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Trading Mathematics and Trend Following

  
  Education
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Some quick points, to be making money, Profit Factor must be greater than 1.

  • Profit Factor (PF)
  • = Gross Gains / Gross Losses
  • = (Average win * number of wins) / (Average loss * number of losses)
  • = R * w / (1-w)
    • where R = Average win / Average loss
    • w = win rate, i.e. % number of winners compared to total number of trades

Re-arranging, we have

  • w = PF / (PF + R)
  • R = PF * (1 – w) / w

Sample numbers showing the minimum R required to break-even (i.e. PF = 1, assuming no transaction costs) for varying win rates.

  • w = 90% >> R = 0.11
  • w = 80% >> R = 0.25
  • w = 70% >> R = 0.43
  • w = 60% >> R = 0.67
  • w = 50% >> R = 1
  • w = 40% >> R = 1.5
  • w = 30% >> R = 2.33
  • w = 20% >> R = 4
  • w = 10% >> R = 9

The style of trading strongly influences the win rate and R (average winner / average loser). For example, (more…)

Traders-Are You Guilty?

  
  Education
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  1. re you trading without a plan? Trading without a plan makes you emotional and a gambler.
  2. Do you ever trade too big for your trading account size? Big trades are bad trades for the emotional engagement and risk of ruin that they entail over the long term.
  3. Do you risk losing more if you are wrong than you will make if you are right? The biggest driver of profitability in your trading will be big wins and small losses. Big losses and small wins is a sure path to losing your trading capital.
  4. Have you traded without studying charts to see what has happened historically with similiar price patterns? If you do your homework you can make money understanding possibilities and probabilities from past patterns. Trading your own opinions will usually put you on the wrong side of the market. 
  5. Did you trade a system before you back-tested it?Or are you just trading blindly?
  6. Have you ever exited a trade due to fear instead of due to hitting your stop loss or trailing stop? The right exit is what determines your profitability and whether your win is a big one or your loss is a big one.
  7. Have you ever entered a trade becasue of greed without an entry signal? Chasing a trade after the trend is over is a great way to lose money consistently and quickly.
  8. Have you ever copied someone else’s trade not knowing their time frame or position size? Ultimately you have to trade your own system and your own method that matches your own personality and risk tolerance. Only you can make yourself profitable with faith in yourself and your method.
  9. Are you that person that loves to short during market up trends and miss a whole up move?The easy money is on the side of the trend in your time frame going against the trend is a great way to lose money.
  10. Are you that knife catcher that keeps going long at the worn time in a down trend? When everyone is exiting a market that is the worst time to be getting long as wave after wave of holders are leaving. 

12 Rules of Market Cycles

  
  Education
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1. Secular cycles are driven by the inflation rate (deflation, price stability, and higher inflation)

2. Secular bulls occur when P/E starts low and ends high over an extended period

3. Secular bears occur when P/E starts high and ends low over an extended period

4. Cyclical bulls and bears are interim periods of directional swings within secular periods

5. Cyclical cycles are driven by market psychology, illiquidity, or other generally temporary condition(s)

6. Time is irrelevant to the length of secular stock market cycles

7. Secular bulls require a doubling or tripling of P/E

8. Secular bears occur as P/E stalls and falls by one-third to two-thirds or more

9. When real economic growth is near 3%, there is a natural floor for P/E between 5 and 10, a natural ceiling around the mid-20s, and a typical average in the mid-teens

10. If economic growth shifts upward or downward for the foreseeable future, the natural range moves upward or downward, respectively

11. Inflation drives P/Es location within the range; economic growth drives the level of the range

12. The stock market is not consistently predictable over months, quarters, or periods of a few years; the stock market is, however, quite predictable over periods approaching a decade or longer based upon starting P/E

The Development of Mindfulness Skills Helps the Trader

  
  Education
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  • Reduce stress
  • Tame the fear response
  • Counter the strong tendency toward loss aversion
  • Strengthen decision making
  • Strengthen internal emotional regulation
  • Improve and develop emotional intelligence
  • Reduce the dominance of intuitive decision making and cognitive error
  • Increase deliberative attention
  • Better see the market and its trading opportunities
  • Stay on task
  • Overcome the negative‐reinforcing properties of ineffective trading
  • Enhance overall psychological well‐being.

3 Hard Questions

  
  Education
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Markets are highly random and are very, very close to being efficient.

If you are a new trader, trading is probably harder than you think it can be. If you’ve been trading a while, you know this. Financial markets are one of the most competitive environments in the modern world. New information is quickly processed and incorporated into prices. This means that you cannot outsmart the market consistently. You cannot invest based on what you think makes sense or should happen because you are up against investors with superior access to information, knowledge, experience, capital and other resources. Most of the time, markets move in a more or less random fashion; you can’t make money if market movements are random. (“Efficient”, in this context, is an academic term that basically means that all available information is reflected in prices.)

It is impossible to make money trading without an edge.

There are many ways to create an edge in the markets, but one this is true—it is very, very hard to do so. Most things that people say work in the market do not actually work. Treat claims of success and performance with healthy skepticism. I can tell you, based on my experience of nearly twenty years as a trader, most people who say they are making substantial profits are not. This is a very hard business.

Every edge we have is driven by an imbalance of buying and selling pressure.

The world divides into two large groups of traders and investors: fundamental traders who base decisions off of financial analysis, understanding of the industry and a company’s competitive position, growth rates, assessment of management, etc. Technical traders base decisions off of patterns in prices, volume or related data. From a technical perspective, every edge we have is generated by a disagreement between buyers and sellers. When they are in balance (equilibrium), market movements are random.

7 Points To Follow If You Are A Trader

  
  Education
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  1.  Expect long hours of study and research. Assume you will lose money in the beginning.
  2. A person interested in becoming a trader must have the mindset of an entrepreneur. Risk, irregular income, and spending money to make money, are all part of the business.
  3. You must trade like a business person and not a gambler. Gamblers need not apply; go to Vegas instead.
  4. Risk management will be your priority. Too much risk exposure will eventually lead you to be an unemployed trader with no trading capital.
  5. You are your own human resource department. Be prepared to manage your own greed and fear.
  6. To keep your morale up, you must keep all your losses small, and allow your winning trades to be as large as possible.
  7. Jesse Livermore’s quote for potential candidates: “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.”

Morales & Kacher, Short-Selling with the O’Neil Disciples-Book Review

  
  Education
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SHORT-SELLINGGil Morales and Chris Kacher, the self-styled O’Neil disciples, have established something of a franchise. This is their third book. First cameTrade Like an O’Neil Disciple (2010), then In The Trading Cockpit with the O’Neil Disciples (2012), and now Short-Selling with the O’Neil Disciples: Turn to the Dark Side of Trading (Wiley, 2015).

The authors remain true to their basic philosophy and method, which they dubbed OWL for O’Neil-Wyckoff-Livermore. Here they apply it to short selling.

They sketch out six rules, which deal with cycle timing, stock selection (in terms of price action and volume), trade timing, and setting stops and profit targets. They display chart patterns that serve as short-selling set-ups. They explain the mechanics of short selling. They analyze five case studies that occurred between 2011 and 2014—AAPL, NFLX, GMCR, DDD, and MCP.

And, in what they consider the “real meat of the book,” they offer 91 “templates of doom,” or “what one might consider models of the greatest short-selling plays in recent history.” Studying these templates—marked-up daily and weekly charts—“can give one an edge in recognizing when a major short-selling opportunity is at hand.” (pp. 175-76)

In a cautionary note, the authors readily admit that “there is nothing mechanistic or deterministic about short-selling. Sometimes these set-ups work beautifully, sometimes they don’t, and the probabilities of success rely heavily on contextual factors. These contextual factors include the current action of the major market averages, the phase of the market, the overall national and global economic backdrop, industry developments, earnings news, and the occasional, random, and sudden positive news or rumors that trigger a bounce in an otherwise weak, down-trending stock. Relative to the long side of the market, my experience is that the short side tends to be far more volatile and fraught with uncertainty.” (p. 176)

However potentially treacherous the short side, there are times that short positions are the only money makers. And yet many investors and traders remain squeamish about shorting stocks, not so much because they fear “the dark side” but because it’s uncharted territory. Morales and Kacher have literally charted the way for them.

Nassim Taleb’s 9 Risk Management Rules (Must Read )

  
  Education
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Rule No. 1- Do not venture in markets and products you do not understand. You will be a sitting duck.

Rule No. 2- The large hit you will take next will not resemble the one you took last. Do not listen to the consensus as to where the risks are (that is, risks shown by VAR). What will hurt you is what you expect the least.

Rule No. 3- Believe half of what you read, none of what you hear. Never study a theory before doing your own observation and thinking. Read every piece of theoretical research you can-but stay a trader. An unguarded study of lower quantitative methods will rob you of your insight.

Rule No. 4- Beware of the nonmarket-making traders who make a steady income-they tend to blow up. Traders with frequent losses might hurt you, but they are not likely to blow you up. Long volatility traders lose money most days of the week.

Rule No. 5- The markets will follow the path to hurt the highest number of hedgers. The best hedges are those you alone put on. (more…)

7 Ways Your Brain Is Making You Lose Money

  
  Education
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“Investors are ‘normal,’ not rational,” says Meir Statman, one of the leading thinkers in behavioral finance. Behavioral finance aims to better understand why people make the financial decisions they do. And it’s a booming field of study. Top behavioral finance gurus include Yale’s Robert Shiller and GMO’s James Montier. It’s also a crucial part of the Chartered Financial Analyst (CFA) curriculum, a course of study for financial advisors and Wall Street’s research analysts. We compiled a list of the seven most common behavioral biases. Read through them, and you’ll quickly realize why you make such terrible financial decisions.

Read. However, once you get the idea of behavioral finance, keep in mind that the names associated with this article don’t have a wise strategy. Trend following is wise. Predictions, forecasts and other la la statements about what might happen tomorrow are only useful if you are masochist.

 

Nicolas Darvas on stops: "no loss-free Nirvana"

  
  Education
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I was just rereading Nicolas Darvas’ How I Made $2,000,000 in the Stock Market and came across this interesting summary of his trading method and risk management approach in the author’s intro. I’d like to share it with you.
Quoth Darvas: 

“I built a fortune with serenity by avoiding premature selling yet making an exodus from most of my stocks with the use of a single tool: the trailing stop-loss. 
I have discovered no loss-free Nirvana. But I have been able to limit my losses to less than 10 percent wherever possible. My stop loss method had two effects. It got me out of the wrong stock and into the right one.”

Full passage in the image below:

Darvas

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