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Trader's Corner

Achieving More Winning Trades: Systems Trading, Part 2

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OIN SUBSCRIBER QUESTION: 
It looks like the rallies in the OEX and NDX have hit or nearly reached the objectives you talked about in your last index article. Do you always get out when your target is reached or are there ways that you modify your strategy if the index trend looks strong still?

RESPONSE: 
I usually take profits on my objectives, but if the trend up or down looks still strong, I may exit on half of my options. 

I do keep raising my exit point on remaining positions; a so-called "trailing" stop, as I try never to give back all of my profit. I will use trendlines most often to find these points and exit calls if the index breaks down below its up trendline; or, with puts, if the index breaks out above a significant down trendline.

I was inclined myself to exit today on all Nasdaq 100 (NDX) calls (recommended on the recent dip to the 1438 area) when the NDX climbed above 1500 today; but, the market looks strong still and I could have as well held some calls and bumped my remaining exit point as noted below. 

My last stated target or objective (Obj.) on S&P 100 (OEX) calls is 565-568, which has not quite been reached. It would be warranted to raise the suggested stop (to protect partial profits) to 558. 

If my objective is reached, and it looks like OEX can get into my target zone here shortly, keep the same protective stop on remaining calls for those who want to hold some calls yet. But raise the stop as the days progress per the below hourly trendline.

I am inclined to exit on all in the OEX, given what I thing will be possible strong resistance at 568. A stop or exit strategy is noted on the hourly OEX chart below...

MORE ON TRADING SYSTEMS - 
OIN SUBSCRIBER QUESTION: 
You were describing how one could use trading system to make your buy and sell decisions. The seems interesting cause I want to do something different than I've been doing which is losing in my options account. I don't have a system and it seems like I react to the market mostly. Later I see that myorignal idea was right, but I forgot about what I was planning at the end of the day. But what you describe seems too complicated for someone who is not a computer person. 

RESPONSE: 
Well, you're right on something. The way I presented the trading "language" for a sample indicator-type strategy (system) was based on an old method where I program the language from scratch so to speak; I'm talking of TradeStation software, which is the one I know that does strategy/system testing and development. 

Today's TradeStation software and I think others are similar, uses something that the TradeStation people call a "Strategy Builder". This allows you to build a rule-based trading system not from scratch but by taking you through what you want to accomplish; where component rules are already set up for you to use, including what "stop-loss" rules, if any. For example, you want an exit signal if, after entering a trade, the index goes X number of points against you. 

As far as exit-if-wrong stops, an example of how they work is that you get home and after turning on your software trading application, a message pops up that you need exit the last calls or puts you bought because the price closed against you by more than your risk point. When you "back-test" the profit/loss of your trading system it assumes you got out at those points. When you build your strategy you put in a dollar amount each point loss or gain represents. It will even figure some "slippage" as we rarely get out just exactly with the loss we pre-figured. 

Let me back up slightly. I said that most trading systems can be generally broken down into ones that use technical indicators or ones that use chart patterns; or, a combination of both of course, but I am trying to be basic here. 

I described having the idea that I wanted to buy an Index (e.g., the S&P 100, OEX) when the OEX Relative Strength Indicator (RSI) goes ABOVE 30 on a daily chart after being under that level; or, whatever level I thing is "oversold", and I can test different levels. I also wanted to exit if I was wrong by 5 points in the OEX. Part of my idea was also that I wanted to be in puts (a "sell short" rule) if the RSI fell BELOW 70, but to exit if the index instead ran up 5 points against me. By the way, setting up the rule this way, is so as to NOT get you into puts when the RSI FIRST goes above 70; RSI may be on its way to 80, back down to 75, then up to 85, before falling! Hey, markets get extreme!! 

This kind of strategy is all relatively easy to set up in these new kinds of software. I say "relatively", because nothing worthwhile is gotten with little to no effort and it takes some hours to learn how to use these kinds of software; more at the beginning. It seems like that only in trading is there the idea that you can put a minimum amount of work for maximum results!

An important concept of strategy testing and development is the TESTING part. You can test your ideas BEFORE you trade by "applying" your strategy or system (like the RSI-related one described), on prior years price data. Just apply the trading system you built and named (e.g., "Leigh's hot-shot RSI strategy") on a chart and it marks every trade that strategy would have gotten you in and out of. After you read the report of how many winners, how many losers, this strategy produced and the dollar profit or loss, you can then decide if it has promise. 

In the foregoing example of an RSI Indicator-type system, you can test the best (e.g., most profitable) RSI "length", the best oversold and overbought levels to use as "triggers", etc.; even, an optimum exit-if-wrong or stop level to use; for example, is it best to risk 5 points from entry or should you give a trade entry a bit more leeway. 

To complete this sort of basic primer on the use of rule-based trading systems I should also describe: 

PATTERN RECOGNITION SYSTEMS - 
Most investors and traders that analyze charts based on technical analysis principles will tell you that they are looking for clues to future market direction based on particular patterns that they have found meaningful. For example, we want to spot any period of a few days duration, when a market begins making higher daily highs or lower daily lows, relative to the preceding session. 

You find, for example, that its quite meaningful in terms of predicting a good-sized advance in the indexes or stocks you follow, when there are at least three days of higher highs. The trading system rule that defines this "condition" can be quite simple. The trading rules might look like the following. 

The condition we are looking for: a high greater than the high of one [1] bar ago (e.g., an hour or day on a BAR or Candlestick chart) and that the high of 1 bar ago is also greater than the high of two [2] bars ago and the high of 2 bars ago is greater than all the high of three [3] bars ago all conditions must be true. The reverse situation applies to a series of lows less than the 1-3 bars preceding it. 

If either of these conditions are met, our trading system goes long (e.g., buys calls) or "sells short" (e.g., buys puts). 
This is about as simple as a trading system gets. Exit in the above system is triggered only by the reverse conditions and there is always a position in the market, absent the addition of a stop-loss "rule", which I do. You may think I never met a stop that I didn't like; its true, if it's I never met an 'ENTRY' stop I didn't like, as long as it allows sensible leeway. 3 points on the OEX can be pretty tight but 7 is more than I want to risk. 

Entire trading systems, and very profitable ones at that, are sometimes constructed this simply. The software application usually then triggers an audible and visual alert when a trading system, applied to any index or individual stocks, is triggered for example, when you download your end of day data or are trading in real time with a live (real-time) data feed. 

BASICS OF TRADING SYSTEM DEVELOPMENT
An exit is assumed if a position contrary to the original is triggered. If your system is long, and short conditions are met, selling triggers both an exit and a new position on the sell side, whether that is a short (e.g., of QQQ) or by buying Index puts. 

Creating the systems "rules" is only part of the process of creating profitable trading systems. 
A trading strategy should have components that govern: 
1. entering the market
2. exiting the market while capturing profits 
3. exiting the market in order to minimize losses 

The above three components often involve three different rules and corresponding "signals" when the conditions (the system rule or rules) are met. For example, if you create a signal that enters the market based on a momentum indicator, you add a trailing stop signal that will capture profits and a stop-loss exit signal that will limit losses. 

A trailing stop is one where the "rule" is that a stop is in place that "trails" the current price by some amount; e.g., 5 points in OEX. An initial stop might be 3 points, then once the Index has moved in your favor, a trailing stop condition kicks in. Again, these are common elements of trading systems but, there are no RULES to say what rules have to be in your trading system. 

Once you have a well-defined set of rules to enter and exit positions and perhaps a system of risk protection or stops (exits), it is then necessary to see how well the ideas comprising the systems performed in the past. This is basically WHY you have to have defined rules only by defined rules, can the software "apply" the system to a market; e.g., show the results of the system to the last 5-7 years of OEX price history. 

Testing involves applying the system to as much price history as can find this could be 5 or 10 years or more. "Optimization" of a rule-based system is often applied here optimization is a computerized test to determine WHICH variables (e.g., which specific moving average or averages) resulted in the most profitable or the most consistent profits for the back period being examined. 

Or, to use our above example, which "length" setting of RSI works best along with which specific overbought or oversold extreme is the most profitable as the "trigger" point for trade entry. What the software does is test all possible combination of lengths and overbought/oversold extremes or, the ones that had the greatest profits. For example, the outcome may be to use a 17 period RSI, and sell after the RSI retreats from a reading above 75 and buy when the indicator rebounds from an extreme below 25. 

MORE ADVANCED - 
Such techniques as "walk-forward" optimization can guard against the tendency to select only variables in indicator or pattern-recognition systems that fit past conditions, but that might not work as well going forward the walk-forward technique involves testing some period for the most profitable system inputs, then applying them for a later period and adjusting the values, then testing "forward" again. 

Regardless of the rules and markets, one of the things that has to be on your checklist when studying results is why did the losing trades lose money? How are they different from the winning trades? It is important to scrutinize the losing trades and investigate what happened on each occasion. The software applications that have well-developed systems testing and development capabilities, have templates and tools that allow the study of all these aspects of trading system results. 

Analysis of the biggest losing trade is a starting point to see how a system doesnt work, so there are no holes in the system rules though which a trade could slip and cause significant losses or more that the maximum you are willing to take. 

A system should be studied on two levels: 
1. As a trading strategy that gives positive trading results or 
the net results of the strategy over time 
And  
2. At the trade-by-trade level to determine is the individual trades are "normal" compared to one another and to the group. For this type of analysis to be correct, all trade results need to be comparable to one another. 

Since we are working in the financial world, this means that we should see all our results in terms of dollars (or monetary units). For example, its not correct to compare the return on investment of buying 100 shares of a 10-dollar stock with buying 100 shares of a 100-dollar stock. The comparison would only make sense if buying or selling some set dollar amount of each; e.g., $10,000. 

SUMMARY OF THE TRADING SYSTEM APPROACH
Regardless of whether you have any interest or inclination to use trading systems now or ever, it is useful to know that there is an option to supplement (or substitute) what is typically the more subjective and personal methods we use to make market decisions. I find that the more investing and trading experience that I have, the easier it is becomes to define what may be sound rules or conditions that need be met to get into a stock or other market. 

Moving from the stage of ideas that "may be" profitable to back-testing these rules is a fascinating and worthwhile process that serves as a "reality check". Often, through the results of back testing, it becomes apparent that even with a promising system, slight changes will result in an investing or trading method that has even greater profit potential. 

Systems testing and development might be something you are not immediately attracted to, but is something that is may be useful after a lengthily experience in using technical analysis. This was the case with me and I thought I would never warm to the approach of a "mechanical system". 

I became enthusiastic about this type of application when I saw that it could validate or, invalidate, long held personal beliefs about what kinds of technical analysis techniques worked best as a basis for market action. 

Moreover, I found that the more I knew about technical analysis and the more months and years that I had observed the unfolding of many different chart patterns, the more I got out of the ability to create trading systems with the new software seen in the 1990s and later especially this was quite the opposite result of what I expected. 

Systems testing and development is a natural continuation of learning technical analysis, especially for those who are more computer savvy or at least comfortable. 

Good Trading Success! 

NOTE - 
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line. 

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