Living Inside a Broken Clock: Thursday, Mar. 4, 2010

by gmak

I am not going to write about the markets today, but about trading. I can tell you that the SPX price will move up and down over the day. The bar can only have 3 characteristics. It can open at the HOD, go down, and close at the LOD.  It can do the reverse (LOD to HOD). It can open, move up and down and close at some point neither at the HOD nor LOD.  Thinking about this, I wonder if their is a relationship between the shapes of the bars. I know the DeMark indicators use a related theme – but more from the relationship between open and close and high and low. Now that I have a truckload of SPX data and that I am looking at relationships to the 50 DMA, this might be a feasible project as well. The closing price data difference from the 50 DMA parses out as follows. -4% means that the difference is between -3% and -4%. My next project is to try to observe the behaviour of SPX prices when the 50 DMA is crossed.

These are some of the gears inside the broken clock.

Today, the market will go up, and it will go down. The same for currencies.  Looking at the last two days, my best guess is a close down from the open. I don’t know where it will be in relation to yesterday’s close.  I just see an SPX that cannot hold the HOD and closes near the open for the day.  I see a mainly red Asia, and a mixed Europe (more green than red). I see a DAX that gapped down at the open but has been marching up in a regular steady channel since then Yesterdays high was around 5830 – and this would be the barrier of choice for today.  It seems like the gap might close and then sell off. These are just opinions and guesses. What I really am coming to believe is that it is possible to play a particular direction on any given day and make some money. I’m talking about living money, not island buying money.

I’ve been thinking about the so-called Trader’s Edge that it is generally accepted that a Trader needs to be successful. I’m curious about what this would be. I’ve seen proprietary trading signals, and different combinations of TA – some of it arcane. I’ve heard traders talk about (and I’m guilty of this too) a higher probabiity trade. Sometimes this means that the expected reward is greater than the expected loss. Sometimes this means that there is a higher likelihood of a particular price behaviour.

All of this seems to depend on an expectation of movement in a particular direction.  This suggests some form of prediction. And yet, we all know that the markets are not predictable. For example. Look at any security. Tell me if the next trade will hit the bid or the ask. And the next one? And the next one? This is the issue with prediction. It is like predicting the toss of a coin. However, Algos manage to play the assumption of a trend for pennies – but they have advance warning of what volume is coming down the pipe at what price. I suppose it is not too far a stretch to assume that some TA gives an indication of probably volume exhaustion in a particular direction. I imagine it would be along the lines of “There have been 15 heads in a row. The odds for 16 heads are so small that….”. Playing the odds would lead one to bet tails – or to look for a reversal.

Can TA provide this sort of information? Perhaps. I have seen and traded TA that indicates those levels where a turning point is more likely. Proper money management – where the loss times probability of being wrong is less than the gain times probability of being right – can make this pay off. 

Back to the trader’s edge. Does anyone really believe that they have the secret combination to insight that will let them win over and over? Probably. I think that it is that belief that is the trader’s edge. If one really believes there is a secret formula, then they are more willing to take an interim loss for the eventual gain. We have all seen the trader whose capital erodes steadily with occasional gains. They show a lack of confidence in their own trade and are too quick to pull the plug – leading to many more losses from exits and smaller gains – hence the eroding capital. Although it may be heresy in the traders’ world, I’m looking at the idea that stop-losses are really ensure-losses. I’m thinking that maybe the stop should be set far enough away to protect against a black swan event but to allow the trade to occur. Geronimo is a case in point. The upside is limited, and the stop-loss is quite far away. I’ve been using this in trading DXY – where the gain is smaller than the portential loss. I find that the wide stop gives the trade time to work. In other words, FCBs can run the stops in the wrong direction. So long as the daily price movement from high to low is wide enough, my price is the trade direction has a good chance of being hit. This is where not being greedy comes in. I also find it helps if I don’t watch the trade – the moves against can be nerve wracking.

This type of tactic is not possible without 1) the confidence that it will work (or a belief in an edge); 2) a sufficient capital cushion to absorb the interm moves against the trade; 3) the ability to supress emotion – I find thatit helps in dealing with risk capital = money that can be lost and not affect your physical or mental well-being into the future. i.e. money you can afford to lose and still feel just as wealthy as before.

While I’m at it, let me lecture you about black swans. They are NOT, as everyone seems to think, events that you cannot imagine happening, actually happening. They are low probability price movements that actually occur more ffrequently that the so-called normal distribution would indicate. This is what “fat tails” mean. If, based on statistics, there is a 1 in a million chance of 10 down days of more than 3% each in a row (as an example), then it is a black swan even if it occurs. Taleb’s trading tactic is based on this.

The fund buys OTM options where the price is, according to their math, not reflective of the actual proability of that price movement occuring. So if the cost is $1 for a $1 mm gain for the OTM option, and the Taleb probability is actually such that the event occurs every 10 years on average, then the fund would parse the capital over the ten years in amounts that would ensure a  usurious profit on the starting capital for when the pay off occurs.

The risk is the “on average” part. Suppose the event doesn’t happen for 20 years and then happens 3 years in a row? Taleb’s fund would be out of business based on the 10 year horizon on average. The successfu funds are those lucky enough to have a black swan even occur sooner in the time expected – which provides an much larger capital base to play the same game and yet hold some in reserve.

I’m continuing to play in DXY, looking for moderate returns on each trade. I’ve been through some wild swings in price relative to the profit being sought – but this is with extreme risk money that has no bearing on my future. I can take these chances. The missing part of the puzzle is proper protection against black swan events, since DXY seems to follow a  defined range on any day – and the near 24 hour trading means that there are no gaps. 🙂

It is very liberating to not worry about the outcome of any trade. To just set an exit price – no stop – and walk away. This may end in an empty account – but it’s not THE account.

watch?v=J0y2dDlFmLg

Cheers.