"Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing. Therefore, just as water retains no constant shape, so in warfare there are no constant conditions."
Sun Tzu

Sunday, August 24, 2008

Analyzing Trades OR What's Your Edge?

Whenever one is engaged in trading, he has to know what his edge is. Why do you have a chance to be successful? Why do you think you can play the game with the big boys, investment banks like Goldman Sachs with highly successful trading desks?

In the last two years, I developed my "holistic swing trading strategy" and frankly, until just recently, I couldn't really explain, why I have been outperforming the markets so substancially the last two years. So what I did was to take a look at the statistical distribution of my trading results. Keep in mind that I am a short term trader, so from January until August 2008, I turned around 180 trades, which is more than 20 trades per month, each of them between two days and roughly four weeks. My return in 2008 so far is up 13% with a standard deviation roughly of the S&P500, which I think is pretty decent (remember the S&P is down 10% for the year). 2007 results are even better.

Looking at some statistical values reveals some information: 47% of succesful trades, ratio of winning to loosing trades 1.5, so my average win is 50% higher than the average loss. Not bad probably for a swing trader; for a position trader, that value would be a disaster (A position trader is in the game for long trends for a couple of months, so his ratio should be much higher).

It becomes really interesting, when creating a probability distribution plot of my trading results. In my case, I'm plotting R values. The R concept is discussed by van Tharp and basically means to normalize results by the initial risk. Idea is to always risk a certain amount of money per trade. In my case, I risk 1% of my portfolio value. So let's say your portfolio is $100.000, you buy a stock for $100 and plan to sell (in case of a loosing position) at $90, the max position of that stock in your portfolio should be $10,000. Let's say, you bought a winning stock and you decide to sell it for $120. In this case, your profit is 20% or 2R.

So here is the plot of my trades for 2008 YTD:

My average R for the year is 0.15, so with every trade, my account grows my 0.15%. With 20 trades per month, I'm talking about 3% monthly return. (The actual number is smaller, since I tend to take smaller risks than what my model tells me, I plan to change that in the future)

Some intersting points:

- The plot shows a "skewed" bell curve distribution, which is good. There are more "high wins" than high losses.

- In fact, 25% of losses are 1R losses (Point 1 on the chart). Maximum loss is 2R. This shows the effect of stop loss points during trading. I am using 'mental stops' and as you can see, I almost religiously execute them.

- There are some high wins between 2 and 4R (Point 2). One of the trading rules says "let your profits run". As you can see, I'm doing that (to a certain exent). I think 'let the profits run' is the wrong wording in my case (Sounds like holding positions for a long time). I prefer Sorros who talks about the need for 'home runs'.

When I look at these home runs, I see that we are talking about just ten trades. Not taking these top ten trades into account results in a return of 0% for 2008! Positive and negative Rs just neutralize each other.

When I thought about this last point, I was quite surprised. What if I would have missed them? It is easy to miss 10 trades if you do 180 of them in a certain period. But then I looked at my system and thought "that's actually great, that is the edge of my strategy: my approach is to find these big swing moves on the long or short side. These moves don't happen very often, but they DO happen. In order to find them , I need to be in the game for all the other moves. Percentage wise, the function of 94% of my trades is to keep the engine running without any return. So with 20 trades per month, I'm trying to capture one or two of these big movers. Since I'm a swing trader, I call these big movers "HyperSwings". Interesting that analysis of my 2007 results revealed the same mechanism with a litte better outcome. 8% of my trades were HyperSwings. The First half of 2007 was a entirely different market, though: trending with low volatility. So my strategy seems to be pretty robust to different market conditions.

When I started writing this post, I was a little bit reluctant to discuss the presented topic, since I felt I "give away the farm". On the other side, I saw that key to success of this trading method is persistence: even after a loosing streak of let's say 7 loosing trades in a row (which is my max loosing streak in 2008) I need to be in the game the same way. Even if I would give away all trading details, many people would trade a different way or sometimes even couldn't invest the time and

So where to go from here? I have a couple of topics I should discuss later:

- a more detailed discussion of the "HyperSwing" trade

- I also plugged my results into a Monte Carlo engine to learn more about the robustness of my strategy. Could be worth a post as well.

I can encourage every trader to start plotting his results on a PDF (probability distribution fuction) chart. You learn a lot.

Do you know, what your edge is?

Happy trading

Friday, August 15, 2008

Shorting Emerging Markets

Since a couple of days I'm kicking around the idea to short Emerging Markets. Story: slowing global growth which should effect countries like Russia, China & Brazil. Many of these economies rely on commodities, which contiue to fall. A lot of posts on SeekingAlpha.com are bulish on the emerging countries, though, which might show that the market doesn't see upcoming trouble yet. Interesting chart observation: the S&P and the emerging market showed some positive correlation until last month. Since then, both curves run into opposite directions. I'm playing this with the Inverse leveraged ETF EEV.

Thursday, August 14, 2008

Morning Outlook

It's no secret that this is a very choppy market. I was suprised by the big move in commodities yesterday. Hope for this to go on for some days to give me a good SHORT entry point again (I'm in the 80 bucks Oil camp).

Some brokers are pretty weak. In particular I'm looking to enter SHORT positions in MER or LEH if they should break their lows. The story is that their trading desks were LONG commodities in the first half. Well, obviously commodities have been hit hard the last weeks...

I' also like MCD. Came down nicely after earnings due to a downgrade. Looks like the perfect swing trade with strong support @ 61

Check out the uptrend of ILMN. Biotech company, BUT not subject to the "classical biotech risks" (failed phase 2/3 studies). I Need to do more research on this, though.

Monday, August 11, 2008

The Bigger Picture

As you know, my entire trading is driven by identification of what I call "dominant market themes" (DMT). These themes are hope/fear based, entirely irrational and tend to drive markets for a couple of days even weeks. In my opinion, identification of existing and upcoming themes is key to successful swing trading. My stock/ETF selection is based on these themes.

Let's looks at the weekly chart of the DJ:

The DMT of the May-July downswing was something like "the economy will sink because of unresolved financial problems of the banks, sluggish consumer spending, rising inflation and therefor limited options of the FED". Obviously, this theme has changed last week and now maybe sounds like; "Commodity prices are crashing, which maybe gives the FED room in the future to cut interest rates again if needed". I expect this theme to result in the upsing 1-2 on the chart. Nevertheless, since Oct 2007, the market remains in a downtrend. In order to decide if we are really in a new bull market, point 2 on the chart will be the interesting subject. At this point, lower commoditiy prices will be entirly priced into the market and participants will focus on other themes.

If, at that point, we don't get positive signs from the economy, I expect a continuation of the longer term downtrend (2-3 on the chart). So if we don't see housing prices at least stabilize in fall, I would be very careful. Also don't forget: Oil is decling (among other reasons) because of low demand in the US. Doesn't sound like positive economic news to me.

So how to play this: I'm obviously long key sectors (Tec, Airlines, Biotech) and short commodities. I'm (slowly) starting to scale out of these positions.