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The Rule of 70
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The Rule of 70

  #11 (permalink)
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@worldwary, great job so far with the journal.



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  #12 (permalink)
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worldwary View Post
About the title of the thread:

...

After a while it became clear that my formula had hit a ceiling, as each successive tweak made no improvement in the formula's success rate. Thus emerged a theory I began to think of as the "rule of 70": no matter how you crunch the numbers, you can't predict the winner of a given game with more than about 70% confidence. ...

So what does this have to do with trading? I see the rule of 70 as a good metaphor for the primary issue I'm currently battling with in my trading, which is how to deal with uncertainty. A formula with, say, a 70% success rate might be pretty good, but I always find myself scratching for more. This accounts for my tendency to jump from system to system: I'm always thinking that there's a safer, surer approach around the corner, if I just keep looking hard enough.

I recognize that if I want to succeed as a trader, I need to develop the ability to accept uncertainty. If I find a system that produces a tradeable edge, I should have the courage to exploit it again and again and again, drawdowns be damned. This has been difficult in practice.

Nice journal you have started with good commentaries and very well expressed. My English will certainly improve by simply reading your journal. I was wondering about the title of your journal and your thesis makes sense. You have posed a valid concern when you wrote I'm always thinking that there's a safer, surer approach around the corner, if I just keep looking hard enough. It's my opinion there are basically two valid paths you can follow, a top down approach that leads to prediction and a bottom up approach where the need for prediction is minimal or practically nonexistent. Within the framework of a top down approach, you'll feel the need to accumulate all kinds of stats Historical datas will become important, major levels of support/resistance will be a huge preoccupation. Conversely, within the framework of a bottom up approach your only preoccupation will be totally centered and focussed on the next move. You are less concerned by how far it will go. In fact, anything that has to do with the future is out of your immediate field of interest. Your preoccupation is more with managing your trade to the fullest. Although the final result may be similar to a top down approach, the focus is diffferent and it may be more appropriate to your personality. Anyway, just wanted to say hello and good journal keeping.

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  #13 (permalink)
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trendisyourfriend View Post
It's my opinion there are basically two valid paths you can follow, a top down approach that leads to prediction and a bottom up approach where the need for prediction is minimal or practically nonexistent. Within the framework of a top down approach, you'll feel the need to accumulate all kinds of stats Historical datas will become important, major levels of support/resistance will be a huge preoccupation. Conversely, within the framework of a bottom up approach your only preoccupation will be totally centered and focussed on the next move. You are less concerned by how far it will go. In fact, anything that has to do with the future is out of your immediate field of interest. Your preoccupation is more with managing your trade to the fullest. Although the final result may be similar to a top down approach, the focus is diffferent and it may be more appropriate to your personality. Anyway, just wanted to say hello and good journal keeping.

Thanks for stopping by!

Can you tell me more about the bottom up approach? Give an example maybe?

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  #14 (permalink)
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A trading day so quiet I could hear crickets chirping through my computer. Grand total of 1 trade today. The system generated two trade signals but I passed on the first (short signal at 11710 just after 11:00 EST) due to my rule to avoid the first trade of the day if it goes against an estabilshed trend. Looked to be shaping up to be an up trend day so I didn't want to short into that.

I took the first long entry signal at 11713 around 1:00. Lost patience and bailed for a loss of 8 ticks after an hour or so when the market dipped below the latest swing low. I don't like to hold these trades after 2:00 as I'm usually on the wrong side of the trend when the afternoon move gets underway. Had I held a bit longer, could have gotten out at breakeven or better.

Actual Net P/L: -8 ticks

System Net P/L: -2 ticks

Not a great day for the system; ordinarily I'd expect more signals. A function of low volatility I guess. More importantly though, not a good day of trading for me, particularly the decision to exit the last trade early.

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  #15 (permalink)
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No trades today. Missed an hour due to a lunch meeting and came back to find that the market had barely budged.

This lack of volatility is really something. Ordinarily I'd expect 4-6 trade signals in a typical day. The system generates signals when it encounters relatively quick movement in one direction or the other. On days like today everything is a slow grind and the system just sits idle.

I've given thought to diversifying by trading a separate uncorrelated market or two (assuming there is such a thing). There must be volatility somewhere, right?

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  #16 (permalink)
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The timing of this journal is truly something. I start a journal about how to deal with uncertainty in light of the fact that market conditions can change and render trading systems worthless, and a few days in I'm all but convinced that market conditions have changed enough to render my trading system worthless.

This isn't actually a new observation in all honesty; the system began to underperform big time in mid-November. Performance worsened through December, which I attributed to the holiday-inspired lack of volume. I figured things would pick up again in the new year, and actually did see a couple of decent days in early Jan. This week has again been awful.

I'll try to post some charts over the weekend to illustrate the difference between what I used to see and what I'm seeing now. I'd be eager to hear other traders' take on how they adjust to market changes like what we seem to be going through now.

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  #17 (permalink)
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I was browsing the daily charts today and found an interesting example of changing conditions.

First pic below shows most of 1994. Choppy and indecisive; lots of sharp corrections.

Second pic shows 1995. That chart speaks for itself.

A swing trader who came to age in 1994 would have been poorly prepared for 1995. The way you made money in 1994 would have been to book profits quickly, and reverse position at the top and bottom of the trading range. Traders would have had itchy trigger fingers once price climbed too far, and would have been rewarded accordingly. The way you made money in 1995 was to avoid selling at all costs, never ever short, and don't wait for a "correction" to get invested again, since it's not going to come. Someone trying to trade 1994 methods in the face of that rally would have either gone broke or sat on the sidelines in bewilderment.

We've of course seen several of these about-faces in the past few years. One thing I've been trying to do is to tie the bigger picture that you see on the daily chart with intraday price movement during the same period. If my observation of recent conditions holds true, the volatility and uncertainty apparent in the 1994 daily chart would have translated to bigger movements, sharper reversals, and more oscillations to the top and bottom of the trading range on the intraday chart as well. Intraday action in the 1995 rally would have looked, well, pretty much like it's looked for the past two or three months. A different animal in other words.

Attached Thumbnails
The Rule of 70-1994_spx.png   The Rule of 70-1995_spx-1-.png  
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  #18 (permalink)
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I haven't been updating this journal because I haven't been trading this particular system the past few weeks. After the recent spike in volatility I decided to revisit the system and see if anything had changed.

Turns out that things have changed, at least temporarily. The number of signals generated by the system in a given timespan, as well as the overall profitability of the system, seems to be highly correlated with the level of volatility in the market. The VIX index appears to give a pretty good proxy of volatility. When VIX is below 18 or so, this system doesn't work and in fact will get you killed. This is the environment I was struggling with earlier this year. When panic is in the air and VIX is in the 25+ range, the system performs like a charm. When there's a "mini panic" like the one that sent the VIX up to 20 or so on Friday, the system does reasonably well but can't necessarily be counted on to continue unless you have reason to believe that volatility will stay elevated.

No surprise, the system was designed in the summer months of 2010 when VIX was high. I thought I'd discovered this great system and then watched in bewilderment as the performance diminished month after month. Eventually I figured out the volatility component and that may turn out to be the key to making this work.

Let me post a couple of charts to illustrate what I'm looking at. My trading method boils down to three elements: a tick chart, a simple moving average, and a moving average envelope that paints lines X% above and below the moving average. You have to poke around to find the right settings for the instrument you're trading, but once you get things calibrated you'll notice that price never tends to deviate too far from the SMA before reverting back to it again. This system seeks to capitalize on this tendency to revert to the mean.

Entry and exit rules couldn't be more simple: Go short on a touch of the upper envelope, and go long on a touch of the lower envelope. Some risk management is necessary (avoiding trades during certain times of day for instance), but when the volatility environment is suited to this kind of trading you can really rake in the profits.

I've attached two pics, the first showing an example of a high volatility environment, the second a low volatility environment. Red arrows mark short signals; blue arrows mark long signals. I've been trading this as an always-in method, so each signal represents a cover-and-reverse.

Note how many signals occur in the high volatility pic as price gyrates above and below the SMA line. About 18 trades in the span of an afternoon; I tally 14 winners and 4 losers, two of the losers basically breakeven. Compare the low volatility pic. Three trades, two of them losers, that last short signal a massive loser of absurd proportions.

Attached Thumbnails
The Rule of 70-high-volatility.bmp   The Rule of 70-low-volatility.bmp  
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  #19 (permalink)
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The pictures in the previous post do a good job of illustrating the difference between what I've observed in high volatility vs. low volatility environments.

In a high volatility environment, the market seems "jumpy"; even when in a trend, price tends to gyrate above and below the SMA, giving multiple opportunities for quick countertrend entries. Even if you get caught on the wrong side of a trend move and have to take a loss, you will generally be able to make up for that loss when another trade comes along a few minutes later. In a low volatility environment, price tends to stay either above or below the SMA for extended periods. If you get caught on the wrong side of this kind of action, you're screwed.

The proper role of stops also differs in the two environments. During high volatility, stops need to be kept very loose if you want to maximize profits. During low volatility, loose stops will lead to blown out accounts.

I guess the obvious answer is that you need to trade the appropriate system for the current environment. Easier said than done though. In this case it may be possible to use the VIX as a guide. Maybe keep the system offline until VIX closes above 20 or something like that, then dust it off and take advantage of the volatility while it's there.

I'm curious if anyone else has observed anything similar to the tendencies I'm pointing out here. What volatility related adjustments do you make to your own trading methods?

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  #20 (permalink)
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Your rules have to be more complex then what you mention, I see multiple touches of the envelopes that do not have arrows. Also, what are your stops and targets? That will affect number of winners and losers.

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