Posts Tagged ‘market_environment’

WWJT Revisited: Define the Market Environment

November 29, 2009

I’m back. Good to be writing again. 🙂 I’ll have some more Thinkscript indicators soon, but in the meantime, here’s a philosophy piece:

To revisit my What Would Jesus Trade post, I was listening to a recent podcast by Jeff Quinto where he was talking with another trader about three types of traders. The type they called “Market Savvy” traders would have a framework to define the market environment first and foremost, before any trade setups were even considered. This struck a chord with me.

As I said in my WWJT post, too often we try to tweak the details of our parameters instead of answering the most fundamental questions. It’s like dressing for the weather. If it’s 100 degrees and sunny outside, it’s really pointless to try to decide the best color of raincoat to wear. By a similar token, if it IS raining, then agonizing about whether a yellow or a blue raincoat would be better is equally pointless.

The same is true in trading. If we are in a heavily trending market, then almost ANY trend following setup will do well, and almost EVERY mean reversion setup will do poorly. It doesn’t matter how awesome your backtesting is or what your particular parameters are; these are just the basic facts. Random chop is not too good for anybody but the brokers, and there isn’t a trend following system that can be devised that can make gold out of sewage. The first and most important step is to define how you will interpret and classify market environments. Messing around with other things at the expense of doing this work is foolishness.

So hadn’t you better do the hard work and define some market environments? As they said in the Jeff Quinto podcast, you can’t really learn this from a book or third-hand knowledge. You have to study the market for yourself, and define a model for yourself. It can be simple–Trend or No Trend. That’s simple. You can then refine it to incorporate any other conditions that you want–volume, choppiness, retraces, etc.

One important thing: The market environment definitions are NOT the setups, or the trade plan! They are simply a way to describe generally how the market behaves and how the price action manifests itself. The trade plan and setups follow from that, and almost effortlessly, I would add.

What to do on an up trend day? Buy pullbacks! Trail stops! Maybe take some partials on strength. That’s an easy call. The harder part is knowing how to identify a probable trend day before the day is over. The gifted traders can see a trend day coming within the first 15 minutes of the open. Even CNBC can see a trend day at 4:00 ET.

What about stops? Well, a trend day should make higher highs and higher lows, right? So your stop goes where your market wouldn’t be acting like a trend day anymore. Simple, no agony or optimizing.

You’ve fought 80% of the battle right here. Now just be disciplined to execute and accept the outcomes you get dealt by the probabilistic universe. Of course, your models will need to have some technical parameters or other measurements, but you make a model as a baseline, and then update it if you get a better one. Are you listening, Prospectus? Yes, I am talking to myself here. Very much so.

Quit agonizing about finding a holy grail or a system that “always” works and instead create your own models for different market environments. I’ll be posting some of mine by way of example, but don’t take my word for it. Please do the work yourself and share in the comments if you feel like doing so to inspire others. Apart from learning a few facts, the only profitable reason to read any blog is to gain inspiration to DO SOMETHING, and then use that inspiration to DO SOMETHING. I myself get too caught up in reading and thinking and wishing (and writing) and don’t DO SOMETHING as often as I should. Hope this inspires us all a bit.

What Would Jesus Trade? (WWJT)

April 21, 2009

Disclaimer: This article applies to myself probably more than any trader that ever lived. I write in the hopes that it sinks in for me, and that helps out some readers.

Back in my Move the Markets days, “Mister White Folks” posted a quote from Elite Trader that is very wise, even though short on grammar and punctuation:

Yep don’t fix what aint broke, chop will still kill this system as it will any other so if you are going to spend time on anything, spend it recognizing when to trade and when not to trade

In general, traders (including myself) make trading too hard by focusing first on things that are not important, and neglect the things that are most important. It seems we put way too much emphasis on the particulars of a system–the setups, stop management, profit targets, false positive signals, missed trades that didn’t set up according to the “rules” but went on to win anyway. This is all psychologically satisfying, but it doesn’t help your trading performance in any material way if you don’t have other more important things in place! Further, this effort would do more for your profitability if applied in a slightly different area than is typically done. Unfortunately, it is easier to fiddle with indicator parameters than it is to tackle the bigger problems.

There is a passage in the New Testament (non-Christians, atheists, agnostics, hedonists and satanists bear with me here…) that illustrates this principle very well. Jesus said to the corrupt spiritual leaders of the Jews:

Woe unto you, scribes and Pharisees, hypocrites! for ye pay tithe of mint and anise and cummin, and have omitted the weightier matters of the law, judgment, mercy, and faith: these ought ye to have done, and not to leave the other undone. Ye blind guides, which strain at a gnat, and swallow a camel.

The Pharisees were unjust to the people, ignored the spiritual laws of God and took advantage of their clerical status in society. However, they made many outward appearances of being righteous. While they left the things that were important to God undone, they justified themselves and pointed to their superficial outward acts as evidence of piousness. Jesus didn’t buy it.

As a trader, do you strain at a gnat? Do you spend all your research and energy to find the perfect indicator, the one right system that gives you 100% wins and no losses? The one that catches every possible winning trade no matter what the situation? Do you constantly try to find THE system, the one that makes the most money, the best one?

Do you swallow a camel? Do you ignore position sizing? Do you take no thought for market volatility or the current environment? Do you leave money and risk management for later thought and action–or worse–no thought or action? Do you ignore the “black swan” that could come and take you out of business forever? Do you break your rules and blow your stops? Do you force trades on days where the market is totally stacked against your strategy, or the volume or volatility isn’t there?

Here’s the cold hard facts of life: Almost ANY trend-following system (channel breakouts, MA crossovers and so on) will do well in a trending market. Almost ANY trend-following system will get whipsawed to death in a non-trending market, whether active and choppy or dead and listless. Conversely, almost ANY range-bound system (mean reversion, oscillators, overbought/oversold indicators, etc.) will do well in a non-trending market. Almost ANY range-bound system will get killed in a trending market as you keep fading the strong move and dying a death by 1000 cuts. The systems work well when the environment is right. If they fail, it’s because YOU failed to implement the correct strategy. It’s not because your stochastic was too fast or slow, or because your pivot point used 24 hour data instead of market hours only data. After personal discipline and psychology, the largest part of the battle is as the Elite Trader quote said: Recognizing when to trade and when not to trade.

So, to speak to my carefully crafted, eye-catching, straw-grasping post theme–What Would Jesus Trade? Going by the scripture passage above, he’d ignore the gnats and quit chewing on a camel. He’d fulfill the weightier matters, and leave the less important ones undone. He’d trade a system that explicitly took into consideration what I consider the weightier matters of trading:

1. Personal Discipline
2. Risk Management
3. Position Sizing
4. Market Environment

If you are not disciplined, the market will pistol whip you and take your money. If you put 100% of your equity in an overnight hold of FAZ, you are about to meet Mr. Risk. If your trade size is too big for your account, your days are numbered. And if you don’t have a way to identify what the market environment is, and when to trade and when to sit out, then no amount of clever backtesting, indicators, statistics, or even the Holy Grail is going to make you win. So quit looking for all that other junk, quit wringing your hands over the perfect system, and concentrate on what the market environment is! It’s the way to the REAL Holy Grail 🙂

I am going to define some VERY simple systems to use as baseline strategies for examining this kind of idea–one for trending markets and one for range-bound markets. I will do some research into how to identify the market environments that we may be in, and then I will use these baseline systems to see how they do against how I define the market environment. This should be 90% of the battle. Only after these things are in place will I personally do any more messing around with indicator parameters or new fancy ways of looking at price data. Stay tuned!