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The Rule of 70
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The Rule of 70

  #1 (permalink)
Elite Member
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The Rule of 70

I discovered the markets about three years ago and have been hooked ever since. I enjoy the mental challenge enough that even if my future self traveled back in time and told me I'd never make a dime from my trading, I'd still do it every day.

System development is my favorite aspect of trading. I'll start with an observation about market behavior, isolate it down to its component parts, scan the historical charts, hammer out a rough set of rules, backtest, sim trade, refine the rules, sim trade again -- then stumble across another idea and start the whole process over again. My hard drive is overflowing with spreadsheets I've created over the years to track this system or that. Some of them had genuine flaws but I suspect that others were workable, profitable systems that I abandoned too quickly after hitting a rough patch.

I realize that most of my trading experience amounts to little more than poking around at this point, and that if I want to get serious I need to apply myself more consistently. This journal is one step in my quest to do so. I chose Big Mike's because I appreciate the collegial atmosphere here and trust that I won't get flamed quite as mercilessly as I would on other trading forums (which shall remain nameless).

I'll post a bit about my trading philosophy and the mental roadblocks I'm seeking to overcome, then will try to post regular updates. I'll be evaluating myself primarily on my ability to stick to my rules through thick or thin. Thanks for reading.

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  #2 (permalink)
Quick Summary
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  #3 (permalink)
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The system I will be trading is a countertrend system that I've developed over the past few months in collaboration with a trading buddy. The system is best suited for periods of chop, such as the directionless movement common over the "lunchtime lull." The system basically looks for breakouts that create short-term overstretched conditions, then fades the move.

Why countertrend? In a nutshell, because I kept losing in such consistent and predictable ways when I tried to trade with-trend. Someone on the other side of these trades, I realized one day, knew precisely how to kill amateurs like me; knew when to entice us in, and knew that we'd leave a trail of stops at predictable places that would generate their own gravitational pull in the other direction when we started to get out. One of my key turning points as a trader was when I endeavored to become that guy on the other side.

Strengths of the system: reasonably high success rate; generates plenty of signals; uncomplicated to trade (unless I make it complicated through overthinking, but that's for another post).

Weaknesses: Tendency to produce outsized losses when strong trends strike; underperformance in low-volatility environments.

Ground rules:

1. Trade only between 10:45 am and 2:00 pm EST.

2. Do not initiate a trade in advance of or hold an existing position into a scheduled news release.

3. Do not take the first signal of the day if it would go against an established trend.

4. After the first signal, stay in the market until a signal in the opposite direction is generated (i.e., this is an always in, stop-and-reverse type system). Exceptions:

a. Catastrophic stop placed at a distance unlikely to be hit; designed primarily to guard against sudden adverse news shock, flash-crash type action, etc. Keeps risk down to a known quantity.

b. Exit at breakeven allowed for a "near miss" trade, where price reverses shortly before generating a signal in the opposite direction and then comes all the way back to the entry point. Take the scratched trade in that situation and look for the next clean entry.

If executed correctly, the system should capitalize on market noise during times when chop is expected, buying low and selling high within the confines of the trading range.

That's it for now. More to follow tomorrow.

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  #4 (permalink)
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About the title of the thread:

Years ago, before I started trading, I went through a baseball statistics phase. I discovered the writings of Bill James and became fascinated with the concept that these highly public datasets of stats -- at bats, walks, innings pitched, etc. -- could be combined in new and creative way to uncover deeper truths about the underlying players.

I started crunching the numbers in a quixotic attempt to find a formula that could predict the winner of a given baseball game. An odd goal, I admit, but a fun mental challenge. I started with a rough formula that took into account each starting pitcher's stats as well as the offensive stats of the opposing lineup, then made a series of tweaks and in the end came up with something that worked reasonably well.

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. Another way to think of this is that the "better" matchup, as predicted by past performance, will prevail most of the time, but there's still a hefty degree of uncertainty. That 30% accounts for things like the ace of the pitching staff with 18 wins and a 0.95 ERA giving up 6 earned runs in the first inning, or the shortstop with a .200 batting average going 5 for 5 with two home runs. These are things no formula can account for. Sometimes players just suck wind, and sometimes they excel. When your formula is based on how these individual players perform, you're at their mercy.

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.

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  #5 (permalink)
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One more comment on uncertainty:

In trading, you're really faced with double uncertainty. On the one hand is the uncertainty that derives from your system's historical performance. If your system generates a maximum drawdown of $2000 in a typical month, for instance, you know to expect at least this severe a drawdown even if the system is performing as expected. That kind of uncertainty is relatively easy to handle.

On the other hand is the uncertainty that derives from changing market conditions. To return to the baseball metaphor, it's as if the umpires had the power to expand or contract the strike zone without telling anyone. One day pitches that used to be considered balls are now called as strikes; pitchers start to generate more strikeouts, batting averages around the league decline, runs scored fall to new lows, etc. Then a few weeks later, as soon as the players have adjusted to the new strike zone, everything shifts again. Strikes are now balls; walks increase; pitchers' stats get walloped; etc. When all you know is that a given player had a .300 batting average under whatever strike zone applied in the past, it's quite tricky to predict how the player will perform today if you don't know what strike zone will be in play.

This second type of uncertainty is the killer. In the past year alone, I noticed at least three major shifts in market dynamics, each of which had the capacity to wreak enormous havoc on systems that were running smoothly just weeks or days before. To put it in the most basic terms, sometimes breakout systems are favored as each intraday move seems to just keep running; other times, reversion-to-mean systems are favored as each incipient breakout seems to fail. Apply a system that's ill-suited to the current market dynamics and you'll get your head handed to you.

This is the major obstacle I've faced again and again. System performs well for a while, then drawdown starts. Is this a normal, predictable drawdown, the kind of periodic underperformance you should know to expect? Or is the market shifting underfoot? There's my career as a trader, boiled down to two questions.

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Are these systems traded automatically or manually?

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  #7 (permalink)
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Hi Worldwary,


Thks for sharing your experience

Are you a full time or part time trader, from a pschycological point of view it makes a great difference. Also, with regards to your drawdowns do you apply a money management strategy. Once a system is not working anymore (according to your personal style) do you still keep record of it or you switch to a new one.
I'm rather conservative with my systems, IMO whether I autotrade or not I try to keep the same system as long as possible (my only rule is I stop live trading once I passed the maximum historical drawdown, I Sim trade and check if it's a temporary DD change, if it's not I backtest again and adapt the system to the new condition).
Truth is, with this kind of trading, I am still losing money but I know exactly why, I do trading for a living my money management saved me from quitting.

I look forward to read your journal

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  #8 (permalink)
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Tundi View Post
Are these systems traded automatically or manually?

Manually. I don't have the criteria nailed down in black and white yet in order to automate it. Part art, part science at this point.

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  #9 (permalink)
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redratsal View Post
Hi Worldwary,


Thks for sharing your experience

Are you a full time or part time trader, from a pschycological point of view it makes a great difference. Also, with regards to your drawdowns do you apply a money management strategy. Once a system is not working anymore (according to your personal style) do you still keep record of it or you switch to a new one.
I'm rather conservative with my systems, IMO whether I autotrade or not I try to keep the same system as long as possible (my only rule is I stop live trading once I passed the maximum historical drawdown, I Sim trade and check if it's a temporary DD change, if it's not I backtest again and adapt the system to the new condition).
Truth is, with this kind of trading, I am still losing money but I know exactly why, I do trading for living my money management saved me from quitting.

I look forward to read your journal

Thanks for stopping by. I have a full time job that allows me enough freedom to follow the markets closely during the day. Still a part-time trader though as work has an ugly tendency to get in the way sometimes.

I have not done a good job of keeping track of past systems once I abandon them. This would be a good idea.

I do not have a solid money management plan in place with regard to drawdowns. I am very conservative with regard to position sizing so money management on a daily basis has never been a major issue for me, but I have not settled on a consistent money management strategy with regard to system-wide drawdowns. This is something I need to look into. So far my practice has generally been to follow a system for a while and get scared out by the first substantial drawdown, then lose focus. Not a great plan in retrospect.

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Marginally profitable day that would have been much better if not for the losing trade occurring during the sharp decline around 1:00 EST. What was that, BTW? Treasury auction results?

Actual Net P/L: 2 ticks

System Net P/L: 12 ticks

System Net P/L is how the system would have performed if I'd taken all signals, with no discretionary adjustments. The difference in this case boils down to one "near miss" stop that I exited for breakeven after it missed my target exit by one tick and then reversed back to my entry price. If I'd held to fruition, that trade would have netted about 10 ticks. The rest of the day was a wash, one losing trade and one winning short into my 2:00 stop time.

Overall I did a decent job sticking with the system. The "near miss" is an acceptable exit strategy as I've developed the rules, but I continue to have doubts about whether it's a good idea. Today's results suggest not. Will keep that on the radar but will not make any official changes for at least a couple weeks.

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