Advanced Thor – Working Without A Net

Scott here. Judging by the emails Mole and I get there are a few of you trading Thor without a proper business plan to go with it.

Let’s be clear. Mole just sends you the signals, how you take them is always a matter for your system, and how position sizing limits work within your system needs to be defined right from the start. The problem for any system which trades more than one markets is correlation. Whatever you “think” the worst case correlation risk is on any given day, you can probably triple that.

Human beings are a smarter than usual species of apes. Monkey like banana, but monkey no count banana well. Always see potential banana and never see potential for banana to be taken away. Makes Scott ANGRY! Every setup look like many banana potential, even when setup marginal at best. Sometimes even see banana where no banana exist. Sometimes not see dangerous predator because too busy looking for banana. STUPID BANANA! But love banana so much, must keep chasing banana!

Technically any setup which is entered at roughly the same time will be correlated to some degree. (read that again it is very important) Every setup measured in USD (gold, copper, soybeans, bonds) is correlated in some degree. Every setup which is a “risk off” asset or “risk on” asset is correlated to some degree. Obviously all the JPY crosses are correlated, all the CAD crosses, etc. All the bonds, all the grains. But GBPJPY is correlated with ES futures, no doubt at all. So you need to apply some intelligent rules of your own design here.

One solution is to trade a tiny subset of markets. Some people take this to the extreme and trade only a single market. I’m a firm believer that this is suboptimal, however if you have different market beliefs (we after all only trade our beliefs) that may not be true for you. To be clear I would never take a potential setup simultaneously in Gold and Silver, ES and YM, AUDJPY and GBPJPY, etc. That should most definitely be explicitly in your rules.

HOWEVER. There is a big difference being stopped out on a long held winner (which is actually what you want) and stopped out day one for a big ass loss. Let’s say you have a winner running for a few weeks in Wheat and get a setup in the same direction in Corn. Would you take it? My personal rules tell me to take it. You might be uncomfortable with effectively pyramiding like that, or you might not. Your rules need to cover it.

Thor has an unusual characteristic in that around 50% of the 1R stopouts happen on the first day, and the big winners are often held for 3-4 weeks. So you accumulate positions like a junk hoarder. Right now in my main account I have 9 positions open, all risking 1.5% of equity, which is about normal. The more positions you have open the more opportunity for human error, market fuckery, mechanical problems where things trigger in a short space of time placing you under pressure. I have someone paid to check my work, which works very well and holds me accountable. This is my current open positions with open profit (in USD) and you can see of the 9 open positions 8 are in profit to some degree or other. This is a pretty typical day, equity was down about 1.1R overnight, a LOT of those positions still have the potential to fuck me over (stops not at breakeven)

real account

What I suggest is to have a risk profile that suits YOU. If you are relatively risk averse I would suggest a limit of 4 POSITIONS WHERE THE STOP IS NOT AT BREAKEVEN OR BETTER. If you are trading high R values 3 positions might be appropriate. Possibly also a maximum % of account used in margin.

In my main account to calculate position sizing I also assume that any position with a stop not at breakeven will potentially stop me out, so I calculate the 1.5% based on equity less 1R for every position not at breakeven. This is sensible to ME, but may not work for you.

I trade 2 accounts, a real account with lots of money in it and a “cracker account” which I trade at high R value and every time I get a little money in I pull some out and live off it. I try and leave the cracker at between 40 and 50K and pull out 10K increments to live off. Except for paying taxes and the like I don’t really touch the big account, but I’ve learned (from Ivan actually) the value of taking profits out to “make it real” even though this is mathematically suboptimal. I very much like the cracker account/real account dichotemy. The cracker account is a small enough portion of my total equity that if it is totally wiped out it won’t make any difference to me, and I find it emotionally satisfying on a deep level to “eat what I kill” and pull $10K out now and again and treat myself to a nice holiday or something I want.

For instance in my cracker account which I trade for income at 4% R value (significant and real risk of ruin)  I hit margin limits very quickly. I cherry pick the best setups and by necessity cannot take every setup. This is the current state of the account, which started trading Thor in August (switched from my previous systems) at $28000 and have pulled out $20,000 along the way. This is a 5 month return of 230% and an annualized return of over 500%. However even though this account is at fresh equity highs, it has endured peak/valley drawdowns of 30%  - not for the feint hearted.

open positions

 

You can see it is using 47K out of 61K in available margin, and I have only 4 positions open. So one more position would max me out, and if those positions move against me (multiple positions have the annoying habit of moving in lockstep one way or the other) have me getting nasty margin call phone calls from the broker. So trading the cracker account for 4% R value involves me cherry picking the “best” setups - which brings in subjective elements which makes life hard/stressful/confusing. This is a difficult approach. Of COURSE it is difficult, shooting for over 400% / year SHOULD be difficult, right?

cracker1

Anyway, I hope this gives you some ideas.

chopper (1)

Scott Phillips

Long Term Perspectives

Equities are bubbling higher with the ES futures touching the 2k mark for the very first time (the cash did it yesterday). Since there’s not much to be said on the trading front this is a good time to run through a few long term perspectives. Now that another major milestone is in the bag the question once again returns to how long equities can keep this pace up!

2014-08-26_spoos_update

Let’s start with price and our volume profile on the E-Mini futures. If you ever entertained illusions of possessing any clairvoyance in regards to the market’s direction then think back to early August when we were in the midst of what looked like a correction with legs. Since that time we’ve seen one of the most profitable reversals of this bull market.

2014-08-26_PnF

Actually there was a very similar one earlier this year in February. Looking at the P&F the setup and ensuing resolution looks almost identical to the one last winter. What followed was quite a bit of sideways churn and plenty of guesswork which lasted all through June. It’s possible that we’ll be entering a high volatility sideways period in a few weeks from now, so enjoy the getting while it’s good. However, that said – I don’t think any correction (sideways or down) would drag out for months again as we usually see more directional tape in the last quarter.

2014-08-26_JNK_TLT

If you recall from a few weeks ago – I was getting quite nervous about the discrepancy between the JNK:TLT ratio and what we were seeing on the equities side. We did get our correction but what’s remarkable is that this chart hasn’t moved an inch while equities were driving higher.

2014-08-26_JNK_LQD

So what gives? Well, it’s a complicated story and quite frankly I’m not a bond expert. But part of the answer may lead back to this chart – a cross between JNK and LQD (investment grade corporate bonds). Seems like bond investors are piling back into corporate bonds and unless we see a significant divergence on this chart there is little standing in the way of this raging bull market. Which unfortunately most retail traders have completely missed out on.

More LT perspectives below the fold – please step into my lair:


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Market Weather Basics

In the past few years I have spent quite a bit of effort categorizing distinct market phases as they clearly can affect both discretionary as well as automated system trading. I often also refer to it as ‘market weather’ and my first treatise on the subject was two years ago in a pertinent post. It mostly focuses on the psychological aspects of how market gyrations affect trading behavior and distorts perceptions among market participants. In combination with a trader’s respective cognitive biases various market conditions will affect one’s daily activities. Whereas a swing trader may be perfectly happy and successful playing the swings in a volatile sideways market a trend or system trader may run into draw down periods, thus affecting discipline due to recency bias.

Of course there are various technical approaches of how to categorize market periods and among my favorites are Van Tharp’s SQN based approach or the StretchStat and VolStat indicators developed by Ken Long. Scott recently covered those in his posts, so if you want more meat on your sandwich then I suggest you point your browser here.

In today’s post however I want to go back to the basics as you don’t really need any fancy indicators in order to develop a pretty good ‘feel’ (if I may use that word) for categorizing various market periods on a chart. The human mind is actually pretty damn good at pattern matching – and with a bit of practice it’ll quickly become second nature. So let’s cover a few core markets of recent past, starting with the bonds.

This is actually a wonderful example as the difference in the two prevalent phases couldn’t be more salient. Starting in early January until the end of the month bonds pushed up significantly in what I would call a low to mid volatility trending phase. If you recall Scott’s treatise on the subject – that is a very common period and one I would categorize as easy to slightly challenging for the average trader. Of course your mileage will vary greatly – again for a trend trader this can be fun, for a swing trader this is more challenging as reversals/corrections are shallow.

The inverse speaks true to what followed – a high volatile sideways market which I consider the most difficult for most retail traders. The reasons for that are plenty and have been rather prolific on this subject and prefer to not repeat myself in this post. Suffice to say that anyone with a directional opinion or expecting resolution will be taken the woodshed all the way through Sunday.

Here is another example – the spoos on which I highlighted three distinct phases. The sell off in January was rather directional but with some volatility in the middle. What followed was a low volatility trending phase. Of course any indicators won’t tell you that until you’re halfway in but the human mind can easily pick up the fact that we have very few overlapping candles and most importantly 10 consecutive higher highs in a row.

Since about mid February things however got a bit more dicey and I would categorize the recent month as a volatile sideways period – once more the most difficult to trade for most participants. Psychologically also rather taxing and it has been taking its toll right here in the comment section (which has been rather quiet in the past two weeks). I always try to warn you guys when I see storm clouds on the horizon but often get the impression that very few are listening. Perhaps educational posts like these will serve to instill a bit more sensitivity as to when trading can be easy and when it can feel like helping Sisyphus push a rock up a steep hill.

Another example gold – I think one of the reasons why we have been rather successful in trading the shiny metal is that gold has the habit of switching between volatile sideways and trending phase with a mix of volatility, usually medium to heavy. You probably remember our gold entry in early February at which point I was expecting gold to continue trending higher. What I did not anticipate is that it would make a sudden u-turn but what’s interesting is that the market phase has barely changed – we are still trending and volatility is probably identical to what it was on the way up. So clearly we must differentiate between direction and market phase. For the seasoned trader direction may be insignificant but retail traders often get married to a particular direction, with the expected results.

And then there are charts which are almost impossible to categorize – I usually stay away from those unless I see then knocking on very pronounced inflection points (a subject for a different day). But when you look at a chart just like this – what do you see? What I see is acceleration followed by slower periods. In terms of volatility that creates a strange mix – the tape looks pretty directional but it’s rather volatile. But clearly this is NOT any easy chart to trade, would you agree?

Here is another example that may be even more pronounced – the fabled natgas contract Just look at how different these market phases are and I haven’t even bothered trying to categorize them. An accumulation of slow/sideways tape followed by quick spikes, long wicks, and sudden reversals. I also see a lot of gapping action and for a futures contract that is very rough to trade. Once again, stay away unless you really know what you are doing.

In summary – market phases are much neglected but integral part of trading and one you should come intimately familiar with. System developers often thrive to write systems that offer a lot of opportunity by being in the market all the time. That’s understandable but it is largely based on an unrealistic assumption that the same entry and campaign rules will work in all market conditions. Instead you will find that some systems promising only a very small or no edge may suddenly work extremely well if used only in the context of certain market conditions. To that end it is important that you sit down and document the characteristics and beliefs of your trading activities and then correlate them with the various market conditions you will encounter. Again, that in itself deserves its own post and I think Scott has definitely pointed the way.

My own work is strongly influenced by market categorization and without padding my own shoulder many here would agree that it has kept us out of various traps in the past. This morning’s spike higher for instance could not have been predicted but it had pretty good odds given what we saw on the Zero as well as in the context of the tape we experienced in recent weeks. Which is why I happily exited my TF trade yesterday according to the rules.

In essence what you always want to ask yourself is this: Does the current market phase impair or support my trading activities? In either case you can either change your current approach or just sit on the sidelines until you see better weather on the horizon. Unlike fund managers or professional traders you are only responsible for yourself and your personal assets, thus you are afforded the luxury of flexibility and the ability to be nimble. Once you are pushing a few hundreds of millions of Dollars around the dynamics of trading become quite different. It’s like the difference between driving a speedboat and an oil tanker. Say what you will – the speedboat is a lot more fun and if you’re lucky you’ll enjoy attractive company in sexy bathing suits.

Well it’s been a rough week and now it’s time to kick up our feet and crack open a cold one. I see you all next Monday morning.

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