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Analyze your Trading Algo with 3D Charts

June 28, 2016 by Lior Alkalay Leave a Comment

These days, any mention of the term 3D is associated with entertainment. But in fact, when it comes to charting, and more specifically to charting your trading algo, 3D charting is not only insightful but provides important practical advantages.

The most common chart to measure a trading algo is profit over time. That lets you know how much money the algo is making over a specific duration, usually from a few weeks to several months. As the chart below illustrates, it gives you a good idea how well your trading algo performs over time and it gives an indication of the periods when it was underperforming.

The thing is that, while profit over time are the two most important dimensions, they leave plenty of dimensions out—dimensions that can help you answer important questions. Such as why, during a specific period, was your trading algo under-performing? Or how much risk are you taking in a given time? Often, the answers to such questions can be the difference between profit and loss, between success and failure of a strategy.

Trading Algo

Trading Algo in 3D

First things first. Before we start running 3D charts on our algo it’s important to go over a few practicalities and make the 3D chart work for you.

Assuming you’ve already exported the data of your algo Profit and Loss to Excel you’re likely to have two columns of data, e.g. Time and Profit. Adding a third column will allow you to run a 3D chart, whether it’s volatility, risk or whatever additional dimension you deem necessary.

Once you have your three columns you click to generate a chart—you must choose a type called 3D surface chart. As you will notice, almost always, the Time stamp will be the X-Axis, Profit the Y-Axis and our third parameter will be the Z-Axis.

Now comes the important part—making the chart comfortable to work for us.You must remember that our goal in using a 3D chart in the first place was to identify areas of either exceptional profits or exceptional losses to optimize our algo.

As can be seen in the charts below, Excel divides the Y axes into ranges and each range is colored. The best practice is to choose the same color for levels that are not exceptional and select a contrasting color for the highest range and another for the lowest range. This allows us to spot the exceptional.

The Z axes changes the angle of the chart; the steeper the angle, the higher our Z parameter—say risk or whatever else we choose.

And finally, make the 3D chart clearer through formatting the Plot area. Play with the Y rotation angle as well as the Debt Level until you are comfortable working with the chart

Trading Algo Case Studies

Once you are clear as to how to make a 3D chart, it’s time to decide which dimension is relevant. Usually, besides time and profit, the following dimensions are worth considering—risk, volatility and duration.

For example, the chart above shows a profit over time of a specific strategy; let’s call it Strategy A. Suddenly, out of the blue, the profit plunges rapidly. It’s not clear why, yet.

Then we add another dimension—risk. Risk, in this case, will be the Dollar amount risked in a given moment. Now, the reason is apparent; just before the profit collapsed, risk was rising, as well. Maybe leverage jumped, maybe several positions were opened simultaneously; it depends on the strategy. But by using a 3D chart we were able to easily detect where trouble was coming from.

Trading Algo

Using 3D charts is not only good to spot weaknesses in a strategy but strengths. Let’s take a look at another strategy, which we’ll call Strategy B.

We will test how Strategy B performs during volatility. In this case, the volatility will be the standard deviation of each pair we trade. What we see is interesting. When volatility is high, Strategy B performs exceptionally well and not so well when volatility is average to low.

Trading Algo

In such a case, we should consider using the strategy only during high volatility to optimize returns.

More uses could be to measure duration per trade. If the duration is getting longer at certain areas perhaps the trigger for the entry or exit is not working well. The benefit with using a 3D chart here is that we put the opening time stamp on the X-Axis and the closing time stamp on the Z-Axis so we can actually analyze duration per trade over time. A 3D chart then is much more accurate than a two dimensional chart where duration is a trailing average.

In Conclusion

There are endless samples and ways in which 3D charts can allow you improve your trading algo and identify both weaknesses and strengths within your strategy. Sure, you can manage with a 2-dimensional chart. But the benefit of 3D charting is that, many times, it allows you to zoom in and identify areas of change much easier.

Filed Under: Test your concepts historically Tagged With: algorithm, leverage, volatility

How to be 99.999% accurate when your system is only 49% accurate

November 16, 2015 by Shaun Overton 9 Comments

Virtu Financial, the high frequency trading firm whose initial public offering of stock was caught in the unexpected firestorm that was the book “Flash Boys” by Michael Lewis, is reviving the IPO plan they shelved last year amid controversy, is seeking $100 million.

Virtu Financial board

99.999 win percentage is an odd statistic

As a recent Securities and Exchange filing reveals, the company, operated by a litany of some of the exchange world’s top executives, boasts that out of 1,485 trading days it has only one losing day.  This is the key statistics that left those familiar with algorithmic trading scratching their heads.

On the surface this 99.999 win percentage is a rather unworldly performance statistic in the world of algorithmic trading.

Virtu Financial notional

Virtu Financial is not a trend follower

The most popular managed futures strategy, trend following, has an average win percentage near 55 percent. Trend following might not be the best algorithmic strategy to compare to Virtu, however, as the firm claims in its S-1 that their trading “is  designed to be non-directional, non-speculative and market neutral.” Micro-trend following and benefiting from market moves in one direction is a popular high frequency trading strategy, but based on their S-1 this is not the primary strategy.

This doesn’t explain the win percentage.

The highest win percentage of all managed futures strategies, near 75 percent, is short volatility, which is also the least popular strategy. While the strategy is known to win most of the time, the key statistic is to understand its small win size and large loss size. In managed futures the size of a trader’s wins can often be more important than how often they win. In the case of short volatility, while they win most of the time, when they lose they lose big – with an average loss size that is close to double that of a discretionary trading category, for example.

While risk in Virtu may exhibit strong downside volatility during crisis, much in the same way market crashes bankrupt many individual market makers in the golden days of the trading floor, comparing Virtu’s strategy to a short volatility strategy is inaccurate.

Perhaps the most applicable managed futures strategy to benchmark might be the relative value / spread arbitrage category. The spread-arb strategy has a high win percentage, near 60 percent, and it also has the best win size / loss size differential. The strategy works by buying one product and then selling a related product. The directional strategy works when a market environment of price relationship dislocation occurs.

While the fit isn’t perfect, nonetheless the most relevant managed futures strategy for which to compare Virtu is its direction-less, market neutral approach taken by certain spread-arb CTAs. The primary difference being Virtu doesn’t hold positions for directional profit. What they do, much like a short term trend follower, is take a position and then immediately lay off risk in a hedge. For instance, they may buy oil and then immediately hedge that position in another market and perhaps even using a derivatives product with different product specifications. In the olden days one could simply describe this as a “market making” strategy, but in the new school world of high frequency trading, separating two-sided liquidity providers from directional trend followers has oddly become more difficult.

99.999 percent daily win percentage overshadows 49 percent intra-day win percentage, highlighting the importance of win size

When comparing Virtu to known managed futures strategies, the 99.999 win percentage sticks out like a sore thumb – until you read the next punch line in the most recent S-1. That is when the firm reveals that its win percentage on an intra-day basis is 49 percent.

This puts the pieces of the puzzle together. The 99.999 percent win percentage needs to be considered in light of the 49 percent intra-day win percentage. This highlights the fact that Virtu, by logical default, is benefiting from size of win. Just like a trend follower, it isn’t always win percentage that matters most but size of win and controlling loss. This is likely the secret sauce inside Virtu’s success.

This article originally appeared on Virtual Walk and was authored by Mark Melin.

Filed Under: What's happening in the current markets? Tagged With: accuracy, CTA, high frequency, managed futures, Mathematical Expectation, percent accuracy, Virtu, volatility, winning percentage

The World of the VIX

June 8, 2015 by Lior Alkalay 4 Comments

The VIX, or Volatility Index, is among the most watched indices in the world, certainly on the CBOE (Chicago Board of Exchange), with most traders checking it at least once a day. Unlike most indices, the VIX’s price is not comprised of stocks or bonds. What the VIX measures is volatility around the S&P500 index using options.

 Why Bother with the VIX?

As mentioned, the VIX measures the volatility around the S&P500 index, or more accurately, the implied volatility around the S&P500 index. You might wonder, “What’s the difference?” Implied volatility is expected volatility, and since in trading tomorrow is the present, that difference does matter. As an index, the VIX is relevant whether you are trading FX, commodities or equities, but it holds a special significance if you trade the S&P500. That’s because the S&P500 is the most tradable (and traded) index in the world with most major asset classes having some level of correlation to it.

When the VIX rises (i.e. becomes volatile), in most cases, it suggests investors are nervous, not just in equities, but across the board. That is why so many investors often refer to the VIX as the “fear index” (my personal favorite, by the way).

In fact, one of the most dominant trades since the 2008 financial crisis is what investors call risk on/risk off. That means markets are primarily trading based on broad risk appetite. For example, when risk appetite is high, riskier trades (such as long equity indices or short dollar) tend to benefit. Simply put, the VIX measures implied volatility over a wide array of stocks. Because implied volatility generally rises with risk, the VIX is seen as a good barometer of risk on/risk off sentiment. The VIX is an important gauge of the market’s mood, whether you plan to counter or go with a trend. As you can see below in the chart (courtesy of V-Lab), the S&P500’s implied volatility and the VIX move almost in tandem.

VIX Chart

VIX: Under the Hood

The VIX is basically composed of the premium that investors are willing to pay for both call and put options on the S&P500. The average expiry date for those options is approximately 30 days and that tends to be when implied volatility is most indicative. The higher that premium, the higher the VIX will be. If we were to link back to the risk on/risk off trade, if investors are worried that risk is on the rise (which causes implied volatility in the S&P500 to jump) then the VIX simultaneously rises. When investors are calm, implied volatility falls and the VIX is lower.

There have, of course, been days when the VIX was rising and market was in risk on mode (and vice versa), but those cases are generally rare. Naturally, as a trader, you must always be aware that anything can happen at any time.

When to Use the VIX?

Now, here is the tricky part of the VIX; the VIX is what is known as a contrarian indicator. That means it is more useful as an indication of a risk of a change rather than an indication of the current trend. Behaviorally, the VIX can be likened to an elastic material; it always tends to gravitate back to balance. When the VIX is at record highs it tends to move back lower. When it’s recovered and hits a fresh low then it tends to move higher. While it’s important to always keep track of the VIX, as seen below, the extreme levels can suggest if the market is in a risk on/risk off mode. When the VIX is at record highs, it might be time to trade on a risk on mode. Why? Because market jitters are likely to wane and therefore risk related trades (i.e. long AUD, EUR, GBP, SPX, etc.) might be the wisest trade. Naturally, the opposite also (generally) holds true.

VIX RangeSource: CBOE

VIX has Cousins

Among all of the indices that measure volatility, the VIX is the most important, especially given the S&P500’s correlation with nearly every asset class. But what happens when you want greater accuracy or more relevance to your current trade (e.g. Forex, commodities or other global Indices)? While the VIX may be the granddaddy of them all, there is a “family” of volatility indices linked to specific indices, asset classes and even to specific trades. For example, the OVX measures the implied volatility on Oil, while the EUVIX measures the implied volatility on the Euro. Can’t wait to meet the rest of the “family”?

Want to learn how to use other VIX indicators? Then stay tuned for my next article.

Filed Under: Trading strategy ideas Tagged With: EUVIX, implied volatility, OVX, VIX, volatility

Risk Management – Deciding When To Hold, And When To Fold

October 10, 2014 by Eddie Flower 5 Comments

There’s a proverb among old forex traders: If you put two newbies in front of the same trading screen and arm them with the same tools, and if each takes the opposite side of a given trade, both will probably lose money, regardless of the final direction of the price move.

Yet, if you put two highly-experienced traders into positions in opposite directions, very often both of them will win the trade or at least break even, in spite of their contradictory trading positions.

Why?

The difference between rookie traders and pros is risk management. In the trading game, successful risk management is the key to survival. Many beginning traders pay lip service to the idea of managing risk effectively, yet few have the discipline to follow through entirely, even with the power of mechanical trading systems.

Forex risk management

Regardless of the exact forex trading strategy or system, loss-taking is a critical component for long-term success.

Any forex newbie can exit from winning trades, but it takes an experienced trader to slip out of losing trades relatively unscathed. In this article I’ve outlined several perspectives on risk management strategies used by successful forex traders across a wide range of markets.

Forex risk management

Most forex traders have a clear idea of their own investment objectives and tolerance for risk. And, most already know that appropriate risk management is crucial for success in any form of trading.

The best trading risk management means using a standard process to identify and analyze risks, then either accepting, mitigating, or rejecting them. For traders, it comes down to finding and assessing opportunities, then quickly acting on or declining those trades.

Basic risk management is two simple steps – Discovering and determining the risks within an investment, then responding to those risks in the best possible way to meet the investment objectives.

Some risks are considered intrinsic risks, or built into the system, while other types of risks are extrinsic in origin. In any event, forex traders have a variety of tools and metrics for assessing risks and setting parameter values. From that point onward, it’s up to the mechanical trading system to work its magic.

Mechanical risk management

Even when relying on mechanical systems, successful traders must be well disciplined and adhere to carefully-planned forex risk management and trade-exit strategies. That’s because people have a natural emotional aversion to taking trading losses, even when necessary.

Mechanical trading systems can help manage risks by better choosing and executing trades, and constantly monitoring positions. They add a layer of impartiality to lightning-fast analysis and trade execution. Yet, there is always room for human error in system design.

Speed plus reduced human oversight equals an increased possibility of trading loss. Mechanical risk management methods must be carefully vetted and tested before they’re implemented.

Most traders are closely focused on the “front end” of forex trading, that is, how to find a winning trade and enter a position at the right point. Other than basic stop-loss orders, few traders think carefully about how best to exit from the trade.

For the long-term survival of any trading system, whether manual or mechanical, the most important issue is how and when to exit from trades. Although less glamorous than the work of crafting a winning entry strategy, the task of building a successful risk management and exit strategy is crucial for success.

Lose your bad trades as soon as possible

Most traders are already aware of the mathematical difficulty of overcoming losses – As shown in the drawdown in Table 1 below, the more the trading-account equity is drawn down, the higher the percentage of subsequent gains required simply to break-even.

Table 1

Lose 25%, must regain 33% to break even
Lose 50%, must gain 100% to break even
Lose 75%, must gain 400% to break even
Lose 90%, must gain 1000% to break even

For example, after losing 50% of the trading account equity, the eventual winning trades would need to earn 100%, i.e. double the account size, simply to break even. Worse, at a 75% drawdown level, a trader would need to quadruple his or her account equity just to reach its original level.

Obviously, very few traders could achieve such a comeback. It’s far better to manage drawdowns by exiting each trade appropriately. Taking each loss at the optimal time allows the trader to stay in the game as long as possible, even after a long string of losing trades.

The runaway loss

Most traders have heard war stories about a single bad forex trade eating up days, months or even years of profits in one gulp. When a runaway loss occurs, it’s more likely the result of error in human judgment rather than from a glitch in the mechanical trading system.

Usually, catastrophic losses result from poor or non-existent risk management, failure to use “hard” stop-loss orders, and multiple trades in which the losses from the average losers are greater than the gains from the average winners.

A runaway loss shows lack of discipline. Instead of becoming enchanted by the dream of scoring “one big winner,” the more prudent strategy for trader survival is to focus on avoiding big losses.

The Golden Rule of Risk Management: Position risk limit

Ironclad stop-loss orders prevent runaway losses. According to the trader’s appetite for risk, the mechanical trading system can set risk limits according to account equity, position size and other parameters, as described later in this article.

Many forex traders advocate a “Golden Rule” of risk management based on position size or position risk limit. They recommend the at-risk account equity should never be more than 1% (conservative) or 2% (liberal) on any single trade position.

From a psychological standpoint, the trader can be indifferent to the outcome of any particular trade when only one or two percent of the account equity is at stake.

And, from a mathematical perspective, it’s important to point out that by risking only 1% to 2% per trade the system can lose repeatedly without approaching the drawdown levels shown in Table 1 above.

Regardless of the mechanical forex system being used, the trader should use only speculative capital. When asked by newbie traders how much money they should use to trade a given system, one well-experienced trader recommends choosing a funding amount which if entirely lost wouldn’t affect the newbie’s sleep at night.

Risk management styles

There are two general styles of successful risk management. Some managers refer to these opposite styles as either the “home run” approach or the “singles and doubles” approach.

On the one hand, a forex trader may choose to take frequent small losses and break-evens while working to harvest all profits from the relatively few big winning trades. Or, a trader may decide to seek many little gains and use infrequent but relatively large stop-losses with a system designed to accumulate the small profits and outweigh the losses.

The trading psychology is more important than the mechanical trading strategy itself. Taking many small losses tends to cause numerous painful twinges, interspersed with occasional moments of pure ecstasy.

In contrast, the “singles and doubles” risk management style offers plenty of minor joys, punctuated by some nasty psychological blows.

The best choice of trading style largely depends on the trader’s personality. A new trader will usually quickly discover which general style best fits his or her personality.

One of the major benefits of forex trading as compared with stock trading is that the forex marketplace easily accommodates both types of trading styles, using many different trading systems.

Since currency pairs trading is a spread-based marketplace, traders shouldn’t be too constrained by the number of round-trip transactions required by any given strategy.

For example, in the EUR-USD market, traders might find a 3-pip spread that’s the same as the cost of three one-hundredths (3/100) of one percent (1%) of an underlying position. This cost is generally uniform, in terms of percentage, regardless of whether the trader is dealing with one-million-unit lots or 100-unit lots of the same currency.

So, if a given trading strategy required 10,000-unit lots, the amount of the spread would be $3, yet for that same trade executed only using 100-unit lots, the spread would be a tiny $0.03.

This is in sharp contrast to the stock market, where the commission on 1000 shares or 100 shares of a stock valued at, say, $20 might be fixed at a total commission of $40.

That means the effective commission cost for the stock-market transaction might range between 0.2% to 2%, thus affecting the trader’s choice of risk management style.

Variability in commission percentages makes it difficult for small traders in the stock markets to scale into their positions because of these skewed commission costs. Yet, forex traders benefit from uniform pricing, so they can use either risk management style.

This freedom of risk management style has drawn many independent traders away from equity markets to forex markets.

4 basic types of stops

Another foundational choice to be made by forex traders based on personality and trading strategy is the type of stop to be used for risk management. There are four basic types of stops:

Equity stop

An equity stop is the simplest type of stop for mechanical trading systems. For any given trade entry, the system calculates a fixed percentage of the account equity, usually between 1% and 2%, as outlined earlier in this article.

For example, for a $10,000 forex account, the trader’s system could risk up to $200, or up to 200 points, on a single mini lot (of 10,000 units) of the EUR-USD currency pair, or up to 20 points on the standard lot with 100,000 units.

Aggressive traders sometimes consider 5% equity stops, that is, a position risk size of not more than 5% of the account equity. This limit is often considered the upper limit for prudent risk management.

Recalling the equity drawdown shown in Table 1 above, it can be seen that with a 5% equity stop 10 consecutive losing trades will cause a 50% drawdown in the trading account.

Also, it should be said that the biggest drawback of using an equity stop is it enforces an arbitrary exit point based on risk management alone, instead of exiting the market as a logical response to price movements.

Still, mechanical trading systems can thrive by using equity stops, especially when combined with other indicators to confirm trading signals.

Chart stop

Mechanical trading systems and expert advisors (EA) use a myriad of technical indicators to generate hundreds or thousands of potential stop levels. The best risk management methods combine the features of both equity stops and technical indicators to calculate chart stops.

One typical example of the chart stop is a swing high/swing low level. In the chart below, a $10,000 trading account with a mechanical system using a chart stop might sell one lot and risk 150 points, about 1.5% of the account’s equity.

swing high low eurusd

Volatility stop

Mechanical trading systems often rely on more sophisticated logarithms to calculate risk parameters based on volatility instead of price movements alone. In any high-volatility marketplace, where prices show wide ranges, the trading system must adapt to the ambient volatility.

This helps the trader avoid being stopped out prematurely by market “noise.” And, the same holds true in low-volatility markets, where the system should constrict the risk parameters in order to avoid giving back profits before successfully exiting from positions.

One of the easiest ways to monitor volatility is by using Bollinger Bands, which rely on standard deviation calculations to measure variations in price. The two charts below illustrate high volatility and low volatility stop levels by using Bollinger Bands.

Bollinger band stops

Low volatility bollinger band stop

As seen in the first chart, a volatility stop lets the trading system employ a scale-in method in order to achieve better overall blended pricing and a quicker break-even level.

Of course, since total position risk shouldn’t be more than 2% of the equity in the trading account, the system choose smaller lot sizes to best fit the total position risk.

Margin stop

A margin stop is a form of risk management used by some cautious traders to reduce the risk and psychological pressure when beginning to trade an entire account by using a single new strategy or system. If used carefully, it can be effective in most markets.

Since forex markets operate twenty-four hours per day, it means that forex dealers could liquidate traders’ positions fairly quickly in case of margin calls. For this reason, forex customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.

The margin-stop risk management strategy is based on the trader’s total capital being divided into various allotments for each of one or more new or different trading strategies and systems.

For example, assume the trader is investing a total of $10,000 into forex trading, and he or she wishes to focus individually on trying 5 different trading systems and strategies in order to determine objectively which is the best “fit” for the trader.

So, the trader will open the forex account by wiring only $2000 from his or her bank account, assuming that each of the 5 receives the same funding proportion. If a forex broker offers leverage of 100-to-1, the $2000 deposit might allow the trading system to control two standard 100,000-unit lots.

Even better, depending on the trader’s risk tolerance and management, the system may trade using a 50,000-unit lot position. That might allow room for as much as 100 points.

As successive strategies are funded and launched exclusively, it’s easier to account for wins and losses due to individual approaches. It allows developers to refine their systems. And, traders enjoy more peace of mind by knowing that an unforeseen “blowup” won’t terminate their trading.

In any event, the primary purpose of the margin stop is to prevent a runaway loss from occurring during the launch of a new strategy or trading system. It also helps enforce discipline in risk and money management.

Know when to hold and when to fold

In conclusion, it can be said that trading success is based on surviving losing trades long enough to finally develop a consistently-winning system. Each forex trader should carefully consider his or her risk tolerance, and craft a risk management strategy to fit.

Mechanical trading systems make it easy to find good entry points, yet it’s just as important to have a sold risk management strategy, plus the tools to determine an exit point immediately after entering any position.

After all, taking the right loss at the right time is a necessary part of the game.

What are your thoughts about losses?

Filed Under: How does the forex market work?, Stop losing money, Trading strategy ideas Tagged With: forex, risk management, volatility

Forex Volatility Trading Playbook

July 25, 2014 by Eddie Flower 17 Comments

The forex marketplace supports a diverse community of successful independent traders who have developed winning strategies that work during changing market conditions. Trend-following strategies are popular among newbies, but veteran traders truly earn their keep during times of volatility.

This article gathers and summarizes some longtime traders’ forex volatility trading strategies that can win even when markets are volatile. In fact, the strategies in the volatility trading playbook work best during times when the gains from trend-following systems lag far behind.

Forex volatility trading

By definition, volatility means that prices rise and fall quickly, and do not show clear direction or trend. Successful volatility-focused trading systems usually feature these characteristics:

• Based on volatility or breakouts from channels or ranges

• Trades are short-term

• Trading systems are very choosy with trades, and are usually out of the market

• Win a high percentage of trades

• Earn only a small-to-modest profit per trade

• Take advantage of small moves instead of big moves

Well-designed mechanical trading systems can anticipate and take advantage of changes in volatility, then exit the trades without giving back the open profits.

Parabolic stop-and-reverse trading strategy

Some forex traders harness the power of volatility by trading parabolic time-price systems. First introduced by the legendary trader J. Welles Wilder, Jr., the parabolic stop-and-reverse trading strategies capitalize on price reversals.

Parabolic indicators help determine the direction of a currency pair’s price movement as well as indicating when the trend is likely to change and a price reversal is imminent.

These indicators work well for determining both entry and exit points in volatile currency markets, since prices tend to stay within parabolic curves during trends. When prices move wildly, parabolic indicators can help show the direction or change in trend.

market volatility

Successful parabolic stop-and-reverse strategies are also time-focused: The mechanical trading system weighs the potential gains against the amount of time the position must be held in order to have the best chance of achieving those gains.

If using a “pure” parabolic trading system, the forex trader would always be in a given market, either long or short. For example, when the parabolic indicator generates a buy signal, the trade is entered. Then, when the trend begins to reverse, the “long” position is closed and a new “short” is opened at the same time.

Still, order to reduce the number of quick shake-outs from volatility whipsaws, most parabolic traders filter their trading signals by using a trading volume screen as well as a variety of other indicators.

Parabolic trading rules

The basic parabolic trading rules are simple – For long signals, the mechanical trading system buys when the currency pair’s price reaches a parabolic point above the current market price, and the trading volume is higher than the five-bar simple moving average trading volume.

In order for a trading signal to be confirmed for this parabolic trading strategy, both parameters must be true during the same time-bar. Here are the general parabolic setup, entry and exit rules used by several successful forex traders:

• Calculate the parabolic points

• Calculate the 5-bar simple moving average (5 SMA) of trading volume

• For long entries, the system buys when the price reaches a parabolic point higher than the current market price, as long as the volume is higher than the 5-bar moving average

• For short entries, the system sells short when a price touches the low parabolic point below current market prices, as long as the trading volume is greater than the 5-bar moving average

• To exit from a long trade, the system liquidates the position when the parabolic points decline

• To exit from a short trade, the system covers the position when the parabolic points rise

• To set the trailing stop for a long position, the system uses the parabolic points below the current market price

• To set a trailing stop for a short trade, the system uses parabolic points above current market price

• Savvy traders often set profit targets like this, for example: 70 pips for GBP/USD or 60 pips for EUR/USD when trading a 4-hour time frame; or, 200 pips for EUR/USD or 250 pips for GBP/USD when trading a daily time frame

Volatility channel breakout strategy

Many successful forex traders use channel-breakout strategies fueled by volatility. Here are the basic indicators and trading rules for a simple channel-breakout strategy that works for especially-volatile currency pairs on time frames of 15 minutes or higher:

• 30 ATR (the Average True Range over 30 time periods) with 5 EMA (the Exponential Moving Average over 5 periods)

• 15 ATR with 5 EMA

• 30 EMA (Exponential Moving Average over 30 periods) High

• 30 EMA Low

• For long entries, the system buys when the price closes above the upper EMA band and the 30 ATR is greater than the 5 EMA

• For short entries, the system sells short when the price closes below the lower EMA band and the 30 ATR is greater than the 5 EMA

• The trading system sets the stop-loss on the lower EMA band for long positions, and on the upper EMA band for short positions

• With fine-tuning, the strategy may achieve fairly aggressive profit targets

Volatility double channel breakout strategy

Other forex traders who specialize in harvesting gains from especially-volatile currency prices use a similar, yet “double” channel breakout strategy. Below are the basic trading indicators and rules for a double channel-breakout strategy that works well for volatile currency pairs:

• 11 Relative Strength Index (RSI) at levels 35 and 65

• 20 EMA High

• 20 EMA Low

• 5 EMA High

• 5 EMA Low

• The mechanical trading system buys when the 5 EMA High is greater than the 20 EMA High and the 11 RSI is greater than 65

• The system sells short when the 5 EMA High is less than the 20 EMA High and the 11 RSI is less than 35

• If the initial setup bar’s trading range is more than double the value of the previous bar, the trading system declines the trade

• The trading system sets the stop-loss at the lower band of the 5 EMA for long trades, and at the upper band of the 5 EMA for short positions

• Aggressive profit targets can be set

Forex trading strategy for extreme volatility

Forex traders who thrive on volatility, there are many profitable trading opportunities. Below is a simple forex volatility trading strategy.

When a long candle appears during a trading session, that is, when an intraday time-bar has a greater range than the previous time-bar, it may be the setup for a trade. Long candles are a sign that volatility has increased, and that a change in trend may be imminent.

Often, after a big candle a new trend may develop, or the previous trend may become stronger. And, the trend will usually be moving in the same direction as the price movement of the time-bar when the long candle happened.

When a long candle occurs, if that candle breaks the high or low of the trading session then the price will probably continue to move in the same direction.

Trading rules for extreme volatility strategy

• A candle or intraday time-bar which is much bigger than any previous candles during the session, but has not yet reached 100 pips in total range

• That same long candle is also now setting a new intraday high

• For long entries, the trading system buys at 1 pip over the high of the previous candle’s price

• For short entries, the system sells short at 1 pip under the low of the previous candle’s price

• For longs, the stop-loss is set at 1 pip below the low of the entry candle

• For shorts, the stop-loss is set 1 pip above the high of the entry candle

• Profit targets are set according to nearby support and resistance levels

• It’s important to note that any entry order should be placed only after the time-bar containing the long candle is completed, and the trader should use at least one other indicator to confirm the signal before entering a trade

ATR channel breakout strategy

Some forex traders who specialize in volatility-focused strategies rely on indicators which use Average True Range (ATR).

The trading system determines the midpoint of the ATR channel by calculating the Exponential Moving Average (EMA) of the time-bars’ closing prices, using a number of time-periods as defined by the “close average periods” parameter. When volatility pushes the currency price out of this channel, the breakouts are easy to trade.

This volatility trading strategy is similar to a Bollinger band breakout strategy, except that it relies on ATR instead of standard deviation as a measure of volatility to define the width of the bands or channels. The trading rules for this type of volatility strategy are simple.

• ATR for 20 time-bars

• EMA of the closing prices of each time-bar

• For long entries, when the last price of a time-bar crosses over the mid-band of the ATR channel the trading system buys on the open of the next time-bar

• For short entries, when the last price of a time period crosses the mid-band of the ATR channel the system sells short on the open of the next time-bar

• Stop-loss orders are set 2 pips below or above the first band of the ATR channel

• The trading system sets profit targets according to nearby support-resistance levels

ATR channel breakout strategy using fractals

Forex traders also use fractal indicators with volatility trading. Below is a simple strategy relying on ATR channels to signal breakouts, and using fractals to determine optimal entry and exit points.

• 130 ATR

• 9 EMA

• When ATR is greater than the 130-period average and the EMA is greater than the 9-period average, trading signals can be confirmed

• When ATR is less than 130 and/or EMA is less than the 9-period average, no trade

• Fractal indicators to show the likely breakout range

• Entry orders are set 1 pip above or below the breakout range

• Enter long when ATR is greater than 130 and greater than the 9 EMA, and fractals confirm the upward breakout

• Enter short when the ATR is greater than 130 and greater than the 9 EMA, and fractal indicators confirm the downward breakout

• Stop-loss orders are set to be triggered if/when the currency pair’s price touches the opposite side of the range

• The trading system closes the position automatically when the volatility decreases, for example, if the ATR goes below 14 EMA

• Set profit targets at a ratio of about 1:3 according to the stop-loss levels; so, for example, if the stop-losses are 30 pips, then the profit target is set at 40 pips

Volatility meters

Forex traders sometimes use “volatility meters” such as the Volameter indicator for intraday trading signals. These volatility indicators spotlight overbought and oversold zones. The trading rules vary depending upon the indicator. Below are the basic setup and rules that some traders use with the Volameter, a popular volatility meter.

• Overbought/oversold indicator

• Volameter

• Pivot-point indicators

Trading rules

• A long trade is signaled when the value of the overbought/oversold zone indicator touches or breaks through a level of -8

• Enter the long trade when the overbought/oversold indicator reaches a level of -4 by placing an order to buy-on-open at the next time-bar

• A short trade is signaled when the overbought/oversold indicator reaches a level of 8

• Enter the short trade when the overbought/oversold indicator touches or breaks through the level of 4 by placing an order to sell-on-open at the next time-bar

• Set stop-loss orders to be triggered at 1 pip above or below the price indicated when the overbought/oversold indicator reaches a level of -8 or 8, depending on whether the trade is long or short

• Set profit targets according to nearby support/resistance levels and pivot points

Volatility creates plenty of forex trading opportunities

There are plenty of good volatility trading strategies in the forex playbook. Traders should welcome volatility because of the profitable opportunities available during trading sessions which feature big price ranges. With appropriate risk management, volatility is a forex trader’s best friend.

Is volatility a friend or enemy of your current trading system?

Filed Under: How does the forex market work?, Stop losing money, Trading strategy ideas Tagged With: atr, breakout system, ema system, forex volatility, volatility

Is Your Account Overleveraged?

March 7, 2014 by Kalen Smith Leave a Comment

Did your broker ever tell you that you can leverage your trade? Here is a quick primer if you aren’t familiar with the term.

Leverage (also called buying on margin) means that you can borrow funds to place your trades. For example, let’s assume that you have $500 in your account. You could borrow $4,500 from your broker to place a $5,000 trade. This means that your account would be leveraged 10:1.

Leverage can be a great way to increase your return. In this case, you would magnify your return 10 times over. The downside with leverage is that it also magnifies your losses proportionally as well.

Dangers of Overleveraging

You shouldn’t be afraid to buy on the margin for fear of making some bad trades. You will inevitably make some wrong trades with or without being leveraged. The problem is that taking on too much leverage can completely wipe you out. Here are some things that you need to keep in mind.

Overleveraging your account is a disaster waiting to happen

You May Face Margin Calls

You need to put aside enough money in your account to cover any losses that you incur. The money that you set aside to cover losses is known as the usable margin. Your broker will allow you to keep a trade open until the loss is equal to your usable balance margin.

This is a complex topic, so let me illustrate with an example. You opened an account with $1,000. You decide that you want to buy 10 mini lots (10,000 units) of the EUR/USD. You decide to use $500 to place a $100,000 trade by leveraging your account 200:1. This leaves you with a usable margin of $500.

Every pip is worth about $10, which means that even small fluctuations can have a substantial impact on your account. You will get a margin call as soon as it falls 50 pips below the purchase price. You would either need to increase the size of your usable margin or close the trade.

Why Margin Calls are a Concern?

As I stated earlier, your losses are significantly higher when your account is leveraged. Rather than losing $50, you will lose $1,000 if your account is leveraged 200:1. This can obviously cost you a lot of money if you made a bad trade.

However, being overleveraged can also cost you if you made the right trade. You may have accurately predicted that the currency would increase by 100 pips in the next 48 hours. However, the forex market is often very volatile. The price may drop by 50 pips before rebounding to the strike price. You would face a margin call and close your trade at a $500 loss before you got to realize your profit.

Placing a trade at a 200:1 margin would have been the wrong decision in this case. What would have happened if you leveraged your account 50:1 instead? Each pip would only be worth about $2.50. You would still have $375 in your usable margin if the price dropped by 50 pips, which means that you wouldn’t receive a margin call from your broker. By the time the price rebounds to 100 pips above the purchase price, you would have earned a profit of $250.

Your leverage ratio would have made the difference between a $250 profit and a $500 loss. It is important to keep that in mind when making a trade.

How Much Leverage Should You Use?

Everybody forex trader makes mistakes. You will become better at investing over time. However, you need to make sure that you don’t lose your shirt before you have a chance to learn the lessons. If you are a beginning forex investor, then you will probably want to use a much more conservative leverage ratio. Some investors recommend using a ratio of 3:1 or having no leverage at all.

Even seasoned traders need to be careful when making trades. Many aggressive traders use leverage ratios under 10:1. More cautious investors may use a leverage ratio of 3:1 or less.

Choosing a leverage ratio is a blend of art and science. Here are some things that you will want to keep in mind:

  • The market volatility. Prices can fluctuate much more significantly at some times than others. The average daily movement for the EUR/USD was 185 pips in 2008, compared to 110 pips in 2013. You can face a margin call much more quickly in a volatile market, so a lower leverage ratio would be smarter.
  • Correlation between currency pairs. Prices can vary considerably between different currency pairs. Average movement between the EUR/USD last year was 110 pips, while the GBP/JPY was 189. You would probably want to use a lower leverage ratio if you were trading the second pair.
  • Duration of your strategy. You will need to consider how long it will take to execute your trade. You may plan to keep your trade open for three days. It may be a good idea to set your usable margin so that you could incur an “average” loss for at least two of those days. If the average pip movement for your currency pair in the current market seems to 150 pips then you may want to make sure that your usable margin can cover a 300 pip drop. You may want to be even more conservative if the market is starting to become even more volatile.

Shaun also prepared a great video showing how the risk of any given trade affects a trader’s chances of blowing up.

There are a lot of factors to keep in mind when you are setting a forex margin. You will need to keep these in mind and decide how much risk you can take. Successful forex traders often leverage their investments, but they know how to do so wisely.

Filed Under: How does the forex market work?, Stop losing money Tagged With: correlation, forex, leverage, margin, volatility

Do Your Stops Give Their Positions Room To Breath?

January 24, 2014 by Andrew Selby Leave a Comment

The perfect stop-loss does not exist. No matter what method you use to calculate your stops, they will never be perfect. In almost every case you will either set your stop too close and force an early exit, or you will set your stop too loose and give back too much of your profit. Setting stops is a no-win situation.

Despite the fact that you will never be able to completely optimize your stops, there is always room for improvement. Even a fractional improvement in the effectiveness of your stop-loss strategy could add up significantly over the course of a couple hundred trades. That is why many traders are constantly attempting to develop a better stop-loss strategy.

stops

Are you limiting your system by using stops that trap your trades in a box and don’t give them room to breath?

Michael Bryant from Adaptrade Software wrote a guest post for System Trader Success where he made his own attempt at creating a unique stop-loss strategy back in 2012. In his post, he explained the problems that traders encounter with the three most popular types of stops. Then, he attempted to create his own stop-loss strategy that would account for the volatility of the market being traded without having to be optimized for that market.

The Problem with Common Stops

The first common stop strategy that Michael discussed was using a fixed dollar amount for a stop. This is when a trader acknowledges that they are willing to lose a certain amount of money on a trade and sets a stop in a place that equates to that amount of loss. The problem with fixed stops is that they aren’t able to adjust for the volatility of a market. If your fixed stop is set inside a market’s normal daily trading range, it is almost certain to be triggered.

The next common stop strategy that Michael addresses is setting stops at key support and resistance levels. He explains that these levels are commonly associated with recent highs or lows. While this option can better account for volatility, these areas of support and resistance are known for pulling prices towards them. It is also likely that many other traders have stops set in these areas.

The third common stop strategy that Michael discusses is using a multiple of Average True Range (ATR) to calculate the stop location. He explains that this is a great way to account for a market’s volatility, but it also leaves us with another parameter for the system that will need to be optimized. This will make the system more complicated.

Michael’s Noise Tolerant Money Management Stop

The stop-loss strategy that Michael developed has two components:

It’s based on the idea that market movement consists of two components: trend and noise.

In order to calculate the noise in a given market, Michael’s first step is to draw a trendline from the earliest close to the most recent close in a given data set. Then, for each data point, he calculates the difference between the closing price and the trend line.

This gives him values that oscillate above and below a zero line that represents price relative to the current trend. The largest absolute value in this newly derived data set represents the greatest amount the price has strayed from the trend during that period. Michael uses this value to size his stop.

With all of the calculations coded into his strategy, there is no thinking or calculating to be done once the stop is set up. Michael points out that the only parameter that needs to be defined is the lookback period that is used to determine the data set. He suggests that because the goal is to properly size winning trades, the only good option for this value is to make it equal the length of an average winning trade according to backtesting.

In order to demonstrate this approach, Michael compares his stop strategy to a system that uses an optimized fixed stop. The results show that Michael’s stop improved the winning percentage a bit, but hurt the strategy in terms of total return and maximum drawdown. While his strategy doesn’t appear to be a significant improvement in this specific instance, it is still an interesting example of the development process.

Filed Under: Stop losing money Tagged With: atr, stops, volatility

Timing Markets Using Volatility

January 10, 2014 by Andrew Selby 2 Comments

One of the simplest goals for any quantitative trader is to outperform a buy and hold approach either through superior returns or reduced volatility. While many traders have more lofty goals, some traders are just looking for basic strategies to time the general market.

Last January, Mike from Don’t Fear the Bear published a simple strategy for timing the S&P 500 based on whether the Volatility Index rose or declined in the previous week. This year, Mike has added an acceleration measuring indicator that makes his simple strategy even more powerful.

timing markets

Mike has put together an impressive strategy that uses the Volatility Index to time the S&P 500.

The Original Timing Strategy

The original post that Mike published last year contained the base strategy that times SPX based on whether VXO increased or decreased in the previous week.

The basic strategy that Mike explained was to hold SPX in weeks where VXO had increased in the previous week. If VXO did not increase in the previous week, the strategy held cash.

In order to filter out some of the biggest losses that showed up in his backtest, Mike added a filter that required the strategy to stay in cash if VXO was more than 20% above its 5 week moving average. This resulted in a pretty impressive equity curve that significantly outperforms SPX, specifically during the crash in 2008.

Improving The Strategy

Mike’s update to this system begins by explaining that many of the weeks where VXO declined were not very bad for SPX. By introducing an acceleration indicator, he is able to separate those weeks from the weeks that were bad.

The acceleration indicator, which he calls H/C, calculates each week’s high divided by the previous week’s close and compared those numbers week to week. He demonstrates through backtesting that weeks where VXO declines and H/C decelerates are actually still profitable. The weeks where VXO declines and H/C accelerates are where all of the major losses occur.

The fact that the weeks where the VXO declines and H/C accelerates are so terrible make them interesting short opportunities. Mike adds one filter to this short component by requiring that the previous week’s VXO close be above 19.

Combining Everything

By pulling together each of these ideas, Mike is able to put together a pretty impressive strategy that does a fantastic job of trading the S&P 500 index.

Just like the original strategy, the combined strategy takes a long position in SPX when the VXO rises in the previous week. The combined strategy also takes a long position when the VXO declines in the previous week, as long as the H/C indicator decelerates.

If the VXO declines, the H/C indicator accelerates, and the VXO closes greater than 19, the new combined strategy takes a short SPX position.

The strategy remains in cash when the VXO declines and the H/C indicator accelerates if the VXO closes below 19.

Mike’s backtesting shows that this strategy has nearly doubled the return of the S&P 500 since 1986.

Filed Under: Test your concepts historically, Trading strategy ideas Tagged With: market timing, spx, volatility, vxo

Retail trader disadvantage

October 28, 2013 by Shaun Overton Leave a Comment

Michael Halls-Moore invited a reply to one of my tweets last week, “Retail traders have an advantage over the pros? Me thinks not.” He wrote a great overview of why the institutional traders look longingly at the retail crowd and all the hoops that they don’t have to jump through.

His points are all valid, but he overlooked the big picture. Pricing is everything to a trader. Retail traders get the short end of the stick when it comes to the cost of doing business.

The cost of trading is massively disproportionate

Let’s say that you’re a would be quantitative trader and that you’re looking for opportunities. Let’s say you trade mini lots in the forex market with 60% accuracy and 1:1 risk reward ratios. If you’re not familiar with what a typical trading system looks like, those numbers means that you have an enormous edge.

Some of the less reputable forex brokers out there charge 3 pip fixed spreads. If you’re trading with a broker offering fixed spreads, I urge you to start price shopping. Fixed spreads are wildly overrated. You pay a huge premium for the certainty of a fixed spread. I can’t think of anything remotely plausible to justify them.

The larger forex brokers charge typical spreads in the neighborhood of 2 pips on the largest majors. Although most seem to find this reasonable, the comparison between a 2 pip average spread and institutional spreads is night and day.

Do you know what the average EURUSD spread looks like on the interbank market? It’s often 0.2-0.5 pips. Retail traders pay an average markup of over 300% on their trades.

retail trader pricing

Retail traders facing the institutions is a bit like David and Goliath.

Retail forex prices have declined in recent years. A few brokers like MB Trading and Pepperstone offer raw spreads with commissions tied to the dollar volume traded. These are, in my opinion, are about the fairest prices available to low balance traders running an expert advisor.

The best deal available to semi-institutional forex traders (CTAs, large balance retail traders, etc) is Interactive Brokers. The customer support is famously poor; they’re cheap for a reason. IB also offers raw spreads with a commission.

My experience with IB has been excellent, but you need to trade size for the economics to work. A 0.5 pip typical spread is great, but the 2 mini-lot minimum trade size and $2.50 minimum commission really adds up. Trading with IB doesn’t approach institutional type pricing until your average trade size approaches 1 standard lot.

So, how does pricing affect the final outcome with our 1:1 risk reward strategy that wins 60%?

  • Free trading: After 100 trades, you’ve earned $600 and lost $400. The hypothetical net profit is $200.
  • Fixed spread: You’ve spent $300 in spread costs to enter 100 trades. The total net profit is -$100 ($200-$300).
  • Average retail: You’ve spent $200. There is no profit because you breakeven ($200 hypothetical profit – $200 in costs). However, your broker loves you for doing that many trades.
  • Good retail pricing: Let’s say the average cost of a trade is 1.3 pips after commissions. You’ve spent ~$130 placing 100 trades. The total profit is $70.

Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker.

Equities pricing

Trading stocks is even more expensive than forex. I remember back in the day when I thought Scottrade was cheap for offering $7 commissions. It gets worse and worse when you go through the list of stock brokers. Most of them try to get away with charging $7-10 per trade. If customer service is important to you, then those are the shops to look at.

If your top priority is trading profitably, then again, broker selection is critical. The only way that a small guy can make it is by chipping away at the costs. Interactive brokers is again a great option, charging fractions of a penny per share traded. If you decide to trade 2 shares of Google (GOOG: $1,017 per share) or 1,000 shares of Fannie Mae (FNMA: $2.35 per share), the transaction costs are tiny. Two ticks in your favor is all it takes to cover the trade.

You might be thinking that I said two ticks in forex is expensive. How can I say that two ticks in equities is reasonable?

Volatility. Two ticks in the stock market is a little hiccup. It’s not at all uncommon to see highly liquid stocks move 2-3% in a single day. Forex is only interesting because of the leverage. The currency pairs themselves rarely move more than 1%, and that’s usually on major news.

Risk Management

Every employee knows that they’re only one mistake away from getting fired. That’s the reason that everyone hates having a boss. There’s a single person with unilateral authority to financially murder you. Who’s going to look upon that as a good thing?

Well, the truth is that bosses exist for a reason. It’s someone that calls you out when you do something stupid. More importantly, the boss has the power and influence to ensure that you stop doing stupid things.

The dream of entrepreneurship is not having a boss. You go on vacation when you can, you don’t have to play office politics, you don’t have to waste time selling good ideas. You just go out and do them.

Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker

I can tell you as a small business owner that the negatives stand out strongly in my mind. When you don’t have someone to hold you accountable, even if it’s a mentor, you make many more dumb mistakes than you should. It takes incredible discipline to hold the line consistently. Knowing that I’m not going to look stupid or have to explain myself to anyone probably gives me a lot more false confidence than I really need.

Self-employed traders working at home experience the same thing. Who calls you out when you’re trading just because you’re bored?

The decline in the trading account points out the obvious, but that’s not enough to necessarily stop the bad behavior. We’re social creatures. Most people need to speak with other people to maintain their sanity. When you’re trading at home alone, it takes a lot of effort to ensure that you’re getting enough social contact. A good boss prevents you from indulging in bad behaviors.

Conclusion

Selecting the right broker is enough to determine whether or not a good strategy will wind up making money or not. It’s expensive to trade. The bigger you are, the better your pricing.

Retail trading prices have reached a point where it’s at least possible to trade profitably. Nonetheless, the number of strategy types out there is limited because the lower, shorter term strategies are prohibitively expensive to trade.

The quantitative traders and hedge funds get the more active strategy space to themselves. Their trading costs are so low that they’re really the only people that can afford to trade actively.

Filed Under: What's happening in the current markets? Tagged With: commission, CTA, equities, expert advisor, forex, hedge fund, insitutional, Interactive Brokers, MB Trading, Michael Halls-Moore, Pepperstone, pip, quantitative strategies, retail, risk management, risk reward ratio, spread, stocks, volatility

SPY Crisis Strategy

October 11, 2013 by Shaun Overton 3 Comments

Yesterday’s musings on an S&P 500 doji strategy led to a general discussion of stocks and market crises. I promised to analyze a price-moving average cross strategy and to analyze the performance in times of exceptional volatility.

The results are in and they’re exactly what I predicted. I’m shamelessly tooting my own horn on this one – it’s so rare where strategies do exactly what I predicts.

SPY Crisis Strategy Returns

The direction of the returns matches any traders definition of crisis and regular trading periods over the past decade

SPY Crisis Strategy Rules

The trading rules only initiate short trades. No long positions are allowed.

Enter short next bar at market when:
The price crossed and closed below the 20 day SMA on the last closed bar
The trader believes that a crisis environment either currently exists or is about to exist

Exit an open short trade when:
The price crosses and closes above the 20 day SMA on the last closed bar

The position size is equal to a fixed dollar value divided by the current share price. As an example, SPY currently trades at $169.24. If you wanted to control a position size worth $1,000, then the number of shares is the floor of $1,000/$169.24 = 5 shares.

This strategy is intended to be timely for the current trading environment. Based on all of my proposed definitions below, most of the crisis alarm bells are ringing at the moment.

Defining a crisis

The most difficult part of this type of strategy comes from defining a “crisis environment” quantitatively. Crises don’t happen very often by definition, so I don’t think it’s a worthwhile endeavor to try to quantity the crisis bit. That said, a few obvious crisis indicators come to mind based on basic market mechanics.

PE Ratio

The morons on Tout TV (CNBC and company) keep on screaming how cheap stocks are. I’m not a fundamental trader, but the PE ratio contains useful information. Even the most hard core technical analysis buff would agree that companies generating huge positive cash flow and earning growth have to appreciate at some point. The argument isn’t about if that type of stock will rise; it’s just a question of when.

I don’t see how anyone could possibly look at the current PE ratio of 19.3 and argue that stocks are cheap. They aren’t. Stocks are currently very expensive based on a historical comparison.

VIX

VIX is a CBOE benchmark index that allows traders to compare the price of front month options traded on the S&P 500. A more detailed explanation of the VIX is available on Wikipedia if the concept is new. There’s nothing magical about the 20 level. It’s my general experience that most traders consider that number the one to watch. They think of VIX < 20 as "normal" and VIX > 20 as a severe market move.

VIX danger level

Most traders regard a VIX above 20 as a dangerous level.

Put-Call Ratio

Options are effectively leveraged bets on market movements with fixed downside risk. When traders load up on puts, they’re expecting the market to fall. When traders buy more calls, they’re expecting the market to rise.

The put call ratio is simply the number of put contracts traded / the number of call contracts traded. A number > 1 means that more puts were purchased that day than calls, indicating an expectation of a market drop.

Theory has it that short term traders are wrong, making the put call ratio a contrarian indicator. I see the put call ratio as more of a lagging indicator.

ES Put call ratio

When a move is real and already happened, traders react too late and buy protection that they no longer need. The 2008 financial crisis a great example when the ratio spiked to 1.5, a wild number. Just in the past week the ratio went as high as 1.3 before settling back down. The volatility in the number indicates a panicky crowd in my opinion.

Margin debt

Leverage is a two way sword. The theory is that it’s a way to multiply returns by risking debt in the market.

Most traders, and especially retail traders, wind up using leverage as the rope to hang themselves with. Stocks are most commonly purchased with cash among investors. Unlike forex and futures where almost every trader enters a position with leverage, the average retail stock trader enters a position using only the cash present in his account.

An increased willingness among traders to move from cash to margin debt is typically a sign of froth, bubble fever or whatever you want to call it. The chart of margin debt from Business Insider and Zero Hedge show that stocks are currently trading near historical highs.

margin debt business insider

Margin debt Zero Hedge

Conclusion

The 20 day SMA price cross strategy is a great way to run account protection whenever market warning signs are going off. The warning signs may not predict the precise market turning point, but the strategy can function as an effective form of insurance.

The strategy would roughly break even over time if someone were foolish enough to run it that way. Say that you mistime the crisis. Big deal. This type of strategy can run for months without causing irreparable harm to the account.

The signals can run in the background. If you’re only a little bit right with your crisis predictions, the risk reward ratio is massively in your favor. If you’re wrong, the consequences appear to be slow losses that lose a couple of percentage points per quarter. If you’re feeling edgy, I think it’s a great strategy to run in the background to calm your mind.

Filed Under: Trading strategy ideas Tagged With: contrarian, dot com bubble, ES, etf, financial crisis, forex, futures, margin debt, moving average, Put call ratio, risk reward ratio, S&P 500, SPY, stocks, VIX, volatility

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