Trading System Thoughts: Context and Using Cumulative Tick on ES/NQ

My time is being stretched in many directions–custom projects, donor requests, beginning iPhone app development, and working on my own trading skills. This post is one focused on my recent trading thoughts.

First, an unsolicited testimonial. I’ve been part of Richard Todd’s Move the Markets Team for a while now. I find it to be incredibly valuable. If you are looking for a community of experienced traders that are serious about improvement, both of themselves and of newer members, look no further. I recommend it highly. There are a lot of free areas to start with, and if you want to go deeper, he charges a modest monthly fee for full access.

As part of a conversation I had recently with Richard, I was once again reminded about the importance of market context. As I talked about in my WWJT posts, in a trending market, almost ANY trend-following setup will work. In a choppy environment, almost ANY trend-following setup will die horribly. The specific setup DOES NOT MATTER. There is no “best” set of parameters to filter out the losers on a setup basis. The problem is not with the setup, it’s with the market context. A raincoat is not the best clothing to wear on all days, just on rainy ones. Flip flops are ideal footwear on the beach, but not for climbing Mt. Everest. You pick your clothes based on the weather context you expect to encounter. Don’t agonize over whether a blue raincoat or a yellow raincoat works best, and don’t look for the magic set of sandals that keep you warm even on a snowy day. Metaphor overload, core dump…

The most important thing is to identify when the markets are likely to trend, and then to apply a trend-following setup (buy a pullback in a trend, buy a breakout, etc.) or sit out. Conversely, identify when the markets are choppy and listless, and apply a range-bound setup or sit out. I have demolished myself in the past two Augusts by playing dummy trades (trend continuation) in a seasonally flat and choppy market. I get stuck in the trap of obsessing over the entry, target and stop parameters, so I needed this reminder to get back on track.

I believe your time is best spent practicing contextual skills rather than mining for the Holy Grail setup or magic parameters. Try these steps:

1. Become proficient in identifying chop and trends after the fact. This one should be relatively self evident. Look at the day’s chart after the close, and annotate where the trends were, and where the chop was. Continue to do this on intraday charts until you can do it instantly and effortlessly.

2. Go to live data and practice identifying whether the market is in a trend or in chop RIGHT NOW. Don’t worry about if the market is going to keep trending or keep chopping. Just correctly identify what it is currently doing. Continue until you can do it instantly and effortlessly.

3. The last step is to start to try to predict what is likely to happen next during the day. Will the trend be likely to continue? Will the range probably be broken? Many things can give clues to this including volume, time of day, support/resistance levels, tape speed, pending news announcements, and so forth. Along the way you should also gain the skill of predicting whether a trading day may be trending or choppy before the day begins, and also knowing what events and price levels would imply a change to that prediction. This one can take years of screen time to become proficient. Patience and work are needed! I have started to notice myself having the beginnings of this skill. I can only chalk it up to screen time. Watching what has worked, what has failed and what has generally happened in the past. Feeding years of price data into the most complicated neural network there is: the human brain.

Note that in all of these things, I have mentioned words such as “likely to continue” and “probably”. None of this is an exact, deterministic science! You also have to be able to think, make decisions and accept outcomes probabilistically. That means that the specific outcome of any one event does not determine whether a probabilistic decision was the right one or not! In a deterministic situation, the outcome judges the decision. Gravity always pulls you down to the earth, 100% of the time. Jumping off a cliff is always a bad idea, because you will always plunge to the bottom. In a probabilistic situation, it’s the odds up front and the information you had at decision time that say whether a decision was the right call or not. The odds will play out to a degree of “rightness” in the long run, even though you may be taking a beating in the short run. This way of thinking is very difficult for many to attain, including myself. My Outcome Simulator is one tool that can help. The excellent book Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude by Mark Douglas is another good resource. But unless you are hard-wired this way, and most of us aren’t I would imagine, this takes PRACTICE.

Now, I’ve been watching the cumulative tick on ES 5 minute charts. I’ve noticed a couple of things. Assuming that the context is a trending market, the cumulative tick does well at picking the trend direction and also giving an entry spot. If the cumulative tick changes from bearish to bullish, then buying the first DOWNWARD tick spike across the average of the tick lows gives a great entry point. You are basically buying the first pullback in what you hope turns out to be a new uptrend, but are using the tick to tell you when the pullback is in play instead of choosing it based on price alone. If you continue to get downward tick pressure on the next bars, that clues you in that the uptrend may be failing. Otherwise, buying should pick back up and you have a winner in very short order. This strategy would work great with a partial exit, taking some off after some number of points and trailing the rest. Here’s an example paper-trade I took in the NASDAQ-100 e-minis (NQ) today:

I bought the gap fill on a tick downspike (gray oval). The tick downspike is the entry signal, but the reason for the trade is the context: I didn’t buy the first downspike because we were still in space over the gap. The second tick downspike was the first retrace to yesterday’s high. Also, a strong opening gap = bullish tones for the morning, so that said to fade the downspike, not go short. I expected a bounce, and we got it, all the way to new highs, even! Opening gaps that clear the prior day’s highs and lows are typically strong. Gaps inside the prior day’s range are less so.

Back to the trade: Ended up “buying” 1 tick above the day’s low so far (!) I traded 2 contracts, both with a 2 point initial stop. One I “sold” after a 3 point target (first green oval) and the other I put on a 3 point trailing stop and “sold” much higher (second green oval). Net +12.5 “points”.

I’ll be posting more charts and a modified cumulative tick indicator sometime over the next week. I’ll also be working on my market context skills, because that is the only effective way to minimize your losing trades, and is the foundation to using a setup in the right way. My ultimate goal is to choose a trending setup and a chop fade setup, know when to use them, and then consistently apply them, accepting the outcomes as they happen. That should be my last hurdle to arrive at net profitability. It’s been a long, hard journey, but I think I can see the oasis from here!

Practicing with Probabilities: Outcome Simulator

I struggle with really internalizing probabilistic thinking, especially when trading live. I can understand the math and the reasoning–I’m a freaking rocket scientist after all. However, a rocket scientist is trained to NEVER be wrong. A trader must be trained to be “wrong” quickly and relatively often, and accept it and move on with their system. Staring a loss in the face (or even worse a string of losses) shakes your ability to believe in it. You doubt your system, and you doubt yourself, and that’s when impulsive revenge trades can come in and you blow yourself up. It takes practice to overcome your emotions, at least for me.

Assuming that you have researched a strategy, know when it should work and when it doesn’t, and are consistent in applying it, if you stick with your plan then the law of large numbers can come into play and your edge can pay off. But how do you know if the edge has changed? If you usually win 70% of the time, but start to win only about 30% for a few days, do you pack it in, or keep going? What if you start a new system? How many trades are enough for your hoped-for edge to show up in your outcomes? How many are too few to call it quits?

I created a tool to help myself practice these things. My Outcome Simulator lets you make simulated “trades” by clicking a button, and see how the results come in based on different probability settings. Hit the “Reset” button to start over. There are three modes to use it in:

1. Targeted distribution–you put in a desired win percentage for a group of 100 trades. A possible distribution is created that is close to your target. The wins/losses are assigned to each of 100 toggle buttons. As you click, they show if you won or lost, and your realized outcome distribution is shown. If you click all 100, your realized actual outcome will match the possible distribution, but for the first few trades the realized outcomes can be far different, as these screenshots show:

2. Random distribution–this mode creates a distribution at random between 0% wins and 100% wins. You can then see how the realized outcomes roll in with those kinds of rates.

3. Hidden distribution–In this mode, a distribution is chosen either targeted or at random, but it is hidden from you (targeted is kind of pointless running hidden, since you put in the number, but oh well). You could be looking at a net winning set, or a net losing set. Click to see outcomes, and try to decide from those if it’s a winner or a loser distribution. Then click the “show” button to pretend that you are quitting trading, and to see what the actual distribution was. When you click show, if the true distribution was below your actual results, then you made the right call, and quit while you were ahead of the possible. Even if you were a net loser on outcomes, if you did better than the true distribution you made the right decision to stop! Conversely, if you were a net winner, but the true distribution was better than your outcomes, you should have kept pressing. It was the wrong decision to quit. You should begin to learn to value the rightness of a decision based on what you knew at the time and in aggregate rather than what the individual outcomes of each “trade” are. It can also tell you a lot about yourself. If you have a run of 5 losses, do you get impatient and start clicking like mad? Revenge trader. If you have a string of wins, do you get fearful and hesitate to click more?

Using the hidden distribution mode can simulate what it’s like to start trading a new system. You don’t really know what actual outcomes you are going to get when you start. In the markets, there is no set “true” distribution. The odds are always changing. But this simulator can give you practice in coming to the decision to stick with a system or bail on it, as well as a feel for how many trades it takes to get a reasonable level of confidence in a system’s viability. For the chronically conservative, this can give you practice at sticking with a well reasoned concept even if you see a string of losses right out of the gate. Then you should be able to get over the hump instead of going back to the drawing board and tweaking setup parameters ad infinitum looking to filter out all losses. This tool is more about training your brain and emotions than predicting or modeling the markets, which I would argue is the most important foundational thing to do before any trade system work.

Of course, the emotional side of being wrong is not really present in a simulation. I can arrange for you to pay me every time the tool beats you if you need me to 😉 But seriously, if you do this enough times, it can help condition your mind to think this way and accept outcomes as they happen under your larger system goals.

This tool is freely available under “Released Tools” at my Google site. If you feel this is valuable to you, please consider a donation to my blog.

Thanks!