The Trading Digest

I hear many trading “rules” that through my backtesting I have been able to debunk, but the one that I hear most frequently is that during market weakness a trader should focus on the stocks that have held up the best. In a market downswing if you are comparing 2 stocks the one that fell the least or has a higher RSI reading would be the better candidate right? We’ve all heard this but does this theory hold water?

I ran some very simple tests to show you what the data looks like. Here are the rules of this backtest:

Condition : McClellan Oscillator is below -100 (a pullback in the market)

I ran 4 separate backtests on the Nasdaq 100 stocks over the last 5 years. In order to trigger a trade the pullback condition must be met and the individual stocks can be in one of 4 classifications:

RSI under 25

RSI 25 -50

RSI 50-75

RSI 75-100

The 5 period RSI is used in each of these cases. I will now exit the trade after 5 days. Here is a graphic showing the results of that test:

Of principle concern in the test I want to see what the average profit and loss per trade in each of these RSI segments will be. Notice how as RSI increases the average profit declines. The most trades and the most common area for stocks would be in the 25 to 50 RSI reading after the market pullback. Also I should note that I allocated 1% of equity to each trade which allows us to hold every Nasdaq 100 stock. You can see this by the very low exposure readings but this allows me to ensure that I am seeing every trade.

Of particular interest is when you compare the 50-75 group to the under 25 group you will notice about the same number of trades occurred. Yet the average winner in the “weaker” group is 42% larger than the “stronger” group with readings of 0.97% and 0.68% respectively.

I have seen this demonstrated in not only the Naz 100 but also in any other grouping of stocks I have tested whether it is the SP500, Russell 1000, and any random grouping of symbols in not only bull markets but bear markets as well.

So do we have the Makings of a Market Myth? I think we do.

Have a Great Day!

Dave Johnson

In this post I am going to try and convey to you a concept that is so critical to system traders but so thoroughly misunderstood by many active traders. The problem that I continually face when I engage in conversation with other traders is that what they call a system is invariably an entry mechanism. Many of these are when some moving average, Fibonacci, overbought or oversold condition has been reached. These are obviously only a few of the many many more conditions that that this “trader” has seen on his charts that look so obviously profitable.

But are they profitable? As a backtester I can test concepts and see what in very general terms seems to “work”. But what of those people that don’t test? Do they know what “works”? Trust me I get emails from and this week met in my chatroom people that are doing things that I know do not work. As a matter of fact virtually all of the commonly held axioms of trading are dead wrong. How do I know? I’ve tested it. John who also writes for this blog has amazing programming skill which have allowed us to test more complex theory’s then I would have ever thought imaginable. So I know when I hear a “system” that does not work. But again they almost invariably mention the entry. Which leaves me shaking my head because having tested hundreds of thousands of concepts across millions of bars of data, entry is of no value when testing a system without exit logic.

When creating a system I need exit rules that will be applied across all of the data - entirely mechanical. I can give you a good example of something that happened in the chatroom of Thursday afternoon. The chatroom is mine and I have made it my goal to destroy the illusions of what works and try to reprogram people to look at the market in ways that do work. In a systematic type fashion. The reason most active traders under-perform the major indexes is because they are invariably doing things that don’t work. Anyway this visitor walked into the chatroom on Friday and said “watch this number on the qqqq 49.64″. The rest of the conversation between myself and Al went like this:

Me (dayvejohnson) : why?

12:20 Al just watch what happens when it hits and then short

12:21 dayvejohnson al silly comments like that sound stupid

12:21 Al why

12:21 dayvejohnson of course it could but whats the logic

12:21 dayvejohnson whats the trade

12:21 Al fib numbers

12:21 dayvejohnson well then its definitely nonsense

12:21 Al extentions

12:22 dayvejohnson because obviously you’ve never tested that

12:22 dayvejohnson when was the last signal?

12:23 dayvejohnson i’m trying to get people in this room to get rid of all the silly nonsense- and yet it still follows us

12:23 dayvejohnson in

12:24 Al sorry dave i don’t mean to be nonsense

12:24 dayvejohnson give me the rules for the fib system…i’ll test it for you

12:24 dayvejohnson guarantee it a loser……

12:24 dayvejohnson i’m just trying to keep things straight here

12:24 dayvejohnson ok?

12:25 Al I will see what happens when it hits the number then we will discuss it means anything

12:25 dayvejohnson it means nothing

12:25 Al what make so sure

12:25 dayvejohnson if the previous 100 occurances showed no edge and this one works how does that leave the people in the room?

12:26 Al i think its all about probabilities

12:27 dayvejohnson uhh ok

12:27 dayvejohnson so there is a probabilty of the trade working?

12:27 Al sure

12:27 dayvejohnson lol

12:27 Al nothing for sure

12:27 dayvejohnson what has your data shown

12:28 Al the data has proven to be good the last a few years

12:29 dayvejohnson what was the largest loser?

12:29 dayvejohnson so i can adjust my position size?

12:29 dayvejohnson avg holding period

12:29 dayvejohnson mae (max adverse excursion)

12:29 dayvejohnson mfe (max favorable excursion)

12:30 Al the beauty of it: loses are so small

12:30 dayvejohnson so whats the exit criteria?

12:31 Al i think we will hit the number today

12:31 dayvejohnson whats the exit again?

12:33 Al You can set your own exit plan according to your risk tolerance - (my interjection here - this is usually when things start to get fuzzy)

12:33 dayvejohnson so you have not really tested it

12:35 Al I sure did

12:36 Al nothing a 100%

12:36 dayvejohnson i know that i am a system designer

12:37 dayvejohnson what i am trying to get you to do is give me the parameters

12:37 dayvejohnson you see to say a number above us is a fib number means nothing

12:37 dayvejohnson whats the trade?

12:37 dayvejohnson your stop?

12:37 dayvejohnson your exit?

12:37 Al wow getting close

12:37 dayvejohnson the whole ball of wax

12:38 dayvejohnson because thats how you test a system

12:39 dayvejohnson do you see what i mean

12:39 dayvejohnson it has no more significance than me saying watch that 49.75 area

yellow area denotes Al’s magic area

So basically thats the conversation. Can you guys understand how useless what he stated was? It was not really “tested” because there is absolutely no exit logic. So what happened? Well we hit 49.68 late in the day on Friday. Now what? Is the trade closed end of day Friday? Is it stopped out because he said the beauty of the system is that it takes “small losses”? Did it already take a few cent profit? It could possibly be a fantastic system. But what is the system? What I am trying to convey here is I hear this baloney all the time. It is of zero value to me - ZERO. This sort of nonsense is rampant on message boards, chatrooms, and blogs.

I have challenged people in the room this week based on a variety of criteria they believe make a viable system. I can prove they are not. I am going to continue to do that. My lesson here is a system is not entry logic alone. Start to test those exits not based on when you think you would get out of the trade but based on a solid consistent set of rules. While in the trade whole bouquets of emotions can and do affect trading decisions

On my old blog I posted the signals for a swing trade system that I had tested in various market conditions over a variety of years. I posted these before the market opened with simple at the open market orders. In the year that I posted these we made 40%. Not bad. But the beauty of this is that before the test was started I posted what the average winner, average loser, and average holding period would be. At the end of the year those numbers were right on the nose. Amazing? How did I know? Because I had seen in backtesting over 250,000 trades and what they looked like through all trade conditions. Nothing magical but just basic standard deviation in price of the holding period I would be holding based on historical precedence. This is powerful stuff.

After dispelling many of these hokey “systems” I usually get asked “So what does work?” For now I will keep that part simple. The goal of this blog is to start covering the varying concepts that do work in very basic form. But what works is the opposite of conventional wisdom. I know thats so hard to grasp because it hits the core of many active traders belief systems. But it is without question why the vast majority of active traders underperform the major equity indexes.

So please feel free to stop in my chatroom. I have been posting my intraday trades for a particular system that is making major reversal calls. This system generally triggers about 2 signals per day. I trade this on both the SP futures as well as the Dow futures. This system is somewhat different than in the live videos I post but uses similar techniques as those. We had a great week trading and in the end I think many that were there have learned a bit having been there. So feel free to stop in but please leave your market myths at home. (the permanent link is the upper left hand part of the page)

Have a Great Night!

Dave Johnson

You’ve read Market Myth #1 and #2. You are no longer tweaking settings constantly or trying to figure out “why” the market does what it does. You have taken a zen like approach and watched the market, studied data, run hundreds of hours of backtests until finally you have found a profitable system. Like many profitable systems, it is long only, trades US equities and buys stocks on dips. The so called “dip-buyers” are quite prolific in the wealth-lab code library.

You go live with your system on 5/1/2007 and things are great, each day you buy a few stocks and they immediately bounce back. By the end of the month your starting account of $100,000 is up to over $105,000, a nice return of over 5% in it’s first month! Then on 6/5/2007, the market dips a bit, your system adds some positions, on 6/6/2007 it goes down some more and of course your systems adds more. You are 80% long going into 6/8/2007 and within the first couple hours you buy enough positions to use up all your available cash, however the market continues to decline. When the smoke clears at the end of the day, you’re account balance stands at $99,500. Down $500 from the start of 5/1/2007 and down over 5% from your peak.

You can’t help but be a bit disappointed to give back all those gains in only 3 days, 3 lousy days.  If only I’d sat out this dip, if only I’d reduced the position size, if only I’d waited longer to buy, if only, if only.  However, the real if only is if only I’d leave everything alone and keep trading the system as is.

Drawdowns are a fact of life, for any trader and especially a system trader.  They are to be expected and even welcome as often a drawdown come before a period of outperformance.  In this case, the drawdown was not even 6%, a tiny wiggle on that beautiful 5 year equity chart generated from baacktesting, but somehow looms much larger when you watch your gains wither away so quickly before your eyes.   The absolute worst thing you can do is try to avoid drawdowns, since by constantly changing strategies or systems to avoid the most recent drawdown, you virtually insure that your system will not be prepared for the next one and you will fail to outperform in up markets.   I’ve never seen a good system that did not have drawdowns of at least 10%+ and the system made famous by the Turtles often experienced drawdowns in the 30-50%+ range.  The difference between a successful and unsuccessful system trader is often the ability to stick with the system through the unavoidable drawdowns…

- John

Tweaking settings. This Market Myth is the carrot that keeps the guru chasing, holy grail seeking, pie in the sky, almost breakeven traders going. All it will take is a bit of tweaking of my indicators and I’ll have the secret to the temple. Unfortuntely what usually follows the carrot is the stick and the lost trader moves on to new settings and new ideas.

Having had the opportunity to intereact with many of the readers of this blog and my former swing trade blog I can attest to the quest for the magic settings. I am here to tell you that tweaking your indicators is not going to make you become the trader you envision. What will work is consistently applying a trading strategy that has a historical and live traded edge.

Basing your trades on buying at the X period moving average versus the Y is not going to be the revelation you think it is. Having backtested virtually hundreds of thousands of variations of the main trading concepts (trend following, mean reversion) I can tell you that the “tweaking” of common trading concepts is not the answer. And it most certainly does not flow from some guru without a historical track record over varying market conditions. ALL systems have their blindspots. The key is to know those blindspots and have other systems that can pick up the slack in that sort of market condition.

So instead of chasing the magic setting I would recommend chasing broad concepts that do work. Find what has worked - not based on what your were told but what you can PROVE with your own research.

Have a Great Day,

Dave Johnson

This is the first in what will hopefully be a series of posts dispelling common market myths that only reduce your ability to succeed at trading.

The first I want to talk about is the common mistake of trying to assign a “why” to every market move. Let me start first with an example. Everyone remembers the huge down day we had on 2/28 which was preceded by a large down move in the Chinese market. After that day, the financial press as well as many traders quickly determined that the China sell off was the “why” the Dow lost ~500 points. Fast forward to yesterday when China experienced a similar sell off overnight, the US markets gapped down a sizeable amount and any trader who beleived that a China sell-off equaled huge down day in the US markets could not wait to get short. Of course the large amount of traders leaning to the short side most likely contributed to the nice upday the US markets ended up with. Why did this happen? Why did a huge selloff in China in Feb lead the Dow’s biggest loss in years while the same thing yesterday led to record highs?

The answer is (and this is the hardest part) that there is not an answer. The market is not an equation to be solved, you can not simply take the same inputs multiple times and expect the same results. Remember the market is made up of numerous participants, all of which have have different emotions, positions and goals every single day. This is one reason why the economic reports are so hard to trade ahead of, even if you knew what the # was going to be, attempting to predict the response is extremely difficult since everything is based on perception of expectations. Therefore you end up in a “the market is expecting a good #, even though the # is good, is it good enough to overcome the expecations and did the participants who anticipated a good number already take their positions, thus driving up prices prior to entry, etc”. It becomes a very circular logic trail which I’m not capable of decoding.

The same applies for any indicator or market internal. Many people view breadth or volume as predictive. It’s not, it’s just a measurement of where things are at a specific time. Don’t let people tell you that a decent size up or down day did not matter because breadth or volume did not confirm. All the matters is that the market is moving in one direction or the other and your positions are either gaining or losing money. If I’m long equities and my portfolio is down 1% for the day, it’s of little consolation that it was “low volume” or “non-confirming breadth”. Remember, when you sell a position at a profit and deposit the money into your bank, the dollars are not tagged with a “these $$$ were made on a low volume rally” post-it that reduces their value.

Making money is the goal, not trying to predict the future. Once you stop worrying about why things are happening and just focus on what is happening, you will find you have much less of a bias and are in a much better position to react to unusual events. As I often tell people when they ask me “how do you think the market will do the rest of the year?”, I can see the Dow ending the year at 15,000+ as well as the ending at < 10,000. There are scenarios that could easily lead to either of those of numerous others. What’s important is not where I think the market will go or why, but that I am positioned to trade my account profitably in any of those scenarios.

- John