course is an art in itself but I thought that a 30 day window may be a good compromise. If you want to put together something more short term then you may look into playing the weeklies. But that’s a completely different story as they move a bit more like futures and react differently to theta burn.

Cheers,




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